Global Perspectives Podcast: ESG is more than a score

Adam Hetts: Welcome to Global Perspectives. Today, we're on to our third conversation with Hamish Chamberlayne, our Head of Global Sustainable Equities and Aaron Scully, a Portfolio Manager on the Global Sustainable Equity Team. On past episodes, the three of us have talked about finding investments that do good for the world and do well for your portfolio. And we've talked about how sustainable trends have been rapidly accelerating after the pandemic, and now during the Biden administration. And today, I'm excited because we're talking about sustainable investing as more than just a “score” and how sustainable investing truly impacts the risk and return of all investors’ portfolios. So Hamish, welcome back to the show and let's start there. So how do we transcend ESG scoring and focus on the world's biggest environmental risks that are affecting all investors, whether they're ESG investors or not?

Hamish Chamberlayne: Sure, yes. Thanks, Adam and it’s a pleasure to be talking with you again. So I think one of the problems with ESG is the fact that we call it ESG, that it's often spoken about as if it's a kind of a monolithic concept. But the reality is, is that that acronym, those three letters cover a huge variety of different issues and these issues are different across different industries, different sectors, different companies. And the problem is that when we put it all together and we try and create a score, there's a huge loss of information. And then the problem is then comparability. How do you compare one industry or one company to another industry or even another company in the same industry where there may be different issues within that ESG monolith?

So, when we think about sustainable investing and for us, when we're thinking about ESG, it's very, very granular. We're looking at every single company individually and understanding the particular risks and opportunities that are associated with that company across those three, broad categories. But more generally, when we think about ESG and how to think about it in a portfolio context and making sure that we not only protect capital and manage risk, but also identify opportunities. You know, we think about some key characteristics of ESG when we think about how to integrate it effectively. And it's important to recognize first of all, that it's not linear. ESG is highly, highly discrete in nature and these are risks and issues that are very visible, but have extremely uncertain timing. And that's a really interesting point is that often in the financial system, we're thinking about how to risk manage and we've also had various books and papers on unknowable risks and things like that. But the interesting about ESG is that these are very knowable risks. They're very visible risks. They’ve just got very uncertain timing.

And then lastly, the fact that it's not homogenous, this is a very, sort of you know, varied and broad range of different issues that you have to think about. So it's very challenging, what we're trying to say is, it's very challenging to sort of incorporate this systematically into portfolio construction.

Hetts: And so the very normal risks of course, climate change, very normal risk and already occurring from a financial perspective. And how do you reflect that in portfolios? And how do you manage climate risk actively in portfolios?

Chamberlayne: Yes, so we see climate change as one of the biggest risk factors in financial markets today. And this is something that we've recognized for many, many years and it's notable how this is now also recognized by many of the leading financial institutions around the world including central bankers. So this has definitely gone up. The awareness of this as a significant risk factor is definitely increased markedly in the last 10 years. And perhaps we can just share some statistics around that, that would illustrate that. And this is from the… So first of all according to Munich Re, one of the world's largest reinsurers since 1980, so in the last 40 years, there have been $5.2 trillion worth of economic losses inflicted by climate-related events – and that's globally. And amazingly, more than 70% of that $5.2 trillion of economic losses has been uninsured.*

And then if we come to the United States and going on to the National Centers for Environmental Information website, this is from the National Oceanic and Atmospheric Administration, just charting the cost of natural disasters in the US economy over the last 40 years and there's a very distinct trend here. So in the 1980s, there were 29 significant events that cost a total of $185 billion. Then in the 1990s, there were 53 events that cost a total of $284 billion. And then a decade later in the 2000s, that increased to 63 events and a cost of $540 billion. And then the 2010s, that rose to 123 events at a total cost of $844 billion. And in the last five years alone, there have been 81 events at a total cost of $630 billion. So, an incredibly clear trend of increasing physical losses as a result of climate change. So, that's highlighting the physical aspect of climate change as a financial risk.

And then the other aspect of climate change is transition risk because there is clear political alignment and commitment around the world about the transition to a low carbon economy. And that transition will involve significant changes across many different sectors. And so there is a risk associated with the changes that need to happen in different areas of the economy and there will be some companies that are at risk in terms of their business model and not being on the right side of that transition.

