Alternatives
Interrogation: 10 Investment Themes for ESG
Hackable automobiles, blockchain, wage gaps and plant-based proteins are all part of the equation for ESG investing. Doug Morrow researches the industry leaders heading the waves.
Reported by Christine Giordano
The report predicts:
- The lithium ion battery market could be worth $250 billion by 2040
- Blockchain could help reduce clearing and settlement costs estimated at $65 billion to $80 billion each year
- The unsubsidized cost of utility-scale solar, at $46 to $61 per MWh, has fallen below nuclear, coal and most types of gas-fired generation.
- Autonomous vehicles may offer up to a 15% to 30% boost in fuel efficiency, and may decrease road accidents, but the regulatory bar may rise when it comes to hacking risks.
Key Insights from Doug Morrow’s Research
- Blockchain: An emerging leader in such applications, Barclays is relatively well positioned to mitigate data privacy risks.
- AV: BMW seems well prepared to respond to future regulations on autonomous vehicles and hacking.
- Cybersecurity: With the market for cybersecurity services forecasted to reach $1 trillion 2021, Symantec is a pure-play cybersecurity firm with ESG capabilities.
- Solar: PG&E is a US utility provider with a strong upside exposure to solar, already supporting 275,000 customers with private solar arrays.
- Energy Storage: Panasonic has a 40% share of the global lithium-ion EV battery market.
- Drug Pricing: With the increased scrutiny over drug pricing, GSK is exploring value based pricing models and may be at a market advantage.
- Diverse Leadership: Females represent 35% of the board, and 25% of the executive leadership of Accenture, which make it positively prepared for creating diverse leadership teams.
- Plant-Based Proteins: Danone’s acquisition of WhiteWave, puts it in a favorable position in the $1 trillion global health and wellness market.
- Tax Reporting: With new tax reporting standards eminent die to lost revenues of €50–70 billion in the EU, firms such as BBVA are well positioned to meet new standards.
- Pay Disclosure: With average worker pay ration of 52:1, Noble Energy is ahead pay disclosure rules that may take effect in the US this year.
What follows is an interview between CIO and Doug Morrow:
Art by Jasu Hu
CIO: How did you choose these top 10 topics for the themes?
Morrow: We took a variety of different factors into account. Our intention was to identify 10 upside opportunities for investors looking ahead, not just in 2017, but beyond. Obviously, we looked at what was going on right now in the ESG world. We looked at market forecasts in some cases. We’re trying to center on themes that would resonate with the market. We also hedged a little bit to get some diversity across ESG. We put a couple of pieces in that look at more of the governance side, such as the Dodd-Frank provisions in the US. And we tried to have some diversity across geography.
CIO: What was your methodology used for assessing companies as leaders within your report?
Morrow: We thought about themes and then identified a shortlist of companies with upside exposure to the themes. We took a variety of different factors into account, not just the indicator score or the ESG score. We also looked at more conventional factors, like exposure to the market. For example, in the case of blockchain, we ended up profiling Barclays, because they actually have a lot more going on with blockchain compared to many of their peers, and this exposure wasn’t captured in the indicator. So, we tried to balance the results of our indicators with some real-world market analysis.
CIO: And to get to the shortlist?
Morrow: It was primarily driven by how the companies perform in our ESG model and, in some cases, on a specific indicator. So, again, to use the blockchain as an example, our analysts who cover the banking center built a composite indicator, mixing some of our metrics that we have in house, and came up with a composite.
CIO: How do plant-based proteins and data security fit into the future of ESG?
Morrow: They’re definitely both important trends. The metrics and indicators that we’re using on a day-to-day basis are increasingly overlapping with what a conventional equity analyst might be looking at, which is another interesting trend.
Data privacy and security go together and fall under ‘social’ in regard to ESG. We chronicled the recent history of data breaches and thought about ways that investors could actually benefit from this trend through companies that offer cybersecurity management services. And we ended up profiling Symantec because it performed well in our model. It was the second-highest-performing company, but it’s actually a pure play, so it’s a crisper investment thesis.
I cannot say that all of these companies are talking about hacking risk in their notes to shareholders, but I can tell you that all the companies we profiled in that shortlist and, certainly BMW, which is who we profiled, are betting on that part of the race, to develop the first fully autonomous vehicle.
CIO: There are so many factors at play when it comes to data privacy and security. How did you find a way to rate it?
Morrow: For data privacy and security, we’re looking at the policies companies have in place. The subcomponents include: whether they have a commitment to implement leading data security safeguards; if they have a commitment to notify data subjects in a timely manner following a breach; limited collection of essential personal identifiable information (PII); and commitment to seek consent for the collection, use, and sharing of non-essential PII.
CIO: How is the market for plant-based proteins changing?
