All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk.
If it moves, measure it. The recent rise in environmental, social and governance (ESG) metrics is no exception to this mantra. So let me start by testing your knowledge.
According to S&P Global’s ESG scores:
Some of those answers may surprise you. In fairness, the assessments are based on a company’s past and current performance, with a focus on steps taken to minimise risk and the extent to which they have disclosed metrics about their activities to date. Approached in this manner, ESG misses out on the environmental, social and governance impact these companies could have in leading positive change in the future and providing the resources to make it possible.
That’s a concern because such scores affect well-intentioned investors’ perceptions and financial decisions. At Baillie Gifford, we aim to focus on the material real-world outcomes effected by the companies in which we invest.
A problem fixed, another created
The investment industry has come a long way in a relatively short period of time in its consideration of sustainability.
Twenty years ago, sustainability masqueraded under the banner of ‘corporate social responsibility’(CSR). Company annual reports contained sections dedicated to the topic. But their principal function seemed to be to list token charitable acts while glossing over the real-world impact of business activities. The sustainability of a firm’s products, core operations and business practices was largely ignored.
Mercifully, times have changed. Social responsibility is no longer seen as a philanthropic ‘nice to have’ but is recognised as a necessary condition for consumer and regulatory acceptance.
Increasingly it is appreciated that considering the interests of all stakeholders need not be in conflict with delivering attractive investment returns to shareholders. Perhaps more than any other issue in history, climate change is making it clear that short-term profit maximisation cannot be the sole purpose of any company.
Company disclosure is changing, and the attention paid to it by the investment industry is increasing. Sustainability is taking centre stage, and it invariably travels under the banner of ESG.
To have such considerations pushed up the agenda is unquestionably a positive development. As asset managers and asset owners come to understand the issues better, progress should follow.
That is not a given, however. The incentive and alignment structures of many in the investment industry remain poorly configured to support positive long-term outcomes.
The threat of greenwashing is real and well documented. But, more importantly, if not approached in a thoughtful and holistic manner then the greater risk is that the focus on ESG fails to deliver the sustainability to which investors and society aspire. At its worst, it may even be counter-productive.
Death by data
The recent explosion of interest in ESG has been accompanied by a commensurate rise in attempts to measure and quantify it.
The CSR report of yesteryear is gone. But in its place has come metrification and mindless scoring. We see an industry being created whose ambition is to distil good and bad into a number.
The inevitable danger is that the focus of environmental, social and governance analysis is drawn to risk and where a company is today, rather than opportunity and what might happen in the future.
This isn’t to say that metrics are irrelevant or that poor environmental or social practices don’t constitute a risk to a company’s prospects. It’s just that when thinking about investing for the long term, we think looking forward matters a great deal more than looking back.
Quantitative methods tend to distract from the importance of qualitative assessment. They gloss over the complexity of the real world and the impossibility of applying one-size-fits-all policies to global portfolios.
Moreover, the obsession with risk tends to obscure the possibility that the environmental or social impact of a company might be the very platform upon which long-term success is built.
If ESG investing is to help deliver a more sustainable model of global capitalism then understanding the nuance is key.
In some cases, a positive long-term view may jar awkwardly with poor short-term impacts or business practices. Weighing up such trade-offs requires the investment of time and the application of genuine insight, the like of which will never be obtained from a spreadsheet.
Scoring and box-ticking may nudge up the lowest common denominator, but it won’t cope with nuance and it won’t identify the exceptional.
Recapturing ESG
At Baillie Gifford, we think if focus on ESG is to have value then it should be in drawing the eye towards the importance of long-term sustainability across multiple dimensions.
Not just because it is financially and reputationally costly to be invested in a company that falls foul of its regulators. Not just because it is morally right to treat workers and local communities with fairness and respect. Not even because without corporate strategies aligned with the goals of the 2015 Paris Agreement on climate change, our children and younger generations across the globe will face challenges that we would struggle to comprehend.
Clearly, each of these is a valid concern and aspiration, but the added benefit for our clients is the impact that we believe taking a broader perspective has on long-term investment returns.
We’ve focused on sustainability for years because we see opportunity, not risk: the opportunity presented by the natural alignment between sustainable activities, long-term company prospects and long-term investment returns for their capital providers.
One aspect is to identify companies whose contributions to delivering a better and more sustainable future are intrinsically linked to their outsized growth potential. This might be:
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Tesla revolutionising the world’s perspective on automotive electrification
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MercadoLibre promoting financial inclusion in Latin America
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Coursera improving access to education for elements of society left behind by traditional education structures
Another opportunity is in identifying companies such as ASML for which a sense of purpose and genuine appreciation of the long term are intrinsic to enduring success.
Look after your staff and they’ll tend to work harder and stick around for longer. Operate within the spirit rather than the letter of the law and regulatory change is less likely to prove a nasty shock when the authorities close loopholes. Think carefully about the indirect consequences of your actions and you are far more likely to avoid scandals and the associated reputational damage. Take a chance on truly long-term innovation projects with the potential to disrupt the status quo and you are more likely to lead your industry and deliver transformational growth.
