Sustainable Investing: Looking Beyond the Scorecard

EPISODE:

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VOICE-OVER: Welcome to Fixing Your Interest. In today’s episode, Grover Burthey, Head of ESG Portfolio Management, and Vicki Gedge, Credit Research Analyst, examine the changing landscape for sustainable investing. They discuss why investors should look beyond ESG scores and ratings, how sustainability considerations can inform credit analysis and long-term investment decisions, and the role of active research and issuer engagement in identifying resilient businesses. They also explore the themes they believe will shape the next phase of sustainable investing.

VICKI: Grover, welcome to the podcast! Excited to be here to talk about sustainable investing today!

GROVER: Excellent!

VICKI: Maybe like looking back, I first joined PIMCO's ESG working group in 2012. Back then, sustainability was viewed through lens of exclusion, but today things have changed. It's much more focused on business resilience, transition risk, long-term value creation. You've had a front row seat to this. What in your view has changed the most?

GROVER: Sure. And then looking forward to this conversation today with you, Vicki. Listen, the space has evolved materially. And I would actually say go a little bit after 2012 to perhaps the signing of, of the Paris Agreement in 2016. And we went through a period of exuberance, arguably to when now of much more pragmatism. And to some extent that's very natural.

Over that period of time, we've had a lot of economic shifts, a lot of economic shocks. We had COVID lockdowns, we've had geopolitical invasions. And what that has meant is that investors have really had to think about things, right? More based on what is practical and likely to be connected to direct outcomes.

Now, with that said, some of the key trends that we observe are very supportive and show that there's good durability despite some of those geopolitical trends. We look at ESG labeled bond issuance, while that peaked at around 1.2 trillion in 2021. And it's a little bit lower now in the 800 to 1 trillion area that's been very stable since 2022.

And then we look at PIMCO’s sustainable assets under management. And we've continued to have very steady growth in that area over the last several years. Now, eclipsing around $600 billion.

VICKI: And when you think about, some investors would say, as we've gone through those trends and transitions, we've added more scores, more ratings, rankings, acronyms. Do you think that's really helped investors to make better decisions or has it just made it more difficult to navigate?

GROVER: It's been positive that the industry has innovated, it's been positive that the industry has aimed to incorporate and develop more quantitative data. But, as you're well aware, Vicki, this is not as easy as, let's say, a corporate credit score that you would use.

Those are gonna be based on long-term empirical data, right? Leverage, financial statements, balance sheet characteristics, sustainability related data is oftentimes more qualitative in nature. So converting that into scores, it is not always that easy. Nevertheless, right, what all this means is that it's really important to have our own frameworks, our own tools, our own methodologies.

When we look at ESG related scores in the industry, there can be huge dispersion. The consistency, the correlation could be quite low. And that may lead some to say, well, this is not helpful information. I wouldn't say that.

I think it instead reflects sometimes the difficulty, right? In terms of zeroing in on one specific, let's say outcome or variable. That's important. It also reflects the fact that different investors, different market participants are perhaps looking at different attributes of a company or an industry. So it's not that one is wrong and one is right.

These have to be used in balance. Here at PIMCO, of course, we invest an enormous amount of time in having our own data to make this helpful and to fit what we think is important as a bond holder, as a lender, and what also compliments our broader credit research process.

VICKI: Yeah, I think that's really key. You know, when we are designing the frameworks that we use internally to make ESG assessments, those frameworks are specific for each asset class. But even within credit, right?

We have a different framework for each industry. With each sector, the weights of environment, social governance are gonna differ depending on what matters most to those sectors. So yeah, I think that's really helpful. Doing your own work, own analysis, but actually making it fit the purpose that you're trying to achieve,

GROVER: Right. And we learn a lot from you all. So being able to take and utilize experience in different industries and different sectors, having that influence what we do on the sustainability side, it works together, and hopefully we can use that right to support the outcomes here from an investment perspective.

VICKI: Yeah, I think it's also really interesting when we look at a lot of the external data or scores, what we see for ESG scores, similar to what we see with credit ratings, it's often pretty backward looking. And I think one of the things that we try to do when we set up PIMCO ratings and we're doing the ESG scores, is try to incorporate that forward looking aspect.

Like where is the company heading? What are the changes they're trying to achieve so that we can anticipate changes and look to the market to see, well, does the market understand this properly? Are they pricing it appropriately and really nuance our investments around them?

