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Sustainable Investing for Institutions

A Case StudyBy Chris Matteini

Sustainable investing is at once intuitive and confusing; itseems like the right thing to do, but there are many differentways to do it. It promises a contribution to solving global

issues, but perhaps at the expense of investment returns. It rep-resents new risks, opportunities, and ways of doing business in arapidly changing world of finite resources. At TIFF InvestmentManagement—a not-for-profit outsourced CIO firm managingapproximately $9 billion on behalf of roughly 600 not-for-profitmember institutions and this author’s employer—environmental,social, and governance (ESG) research is one component of themanager selection process.

Investors need not bear the weight of the world to implementan effective sustainable investment strategy and make a differ-ence through thoughtful capital allocation. Sustainability issuesare business issues that affect corporate value, and investmentanalysis must consider ESG information to be considered com-plete; for example, energy use is a cost, and different sourcesof energy present different risks. Poor supply chain management,including the use of child labor, can destroy a brand. Diverseand independent boards are often more effective than homoge-neous and intertwined ones.

The sentiment around business practices as they relate to envi-ronmental, social, and human capital is changing; business modelsare adapting to this, and ESG issues are increasingly becomingbusiness issues. But not all ESG factors affect all industries, anddecision-useful ESG data is still relatively hard to come by. Thereis no widely accepted domestic or global standard for corporatereporting of ESG information; therefore, not all companies report,and those that do use disparate approaches. Many investment man-agers incorporate some form of ESG into their research processes,but not necessarily in very thoughtful ways.

That said, the sustainable investment movement, in its differentforms, has tremendous momentum. By the end of 2016, globalnegative/exclusionary screening assets under management (AUM)had ballooned to approximately $15 trillion, ESG integration AUMhad risen to over $10 trillion, and corporate engagement/share-holder activism strategy AUM was over $8 trillion (GlobalSustainable Investment Alliance, 2016 Global SustainableInvestment Review, http://bit.ly/2MRLRCu). The United Nations’(UN) Principles for Responsible Investment (PRI) signatories, ofwhich there are over 2,000, manage $81 trillion in aggregate AUM(UN PRI). The EU Nonfinancial Reporting Directive representsa critical step in the history of capital markets. UN SustainableDevelopment Goals (SDG) and the UN Framework Conventionon Climate Change Paris Agreement are but two examples ofinternational cooperation aimed at solving ESG problems.

Still, while institutional investors may believe in these initiatives,the concerns of investment execution and performance remain.TIFF’s members, for example, have annual spending rates typicallybetween 3% and 5%; their portfolios need to achieve real ratesof return in line with those targets in order to support their missionswhile maintaining their purchasing power. Furthermore, investorsmay accept that ESG factors affect corporate value and are thusrelevant to achieving performance goals, but there is still no stan-dard framework for measurement or comparison across industriesand companies. The Sustainability Accounting Standards Board(SASB) offers an excellent ESG reporting framework, but no oneis required to use it. The EU Nonfinancial Reporting Directive ismandatory for approximately 6,000 large companies in Europebut provides a great deal of flexibility to corporations in terms ofwhat they disclose: “relevant information in the way they considermost useful” (Robert G. Eccles and Mirtha D. Kastrapeli, TheInvesting Enlightenment: How Principle and Pragmatism CanCreate Sustainable Value through ESG, State Street Corporation,2017, http://bit.ly/2tJYkQi).

The current lack of ESG reporting standardization presents bothinvestment risk and opportunity. The risk is in not fully under-standing investment vulnerabilities associated with ESG factors;the opportunity results from information asymmetry. For example,the total share of global greenhouse gas (GHG) emissions thatfall under a carbon pricing regime (e.g., carbon taxes, cap and

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trade) increased from less than 5% in 2005to roughly 13% in 2016. The number oflaws and executive acts related to climateincreased from just over 200 in 2005 to1,200 in 2016 across 124 countries(Generation Investment Management,2017 Sustainability Trends Report,http://bit.ly/2KnMoxK), and these numbersare likely to rise. An analysis of companieswith material exposure to carbon and cli-mate-sensitive regions would be incom-plete without an understanding of the costsof emissions and regulatory compliance,which is not standardized. Those invest-ment managers who do the work to coverthis information gap will have an edge.

TIFF’s ESG ProcessAs stated above, TIFF believes that sus-

tainability issues are business issues. ESGfactors can affect direct costs (e.g., energyuse and sources), revenue (e.g., increaseddemand for sustainably-manufactured prod-ucts, decreased demand for non–sustain-ably manufactured products), assets (e.g.,stranded coal plants), liabilities (e.g., law-suits related to environmental degradationor poor labor practices), and cost of capital(e.g., higher for companies with physicalassets in locations exposed to rising sealevels, increased storms, increased drought).ESG information, while spotty at themoment, is simply additional and relevantinformation that should be incorporated intocomprehensive business analyses.

