This article was first published in the Investment Innovation Institution (i3) on 30 June 2021 here.
Taking a quantitative approach to ESG allows investors to capitalise on companies moving towards greener and more sustainable business models, rather than simply screening out the biggest polluters and narrowing down the opportunity set, CFM’s Pierre Lenders says.
For a long time, environmental, social and governance (ESG) has been the domain of qualitative research, where analysts engaged with companies and trawled through disclosure statements to get an idea of how sustainable companies were.
But as more data has become available and quantitative techniques have improved, systematic approaches to ESG have come to the fore.
Pierre Lenders, Head of ESG with Capital Fund Management (CFM), had an early interest in the intersection between hedge funds and responsible investing, and co-founded a technology firm, Prius Partners, in 2012 that looked at whether it could harvest alpha from ESG data.
But Lenders was a bit ahead of his time as hedge funds didn’t embrace sustainable investing until much later.
Yet, now ESG has become mainstream and the data set is broadening.
The trick is how to interpret all of this information and place the right weighting on each signal, Lenders says.
“When we say ESG, we are really talking about a catalogue of factors, right? And like a poet, who wouldn’t want to use every word in the dictionary, I don’t think that an investor should want to practise every ESG dimension constantly and with the same intensity,” he says.
“There are particular factors that are important at certain points in time, at least for certain segments of the market. So to me it is a matter of trying to find out what the themes are that the market will [react to], for good or bad reasons.
“And then as an investor you should be aware of that because there is alpha in being ahead of that curve.
“To me it is like a surfer who has to see the waves coming and has to position the board on the right wave.”
To stay ahead of the curve, Lenders tries to identify themes before they become acknowledged by the market. Often this means looking for evidence outside of financial markets and estimating the probability of it becoming a material issue for companies.
“We are applying natural language processing to analyse the broader conversations taking place in the media and other public sources to detect topics that are gaining traction,” Lenders says.
“Especially in the E and the S, you see topics being discussed in circles that are not necessarily close to markets: NGOs, industry gazettes or local newspapers.
“So something may not be big news for financial markets yet, but you can see that this topic starts to gain traction and starts to get closer to market participants. It might increasingly be discussed by regulators and then you are really touching on the possibility or probability that this becomes financially material.”
Once a theme becomes material, then the next step is to find workable data that gives insights into whether one company does better on this front than another.
“If I take the example of biodiversity, then it is incredibly material, but whether or not we should integrate that in our trading program is another matter,” Lenders says.
“We need to detect whether from a trading standpoint it is going to be an important theme over the next six to 18 months.
“With biodiversity, for the first time we are now seeing regulators starting to take measures. For example, France is introducing biodiversity as a key topic in the famous Article 173 or its descendant.”
French financial institutions are required to disclose both biodiversity and climate-related risks and impacts to the French financial regulator under Article 173, which is a disclosure clause in a much broader law on energy transition for green growth.
“It is not clear yet whether that is going to be financially material because you need the attention of circles that are very close to markets, including regulators, but you also need the data,” Lenders says.
“People can only act on data that says that this company is doing a better job than that company. That is still very unclear whether the data is here to service that purpose.”
More comparable data is available on carbon emissions, but Lenders says it is not simply a matter of finding the companies that have the lowest emissions, as these are often few and far between and demand premium prices.
“For instance, if you are looking at utilities, then it is very much the direct emissions that matter, which are driven from their technology needs, but it is also about what they are planning to do,” he says.
“So if an electric company is still relying on lots of fossil fuels, but has very aggressive plans to convert to a much greener generation of electricity, then that is a very important factor as well.”
The much-talked about stranded asset problem is also an important issue, but he says it is simply one factor among many. He is particularly interested in the potential of scope 3 emissions to gain in importance.
Greenhouse gas emissions are categorised into three groups or ‘scopes’ by the Greenhouse Gas Protocol. Scope 1 covers direct emissions from owned or controlled sources, while scope 2 covers indirect emissions from the generation of purchased electricity, steam, heating and cooling consumed by a company.
Scope 3 includes all other indirect emissions that occur in a company’s value chain and includes emissions that are generated in the production of the ingredients that go into a company’s products.
“We will obviously also look at [companies’] scope 3 downstream emissions,” Lenders says.
“We know that it is still quite far from being fully satisfactory in the sense that you don’t have exhaustive disclosure by companies yet. It is only 15 per cent of companies that really have sufficient disclosure to be used.