These benefits may not be easily measurable when the costs are first incurred, but they have a tendency to become significant if you stretch your time horizon far enough.
Too many stock market participants focus on short-term outcomes. Sustainable behaviours invariably show their value over the long term. The alignment of interest for genuinely long-term shareholders is clear.
The final opportunity is in engaging with ESG laggards or those companies less well positioned for changing regulatory and societal demands. The cement manufacturer that needs to accelerate its investment in zero-emission technologies, perhaps, or the clothing manufacturer that needs to improve the oversight of its supply chain.
To use climate change jargon, it’s not just about the ‘solution providers’, it’s also about ‘transition companies’. Essential service providers that can lead their industries towards sustainable operating models are key to securing a brighter future for all.
Those that embrace the chance to lead could transform their own prospects by playing a vital role in reducing the impact of activities or industries where behavioural inertia is hard to overcome and practical alternatives are hard to identify.
We do not impose a particular investment style on our investment managers. We abolished the role of chief investment officer many years ago and place our faith in the value of aligned autonomy across different teams.
As befits such an approach, while all our equity investors are focused on growth and the impact of sustainability on long-term outcomes, how that is reflected in portfolios may differ. Some will seek out those companies driving transformational change while others will see the merit in helping laggards to improve.
Identifying and capitalising on each of these opportunities requires something more than an analysis that merely scrapes the surface. It requires time, it requires thoughtfulness and it requires insight.
Creating eco-friendly cement
CRH is a world-leading diversified building materials business. Its products include cement, the key ingredient in the concrete that remains essential to the construction of most bridges, dams, roads and other structures around the world.
Concrete is used so widely that it is estimated to be the world’s second most consumed product. It is, however, notoriously greenhouse gas (GHG) intensive and estimated to account for about 8 per cent of all global GHG emissions.
Cement only accounts for 16 per cent of CRH’s revenues but is responsible for 70 per cent of its direct (Scope 1) emissions, so, with carbon taxes increasing, the risk to profitability is clear. With no scalable, cost-effective option for carbon mitigation currently available, the race to find a solution is on.
Tweaking the existing process for making cement offers limited gains. Long term, the solution may be carbon capture and storage. But the costs remain prohibitive.
As costs rise and the market takes a dim view of such ‘dirty’ operations, the quick and easy fix for CRH would be to sell out. Overnight its GHG footprint would shrink and shareholders would feel better about their ‘lower-carbon’ portfolio. But would anything really have changed for the better?
Quite possibly not. If sold to a private buyer interested in short-term profit maximisation, the global impact of such a sale could actually be significantly negative.
Hidden from public scrutiny, such a buyer might rationally cut back on investment and extract as much value as possible before regulation forced the business into closure. In the meantime, it would release thousands of tonnes of carbon dioxide and the world would be no closer to finding a sustainable way to manufacture a product that is likely to remain vital to building infrastructure in developing nations for decades.
Taking a long-term view, we’ve been engaging with the company to support a different path.
Research and investment into lower-carbon techniques will cost money and may run ahead of customer interest in ‘green cement’. But if the company can get ahead of the game and emerge with a product that is cheaper and greener than those of its peers then the rewards - higher customer demand, a manufacturing cost advantage over peers and a lower carbon environment for everyone to enjoy - should justify the investment.
Investing in our capability
Over the last decade, Baillie Gifford has invested heavily so we can deliver on our aspiration to add value through more explicit consideration of sustainability.
We’ve grown our headcount of ESG specialists sixfold since 2010, identified best-in-class data providers to support our analysis and developed bespoke in-house systems for voting and engagement recording.
We know that data, systems and recruitment alone are not what make the difference though. It’s easy enough to hire a specialist, but if you really want to integrate sustainability it takes something more than an army of experts sitting in splendid isolation from the core investment process.
The veneer of respectability may look good to the outside world, but it is likely to remain just that – a veneer.
We believe ESG specialists should be integrated into the investment teams with which they work and that every investor should consider sustainability as a core part of their role, not an add-on to be outsourced.
To ensure our investment managers have the necessary skill set, we invest time and effort in education on what can be challenging and often very technical areas. Dedicated internal research groups raise awareness around key topics of interest (human rights, climate change, data ethics, corporate governance), providing a central focus point for the sharing of knowledge and best practice.
We’ve worked with The University of Edinburgh in various ways for many years and recently enlisted its support to run bespoke, multi-week courses on climate change for our staff.
Our support for the James Hutton Institute has brought us new insights into the many complex challenges and opportunities ahead of the global agriculture industry.
We’ve worked with Professor Mike Berners-Lee of Lancaster University to develop a framework for assessing the climate transition readiness of our portfolio holdings and will shortly start on a follow-up project to extend our understanding of biodiversity.
We’ve also been working with Johan Schot and his colleagues at the University of Sussex to explore the role that investors, along with other stakeholders, can play in steering innovation towards a more sustainable trajectory.