GROVER: So that's a very fair critique of the industry. Oftentimes, ESG related data is at best reflective of the current moment in time, at worst, entirely backward looking. It can often really underappreciate the importance to an investor of what's gonna happen in the future.

We hope to generate alpha based on forward developments, forward outcomes, right? Past data may be highly correlated, it may not. So we definitely want to take into account, where do we think a company is going? Where do we think a management team is making improvements?

Of course, in a sustainability related data point or an ESG score, that's gonna be factored and influenced by environmental governance, social topics. But that should have a lot of overlap with our fundamental credit view. Those scores, those ratings should work together. And again, a forward looking basis that you get from our active research is really the ultimate goal.

VICKI: Yeah. Now that makes sense. And often, we see examples where the data or the metrics will tell one story of a company, but actually the fundamentals will tell another. So why aren't scores enough?

GROVER: Well, that's a very good question. At the end of the day, scores are never going to be enough on their own because you're trying to get to one output. But when we look at companies, when we look at different credits, we are trying to think about them relative to the peer set.

We're trying to think them relative to other options in the marketplace, different sectors, and the context of where we should be overweight and underweight. One sector that's a good example of this would be automotives, right?

You have longstanding companies in the United States and in Europe, the incumbents who, for a variety of commercial reasons have allocated different amounts of money, made different sorts of balance sheet commitments to the electric vehicle space.

Now, in isolation, having a prioritization, having emphasis on the transitioning from combustion engines to electric vehicles, that can be seen as a positive ESG component or a positive ESG characteristic.

But as we know, Vicki, it's far more complicated than that.

And one thing that we've done in this space, and of course we've worked together on this with the broader teams, is, well, let's not only look at the actual automotive companies themselves, but how about the supply chain? How about the suppliers?

There're gonna be winners and losers in the actual manufacturers, but looking upstream, right? We hope to generate alpha by going into the names, the suppliers who are going to be able to grow their business, sort of irrespective of who their clients are.

VICKI: Maybe a challenge that sometimes comes up is credit investors often find governance is more impactful than environmental metrics. Would you agree with that?

GROVER: The benefit of governance is that it's universally applicable. And as you mentioned earlier, Vicki, when we don't look at, let's say the energy sector, the same ways we look at the technology sector, the same way as we look at industrial spaces, they're gonna have different sorts of environmental relevancies.

The materiality of different types of either energy or waste or water characteristics is going to vary. Governance is gonna be important at a pretty reasonable level for most sectors. And so to some extent, it gives you a good common denominator, right?

And it's also an area where we can look at our historical experience and very much connect that ultimately to investment performance. So it's not to say that it's more relevant, but to some extent, the consistency is more pronounced for governance. Whereas environmental topics can be very sector dependent.

Social topics can be very sector dependent. So it's not that one is more or less relevant, but they may have different levels of materiality, applicability, right? And then that may influence how much we factor that into our ultimate recommendations.

VICKI: Yeah. And I think we often see, where as credit research analysts, when we're going through that process of assessing a company's ESG credentials, one of the areas where we might raise a flag, which supersedes the overall score or maybe pattern that we've seen is on governance because we have outsized concerns about whether our incentives are aligned.

Maybe changing focus slightly over the last few years, we've seen changing regulation, political scrutiny, maybe less of an emphasis on ESG targets at least publicly. Has that changed how investors approach sustainability or just how they talk about it?

GROVER: First of all, we think it's very healthy for the industry to evolve over time and what some may interpret, let's say, as a deterioration in certain components in sustainability, what some may say or may observe as being a decrease in adoption, that those are subjective observations. What's important to us, and what gives us a very constructive view on this space, on a go forward basis is the fact that it is evolving.

And so it's natural for investors from market participants to challenge the assumptions they've had in the past. Right now, I would say that we're shifting or we're balancing a focus between industry level targets, economy level targets, different types of pledges, which can still have a role, right?

But balancing those with bottoms up analysis, balancing that with direct conversations, with management teams, understanding what businesses need to do, what's available to them,  and trying to find common ground in terms of what we as an investor can expect versus what a company or counter partner that we have in the market can realistically implement.

So that's fruitful for the industry. It's good to have conversations when we speak to management teams, that are constructive in nature. You mentioned incentive alignment. We want to be aligned and of course PIMCO's platform and our ability to really engage, directly utilize our historical relationships with these companies.

