This article was first published in the Quarter 4 2020 edition of Consider this. Click here to download the complete edition.

Key take-aways

Although analysing ESG factors can be complex, at Prudential the process does not involve elaborate formulas or reams of third-party data. Rather, the analysis is often not mathematically quantifiable, instead relying on a subjective call by the expert investment analyst supported by the team. ESG integration is understanding the risks and opportunities around the valuation of a particular stock associated with ESG factors.
We strongly believe the analyst of every stock has to be an expert on the material ESG issues that bear on their companies, rather than using an outside third party.
For Prudential, ESG is not about the exclusion of certain stocks or sectors in a “negative screening” that reduces the investment universe.

The integration of environmental, social and governance (ESG) concerns into an investment manager’s process of building and managing a portfolio is not a common topic. This can leave two misconceptions among investors. The first is that this is because it is highly complex and technical, making it a “black box”. The second is that it is either a special “screen” upfront, or more cynically, an after-thought garnish or “green wash” check once the investment process is complete. For Prudential this is certainly not the case. Here we share our approach to ESG investing.

ESG integration is not new

Before delving into Prudential’s ESG integration and removing these misconceptions, it should be highlighted that ESG integration is less mysterious, and more common, widespread and long- standing than one might imagine. Whether conscious of the label or not, serious long-term investors have always been alive to the material impacts ESG factors can have on the value of particular assets, irrespective of their source. More recently, ESG, Responsible Investing (RI), Sustainable Development Goals (SDGs) and the accompanying alphabet soups of principles and codes have helped refine and articulate some concerns and categorise them. By way of example, however, badly run ventures with shocking oversight, or terrible and oppressive staff policies, have always raised red flags for investors going back centuries. Other factors, such as climate change, are either new or have become more important in recent decades, but if it is something that affects the valuation or income stream of an asset, it is guaranteed to have been given consideration by a professional investment manager. Prudential has been including ESG factors in our investment process since our inception.

The black box

Can ESG integration into the investment process become highly complex? Absolutely. These days third-party data providers will provide ESG-related categorisations and risk levels on granular or collective levels, and data can be sliced and diced to a huge number of variations, and overlaid onto portfolios with heat maps, risk ratings, weightings, and any other approach that can be imagined.

Can this information be useful? Yes, it can provide flags for areas that might have been missed, and for monitoring purposes.

But do investment managers like us use these extensively in our investment analysis? No, because unlike the perfect, accurate summary a flight deck of instruments provides on an aircraft, these measures come with certain problems. These include:

1. ESG risks are not typically mathematically quantifiable. Carbon taxes are easy to ascertain over the short term, but most ESG issues are far less certain. For example, it is impossible to, with any degree of certainty, quantify how a collection of diverse governance failures can be accounted for in a mathematical valuation model. Very few ESG issues can be distilled to a number with any degree of certainty

2. Ultimately, the call on the risk or opportunity is subjective.

Much of this boils down to a matrix of criteria a company must fulfil -- for example how many times the audit committee met that year, attendance at committee meetings, and the existence of a policy on X or Y factor on the corporate website. While a company might comply with these criteria, there may be no insight into the quality of those meetings or the application of that policy. We know of a few failed SA corporates that ticked many boxes on committees and oversight. If the overall quality is poor, this can become a material risk that may get diluted or overlooked within a company’s overall ESG assessment.

So who would one like analysing these risks? A black-box approach of formulas? No doubt it is best left with the dedicated investment analyst working closely with colleagues and with the portfolio managers, engaging and debating the merits and risks of each aspect of the company, the engagements required with management, the independent information required, etc.

This is not to say ESG databases and matrices provided by third parties are without use, provided they are up to date and relevant.

This is why the analyst of every stock has to be an expert on the material ESG issues that bear on their companies. It is the analyst who has met with management over the years who must highlight to the investment team that, for example, the collective culture of a listed company, or perhaps the dominance of a founding member of the firm, is becoming a material concern. It is the portfolio managers who have listened to and interrogated that analyst in the investment team meetings who will then have a shared view on the sustainability, structural integrity and culture of that firm.

ESG is not screening

Many funds on offer in South Africa are labelled ESG funds because they do upfront screening -- certain companies are automatically excluded from the investment universe due to specific characteristics or a lack thereof (also called negative screening).

Interestingly, the United Nations Principles for Responsible Investing (UNPRI) defines ESG integration as: “the explicit and systematic inclusion of ESG issues in investment analysis and investment decisions.” It is also states that “It does not mean that….. certain sectors, countries, and companies are prohibited from investing”.

For Prudential, ESG is not about the exclusion of certain stocks or sectors. ESG integration is understanding the risks and opportunities around the valuation of a particular stock associated with ESG factors.

Negative screening is not an ESGrelated objective analysis, but rather a subjective and personal moral call on the scope of the investment universe. This can be a very good thing on a personal level, and it may mitigate some risks, but investors must understand what the asset manager is doing in this space and what this means for them. We do screen for certain risks for our clients on request, but clients must understand the implications of this process, which in the South African equity market can massively shift the investment universe and have severe consequences on diversification benefits, while also bringing other risks.

Most critically, screening is not just about removing risk, it also entails removing ESG opportunities. It assumes that all ESG is about risk management. To the contrary, ESG is understanding and evaluating opportunities. Markets misread ESG risks as much as they misread any other risk. For example, if one of Prudential’s analysts has a close relationship of information-sharing and engagement with a precious metals miner who has excellent relations with the community and staff, and who is very responsible in mitigating and managing environmental risks, and is striving to achieve cleaner energy, Prudential may require a lower risk premium for investing in that company than the general market requires.

Screening is also not a silver bullet. A bank may not be negatively screened based on its industry, yet it may be funding projects that are displacing communities and placing environments at risk, it may be harbouring corrupt executives, and the bank itself may be at risk of regulatory fines both locally and abroad.

ESG integration is not a “bolt on” process

Prudential has always believed ESG must be woven entirely through an investment manager’s process, from the investment analysis, to the presentations and debates with teams, to influencing voting on the stock, and guiding portfolio construction. Finally, it must be part of the continuing monitoring and review of a portfolio. It is part of our investment DNA. The danger of adding ESG as a separate component from an outside source or team is highlighted above. On this note, we held Steinhoff at maximum underweight in our portfolios for many years, and we avoided African Bank equity, not because the companies had failed to “tick boxes” in a matrix on audit policy, attendance, meetings, or the independence of committee members. One can fool matrices and black boxes, and even those with some knowledge of a company can be duped by policies, superficial disclosure and apparently well-intended management. For us we were able to see the red flags thanks to our investment analysts who live and breathe the stock, who see the committee meetings but still have the deep concern that the picture is somehow not complete.

In conclusion, for Prudential our approach to ESG investing is not about the up-front negative screening of an asset, or a bolt-on process by a third party or non-team member. Each of these approaches does have its place, but for us, most effective form of ESG investing is the full integration of these factors through the entire investment process, as part of our DNA. This is shown in the diagram, where each of the five steps in our process incorporates the consideration of ESG factors, along with myriad others that go into analysing an asset and building client portfolios.