As has always been our approach to investment, we believe there is a great deal to be learned by looking outside the financial services bubble and questioning the foundational assumptions under which our system operates.
Making our impact count
One ESG challenge levelled at listed equity investors is the question of additionality. What do we add by investing? A slightly lower cost of capital? One more dissenter at the annual remuneration vote? We can do more.
The concept of corporate engagement has taken on unhelpfully aggressive connotations within financial circles, hijacked by activists looking to make a quick return.
Good engagement should be a genuine two-way process by which management and shareholders work together to overcome difficult, long-term challenges.
As one of the very few real long-term holders of shares in the market, we are in an almost unique position to build valuable relationships that might ultimately lead to some degree of influence. As a result, we are in the fortunate position of having built up a high degree of trust with a variety of companies across the world.
These relationships have often been built over decades. Sometimes our role will be to challenge. Often our value will lie in providing support.
It is our experience that the outliers that make the greatest impact over time are seldom slaves to orthodoxy and custom. The key is that by understanding a broader range of issues, we put ourselves in a far better position to provide this challenge and support.
We can have higher-quality conversations with senior executives and board directors, and in doing so increase our influence. With that influence, we aim to help companies make better strategic and operational decisions that result in better long-term outcomes, not just for shareholders but for all stakeholders. This, surely, is what sustainable investing and the incorporation of ESG should be all about.
We recognise that not every company relationship we have will be as impactful as the other. As in investing, it is in the extremes that we are likely to add the most value.
Where we do make a difference, however, it is unlikely to occur because we bombarded the company with requests that sought to minimise our clients’ exposure to every potential ESG ‘risk’ highlighted by third-party data providers.
Our approach will sometimes leave us looking at odds with the industry consensus and may result in longer, more nuanced client conversations.
Ultimately, we’d rather help our clients to understand real-world impact than fob them off with box-ticking, however much more convenient that might be.
Conclusion
We make no claim to have all the answers.
We know that the explosion of interest in ESG and sustainability in recent years has created complexity and challenge for our clients, just as it has for our investment managers and the companies we invest in.
Our starting point as active managers with a genuinely long-term mindset positions us well as consumer, client and regulatory expectations evolve, but we also know that we still have much to learn.
As the investment industry scrabbles to look good in the age of ESG, the quickest fix is to focus on data and metrics. Calculate an ESG ‘score’ using a third-party data provider and tweak the portfolio to make yourself look good.
Will such an approach make the world a better place? Will it guarantee attractive investment returns? We think not.
Data will matter over time to demonstrate progress – how else can we prove we are making headway if we have no reference points? Nonetheless, we’d rather drive while looking forwards rather than exclusively focus on the rear-view mirror.
Better regulation and better disclosure should help to steadily improve the quality of ESG data. But just as access to all the historical financial data in the world won’t turn you into a great investor, so will it prove in the realm of ESG and sustainability.
Over the next decade and beyond, the importance of sustainability will no doubt keep rising. But the opportunity is not in playing the numbers. It is about meaningfully engaging with the issues, understanding why they matter and seeing not just the risks but the opportunity that they present.
If there is any chance of avoiding climate disaster or delivering sustained and meaningful improvements to financial and social inclusion across the globe then that is what it will take.
At Baillie Gifford, our aim is to be in the vanguard.
Growing crops, not greenhouse gases
Baillie Gifford is sponsoring an Entrepreneurial Research Fellow at the world-renowned James Hutton Institute (JHI) to lead transformational research into ‘climate-positive farming’. The aim is to achieve net zero or even negative carbon emissions, while also protecting and enhancing the natural assets of a farm and ensuring the long-term financial sustainability of its business.
Emerging demographics and changing climatic conditions are forcing fundamental shifts in the way we farm, the way we manage land and the landscape of the $5tn global agricultural industry. Long-term winners in this area will identify and adopt agricultural practices and technologies that sustain high yields of socially relevant produce while limiting environmental degradation.
The JHI is at the forefront of multidisciplinary research in many areas relevant to these transformations. Founded in 1924, it is a widely respected agricultural research institute based in Scotland. With over 500 permanent staff, the institute houses leading experts ranging from social scientists and ecologists to geneticists and molecular biologists.
It has a commercial arm that works with various industries and is particularly famous for its breeding of plant varieties – for Ribena and McCain’s chips, among many others.
The JHI’s ambitious project is to transform a 1,000-hectare mixed research farm into Scotland’s first ‘net carbon negative’ farm. This will require substantial land use transformation and renewables investment, including the development of HydroGlen – a small-scale ‘green hydrogen’ facility.
The project will provide valuable insights into how the world might navigate one of the most vital and challenging transitions of the climate and biodiversity crises.
Risk Factors
The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in June 2022 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
This communication contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research, but is classified as advertising under Art 68 of the Financial Services Act (‘FinSA’) and Baillie Gifford and its staff may have dealt in the investments concerned.
All information is sourced from Baillie Gifford & Co and is current unless otherwise stated.
The images used in this communication are for illustrative purposes only.
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