Investment stewardship and climate change
I want to discuss the climate-risk related aspect of the well-known collision between active engagement of asset managers and fiduciary duty of corporate governance to lead a company in the company’s best interest. This collision or a friction of interests is a permanent feature that originated by different perspectives, management horizons and legal frameworks. It is being studied by academics and industry practitioners for a long time. I see an interesting aspect of this conflict developed particularly around the topic of climate and transition risks.
Corporate governance approach of many modern corporations is influenced by the neoclassical economic theory (Friedman, 1970) that suggests shareholders have a dominant position in the corporation. The logical conclusion is that company executives must focus first and foremost on generating benefits and profits for this group. Another theoretical position emerged later (Freeman, 1984) with the view that other stakeholders, including employees, local communities and suppliers, are also important corporate beneficiaries and their interests must be taken into consideration by the executive team. This approach became more popular in noughties and recently is treated as a mainstream.
Meanwhile the asset management industry has its own history of burgeoning sustainable investment philosophy. That originated at the end of twentieth sentry in the form of negative screening of controversial business activities by faith-driven investors and responsible investment activities by investors with social and environmental values and beliefs. After development of mature methodological approaches, regulatory frameworks and creation of data infrastructure, the ideology shifted to a claim of a better financial performance and equity valuation of the companies with strong records of governance in social and environmental aspects. Scientific research substantiated this additional value by proactive risk mitigation and ‘doing well by doing good’ that includes reputational effect, successful product differentiation, employee satisfaction and in some cases better operating performance.
Long-term Views and Active Ownership
More recent changes in the structure and dynamic within the society, economic globalization, evidence of climate change, improved level of education and dramatic speed of communication created a higher bar of ethical behaviour for corporate entities. Licence to operate for the firm is given by the society and nowadays society asks for more. Customer demand and technology innovations let us better measure the impact of enterprise operations and reliably capture corporate externalities. That in effect is reflected in asset management and investment practice with the return of values-based investment approach that focuses on non-material values rather than financial performance.
Asset management companies actively use diversification to manage risks in customers’ financial portfolios. But large institutional investors found themselves in the situation when they have long-term liabilities, while companies they invest in are often dominant within their sectors and become too big to fail. That pushed asset owners and asset managers to adopt a long-term view on their investments.
Once they adopted this long-term view, they also had to accept that long-term financial performance of the companies where they invest heavily depends on long-term health of the environment where they operate. That is where the impact of a company onto society and environment become really important for long-term financial performance of the portfolio.
To efficiently operate in the changing environment asset management companies adopted an active engagement approach and developed investment stewardship practice. Stewardship is defined as a responsible allocation, management and oversight of capital to create long-term value for clients and beneficiaries leading to sustainable benefits for the economy, the environment and society.
Investment stewardship has already become an integral part of asset management offering across the industry. Key element of stewardship is active engagement that usually includes building relationships with investees, setting expectations for the management team and sharing experiences between companies.
Investment Stewardship and Conflict of Roles
Emergence of the world of ESG data created new measurement stick structure to the executive team accomplishments. ESG ratings provide an additional perspective on how the company is performing in addition to profit and financial performance measures. These may be different views based on the product – some ESG metrics presumably provide insight to the future financial performance. The other type of ESG scores measure the impact of the firm to the outside world. Combination of these allow investors to make financially motivated or ethically motivated investment decisions.
Things change when ESG scores are used for Investment Stewardship purposes. Asset Management companies often use bundled ESG scores to set expectations and drive stewardship relationships with companies they invest to. But using the same umbrella name, ESG scores have large divergence in scope, weights and have different purposes. That makes final results very sensitive to multiple decisions made during the score construction process.
To put things into the proper perspective, ESG scores are dramatically different to credit risks ratings. Credit risk agencies build converged assessment of the corporate entity based on historical probability of default in similar circumstances and forecast of the cash flow into the foreseeable future. This is an objective assessment of a full set of known facts applied to the universally accepted model. The final result may be adjusted by analysts based on additional judgments of the aspects that are difficult to quantify, but this is limited.