Morrow: Some think it’s one of the most important strategic battlegrounds for big food in the next 10 years. So, definitely, it’s a broad-based trend, you know, consumers, but especially millennials, are increasingly motivated by ingredients, supply chain considerations and the social and environmental impacts of production. So, I think those factors are changing. There’s more and more evidence about the amount of water it takes to support animal proteins, so there’s that driver as well – although, some plant-based proteins themselves involve quite a bit of water as well. And we looked at Danone because it made a strategic acquisition with WhiteWave to get exposure to this market, as well as the organic and dairy-free markets.
CIO: You also included the hacking risk of automobiles…
Morrow: Which will ultimately become a much more important focus for regulators as autonomous vehicles (AVs) take off. Indeed, an important barrier to the mass adoption of AVs is hacking risk. The risk is out there and it will have to be carefully managed by auto manufacturers and their suppliers
CIO: But how did you measure a car’s hackability?
Morrow: Obviously it’s difficult to anticipate. But we have an indicator that measures quality management systems from manufacturing companies, and the extent to which they’re certified to third-party standards. And we use this as a proxy. We basically argue that companies that score well and are ahead of the curve right now will be better prepared to adapt as regulators move on this, which we do expect to happen.
It’s not just what’s being disclosed, it’s where it’s being disclosed.
How we got to the shortlist is we looked at companies that had announcements in their financial reports and other types of reports about how they’re betting on AVs. So, that’s how we got to the shortlist. And then, we cross-referenced those companies with the QMS [Quality Management Systems] score. So, I cannot say that all of these companies are talking about hacking risk in their notes to shareholders, but I can tell you that all the companies we profiled in that shortlist and, certainly BMW, which is who we profiled, are betting on that part of the race, to develop the first fully autonomous vehicle.
CIO: What gave BMW the edge? What was particularly impressive about it?
Morrow: Well, we like BMW because they score favorably on our QMS indicator, 100/100. This bodes well, we think, for their ability to respond to tightening [regulations]. And they were also the top overall performer on our broader ESG model. And, by virtue of being in this shortlist, they have upside exposure to AVs. They’re planning to launch iNEXT, which is their entrant autonomous vehicle, [partnering with Intel and Mobileye] by 2021. But we will see.
CIO: Which part of your report paid attention to Dodd-Frank?
Morrow: Pay gap. US companies may soon have to start disclosing their CEO-to-median-worker pay ratio through a provision in the Dodd-Frank Act. While the ruling may get repealed, we believe the long-term trend in the US and elsewhere points to improved pay transparency and disclosure, especially because, irrespective of regulation, investors are increasingly requesting this type of information. We profiled US companies that, for several years now, have actually been disclosing this ratio well [in] advance of the Dodd-Frank provision. And we profiled one of those companies: Noble Energy. They’re an oil and gas producer. They have a [salary ratio between CEO and median employee] of 52:1, which, relative to US firms, is a relatively small ratio. It’s not uncommon to see ratios of 250:1, for instance, in the US.
CIO: Other companies had lower ratios of 7:1 and 14:1, why choose Noble overall?
Morrow: We ended up with Noble because, in addition, it also had the highest ESG score of the four, which we liked. It was 66/100. It’s more about the idea that regulations in the US for disclosure of this type of information might be tightening. And these are the types of companies that investors can explore that are relatively well-positioned to comply.
CIO: How were you able to rate European tax evasion?
Morrow: It just has to do with the crackdown that’s taking place in the EU over beneficial tax treatment. So, this all came to a head in many investors’ minds back in August, when you may have seen that the EU Commission found that Ireland had granted illegal tax benefits to Apple, and ordered Apple to pay back $13 billion Euros in taxes. This was not the first time. There’s a lot of history of the EU Commission doing this type of thing. The EU bar is basically rising and companies are going to find it difficult to increasingly benefit from these types of arrangements. So, we looked at companies that had developed beyond compliance tax disclosure policies. I realize it’s a little esoteric, but there are indicators that actually measure this. So, we look at just how broad and how sophisticated a company’s tax reporting is. All the companies on the shortlist are going beyond compliance tax reporting in Europe, and providing a country-by-country breakdown of taxes paid, things like that.
CIO: Is that a relatively new rating?
Morrow: I think momentum is accelerating because of things like the Panama Papers. Obviously, that has raised everyone’s awareness about the whole scandal around hidden tax arrangements.
CIO: The report also talks about the prices of solar and wind power. Where does that fit into this whole ESG equation?
Morrow: It’s definitely a global theme: the price competitiveness of solar. It’s just absolutely remarkable how quickly solar and wind have become essentially price competitive with fossil generation. So, now, in the United States, for instance, solar utility scale projects are price competitive with fossil fuel generation. We see that as being the primary driver in this market. So, utilities and households are finding ways to boost their exposure to renewables, because it’s an increasingly cost-competitive method of generating electricity.
