With ESG becoming an ever-greater focus for investors, TT’s Head of ESG provides a summary of how we integrate ESG analysis into our process to help generate superior risk-adjusted returns for our clients.
In a year that will long be remembered for the wrong reasons, one positive milestone was reached: 2020 was when ESG finally went mainstream. Over the course of the year, more than US$170 billion flowed into ESG equity funds. The most widely held companies in these funds saw their valuation multiples expand dramatically, with their premiums versus their respective sectors more than doubling over the year (source: Goldman Sachs research, 6th November 2020).
Such investor optimism is partly driven by expectations that governments will pursue more active climate agendas. Countries around the world have responded to Covid-19 with substantial stimulus plans, in many cases including ambitious climate and environmental objectives. As of September 2020, US$1.7 trillion was earmarked for green stimulus, with the European Union leading the way, both in terms of ambition and regulation. Biden’s victory in the US presidential election has the potential to increase environmental investments further still. Meanwhile Asia’s largest economies – China, Japan and Korea – all committed to net-zero emissions. This will require a substantial increase in renewable energy generation – renewables still supply only a quarter of the world’s electricity – as well as investments in technologies to decarbonise heavy industry.
The increasing interest in ESG also reflects investor concerns that many companies are facing growing ESG risks. Notwithstanding the 7% fall in global CO2 emissions in 2020 due to widespread economic lockdowns, we continue to see physical climate risks materialise at an accelerating pace – from one of the most dangerous wildfire seasons in the western United States to the Arctic experiencing record high temperatures. Covid-19 also heightened ESG risks for companies that entered the downturn with stretched balance sheets, raising the risk of equity dilution and related party transactions. Corporates have responded to the crisis by cutting their capital expenditure and headcount, thus increasing the likelihood of adverse health & safety outcomes and associated liabilities.
Even before Covid-19 turbocharged both ESG risks and opportunities, our goal at the outset of the year was to strengthen TT’s ESG integration further and ensure that nascent ESG risks are identified and properly accounted for. TT’s process starts with our proprietary ESG screen, where we compare a company to its sector and geography in terms of overall ESG perception, controversies, governance risk, carbon intensity, physical climate risk exposure, and social risk factors. We aim to understand material ESG issues that have investment ramifications in order to incorporate them into our valuation process. If we are considering investing in companies that have previously encountered ESG controversies, we look for evidence of accountability and cultural change.
We also monitor significant ESG controversies in our portfolios on a real-time basis. Where we have concerns about ESG practices or controversies, or where ESG disclosures need to improve, we actively engage with company management to encourage change. Indeed, inconsistent data disclosure has been a longstanding issue in the ESG world – smaller companies without dedicated ESG teams can be at a disadvantage in terms of their ESG ratings and communication. As their ESG disclosures improve and are recognised by the market, they can often prove to be attractive investment opportunities.
On the opportunity side, we actively screen our investment universe for companies that provide solutions to climate change and environmental degradation. In May 2020, we launched our Environmental Solutions fund to specifically invest in these opportunities. The fund finished the year up 96.8% gross of fees (past performance is not a reliable indicator offuture results and you may not retrieve your original investment). We look to include these investment opportunities in our other portfolios as appropriate.
In conclusion, enhanced ESG analysis allows us to understand a company beyond its financials, helping us to avoid hidden risks and capitalise on underappreciated opportunities. By incorporating differentiated and financially material ESG insights into our analysis, we believe we can generate even stronger risk-adjusted returns for our clients.
The above is based upon TT’s current opinions. There is no assurance that such projections will occur and actual conditions may be significantly different than shown here. All expressions of opinion and predictions are subject to change without notice. Nothing in this article constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT International Asset Management Ltd is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA). © 2021 TT International