Hetts: Okay, this is great. So I think what we're digging into here is the E of ESG and I think scoring of course, usually stops there when most people are looking at it. And underneath it, I think we're getting to something more tangible for portfolios. So, on the, I guess call it the physical risk, which is more climate driven, I was reading some of those stats along as you were talking. So the last five years, we've had basically almost triple the events and costs as the 1980s in its entirety. And even, we're running at a higher rate than the 00’s, it’s entire decade just in the last five years. So, obviously accelerating quickly on these losses from these climate events. So, to dig into that and the physical risk from climate change, what are these events? Is this just hurricanes and fires, mostly? And then how does that translate into portfolios? For example if it's mostly hurricanes, are you just concerned about securities that have a huge presence in the Southeast U.S.? I'm guessing a lot more complicated than that, but how does this then factor into risk management at a portfolio level?

Chamberlayne: So yes, so when we're talking about physical risk, predominantly we're thinking about risk to physical assets. In terms of the risks, it is more varied than wildfires and hurricanes. Munich Re has eight classifications of climate-related risk which constitute wildfires, thunderstorms, which include hail and tornadoes, floods. Then you’ve got winter storms, tropical cyclones, droughts and heat waves and then earthquakes and volcanic eruptions. Now of course, when thinking about the United States, not all of those climate events are necessarily evident on a regular basis in the United States and when we think about the United States, it’s much more about wildfires which have been very evident on the West Coast in recent years and then obviously in the South and the East Coast in terms of hurricanes and floods have been a big issue. But in terms of those eight risks, those are the eight climate risks that Munich Re has identified as contributing to that $5.2 trillion worth of global economic losses as a result of climate events.

And when thinking about physical risk, it's very much as I said, thinking about where there are physical assets. And so, where companies might have real estate or where companies might have their factories. And it's not just in terms of their exposure to climate events, but also in terms of their exposure to the natural capital that they rely on for their operations.

So, we do think about semiconductor companies that might have their factories in areas that are prone to drought. And water is a very important aspect semiconductor production and production for many consumer goods and industrial processes.

Hetts: Okay and then you mentioned transition risk being in our piece, which is the global transition to a lower carbon economy. And you said that's disruptive to some sectors more than others, so can you give some examples there of the disproportionate effect that the transition might have on certain segments of the market or an investment portfolio?

Chamberlayne: Absolutely, and I think at a very superficial level when people think about transition, they think about renewable energy against say, fossil fuels. But transition risk is much more complex than that because if you look at it, I think the best way to illustrate the complexity is actually to look at where emissions come from. And if you look at the global chart of emissions across sectors and industries, it's a very, very complex picture across industry, across agriculture, across communities and cities and across transportation. And within that, many different sub industries and sub sectors. So transition risk is this idea that we have to go towards a decarbonized society. And every sector and every industry is going have to think about how it's going to decarbonize. And many companies are very much dependent on fossil fuel energy and fossil fuel power generation.

So when we think of transition risk, you can either be at risk if you are a physical producer of fossil fuels, but you can also be at risk if you are providing services to fossil fuel sectors. Or if you are creating technology that requires fossil fuels. So for instance, there are many automotive suppliers that have technology for efficient combustion engines. And ultimately, they are also at risk from the transition to a low carbon economy. Companies with technology for fossil fuel power generation are at risk as well. So when we look at this complex picture, we think it's incredibly important to think about the companies end markets and what the technology or their products and services are actually being used for in relation to transition risk.

Hetts: This is great. So I started off talking about transcending ESG scoring and so here, we're digging into the E and just showing how much nuance there is in just these two places around physical risk and transition risk. Do you have any examples over the last few years where there have been events at a physical risk, or just in general transition risk, where it’s really had a disproportionate impact on different companies in real life?

