The concept of environmental, social and governance factors – the “E”, “S” and “G” of ESG – can of course be expressed in a snappy three-letter acronym. In our view though, to do so over-simplifies what is in fact a broad, albeit subtle, categorisation of risks to analyse and manage, and which vary markedly from one sector to another.
Ours is not an “impact” investing strategy, but we have always emphasised the importance of risk management to our philosophy, and we see ESG factors as a crucial subset of credit risk analysis. Here, our experience of managing portfolios focused on high-yield credit alongside our investment-grade strategy has been particularly beneficial, not least because potential dislocations have a habit of making themselves known initially in the lower-grade segments of the credit market.
One of our primary goals is to identify risks that might emerge from ESG factors, and which could in turn have a negative impact on sustainability in the broadest sense. When assessing ESG risks, it is critical not only to consider the more widely discussed issues, but to look closely for indications of future risks that may emerge from left field to roil the outlook for a particular business or sector.
The value of seeking to pre-empt such risks is hard to overstate; a sudden deterioration in risk factors assessed within a robust ESG framework can have potentially terminal consequences for a business. In practice, we seek to identify and manage tail risks whether they are categorised in an ESG framework or otherwise. Put another way, we believe investors should be paid for the risks that they take, including reputational risks and potential risks stemming from those including, ultimately, risks to cashflows.
From the E to the S…
While much of the current public discourse around ESG considerations for corporate bond investors focuses on the “E” (perhaps understandably, given the well-documented challenges of the energy sector, emissions, and pollution more generally within the overall context of climate change), we would argue that it is every bit as important to pay sufficient attention to risks captured in the “S” and “G” factors. In the simplest terms, we believe that ESG integration is about a lot more than “being green.”
In the current environment, it is the “S” of ESG that is perhaps the most interesting factor. Certain social risks are of course already prominent. In common with some of our peers, we have for example long been vocal on the topic of tobacco sector bonds. An industry whose main product has led indisputably to the deaths of millions of its consumers over many decades understandably raises ESG red flags aplenty. That a growing focus on ESG considerations could lead to ever greater challenges for the sector is a tail risk the market is increasingly coming around to accepting. This is epitomised by the recent headlines that the Biden administration is weighing a nicotine policy that includes a ban on menthol cigarettes.
But broader scrutiny of “S” factors is also changing, and we believe that the Covid-19 experience has accelerated underlying societal shifts which were already smouldering before Covid hit. A strong example is in the sharp decline in social tolerance of tax avoidance. This in turn has led governments to apply growing pressure on businesses to pay their fair share in tax, with particular attention devoted to the many investment-grade issuers that may historically have engaged in what is sometimes referred to as aggressive tax planning. Combined with this increasingly global pushback against corporate exploitation of tax regimes is a broad acceptance that corporate tax more broadly must increase to pay for the economic damage of Covid, especially across segments that have sailed through the downturn with relative ease.
We believe that this reflects a material shift in attitudes regarding the appropriate balance between public and private sectors, and the role and funding of government. The transition from monetary to fiscal stimulus, while welcomed by many economists, will necessarily mean a larger role for government, and more regulatory and political pressure on the private sector.
Governmental pressure on corporates also reflects signs of a potential re-balancing in the economic returns towards labour – for so long tipped firmly in the favour of capital. The age of digital and technological innovation combined with global optimisation of manufacturing supply chains has led to disrupted labour markets and social tensions in developed economies which politicians can no longer ignore. This tension has already been reflected at a macro level in events such as the election of Donald Trump and Brexit.
The fightback is now beginning at a corporate level, with, for example, heated debate around worker rights in the “gig” economy (think Deliveroo, Uber, zero-hour contracts…). Indeed, it is “S”-related considerations that are the primary drivers of changes to the perception, and acceptance of the behaviours of, tech-enabled companies in our societies. But while the behaviour of “digital polluters” is increasingly making newspaper headlines, what is less clear is whether the associated credit risk is being appropriately priced by investors.
Closer scrutiny of social factors is by no means wholly reserved for tech-enabled businesses. We have long identified, for example, the “stranded asset” risk embedded in commercial property as the shift away from bricks-and-mortar retail to online disrupts their customer base.
From the S to the G…
A further tenet of the integration of ESG factors into our investment philosophy is corporate engagement, and the extent to which we can influence and change management perspectives for the better. It is important to restate that ESG considerations are not the preserve – or indeed the sole concern – of equity holders. While bondholders are not bestowed with the voting rights enjoyed by shareholders, this in no way implies a lack of responsibility for bondholders to seek to influence behaviours.
We believe passionately in our responsibility to contribute to the promotion of ESG best-practice. In recent years, we have pro-actively engaged with the management of many businesses whose bonds we own, as well as those in which we are not holders. Where responses to questions about ESG risks have been unsatisfactory in our view, we have decided against investing. Topics of engagement vary significantly, and have been as wide ranging as pushing for shifts in capital allocation, relationships with regulators, disclosure requests, fossil fuel financing commitments and net zero emissions targets.
We would argue that the financial services sector is an area deserving of still-greater scrutiny around governance risks. The recent travails of Credit Suisse with Archegos, and the collapse of the specialist lender Greensill Capital over imprudent lending practices are two cases in point to demonstrate what can go wrong when the “G” of ESG is given insufficient attention. Against this backdrop, with memories of the global financial crisis still vivid, and given the scale of capital impairment for bondholders that can result from a bank failure, it remains a sector that we believe deserves in-depth examination.
Is the Bank on your side?
If the Covid-19 pandemic has changed many aspects of our daily lives, then one of its most significant legacies may be a radical reappraisal of the popular perception of the “right” balance between corporate profitability and social wellbeing.
Unsurprisingly, this is a reality that has not been missed on governments. The key question though, is whether credit managers have been sufficiently quick to adapt, to be aware not only of the more obvious ESG factors, but also to remain alert to emerging risks.
The signs that further risks will emerge are there…for those who are prepared to look. Take for example recently announced changes to the Bank of England’s approach to corporate bond purchases, making climate factors a core consideration. We believe the importance of this development will make itself known not in the prevailing “risk-on” environment, but as and when credit market volatility rears its head once more. Should central banks restart their bond purchasing programmes to support a weaker credit market, we would not be surprised to see purchases focused pointedly away from issuers scoring poorly on environmental-impact criteria. With the precedent for selective support now established, the incorporation of broader ESG considerations into central bank mandates would seem likely.
This is potentially game-changing. Absent central bank support in an environment of widening credit spreads, we believe there is scope for issues from ESG-challenged sectors to underperform significantly. As with many of the risks forming part of a broader ESG framework, time will tell how many investors have factored this latest development into their portfolio construction process.