1. The state of play in ESG: where we are and how we got hereWhile ESG was a somewhat niche term a decade ago, it would be rare to find a manager or allocator of capital today who has not heard of the term. However, while the integration of material ESG issues at its core is about widening the aperture you look through when assessing an investment for both expanded due diligence and value creation, there is no clear consensus on how, where, or when to integrate environmental, social and governance issues into an investment process, if at all.
South of the border, ESG has even become part of the political agenda, and the attempts to lump together the ESG mandate with a “woke” agenda is an example of how far from the intention of value-creation and risk-mitigation the ESG narrative has strayed.
Adding to the confusion is a fundamental misunderstanding between Impact and ESG. Impact investing can be simply defined as an investment strategy with an intentional and measurable E, S, or G target. Whereas ESG integration is not an investment strategy in itself, but is part of an investment strategy.
Another issue is the mislabeling and misuse of ESG to promote and sell products, an offense that has caught the attention of regulators as well as the ESG naysayers. This had led to provocative headlines and dramatic predictions of the death of ESG. Recent claims of “greenwashing” from ESG labeled funds are symptoms of an approach to ESG not being driven by investment strategy but rather the hands of marketing, IR, and PR.
Finally, the difficulty in attributing alpha or outperformance versus a benchmark to ESG integration practices has created an “ESG integration paradox” and poses a particular set of challenges to asset managers and asset owners. If the relationship between a manager’s ESG-integration maturity and their risk‐adjusted excess performance, or alpha, were linearly correlated, then the decision to integrate ESG would be easy. While downside risk benefits are easier to understand, valuing the financial performance of material ESG issues remains a challenge as these can often be qualitative and sometimes even subjective in nature.
However, this is not going to go away soon. Acronyms may change and political agendas will continue to create debate among market participants, but sound investment management will always prevail. No matter the rhetoric, politics, labels or acronyms, identifying, assessing and managing the material issues of an investment (including relevant E, S and G issues) is simply a means to better risk mitigation, longer term resilient returns and more positive outcomes of an investment strategy.
2. Two overarching challenges for cross asset global investment managers and asset owners: identifying ESG integration maturity and compensation / fee structures
There are many challenges for asset manager and asset owners today when it comes to sustainable investing. However, two overarching ones stand out.
A major challenge is truly understanding how an investment team (whether an internal team or an external manager) is integrating ESG. There is no one way to integrate ESG, and there is no one set of market best practices. It is dependent on multiple factors. At CGC we evaluate investment teams on a maturity scale of 1-5 (between no integration and innovative) for each of 60+ sub-categories of ESG integration practices across the end-to-end investment lifecycle, that varies depending on the asset class, the investment strategy, and the maturity of the manager to name a few. This is done through conversations with investment teams not standardized questionnaires. It doesn’t really matter if a manager has an ESG policy, what matters is how the investment team is implementing the ESG intention of the fund. You need to know what questions to ask and what answers to listen for.
Another challenge is the fact that traditional compensation and fee structures are not aligned to ESG integration practices, and long-term value creation. While much has been written on the short-term focus of compensation structures for investment teams, this also remains a key challenge for ESG integration.
As mentioned earlier, if the relationship between an investment manager’s ESG-integration maturity level and their risk‐adjusted excess performance, or alpha, were linearly correlated, then the compensation issue would be more easily resolved. However, valuing the financial performance of material ESG issues remains a challenge. It is difficult to value these issues and hence calculate risk thresholds, constraints, and limits and apply these to an investment fund. The exception to the rule is carbon, which we can put a price on today. The market though has still not fully priced in the effects of climate change and risk methodologies and fair market valuation have not caught up.
During the 2008 financial crisis, as assets, securities, and loans were significantly de-valued, causing a rash of insolvencies and defaults, opponents of fair market valuation argued that the market was pricing in a risk that had already happened and was unlikely to re-occur. Today we find ourselves in the opposite situation with a risk – climate change – that is known and will occur but that is still not yet being fully priced into the market. If there was a sudden repricing of climate change risk, we could potentially see the same impact we witnessed during the financial crisis.
Going forward, as ESG due diligence of managers (internal and external) becomes more detailed and sophisticated, we expect to see the level of maturity of a manager’s ESG-integration practices being reflected in compensation and fee structures; and as ESG issues are increasingly priced into the market, we expect to see the level of maturity of a manager’s ESG-integration practices being reflected in their longer-term performance results.
3. Additional challenges for the Canadian pensions
Canadian pensions have been global leaders in the investment world for many decades, with the “Canadian Model” being a role model for many pension fund schemes. However, they also have additional specific challenges when it comes to integrating ESG and shifting their portfolios to longer term sustainable investments.
