Contributed by Ann Marie Orchard (New York City)

The US Congress appears poised to pass carbon cap and trade legislation, perhaps as soon as the third quarter of this year. Although there has been a market price on carbon in the UK and Europe for some time now, the US has no broad mechanism for factoring in an implicit price for carbon. Until now, efforts have been limited to regional attempts to develop progressive responses to climate change risks, in the absence of formal policy. But, the world is changing, and the heightened awareness surrounding sustainability is making an appearance in the asset management industry.

In the world of those who manage money or other assets, sustainability has a specific definition: the integration of environmental, social and governance (ESG) factors into the investment decision-making process. How does this particular application of sustainability enhance risk assessment, and how can this enhanced analysis allow managers to seize opportunities and manage risks that are associated with these emerging ESG factors?

The beauty of practicing sustainability in the setting of an asset manager is that you have the opportunity to learn and look at major emerging issues across diverse industries and sectors, as that is how the institutional business is generally structured. Managers, initiate manage, and close out positions in many sectors, unless they are focused more exclusively by their investment mandate on select industries.

To understand what may constitute material investment risk for today’s money manager, we can look at:

  1. Environmental: the physical environment impact, greenhouse gas management, climate change regulations, waste and water management;

  2. Social: labor (health & safety compliance); supply chain management, product safety, consumer relations, community/stakeholder involvement; and

  3. Governance: transparency, accounting and reporting; board independence; and management compensation.

The other necessary question is why do we care about these newly defined risk factors? For each risk classification, we care because of the potential they may have to impact the value of our holdings and our portfolio performance, e.g., in the following ways:

In investment management, similar types of analyses have traditionally been the focus of SRI (socially responsible investment) managers, who have played an important role in what is referred to as values or mission-based investing. This approach is often based on “screening,” in order to exclude certain behaviors from a portfolio, e.g. excluding manufacturers of tobacco, cluster bombs or firms that do business in a specific controversial area such as Sudan today or in the past, South Africa under apartheid. An example of positive screening can include a “best in class” approach, which focuses on the sustainability or SRI leaders in a sector, leaving out companies in that sector who do not meet a minimum threshold, but keeping companies who do meet minimum criteria on sustainability attributes.

The industry is served by specific research providers who supply data and other analytic tools in support of values or mission-based investing. There are also a number of indices which have developed over time to benchmark the performance of such portfolios, including those provided by KLD, SAM, FTSE and recently JPMorgan and S&P. These indices have expanded their focus from mission-based to benchmark performance on a broader set of sustainability criteria, e.g. the KLD Climate 100 or the Dow Jones Sustainability Indices for the World and North America.

However, ESG integration is separate and distinct from mission- or values-based investing because it is premised on the view that the world has changed due to:

  1. Growing economic and social aspirations of people in emerging or frontier countries,

  2. The increased presence and influence of the BRIC [Brazil, Russia, India and China] countries,

  3. A strong and growing global demand for basic commodities for industrial and agricultural production, and

  4. The view that water could the next big global shortage, and

  5. Projections of the effect of climate change on all of the above.

As a result of such change, the risks associated with ESG factors, in many instances, can be material to company and portfolio performance.

NGOs have created awareness and engagement on ESG analysis topics and have allowed for the establishment of the Global Reporting Initiative (GRI), a framework for reporting on issues of sustainability across industries and an accepted framework of engagement, advocacy and consultation. Whether the focus is on the preservation of timber in North or South America or Indonesia, safeguarding the environment globally, growing sustainable palm oil, bringing improved health care or micro-financing to developing nations, or advocating for improved corporate governance, the NGO community has been a driver of corporate and organizational change on many ESG challenges. The expertise and influence that NGO’s have developed over time has allowed them to become stewards of good behavior and, in many cases, friends, rather than antagonists, of the corporate sector. Established organizations such as the UN Environmental Program-Finance Initiative and CERES (Coalition of Environmentally Responsible Enterprises) are considered thought leaders in the integration of ESG factors into the investment decision-making process. UNEP-FI has done early and pioneering work examining the legal and fiduciary basis for integrating ESG into the investment process.

There are also many other sources who collect and analyze sustainability data and make it available to analyst and portfolio managers. It is then up to the asset managers to determine how to best use this data, how to discern what is material and what is not, and what strategic impact this information can have on company performance.

The above column is the first of a series which will appear from time to time with the purpose of informing and educating our readers about concepts and practices of sustainability in today’s world. The view will be from the perspective of a practitioner in the asset management sector, but will not be confined to that sector, but will look at sustainability topics across various sectors and industries. >