Chamberlayne: So it's interesting timing for this conversation because obviously, we're seeing you know, rising fossil fuel prices and rising commodity prices at the current time and this is actually something that we've always expected. So we have a long-term bearish view on fossil fuel prices and on the oil sector, in particular. But it's but it was never going be a straight line. The reality is today that even despite all the technological progress that we've made over the last 10 years, fossil fuels still constitute 80% of the total primary energy supply in the global economy. So the global economy today is still very much dependent on fossil fuels. We've just been through a significant economic shock in relation to the COVID-19 pandemic and now the world is coming out of this, I suppose, sort of economic freeze and economic activity is picking up very quickly post the pandemic. And there has been underinvestment in fossil fuels over the last few years and you're seeing a sort of a natural supply tightness as demand comes back.

So I think when it comes to ESG, you've got to balance the near-term with the long-term. And I think that's such an important point to make because ESG, almost by its nature, we think about ESG and different types of ESG risk, often we're talking about our longer-term risks and these are risks that we know are there where the timing is uncertain and really having an appreciation of ESG is really about managing the risk of discontinuity and having uncertain payoff. So it's almost like insurance in your portfolio.

Ultimately, we believe that this cycle in fossil fuels will be the last cycle, that the long-term trend is down and this is the decade where we really expect to see an acceleration in a lot of the clean technology sectors and industries that we believe have a very bright future ahead of them. I think the thing that we also point to is that higher fossil fuel prices ultimately support the economics of transition.

Hetts: Okay, Hamish, that was great. Thank you. And again, I think it's so important to what you're really doing is digging deep into the E of ESG and focusing on climate change and the physical risks that it can create and the transition risks of the low carbon economy evolution. And not just as scores there, but those are risks that I think we've seen that you can actually quantify into actual potential portfolio exposures and importantly, potential portfolio losses. As you put it, these aren't these black swan style risks. They're right in front of us and they're already occurring and you can measure that risk on a portfolio. So I really like the direction that we just took the conversation there as making that environmental risk a lot more tangible and practical for everyday investors, whether they're ESG investors or not. And then thinking about investors more broadly, Aaron, let's turn to you and just look at the general macro environment today that everybody's dealing with. As your team is looking at today's macro environment, what do you think are the unique concerns or opportunities specific for ESG investors like yourself?

Aaron Scully: Yes, thanks for the question. Thanks for your time. Excited to be here. It’s hard not to look at the headlines, see the news that just continues to talk about inflation and you hear these analogies all the time of we're going back to the 1970s. And to be honest, I think you can make a compelling argument for that. Yes, there are a lot of similarities. But I also think there's a few important differences between today and basically 50 years ago. And the first is just where we are from a debt to GDP standpoint. All the governments of the world, all the major countries have taken on massive amounts of debt. And so why is that important in the context of inflation?

Well, if we look at Japan, and Japan they say is if you want to see your future as an American, look at Japan and see what's happened over the last 30 years. Japan went on a spending spree where they saw debt to GDP just skyrocket. And over that same time period, it was not inflationary. In fact, quite the opposite. It was deflationary. And so why is that? Well, if you look back in history, there's an important threshold of roughly 90% net debt to GDP where all of a sudden the velocity of money just plummets and actually start to see consumers and businesses start to hoard cash and not invest because they're fearful that there's going to be higher taxes and they expect slower growth. On the government side, governments actually increasingly allocate their spending to consumption and they stop investing, making big capital investments and again, that's very contrary to economic growth.

So all these things drive deflation oddly enough, once you get to a point where you've taken on too much debt. And unfortunately, most of the major countries were well above that 90% threshold now. So that's the first thing that will come combat this inflationary tendency. The second and we talked about this a little bit with Hamish, is just technology. Technology is incredibly deflationary. If you look at the pandemic, this drove up the adoption of a number of technologies that in turn, drove productivity. So if you look at GDP, the US effectively got back to its pre-pandemic GDP with 7 million fewer jobs. So we were able to produce the same amount of stuff, but had 7 million less people employed. I think that's telling on productivity.

And so there are many examples of technology driving productivity and being deflationary. Hamish brought up renewables. Renewables, while we see these spikes in energy prices, that actually will drive even greater adoption of renewables. And renewables in most cases now, are cheaper than traditional thermal generation for electricity. And so we expect the price of renewable energy to continue to come down. We expect adoption of renewal energy to increase and so this should be deflationary over time.