VICKI: Yeah. And I think maybe you can delve a bit deeper onto that engagement. I mean, we do find, obviously through the engagement you are able to understand more of that context around, maybe the challenges companies are facing with achieving some of the targets or developing them. But maybe just more than you would get written in the documents. What role do you think engagement plays in the investment process?

GROVER: It's critical for an active manager. This is where we believe we can really add value. We prioritize our engagement here based on where PIMCO has exposure, where we have exposure in our funds, exposure across our platform. We prioritize it based on where we think the themes can really matter where they can be material.

It's important because it gives us direct interaction with the management team. This compliments PIMCO's longstanding diligence and research efforts. It's important because it helps inform our process.

It gives us insight to the point that you made that we may not immediately observe by a publicly available document that we may not necessarily observe from an earnings call, speaking to these teams directly, being their partner along these journeys that not only helps better inform our sustainability views but that hopefully helps us to make overall allocation decisions for various accounts.

It helps us to think about what the issuance profile may be of the issuer in the future. It helps us understand how the risks and opportunities in the market may change for them, and ultimately helps us make recommendations. And again, those have to be aligned with the respective counterparty.

But as we think about many of the key topics across sustainability, these are more and more connected to value creation and we should have a very good alignment with those who we engage with.

VICKI: Yeah. And I think we do. I mean, I see myself when I'm engaging with companies together with your team, you oversee the ESG research team when we're collaborating and actually engaging together with companies, I think it's important to note it's a multi-year process.

The way you are able to assess what a company's doing, how are they aligned with their targets that they've set? Are they making progress where the challenges are and really understand the direction that they're going in.

And I think especially as they maybe think about introducing sustainability labeled debt into their capital structure. So whether that's green bonds or sustainability linked, as they look to, how do we best reflect this is our targets and our goals, how do we reflect that in our frameworks that we include in them? And we've definitely seen a lot of useful two-way conversation.

GROVER: That's exactly right. We want companies to understand that while there may be more effort from them, while this may be more, let's say transparency than they're legally required to do or required to do by regulatory means that there is a benefit to this, that this again helps them really get the maximum utilization off of the business plans that they have in place.

With our global visibility, our vantage point in the market we've observed, let's say management initiatives, best practices that have worked well in one geography, in one sector, we can then transfer that to another area, right? And we think we're in an advantageous place to make those observations, but it's absolutely a two-way street.

And one of the benefits that we have here is that we have been, as you're well aware, engaging with these companies on topics for many, many years. So this is not a new initiative for us. It perhaps is evolving in terms of those questions that are being asked. But, we have, in most cases, the goodwill to be able to track that progress over time and hopefully have positive outcomes.

VICKI: Great! A question that I often get from clients is, how does engagement differ for bond holders? And do we have the same leverage that equity investors typically enjoy?

GROVER: Right. Well, first and foremost, we certainly think about this as a lender. PIMCO of course has been a lender to many of these, let's say, higher admitting sectors, higher materiality sectors through many market cycles, through many different economic environments. And we've seen where you can incur credit events.

We've seen where businesses can have balance sheet shifts happen much more rapidly than perhaps some scenario analysis would imply. So we wanna protect against losses, right?

As a bondholder, we're senior in the capital structure, that of course, helps us in times of stress, but it doesn't make you immune to it. And so it's important for us to think about things like residual asset value and let's say the potential transition risk or physical risk that a business’s real asset base or physical footprint has.

It's important for us to think about how profitability and margins could change very, very rapidly. And the free cashflow impact of that, let's say if certain sectors fall out of favor for sustainability reasons.

So we really do have to think about it in terms of where we're in the capital structure and in comparison to the equity market, well, the reality is that particularly in these sectors where there is a large investment need, there's very regular public market activity.

And so even in addition to what we may have in terms of regular interactions and engagements with companies, either after a quarterly earnings report or during other outreach they have, we're also gonna be able to interact with them and their advisors during their primary market issuance. And if that happens two or three times a year, that's a very frequent touch base.

And  one positive observation that we've had is that by giving them the confidence,  that there are large institutions in the market that factor these types of sustainability topics into what we do in terms of orders and interest that gives them the justification to remain, let's say, transparent and ambitious on many of these topics.