The original industry relationship between investors and investees is that the executive team manages the company and focuses on bringing financial performance, usually in 1-year intervals. Asset managers evaluate the company and forecast performance. If the company performs badly and forecasts worsens, asset managers and asset owners are free to find better opportunities somewhere on the market. That essentially gives the management team the signal that something is wrong and it’s time to improve performance (or revise management team).
Credit ratings are generally accepted as objective reality. There is no ideological, societal or other non-financial pressure on the company management. Executive team decisions stay purely rational and are aligned with interests of all stakeholders and shareholders at any time horizons. Practically if a company needs cheaper finance, it will work to influence factors in the credit risk model. Fixed income and equity market will reflect “fair” value of debt and equity (with many caveats to market efficiency) to reward successful efforts.
There is no such alignment on ESG scores among executive management, shareholders and separate types of stakeholders. Different things are material and important for them, all groups have different time horizons.
One may set-up engagement from two ideological beliefs. The first one is the belief in responsible investments as a way to benefit society and the environment. The second one as a way to improve financial performance of your assets.
If the rationale for the active engagement is societal and environmental improvement despite potential financial performance setback (mainly non-economic motives and believes), then asset manager is playing a role of advocates on behalf of the society and put additional non-financial condition on what can or can’t be done to run enterprise at a maximum financial gain. If the rationale for the active engagement is long term financial performance (based on the assumption that ESG responsible behaviour and timely incorporation of climate risks and development of transition plans will limit damage and improve long term performance) then it is actually direct involvement into executive function.
The first approach may be accepted based on ethical reasons. But the second approach puts the asset manager into a difficult philosophical position. They essentially declare that they know better than the executive team how to manage the company as they are better prepared to see the future. On the other side, for executive teams that give escape routes from other important financial and non-financial commitments. Finally, this partially transfers management responsibilities from the executive team into the asset management company.
Climate Risk and Corporate Governance
One may find some divergence between climate impact indicators and other ESG indicators. I think that may be useful to separate them into different categories. For a start, climate impact is by definition global. Impact of company operations captured by other ESG indicators is local both at societal and environmental aspects. It is also true the other way around. Local physical risks and transition risks are driven by global climate change dynamics.
The latest development of climate risk models and stress test frameworks proposed by regulators provides additional argument that ability of executive teams to recognize and reasonably act on climate risk is an important consideration to assess long-term resilience and financial perspective of the company against long term climate trends and scenarios.
General investment stewardship practice at many global asset managers assumes communication behind the closed door to establish expectations unless management does not cooperate enough. But the combination of global impact and external models gives carefully prepared investors the possibility to foresee climate risks in a better or at least equal way compared to the company management.
For the climate risk, would it be a better approach to publish an assessment model for the company climate risks into public domain from the onset of the engagement relationships? If you model and understand the climate and transition risk of the corporation and its key assets – why do you discuss them in the executive rooms? Why not to publish all details of the model, know risks, and assume optimal transition plans with key milestones? The publication of the model definitely has a chance to influence share prices. Same way as publication of quarterly reporting and sales forecast is influencing share price. This may need to be regulated to some extent.
My argument is that active engagement on climate risks should not be about pre-emptive collaboration with company management in an attempt to influence its behaviour. This will only lead to erosion of the executive responsibility. The much more effective active engagement is the development of quantifiable risks and optimal plans for the company and distribution of them into the public domain (similarly as credit rating is publicly available). And normal market dynamics will lead to adjustment of the equity prices, and gives executive purely financial reasons to manage the company as close to the optimal transition route as possible.
I think that the optimal way for the ESG market would be creation of climate assessment agencies that would provide independent assessment of climate risks for companies based on generally accepted approaches and methodology similarly to credit agencies that provide and maintain publicly accepted credit ratings. That might be separated from the ESG score bundle altogether. And that should not look like an “ESG vulnerability index” as proposed by some analytical companies.
The publicly available climate risks assessment model for the corporate entity must include as little subjectivity as possible. It may potentially include distribution functions for major climate risks, probability of climate-initiated cash-flow default and credit rating outcome under assumption of carbon taxation.