First of all, Canadian pensions like a lot of asset owners, have the challenge of an “investment only” legal mandate (with the exception of CDPQ). While the case can be made for increasing sustainability factors, there is no industry accepted methodology for including the financial impacts of these issues in most valuation models. There has been some recent research, such as that by Jon Lukomnik and Steve Lydenberg which reveals that Pension Funds need to “level shift” their purpose and mandate beyond just an “investment only” legal mandate. If this happens, it will not happen overnight, and will require a transformation of the design, role, and purpose for the funds.
Another challenge is the lack of industry best practices for ESG risk and valuation methodologies. One of the underlying strengths of the Canadian pension model is their focus on sophisticated risk management methodologies, reporting and analytics as a primary tool for investment oversight. However, few are including ESG factors in their risk activities, often due to inherent data challenges (i.e., lack of availability, unclear quality, etc.) as well as the qualitative, sometimes even subjective nature of these issues. Lack of industry best practices in how to value and manage ESG issues in a total fund approach makes it challenging to fit this type of investing into the Pensions’ current risk models and risk appetite processes.
A third challenge is the structural organization when it comes to sustainable investing. While the pensions all have large responsible investing teams, these were historically focused on active ownership such as proxy voting and engagement as part of the fund’s fiduciary duties as opposed to investment analysis and research. This is changing, and RI teams are increasingly being integrated into investment teams. However, this can still be challenging given the historical focus on centralized, non-investment resources in these teams.
4. The opportunity: How the Canadian pensions can become the global north star for sustainable investing
Canadian pensions are amongst the largest and most sophisticated investors globally. The past has shown that they can be agile, innovative and leaders in identifying industry and global investment trends. Despite the challenges mentioned above, and by using their impressive collective intellectual and investment capital, there are ways that Canadian pensions can become the global role models, this time for sustainable investing.
First of all, they can lead by cutting through all the “ESG noise” to focus on what true resilient long-term investments look like. This means forgetting about labels, acronyms, and politics, to ensure that each investment strategy is authentically integrating ESG and sustainability (depending on the level of intention and relevancy of the strategy). This means doing a very comprehensive due diligence of each strategy which includes: determining how the strategy capitalizes on the prevailing sustainability global mega trends (such as resource scarcity, global decarbonization, etc.); identifying all the underlying material risks (including E, S or G issues); assessing whether the investments will remain financially and operationally resilient through different economic cycles as well as through disruptions from major sustainability events such as climate-related disasters; understanding what sustainability tradeoffs have been made, and what positive and negative externalities have been created.
Secondly, a new risk model is required. The risk of a non-sustainable global economy needs to be accurately reflected in portfolio risk limits, thresholds, and exposures. Board risk appetite statements and investment policy statements also need to reflect this reality. To help advance the risk model, new performance metrics, targets and risk budgets need to be developed and monitored at the most granular holdings level. Canadian pensions are already very risk aware entities with robust and sophisticated research and analytical capabilities and are therefore well placed to help create this new risk model.
Third, while Canadian pension funds have always been exemplary active owners and stewards of capital, as the global economy needs to transition to a more sustainable world, the pension funds can play a key role to ensure that the companies, industries, and sectors that are taking steps to ensuring a resilient, sustainable economy have the long-term capital support to do so. Engagement with investee companies must therefore transition to a more “strategic engagement” model which will in some cases, require engagement for complete industry and sector transformations, effectively refocusing engagement activities on the Beta returns of the industry or sector as opposed to the Alpha returns of any one investment.
By truly integrating ESG and sustainability across all their investment strategies, by working to create a new risk model, and by transitioning engagement activities to an industry level, the Canadian pensions can be the global role models in sustainable investing, ensure their capital is being used to help the transition to a sustainable global economy, potentially even stave off another financial crisis, all while ensuring that they are creating long term value for their beneficiaries.
Let me begin by thanking Tamara for writing this comment and providing great insights here.
Tamara has extensive experience in investment management and sustainable investing and it shows:
Tamara has over 25 years of combined experience in capital markets and ESG strategy. She is based in Montreal and works with investment management firms and asset owners to advance their ESG integration practices across both risk and value frameworks. She was previously the Head of ESG Integration for KKS Advisors, a global ESG Advisory firm. Tamara has held various front office investment management positions for the Bank of Montreal and Credit Lyonnais in the global derivatives and foreign exchange markets and was previously the head of research and risk for a start-up fixed income asset management firm in Montreal. Before founding Close Group Consulting, she spent 10 years in senior leadership roles within the risk and public markets investment groups of PSP Investments. She is also the founder and creator of the Sustainable Risk Assessment Framework
Tamara holds the Chartered Financial Analyst (CFA) certification and is a member of the ESG Examination Subcommittee for CFA Institute, a council member of the Canadian Advocacy Council for CFA Societies Canada. She is a Board director for Evovest, an investment management firm using artificial intelligence and evolutive learning techniques to manage investment portfolios. She is also a Board director for CFA Montreal and was previously the Chair of the ESG Committee. Tamara is also a member of the Investment Committee for the JGH Foundation. Tamara is a Strategic Advisor to the Veristell Institute, a globally focused think-tank on ESG and Corporate Purpose, and an Advisor and Contributor to Practical ESG, a source for ESG thought leadership. Tamara is a regular contributor to industry journals and author of thought leadership on ESG, risk management and sustainable investing and is a sought after speaker. She earned a Bachelor in Economics from McGill University and a Master of Science degree in Finance from the John Molson School of Business. She is based in Montreal and is fluent in English and French.