VICKI: Yeah, that's a good point. I think, you know, we are often one of the biggest lenders to a company. So I think when we are asking those questions, and especially when that's all the way up to CFO level, that they take notice of it. I think one thing we see where we have a company say that we've historically liked, we've invested over time so they can see that we have participated in the capital raising.

If we then do not participate, they notice, we'll get calls from CFOs or treasurers to say, okay, I noticed you didn't buy it. Like, why? What was that? And especially if that's a label bond, a green bond or, and we say, well, look, we've talked to you, we've raised these concerns, but this is a reason and it is a barrier to us investing. So we're able to vote with our fee, which I think helps.

GROVER: Right. And maybe another way to put it is in the fixed income market, this is a repeated game. We are both going to interact over the years, right? PIMCO, we're gonna be here for many years. Those of these companies, they're hopefully also gonna be there for many years. So it's in both of our interests to keep that dialogue going.

They want to maintain market access, right? We want to maintain our ability to prioritize and emphasize the names that we like, credits that we have a positive view on. And so it's very symbiotic. And that, again, also brings those other counterparts to the table for these discussions.

VICKI: Yeah. Okay. I think some investors will hear a lot about engagement,  as a part of the process and has been for a number of years, but the question is, does it really change outcomes? So how do you define success for engagement?

GROVER: Sure. First of all, we do track and record these interactions as you're well aware, Vicki, and you help us with that. We over time then try to connect the dots, try to identify patterns, right? Does it have positive outcomes? Well, it depends on how one defines that, right? A positive outcome can be very situation dependent, very sector dependent.

I think we've been incredibly encouraged by what we've seen in the utility space across many geographies, right? In terms of companies pursuing a more diverse energy mix, pursuing, let's say, more representation and lower carbon intents, sources of power and renewables and wind and solar, now, battery storage. 

Seeing them do that and implement over time, right? Because not only of that engagement but because of the economic benefits, because of the increase and decreasing costs in those areas, but certainly because of our ability to invest in their green bonds to support their ability to utilize that market.

And we definitely look at bond market issuance in terms of green bonds or labeled bonds as one positive engagement outcome. And on a go forward basis, industries are changing. And so just because a company may have made one representation in the past, we do want to acknowledge that they have to respond to the economic realities.

And so these targets in our tracking may evolve with the economy and with the business, but we do have to hold ourselves accountable as well and ensure that we're having some progress on these initiatives.

VICKI: And have you ever exited an investment because of an engagement outcome?

GROVER: So back to the previous point, again, one of the purposes of this is not solely to judge, let's say the outcome of the engagement, but to gain that extra insight that we receive by interacting and discussing with the companies directly. And the answer to the question is, yes, we have. And that in some circumstances can be because of a reduction, right?

Or let's say a repeal of certain ambitions or other targets or goals that the company has, particularly in the broader context of our credit view. But oftentimes it's also simply because we're discovering new information that we didn't fully appreciate before.

And I can think of a specific example again, in a consumer lending space where a company made very significant and very material social claims, argue that the business has social benefits for certain types of borrowers based on demographics and other socioeconomic considerations.

And as we dug in deeper, as we started to learn more about the business model and the industry, we realized that a lot of this was exaggerated, right? And that the benefits were not necessarily universally positive, and that there can be very negative credit realities for certain of those borrowers.

We exited that investment based on the engagement observations and what we ascertained from that. And so it certainly can impact what we actually do from a portfolio perspective. And while we hope that that's a rare case, it does take place.

VICKI: And do you think investors focus too much on trying to identify the sustainability leaders and maybe missing opportunities where companies are actually successfully adopting to the change?

GROVER: We wanna have an impact in what we're doing. We want to have an impact in what we're doing. And the way to maximize the potential for impact is to have as broad of an investment universe as possible, right? And also to respect the fact that many companies are in very different places. There are different places in terms of their investment cycle.

There are different places in terms of their sustainability journey. And so if we only prioritize and allocate capital to names that were proven leaders, those that were the most credible in the marketplace, arguably we're missing a very meaningful opportunity, right?

To capture those companies who are earlier on where there's going to be more tailwinds, more potential impact on the actual investment outcomes. And where we as a lender can really play a key role in that, as opposed to financing a business that has already made that progress. So when I say that the industry at large places has too much emphasis on it, I'd say that's debatable. But our view at PIMCO is it's important to be balanced, right?