Another favorite example is software. Software is driving greater efficiency and deflation. Software allows companies to do more with the same number of employees, right? So examples include automating sales tax collection or automating payables or inventory. You can effectively take workers that were spending a lot of time on pretty boring mundane jobs that took a lot of time and you can take those employees and put them into higher productive, higher value add positions. And the reality is there are just not enough workers right now and so companies need to adopt software. And so software should also you know, drive I think, deflation, greater returns for these companies.

So anyway, let's say that all these factors are not enough to combat the inflationary impacts of government policy, wage spikes and supply/demand imbalances like we see in a lot of these raw materials. Let's say that we actually see some inflation. Perhaps there is another cycle where energy prices continue to go up. And obviously, that would be good for the oil makers' performance. However, as I said before, those same energy prices are going to drive greater demand, better economics for renewable companies, both developers and to some extent, the companies that make the turbines for wind.

Another obvious area is banks. You know in a higher inflationary, higher interest rate environment, banks will probably outperform. However again, we feel that a number of banks will be disrupted over the long-term. And our lens is the long-term. We think that a lot of these banks are challenged and a number of Fintechs will come in and disrupt them.

So the reality is that I think of natural immunities against inflation. You know, the first off is best-in-class companies. These are companies with strong competitive positions and also tend to have very high margins. These are companies that have pricing power and they can easily pass on any inflation to their end customers.

And then just also again, companies that help drive productivity and greater efficiency. And so the aforementioned renewables and software, these are companies that society is going to demand more of especially in a high inflationary environment.

Hetts: Okay, thanks, Aaron. And in that answer, I picked up some pessimism on traditional banks. So does that pessimism come from a sustainable perspective or just a structural economic perspective?

Scully: Great question and let me just be clear. I think we're open to traditional banks, but our sustainability lens gravitates towards companies with cultures of innovation, strong operational ESG cultures. And what we've found historically is a lot of these traditional banks are unwilling to cannibalize their old business models. They're unwilling to innovate and so we just tend to find and gravitate towards those emerging companies that are challenging those traditional banks.

Hetts: Okay, thanks, Aaron. Hamish and Aaron, this was great. I think we're getting pretty deep under the surface of ESG and having a pretty unique conversation here. So really helpful for me. I learned a lot. Before we actually close this out, any last thoughts from either of you guys?

Chamberlayne: Yes, sure Adam and perhaps I'll just sort of finish by kind of you know, trying to frame our thinking about the next several years. And you know ultimately, we believe we're standing at the beginning of a transformational decade where we're going to see a great acceleration in investment and deployment of clean technologies across multiple sectors, across transportation, across power generation, across real estate both residential and commercial and across industry. And we believe that transformations can be driven by this idea of decarbonization, this incredible investment trend that we see coming up over the next decade.

It's obviously an interesting moment to be talking about that because we see rising fossil fuel prices and concerns around inflation. And ultimately, we have come out of this incredible economic period where the economy has been frozen due to this COVID-19 pandemic. And suddenly, people are just turning the lights back on and everyone's getting back into ramping up activity. And there are clear supply constraints around that and that's feeding into inflation. And obviously, we're seeing rising fossil fuel prices. And partly, that's because of underinvestment over the last several years.

You know, I think we're very prepared for this idea of greater volatility over the next few years and supply chains do need to recalibrate and adjust and there will be some volatility associated with that and rising prices. But the thing that we keep an eye on is, are these long-term trends which we think are so powerful and so clear to see? And we always remind ourselves that ultimately, higher prices contain the seeds of their own destruction. As Aaron was talking about you know, higher prices ultimately incentivize investment in inefficiency, in substitution, in technology.

So we remain very optimistic about the next decade. And we're very much focused on finding these companies that we believe are going to be defining the world that we're going to live in over the coming years.

Hetts: That's great, Hamish. Thank you. I think we'll close it out there. Thanks again, you and Aaron for being on the show. And to our listeners, if you liked what Hamish and Aaron had to say, you can see more of their views on the Janus Henderson website along with views from our other investment teams and thought leaders and we look forward to bringing you more global perspectives in the near future.

 

*Source: Munich RE, “Risks posed by natural disasters,” 2018.