ESG, no more a question of "if" or "when", but "how"

The experts of SYZ Asset Management argue that carbon is a particularly important indicator in the global Environmental, Social and Governmental (ESG) framework: it is a widely scrutinized indicator by regulators, reliably estimated, and appears to be linked to performance in many industries.

Scrutinizing a company's carbon footprints before initiating a position may not only be worthy for "mother earth", but also sound from a performance and risk point of view. A clear illustration of this dynamic is China, say Roberto Magnatantini, Global Equities Expert as well as Shoaib Zafar and Guillaume Compeyron, Analysts at SYZ Asset Management. According to the experts, the country may not be the first name that comes to mind when thinking of environmental virtues. But the Communist Party is taking the threat seriously: it is estimated that 40% of all factories in the country have been closed at least temporarily over the recent years to be inspected which led to 80'000 factories being prosecuted or fined by the environmental bureau. Yet, the most promising achievement so far has been a government pledge to cut its emissions of hazardous particles by 25% by 2035 compared to 2016 and the creation of an Emission Trading System (ETS) for companies in the power sector.

Mitigating the ESG risk
The last decade was filed with company controversies regarding ESG concerns. The potential pitfalls faced by companies are diverse depending on the type of business, state the experts. According to them, an obvious intangible risk lies with governance, as fraud can lead a company to bankruptcy, or at least to a transitory loss in confidence.

Whatever the nature of the risk, both society and regulators have become increasingly sensitive to ESG issues, forcing investors into increasing their awareness irrespective of their own beliefs. The experts state that it is not a matter of conscience anymore, but a need to preserve the value of investments in the face of rapidly rising potential liabilities. Here is where carbon comes to the forefront. As highlighted by a survey of more than seven hundred specialists sponsored by the World Economic Forum (WEF), extreme weather events and natural disasters were both ranked as top 5 risks in terms of both likelihood and impact on businesses.

ESG criteria prone to manipulation
ESG criteria may be a key to capture business sustainability, but their inclusion into an investment process is not as straightforward as it may sound. To make things worse, even when the information is available, its quality is often low and prone to management's subjectivity, if not manipulation.

A further problem is the distinction between qualitative and quantitative data. The inclination toward greenwashing (i.e. promoting an ESG friendly vision of a company via amplified marketing without implementing actual practices) is especially high at large companies, comment the experts, as they are able to produce a hefty amount of policies and objectives regardless of their real efforts. An evidence of the greenwashing phenomenon can be found in the data reported: according to Goldman Sachs, the companies in the MSCI ACWI disclose on average more binary data related to policies than performance data related to policies (54.9% vs. 11.6%). This can lead to facetious situations where a company may achieve a very good overall ESG score while being exposed to severe controversy.

According to the experts it is for all the above reasons, that taking GHG emissions into account brings a double advantage. First, they are difficult to manipulate since they are either reported by the companies through the audited Carbon Disclosure Project (CDP) framework or estimated by experts such as Trucost, a Standard & Poors subsidiary. Secondly, analysing the full carbon footprint also tackles the issue of "fabless" companies by taking into account not only the company’s own emissions but also those of their whole supply chain.

Link between emission reductions and performance
The demand for investments embracing ESG factors is gaining traction across Europe with individuals and institutional investors increasingly abiding either by conviction, or by obligation. From an investor’s point of view, opportunities linked to carbon avoidance exist, as various companies engage in the provision of clean energy. But limiting tje scope to those companies dramatically shrinks the investment universe, warn the experts, and thus not only reduces the potential for performance but also increases concentration and thematic risks. In their view, a better starting point would be to keep an investment universe as wide as possible by initially excluding only the worst offenders, and then pick the best available companies in each industry.

Furthermore, a very important question remains to be answered with ESG in general: can it create performance? While many contradictory studies highlight the difficulty of assessing the impact of "soft" data, the Carbon Discloser Project finds a direct link between engaging in emission reductions and performance in a study led by PWC. Over a period ranging from 2005 to 2011, it was found that companies which fully integrated climate change into their strategy substantially outperformed the broader market. Goldman Sachs, in a 2017 note regarding the use of ESG data by PMs, analysed various metrics to determine which one could be a reliable source of alpha generation. One of their key findings was that low carbon emitters tended to outperform, particularly among oil producers, refiners, chemicals, infrastructure and utilities.

In summary, empirical evidence points to an increasing impact of ESG factors on stock performances. GHG analysis offers the double advantage of being objectively measurable and having sizeable environmental and social consequences. Reducing the overall carbon footprint of a portfolio should thus reduce its risk, while also helping the planet and the investor’s consciences, conclude the experts.