It's important to look at companies across the spectrum and also really identify areas where, as a lender as a significant meaningful asset manager, we can be a catalyst in certain outcomes.

VICKI: Maybe if we sort of start to wrap up the conversation, just thinking about, as sustainable investing continues to evolve, what do you think investors should focus on most for the next kind of few years?

GROVER: The next five years are gonna be really, really critical for this space, right? We've evolved, again, from an area of, let's say, very high expectations to one of more pragmatic expectations. But we also have to make sure that the industry remains focused on the ultimate goals here.

Ultimate goals in particular being, trying to mitigate greenhouse gas emissions globally, trying to provide a future for our children, for the next generation that protects natural resources, trying to be a good steward in the industry and being active externally.

These are all important. What the industry has to do over the next five years is really crystallize. Some of these goals, again certain, I would say industry standards put in place and over the last 10 years have evolved. They remain in place, but the next five years will be critical to ensure that they survive for the next 20 years.

And the industry is in a good equilibrium right now. We're positive on that, but it's not guaranteed to remain in place. In terms of specific themes, we're certainly focused on physical risk. There are the practical implications of warming are more or less locked in. We're seeing that across many geographies this summer already.

We're focused on the implications of insurance costs on that. We're focused on the potential disruption to different business models as we're in a hotter environment, and we're also focused on continued geopolitical tensions. And the fact that investors have to regularly react to this. It's hard to predict what will come. But it's also pretty fair to assume that we're gonna continue to have more swings in terms of what policymakers expect, what policymakers want globally.

VICKI: Okay. So before we finish, I thought, maybe we'll just do a quick fire round of questions. So short answers only. What is the biggest misconception about sustainable investing?

GROVER: That it's altruistic? Most market participants, maybe not all, most are certainly looking for positive investment outcomes from this activity.

VICKI: Okay. Most overused ESG term,

GROVER: I really hate greenwashing, I hate that term. It comes up very regularly. Most in the industry are trying to do something with the right intentions in mind. And this notion that we're all sort of misleading each other or misleading others, I think is very over exaggerated.

VICKI: Yeah, now I'd agree with that. One area investors are not paying enough attention to

GROVER: Artificial intelligence. On the one hand, this is a topic in almost any investment conversation that you have, but in sustainability, perhaps less so, and we're definitely focused on the labor impacts, we're focused on the environmental impacts, we're focused on the innovation impacts and the likelihood that artificial intelligence can hopefully solve and address many of these issues.

VICKI: Most important management, quality,

GROVER: Incentive alignment. We've spoken about it a little bit, but that's really where the governance credit side, the sustainability side, could all come together quite neatly.

VICKI: Yeah, I would add humility. I think, anytime I have a conversation with a management team, you want 'em to be a bit humble about… One sustainability trend that will matter more in five, 10 years than it is today.

GROVER: We are hopefully on the cusp of a lot of meaningful breakthroughs. We think about topics in healthcare and pharmaceuticals, solving diseases. We think about areas and nuclear, base load power at hopefully very compelling economic costs.

We think about areas in terms of agriculture and crop yields and productivity. Oftentimes this space can really focus on the areas that can make you a little bit depressed. It's going to be even more, I think, prominent and common focus on the solutions part of sustainability. Where in the economy are we really financing outright solutions, solving major problems, directing capital in a meaningful way,

VICKI: More positive, hopefully to look forward to. Excellent! Well, Grover, thank you very much for being here with us today! I think, in summary, our discussion is really highlighting that sustainable investing continues to evolve. It's an area that we've seen a lot of change over the last 10 to 15 years, and we're probably gonna continue to see that change.

But what's really important is taking the time to do the analysis, to have the insights, not just rely on the data and scores that you might have. I think, one thing we are trying to do is really on behalf of our clients is just make sure that we're engaging with and investing in businesses that are resilient, they're proven, they can adapt to change, that they have long-term value creation in mind. Thank you for joining us! 

GROVER: Thank you for the conversation, Vicki. I enjoyed it!

VOICE-OVER: Thanks for joining us on Fixing Your Interest as we explored how sustainable investing is evolving and what that means for investors. Stay with us as we continue to navigate the challenges and opportunities across the investment landscape. For deeper insights, analysis and resources, visit PIMCO.com.

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