Dismissed as a likely fad or “flavor of the moment” as recently as five years ago, the idea of incorporating an ESG lens in the investment process – namely, taking into account environmental, social and governance issues – now looks here to stay.
One measure of the growth in ESG is the continuous rise in the number of companies – PIMCO among them – signing the United Nations Principles for Responsible Investment (UNPRI) since it launched in 2006. As of July, the PRI Association reports more than 1,200 signatories representing $34 trillion in assets under management (AUM), with over half of the externally managed assets designated as “ESG-integrated.” (See Figures 1 and 2.) Another sign of the growing acceptance of ESG investing: Barclays and MSCI introduced the first fixed income ESG indexes in June.
Moreover, we see interest in ESG moving well beyond its traditional core base. Whereas five years ago the interest was concentrated largely in Europe and Australia and among U.S. foundations and endowments, we now see a great deal of emerging interest (and actual assets being deployed) from corporate and public pension funds, high net worth investors and family offices, and other types of investors not previously associated with ESG investing.
At PIMCO, our mission is to manage risk and deliver returns for our clients. We believe that thorough risk assessment, which underpins good investment decisions, includes an analysis of ESG factors. This recognition forms the foundation of our approach to investing responsibly. It is also consistent with our conversations with a growing number of investors who now regard ESG as a fundamental component of the way they invest – a basic principle of their approach to investing.
Existing ESG approaches
To date, much of ESG-related investing has been focused on negative screening, essentially removing potential names or even sectors from the investable universe. By definition, such an approach limits the investment universe, sometimes in an inevitably blunt fashion. So it should not be particularly surprising that a large number of screening-based vehicles have underperformed the market, while exposing investors to a higher degree of volatility than similar non-ESG products.
Proactive and non-negative screening methods of engaging on the ESG front have been limited. While early-stage venture capital and growth equity funds have been able to participate in some of the more exciting “clean-tech” opportunities (such as solar, wind and fuel cell projects), there have been very few such opportunities for other types of investors. Fixed income investors, for example, are largely focused on more mature or established sectors, and the types of companies issuing large volumes of debt are often more likely to be disrupted by the advent of new and cleaner technologies than to be the leaders in these emerging areas.
Rather than accept the status quo, many investors are now asking us if there is a better way to approach ESG investing. Is there an approach that couples sensitivity to ESG issues with a focused and proactive investment strategy that enhances the potential for alpha, or above-market return?
Toward a better approach
We believe that there is a better way to invest – a holistic view that seeks to proactively generate positive impact and returns, both for investors and society. In our view, this approach rests on these fundamental pillars:
- Identify and analyze key ESG issues facing a given investment sector. Fundamentally, we believe that ESG issues can and should be viewed as risk factors (i.e., contributing to the balance between upside and downside return potential, as well as volatility and correlations) – drivers that bring fundamental and often paradigm-shifting change – and should be examined alongside traditional financial and operational risk factors. (See Figure 3.) By identifying and incorporating ESG risk factors into our research process, we can potentially minimize the impact of negative ESG-related developments and uncover proactive opportunities to generate return by investing in sectors and securities that are likely to benefit from ESG-related trends.
ESG issues have played a significant role in investment returns, including:
Engage with the issuers of securities (companies, sovereigns, municipalities, etc.). Our deep-dive research process identifies ESG-related issues, but identifying the issues is not necessarily sufficient. These issues (and concerns, if that’s the case) need to be communicated to a company’s management, just as we raise other operational and financial issues. Large institutional investors, in particular, have the opportunity to bring these issues to the attention of a company and ensure that they are on the agenda. We believe that this can be done in a positive fashion, encouraging positive steps by issuers and recognizing accomplishments and progress, rather than just focusing on gaps and failings. Ultimately, by engaging with management teams and encouraging them to address material ESG risk factors, in addition to traditional financial risk factors, we believe companies will enhance their competitive position, which will have a direct positive impact on our clients’ investments.
- In the tobacco industry, societal, health and regulatory pressures have led to a constrained operating model in which the companies involved must adhere to very strict terms.
- In the banking sector, governance and control issues have led to a series of highly publicized risk management failures, including fines/penalties, such as the recent J.P. Morgan “whale” trading issue.
- In the oil and gas sector, where environmental issues (such as BP’s Macondo spill in the Gulf of Mexico and Chevron’s Brazil spill) have significantly impacted the performance of the companies’ securities (debt and equity), as shown in Figure 4.
- On the flip side, the positive impact of the environmental component of ESG, such as demand for electric cars, has led to the emergence of new producers, like Tesla Motors.
Support the development of markets for ESG investments. Large institutional investors can encourage the development of financing mechanisms that promote socially beneficial investments. While there are nascent efforts across the industry in this regard, we believe that much additional work needs to be done; the green-project bond market, for example, remains small relative to the annual infrastructure development market, and especially relative to the potential investor demand for green bonds. PIMCO is: (1) actively encouraging green and project bond issuance by utilities and other infrastructure developers; (2) looking at private placement and direct investments in green-related infrastructure projects; and (3) engaging in conversations about the development of securitization markets to help finance the widespread adoption of solar and energy efficiency projects.
While a great deal of progress has been made, more needs to be done to create a landscape that reduces frictions and eases the investment process. For example, definitions and nomenclature are still unresolved: What really constitutes a “green bond” or an “ESG investment?” Once clear definitions are established, there is the considerable challenge of defining the investable ESG and green universe – such as creating a database of investable green bonds and loans from a fixed income investor’s perspective. Similarly, reporting needs to be standardized. The roles of sovereign governments and the public sector in general need to be explored. The list goes on. Industry-wide forums and discussions will be key to progress in what will likely be a long and challenging process.
In summary, as a signatory to the UNPRI, PIMCO is integrating the challenges and opportunities of ESG into our investment process. To be clear, ESG risk factors are an input into our investment process, not an objective. Our objective remains to make financial judgments on a holistic set of risk/reward factors that will ultimately allow us to deliver outcomes for our clients that are consistent with their objectives and needs. In this regard, our long-term, top-down perspective acknowledges the importance of ESG trends and drivers over time and allows us to identify potentially attractive investments. We combine this with rigorous bottom-up analysis to identify the most compelling individual sectors and securities in today’s market. We continue to analyze the evolving issues around ESG and discuss internally how best to address them. In our view, investing responsibly involves respecting the balance of financial opportunity and ESG factors, which together have the potential to impact society in a positive and meaningful manner.