TIFF has a process for testing managers’understanding of sustainability trends andESG factor impact. This process goesbeyond asking for and reading ESG poli-cies, which, if they exist, can be misleadingat times. It begins with a line of questioningdesigned to assess how managers thinkabout and process ESG information gen-erally. One of the first questions is, “Doyou have a formal ESG policy?” This maysound simple at first, but implied in thisquestion is another: “Why or why not?”This can lead to a robust conversationabout the manager’s philosophy aroundsustainability, ESG, climate change

impacts, and other matters. TIFF is notdogmatic about requiring formal ESG poli-cies. Far more interesting is the why orwhy not and the myriad questions thatresult. For example: Formal ESG policy ornot, do you consider ESG factors whenevaluating businesses? If no, why not? Ifyes, how and when in the process? Whois responsible/accountable? How do youdetermine which factors are material to cor-porate value? Can you provide an exampleof how ESG factors have impacted aninvestment decision? This delves into themanager’s process, creating an opportunityto add value to that process.

TIFF has several dozen questions relatedto general ESG philosophy and process.

Not every manager is asked every question;rather, they are asked what TIFF considersto be material, depending on the manager,and their answers are tested through a dis-cussion of specific investments. It is easyto write a formal ESG policy that statesone believes in the importance of analyzingvarious forms of capital; the proof is in theactual incorporation of ESG informationinto business analysis. Questions that testfor this include: What is the energy inten-sity (unit of energy per unit of output) ofCompany A, and what are its sources?What is Company A’s exposure to climaterisk, and how did you determine this? HasCompany A experienced labor issues?Does it have a diversity policy? What isthe composition of the board? Is manage-ment compensation tied at all to ESG met-rics? Again, these are examples from alonger list, asked depending on what ismaterial to the company in question.

There is no one right way to integrateESG. Some managers with glossy ESGpolicies may not always practice what theypreach; others without formal policies, whomay not even know what ESG stands for,incorporate ESG information naturally asone component of a thorough due diligenceprocess. Managers who avoid certainindustries because of obvious negativeenvironmental impacts (e.g., mining) mayfail to recognize the less obvious impactsof the industries in which they invest (e.g.,consumer products, via product life cycles).Managers who do invest in mining com-panies—the world will need metals to meetsustainability goals; think electric vehi-cles—may have robust processes around

partnering with the most sustainable ofthese companies or engaging with man-agement to improve sustainability perfor-mance, with the belief that this mayimprove a company’s bottom line.

Avoiding Simplistic ThinkingAll of this emphasizes the importance

of testing what is said and written. It alsohighlights why TIFF employs ESGresearch as one component of its managerselection process and not the dominantdriver. TIFF’s primary goal is to find man-agers with competitive advantages andstrong alignment of interests.

Negative/exclusionary screening is effec-tive in aligning investments with a set ofvalues. TIFF subadvises a negativelyscreened portfolio adhering to United StatesConference of Catholic Bishops (USCCB)guidelines. Because negative-screen invest-ing is fairly easy to implement, it often does

ESG information, while spotty at the moment, is simplyadditional and relevant information that should be

incorporated into comprehensive business analyses.

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not in itself offer an opportunity for signif-icant investment outperformance, unless onebelieves that the excluded companies willunderperform over the long-term. Certainunderlying managers in other TIFF productsdo in fact avoid certain types of businesses,not because of a mandate to do so, butbecause they view these businesses asunsustainable by virtue of the fact that they

sell products that harm their customers orthe environments in which they live; how-ever, while negative screening serves animportant purpose, it is not a primary sourceof investment competitive advantage.

Positive screening, or investing onlyin those companies that score highestaccording to some ESG ranking method-ology, also has a low barrier to entry.

The vast majority of managers TIFF hasmet with who use positive screens usedata or employ a methodology developedby a third party. This is herd thinking bydefinition, and certain ranking method-ologies can be subjective and flawed.Impact investing is compelling for manyreasons, but it is also highly idiosyncraticand a fuller discussion of it is outside thescope of this article. Shareholder engage-ment can be effective, but TIFF does notview this as a separate strategy, but ratheras an extension of strong active manage-ment with long-term horizons.

An additional component of TIFF’sESG process is monthly ESG committeemeetings attended by senior members ofthe investment team, representing allasset classes, and professionals fromother groups within TIFF. All managerinteractions related to ESG are docu-mented, and an ESG section is includedin all investment memos, which are sub-mitted to the investment committee andthe board. There is regular dialogue withSASB—TIFF CIO Jay Willoughby is onthe board of the SASB Foundation—andthe development of ESG frameworksand regulations are tracked. TIFF invest-ment staff attends conferences, not onlyon sustainable investing, but also onindustries that are experiencing and driv-ing sustainability-related change.

This last point speaks to what is per-haps the most important thing TIFF cando when it comes to sustainable invest-ing: partner with investment managerswho have competitive advantages basedon an understanding of industry changesdriving the sustainability movementglobally and the different businessessolving global issues. Managers will notfind these businesses using negative orpositive screens, but through excellencein investing, primary research, and adeeper knowledge of how ESG factorsaffect corporate value. ❑

Chris Matteini is an analyst at TIFFInvestment Management, Boston, Mass.

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