Environmental, social, and corporate governance (ESG) investing is often perceived as a “civil society movement,” disconnected from economic rationality. Guillaume Mascotto, Head of ESG at American Century Investments, acknowledges that the rise of ESG reflects a change in societal patterns (e.g. transnationalism, generational changes), but he defends the idea that ESG is also a reflection of current and future changes in economic patterns – industrial exposure to physical and transition climate risks, technological advancements, etc.– to which investors need to adapt.
In part, due to its relatively recent arrival on the investment scene, ESG remains a mutable concept, lacking uniform, coherent definitions and a solid baseline for analysis and measurement. One natural response to conditions like this is a flight to so-called “scalable” evaluation – ratings, scores and other beta-type filters. However, most solutions available in the ESG space tend not to be contextualized per financial materiality and company fundamentals. As a result, an overreliance on guidance of this type runs the risk of limiting the ability of investors to understand which ESG issues are, in fact, financially material, and on what time horizon they will affect companies. In other words, “why and how can ESG move the needle?” Mascotto says.
An alternate response to unclear guidance is to double down on enthusiasm for assets that are strongly associated with positive societal and environmental impacts. Here too, what defines “impact” is not clear and can easily be misguided (or “washed”). For example, a power plant run on nuclear power is no doubt exposed to potential radioactive risks, but if it brings power to underserved communities or allows hospitals to run and continue saving lives, should the social impact necessarily be nullified? Similarly, aggressively harvesting trees can pose a risk to biodiversity, but reading school books printed on SFI or FSC-certified fiber has been shown to play a role in helping a child’s learning and literacy. Pulp manufacturing, while also derived from trees, is crucial to bringing hygiene products to the elderly and to remote communities in emerging markets. In these cases, could an overreliance on environmental impact theme come at the expense of the social impact theme?
The authors of several recent papers, including Mascotto for American Century, have emphasized that incorporating ESG factors into a portfolio should unfailingly focus on the investment process – in other words, it should be about investing first and foremost.
While it’s true that including ESG or impact factors into investment decisions serves an overarching vision in which responsible corporate citizenship is valued over lax or neglectful corporate conduct, markets and stock valuations belong to a dense world of volatility beyond the reach of binary concepts of positive or negative. This is where an approach to ESG investing that seeks to achieve an equilibrium between ESG quality and expected returns comes into play. At the end of the run, Mascotto says, “We are a main street asset manager and we have a duty to ensure the long-term economic and social viability of our clients.”
ESG wants to talk – and needs to
Against this backdrop, American Century applies a holistic approach to ESG investing while remaining resolutely focused on delivering solutions that meet its clients’ needs. Combining macro and sector inputs with a focus on issuer-level financial materiality, American Century’s ESG integration framework is aligned with the firm’s fundamental research process. In accord with that precept is the still wider mandate within American Century’s ESG group around the importance of “re-injecting bottom-up fundamental analysis” whenever ESG considerations have been applied to a current or potential portfolio addition.
Mascotto extrapolates from this to a general rule his group makes certain to follow. “We want the financial and ESG verticals of information to continually talk to each other,” he says. The idea is to ensure investment analysts are incentivized to participate in the ESG assessment by allowing them to provide input regarding the financial materiality of ESG issues to which their companies are or could be exposed.
Opening the “black box”
Does a company’s risk exposure to ESG issues translate into investment risk – and if so by what degree and in what manner? Similarly, if a company’s business lines or debt proceeds hit the mark from an environmental impact perspective, is the company’s impact profile naturally aligned with the other pillars of ESG risk assessment? Posing these questions in this manner serves to defuse unintended biases, and pivots the discussion back to an evidence-based evaluation of company fundamentals and financial materiality. At American Century, this is when the exercise of “opening the black box” comes into play.
On the risk side, instead of focusing only on an issuer’s level of ESG disclosure or negative “externalities” (e.g. carbon emissions), American Century’s ESG team works with investment analysts to dive deeper into the issuer’s ability to manage any potential costs associated with exposure to ESG issues. For example, if the ESG issue to which a company is exposed could alter its growth trajectory over the medium to long term, the focus will be on the potential impact on earnings visibility through supply and demand assessments. Or, if the ESG exposure results in an immediate to short-term cost to the company’s market valuation or debt spreads, the focus is directed toward management’s remedial actions and whether any decrements to the company’s fundamental business profile could be warranted.
On the opportunity and impact side, new regulations or technological innovation can alter supply and demand fundamentals and, by extension, expose companies to potential risks, including loss of competitiveness or rising compliance or production costs. But these trends can also influence companies to react positively by innovating or repurposing assets toward business lines with either lower regulatory compliance risks or the potential for yielding positive social and environmental dividends.
“Our framework generates ESG assessments that are not static in time,” Mascotto says. Rather, the ESG views elevated to portfolio managers are both “risk-based and forward-looking” in order to assess what Mascotto calls “downside ESG risk propensity” and to capture “ESG upside potential.”
Achieving ESG synthesis
“The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process,” Austrian Economist Joseph Schumpeter wrote in 1950. One interpretation of this statement could be that our economic system, and the financial architecture that supports it, is in constant motion. Consequently, it would stand to reason that investors must be able to continually adapt their strategies and economic outlooks to this evolutionary process. After all, as Mascotto says, the market behaves as a “discounting vehicle” based on various “forward-looking pointers and assumptions.”
Likewise, the investment community’s conceptual understanding of ESG, and its role in investment decision-making, is also continually unfolding. In Heideggerian terms, if the original thesis is that ESG issues fall outside of the investment scope, and the anti-thesis is that ESG reflects structural social changes which could have deep economic reverberations, Mascotto would like to think that, at some point, ESG integration could emerge as the “logical result of a long synthesis” folded into the regular investment process to ensure the long-term viability of the client investor.
The opinions expressed are those of American Century Investments (or the fund manager) and are no guarantee of the future performance of any American Century Investments fund. This information is for educational purposes only and is not intended as investment advice.
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