“So there is a lot of modeling and you have to make sure the modelling goes deep enough into firms so that you have some level of differentiation appearing between company A and B.
“A good example would be if you are using milk in your product, you have to rely on a coefficient matrix which shows that your footprint is much higher if you use animal based milk than if you use a plant-based milk for instance.
“So it only tells you the in-between story, but I dsagree with those that say scope 3 is too bad to use. I think that is a bad excuse for not trying to do the work.
“Especially because at the moment there is quite a significant carbon price, at least in Europe, for certain industries and that circle is starting to get bigger. I think that food could get in scope.
“I think that scope 3 will be a telling factor.”
Interpreting the relevance of all of this data is a constantly moving feast. Where only a year ago it would have made headlines if a company announced it was aiming to be net zero by 2050, it is now a requirement in many countries and so a statement on this topic doesn’t move the needle.
“What is more interesting are the intermediate steps, the 2030 targets, or more importantly what measures companies have been taking to walk the walk,” Lenders says.
“Have they already started demonstrating through their capex that they are investing in ways that will allow for the divestment of assets or making steps that are required to meet their intermediate targets?
“You can also look at hiring practices, et cetera. So you can look at a whole range of indicators to see whether companies are walking the walk.”
Old Skool ESG
Lenders’ approach of looking for correlations between stock prices and relevant ESG events ensures he picks up trends while keeping the investment universe broad. Restricting the universe by applying negative screens doesn’t make much sense to him because some of the biggest gains will be made by the heavy emitters moving to cleaner models.
“In the past, people thought: ‘I’m a good implementor if I implement E, S and G and for that I use ratings.’ This is a problem because in a way it is the worst enemy of sustainability to use the old version of ESG,” Lenders says.
“It can not be conducive to performance. You just use your ratings, your performance scores and you do negative screening and divest from the 20 per cent worst companies as rated by this or by that.
“You don’t have any added value, you just limit your universe in a similar way that other people have limited it. And so you give up your opportunity to be more agile and make better returns.
“Besides, if you are allocating your capital only to companies that are already virtuous, then what is your impact on the world? You are not having any impact.”
This approach made sense in the early days of sustainable investing because there simply wasn’t enough data to take a different approach. But Lenders believes more progress can be made by rewarding what he calls ‘greening and greener’ companies.
“It was the only possible way to start with because it needed to be simple. And maybe in the beginning it did have an impact because if you consider a world where being a good ESG company wasn’t recognised, but it was going to be recognised, then there is some alpha there,” he says.
“But now that ESG is being considered by everybody, there is no alpha left in that play and what is at stake is no longer trying to be as green as your friend and buying the bubble. Now it is much more a matter of the entire economy moving from being brown [to green] because we are still on a four-degree trajectory, more or less.
“It no longer concerns a few billion of the economy, but it is the entire market that needs to move. This means that a lot of investment needs to be made to green the brown companies. So applying basic filters with basic scores is counterproductive.”
Another ESG theme that is gaining momentum is the rise of the plant-based food industry. This doesn’t relate to just a minority of people who have chosen to embrace a vegan lifestyle, but is also relevant to the broader food industry where companies might have to disclose the carbon intensity of their ingredients.
For example, ESG standard-setting organisation SASB is currently undertaking a project that assesses the meat and dairy industry.
“That [project] may end up translating into a set of matrices that corporates will need to disclose on,” Lenders says.
“That may include something like: what is the percentage of animal proteins in your products? Or what is the percentage of grain that you use across the entire product that has been cultivated on farms that practise regenerative agriculture?
“There is a realisation that agriculture has an incredible footprint, not just in terms of emissions, but also in terms of water. I believe 75 per cent of water consumption is linked to agriculture.
“Then you have the degradation of top soils; top soils are disappearing and about 70 per cent of land that is cultivated in an aggressive manner is in bad shape and might at some point not be able to grow anything anymore. This, in a way, is more scary than climate change.”
He says the world is still way behind in tackling these issues with agriculture compared to the gains made in tackling climate change. Yet, addressing agricultural practices could lead to big jumps in improvements.
“The gains at hand are incredible. If you eat in a sustainable way, versus eating in a non-sustainable way, that gap is much bigger versus what you see between heating yourself sustainably versus unsustainably,” Lenders says.
“The opportunity for doing things better is absolutely enormous. I think it will be quite the story in the next few years.”
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