Seeing the bigger picture

Nico Aspinall explains why the ESG approach’s holistic view of risk is increasingly attractive to investors

What do you think ESG stands for? You wouldn’t be alone if your first reaction is ‘economic scenario generators’, but in the investment industry, more people would now say ‘environmental, social and governance’. The rise of ESG investment is a relatively recent phenomenon, and it’s important that actuaries keep up.

ESG investing is on the rise for a variety of reasons. First, there is increasing apprehension that the short-termism of markets does a bad job at creating value for long-term investors. People are coming to realise that a failure to recognise ESG can actually be value destructive, with short-term profit masking the problem.

Additionally, governments around the world are recognising that they need institutional investment to ‘green’ the economy, and consequently are increasing regulatory requirements around ESG. 

Finally, scandal after scandal in corporate behaviour has demonstrated a lack of stewardship by some institutions, and society is starting to highlight the inadequacies of our institutional investment framework. ESG seems to be the answer to all this. 

It offers investors a list of issues that may affect a business in the future, but which aren’t captured by core financial statements and projections. They’re still financial issues but predicting the financial consequence of them involves seeing a company in a wider context. The phrase ‘ESG’ splits issues between:

Environmental issues:

• Climate change
• Natural resources (for example access to water, ores/minerals)
• Pollution (for example plastic)

• Human capital (for example training, pay, inequality)
• Product liability
• Inclusion and diversity

• Corporate governance (for example board structure)
• Corporate behaviour (for example corruption, competition and ethics).
  
  

This can be seen as a list of risks but there are also opportunities here. Many companies’ products are intended to offer better ways to address ESG challenges, particularly in the environmental space. ESG could also help pick out the winners of the future if they hint at reduced future costs for early adopters. Of course, as different issues rise to prominence, or are addressed by society, the list will evolve. ESG reflects what investors believe will be most important to businesses during the timeframes they want to invest in.

Defined contribution (DC) pension schemes in the UK are facing new regulations that will require them to make statements about their policies on all material financial factors, including ESG – and specifically climate change. DC schemes will be obliged to put these into their Statements of Investment Principles and make them available online. Eventually, the wider savings industry will likely be forced through the same processes – and why not? DC probably has the smallest investment budget of any institutional product, so if regulations apply here, why not elsewhere?

What should we do about ESG?

ESG forces us back to a risk management approach of forward-looking governance, and away from a rear-view mirror, extrapolative approach based on past history. ESG risks are not visible in backward-looking returns, VaR or volatility analysis: they haven’t happened yet. We may be able to learn from past ESG issues, but we need to carry out forward-looking assessments of current issues and their range of possible outcomes. Again, this is over the timeframes relevant to our DC members. Actuaries are ultimately risk managers, so this is perfect territory for us. We just need to use more general risk tools alongside our quantitative models. 

There is no reason for not assessing an ESG risk: the absence of a model is no excuse. We need to justify why each issue is, or is not, reflected in our portfolios. Beyond prioritising limited resources, there are two good financial reasons not to do anything: we don’t believe the risk has a financially material effect on our portfolios over the time horizon, or we recognise the materiality of the risk, but cannot find data which gives us insight on how to reduce the risk or increase profits for members.

To a large extent we expect that DC schemes demonstrating compliance with the new regulations would go through this kind of assessment on ESG risks, starting with what they expect to be most material. I believe climate change should dominate thinking, and certainly the explicit reference to it in the regulations means the government wants this, too.

Improving investment outcomes 

I anticipate that some approaches to understanding the financial impact of ESG issues will be based on a general theory of the adoption of technology. This classes most ESG issues as being sigmoidal changes, where we can identify stages of market penetration, with early adopters leading and paying to make the technology more efficient. Then mass implementers will profit from widening usage and finally residual infrastructure will manage the new network. For example, on climate change, at some point society won’t be able to generate any (net) carbon dioxide. We can all debate how long this take, and where exactly costs and profits will fall, but this could become an exercise in calibrating a model to reflect our regularly updated views.

To implement such an approach we will need to incorporate structural views of how sigmoidal technological change happens, and where costs and benefits lie. Then, using scenarios weighted by our risk process, we can try to work out the measures most aligned to our ESG issue and estimate the price exposure to them that we should carry. If the market currently over-values the exposure, we should find ways to get rid of it, but in the event of under-valuation, we should find ways to get in. In this way we’re managing risks and opportunities in the portfolio commensurate with the time horizon.

Where’s the evidence?

Because ESG relates to future events, there is no data on whether making allowance for it ‘beats the market’, but expert opinion on the future also constitutes evidence. The US military has a saying: ‘plan beats no plan’. Excluding ESG is the no-plan approach. Many people will be thinking, ‘This is an active management approach!’, and I agree – to some extent. However, I also see investing in indices as an active decision; it’s just the cheapest choice of setting your active risk budget to zero. 

I don’t know whether we will believe that ESG gives us insight into future returns after considering our research; if we don’t, we may go back to more traditional index investing, because we know it is cheaper and more liquid than a more involved approach. What we will have done is make our beliefs on ESG risks explicit to our DC members and subject to their scrutiny. That is positive if we are to see people engage with their pensions. I hope we’ll be convinced that ESG insights can help support them in retirement too.

Interestingly, given their historical role, there is evidence being promoted by index houses (MSCI, FTSE) that investment managers more aware of (eg managing down) ESG risks offer better risk adjusted returns over around a five-year horizon. This is encouraging, but shouldn’t be taken too far. ESG is also a screen of better management – if a board and executives are aware of ESG risk, they’re also probably more on top of distribution, production and finances. It’s difficult to ask the statistical confidence question, but the qualitative answer appears to be that better companies for long-term investing are better at ESG – so if this is a route to finding better companies, then use it!

What about benefit liabilities?

Hopefully you will have seen the Resource and Environment board’s practical guides to climate change, among them guides focusing on mortality and on the sponsor covenant for defined benefit pension schemes. Some ESG issues could affect mortality, but almost all could form a part of a covenant assessment for any of the sponsor, provider or parties to a buy-out. Again, this takes ESG to mean asking wider questions about the long-term prospects of a company than just its financial statements. 

ESG investing is itself facing a sigmoidal technology change – once it has happened, I don’t think we’ll go back. In the face of change, all business managers are faced with three possible options: get ahead of the curve and invest in the change to dominate the new landscape; run down the capital invested in the old technology and hope to maximise the capital paid back while demand falls; or sell out and use the capital generated to go into other markets.

Investors will increasingly frame their choices on the ESG versions of these, alongside more traditional market factors. As actuaries, I’d urge you to do the same.

Nico Aspinall is CIO of The People’s Pension and an IFoA Council member