PG&E we like for a bunch of reasons. We have an indicator that looks at carbon-efficient energy mix. They have about 152 megawatts of their own solar capacity. And they also support over 200,000 of their own customers with private solar arrays. They’re definitely among the most advanced US utilities on overall renewable strategy.
CIO: And why lithium ion batteries?
Morrow: The market’s surging due to electric vehicles. So, that’s creating more demand. The whole market is just set to explode over the next 10 years.
CIO: Are you also measuring the environmental impact of the lithium ion batteries?
Morrow: We made that point in our paper because we think it’s something that probably a lot of investors don’t think about. Making and manufacturing lithium ion batteries can use a lot of energy and toxic chemicals and things like that, so, we would say investors need to be cognizant of these risks, and their potential to cause supply chain disruption, but not withstanding these concerns, we definitely see this as a major growth opportunity.
CIO: Why is Panasonic at the top of the list?
Morrow: Panasonic has about a 40% share of the global market and the biggest exposure to lithium ion manufacturing. It performs well on the indicator that looks at sustainable products and services, including lithium ion batteries.
CIO: What would be your advice to a CIO as far as measuring the risk involved with the production and the environmental risk?
Morrow: I should stress that, when we’re doing our research, we’re not typically looking at many of the factors that one expects a CIO would be looking at in terms of balance sheet strength, cash flow generation and price analysis. But you could definitely blend the two and do a fundamentals analysis to come up with a shortlist of companies with exposure to this theme. And then you could take a deeper dive and overlay their strategies for dealing with the types of risk that we’re talking about. So, for toxic chemicals, there are wide differentials in how companies are positioned on these types of issues. Like big gaps in environmental management systems, how rigorously environmental policies are enforced, the extent to which they monitor their suppliers on their environmental performance.
CIO: Tips to help due diligence?
Morrow: We’re seeing a trend where a lot of this information is actually migrating to the MD&A discussion in the annual report, and 10Ks in some cases as well. So, as I like to say, it’s not just what’s being disclosed, it’s where it’s being disclosed as well that’s important.
There’s also the Carbon Disclosure Project, a firm based in London, which provides a whole inventory of corporate energy and greenhouse gas emissions data.
CIO: What are some good questions to ask companies?
Morrow: What are you doing to prepare for a two-degree world? What’s your climate change strategy? And then, you know, setting up a dialogue to explore ways for companies to develop more responsible environmental or social practices, and most importantly, how these strategies can be in shareholders’ financial interest. There’s a whole body of literature on the benefits that actually come out of those types of engagements.
CIO: What would be your advice to a CIO who’s investing over, let’s say, a five-year horizon, on how to consider water scarcity in due diligence?
Morrow: I think it depends on a bunch of factors, but for sure, I think it’s something that is not inconsistent with fiduciary duty. There’s just so much evidence coming out now that water shortages can have an impact on production. I would say the first thing to do is to look at the industry in which the company operates. Some industries are just fundamentally more exposed than others, because they use a ton of water: Banks, not so much, but mining companies? Absolutely. There was a report recently released that said water is the number one issue right now for mining companies.
CIO: And are there certain countries that are especially of concern when it comes to water scarcity?
Morrow: There are a few basins in China that are particularly problematic. Even parts of the US still – it’s often a question of how equally it is distributed across the country. And whether the government changes the regulations.
CIO: Do you think water will be part of disclosure in the future?
Morrow: Yes, I do. I think what happened to carbon will happen to water. The big problem with water is it’s not priced according to its value, because it’s complex, but I think if water costed more, there’d be more incentive to use it efficiently.
CIO: Any big risks that are little known that CIOs should be aware of when it comes to ESG investing?
Morrow: There are lots of risks out there that I think, when you look at the world through an ESG lens, can help bring some risks onto the radar that might otherwise not be on it. Human capital and water should definitely be on a CIOs radar. There’s a growing body of evidence to show that companies that do well on holistic ESG measures: good environmental programs, good social, good governance policies, make better long-term financial bets. In some cases, researchers found that companies that score well on ESG metrics tend to attract and retain better employees, tend to suffer less regulatory penalties, tend to be better at managing customer relationships, tend to be generally more efficient. You can sometimes think about ESG for a proxy for efficiency, if you can see where I’m coming from.
Like a company that manages energy efficiently, even though it might not be a huge cost relative to other costs, is probably doing other things efficiently too, so some people think about ESG as a proxy for overall efficiency.
CIO: And could you apply that to countries with good ESG standards?
Morrow: It’s a little bit different with countries because it has more to do with resources and different gaps in strategy, but yes, you could make the parallel in the sense that there are definitely large differentials in terms of environmental policy and things across countries. CIO