I met up with her for a coffee a few weeks ago and was really impressed with her experience and knowledge.
As an aside, I do not meet people just like that for the hell of it.
I met up with Francois Trahan earlier today and we enjoyed a nice lunch but he's more of a friend and we go back years (haven't seen him in a long time, that no sugar diet is amazing, he looks a lot younger!).
Anyway, I'm still battling sciatic and waiting to get my cortisone shots but in the meantime, told Francois I want to lose 20 lbs fast and cut alcohol, sugar, and junk food al out (literally chucked any snacks in the garbage).
I also talked to Francois about the amount of BS out there by a bunch of third-rate technicians who think they can use simple daily charts to predict every market move.
Let me clarify for you where the market and economy are headed over the next couple of years: down, down and DOWN!
Capiche? Been at this game for a very long time and when my sixth sense kicks in, I know when we are at a major inflection point, and it's here.
That's why after being up 80% in the first six weeks of the year trading two biotech companies (TGTX, MRTX) I sold it all right before Biden's State of the Union and loaded up on US Dollar ETF (UUP).
Now, I am sleeping like a baby, know I can trade and make more but don't need or care to, so I can relax and focus on other more important things.
But the amount of nonsense out there is incredible which is why I enjoyed meeting Tamara and talking sustainable investing with her.
Remember when I told you most consultants are useless? I stick by that but some of them are real gems and they can add meaningful insights to your operations.
That's how I feel about Tamara and her experienced and knowledgeable team, no ESG "fluff" which is meaningless, she really provides great insights because she worked at PSP and other places and has the experience and credentials to add meaningful value.
I'm not an ESG expert, far from it, but I know ESG BS when I see it, and let me tell you, as the bubble in everything blew up especially since the pandemic hit and the tag line was ESG this, ESG that, DEI this and DEI that, I saw my fair share of BS and sometimes it even came from Canadian pensions I cover.
I loathe hypocrites and hypocrisy so when I see an investment manager blowing smoke up my behind, I don't care who they are, I will call them out.
Yes, Canada's large pensions are leaders in sustainable investing, CDPQ is ahead of the pack and it has absolutlely nothing to do with their decision to exit out of oil & gas last year.
In fact, I think this wasn't a wise decision and it might end up costing their members over the long run, but despite that fourth pillar of their sustainable investing strategy, CDPQ has really taken the lead in this area and others are closing in fast.
Still, I was talking to my favorite retired actuary in Toronto last week, and he remarked: "If Canada's large pensions practiced half of what they demand from public and private companies internally, they would have big problems."
He may be a bit too critical as they do lead by example in some areas like gender equality, but on others like compensation and even governance, he may be right.
And I told him straight out: "What's good for the goose is good for the gander, so Canada's large pensions must lead by example on all fronts!"
Even ESG, what is the exact carbon footprint of a Canadian pension fund? Do they publish details on how many trips each department took at what cost and whether they were truly necessary?
On governance, I went over IMCO's governance problem last week (a lot more to come on this) but there are lapses everywhere, not just IMCO (admittedly, it's really bad there).
Let me be blunt: when I see Canadian pension fund managers leaving their position to get a job at a fund they invested in, it infuriates me.
It's total abuse of power and should be illegal, period.
"Well, Leo, it's a free market, and Canadian pensions hire top talent and they can go work wherever they want."
Oh please sell that nonsense elsewhere, it's wrong, wrong, wrong and you all know it!
Anyways, more on that in a follow-up comment.
Back to Tamara's comment.
I come at ESG and impact investing in a very practical and philosophical sense.
The world is going to net zero by 2050 but transitioning to net zero is no easy feat, it's going to get a lot harder as that date approaches.
The first part is easy and there's been a lot of cheer-leading, the harder part comes in implementation because it requires adoption of standardized data and a willingness among asset owners to really think carefully about integrating ESG or whatever you want to label it in a careful and measured way.
For me, the primacy of maximizing returns without taking undue risks is there but as the retired actuary rightly noted: "What the hell does that even mean?".
There seems to be this group think permeating Canada's large pensions when it comes to responsible investing. They're all pretty much on the same page but it's a difficult landscape to navigate and they cannot lose sight of their mission and focu son risk-adjusted returns.
But as Tamara right notes:
Third, while Canadian pension funds have always been exemplary active owners and stewards of capital, as the global economy needs to transition to a more sustainable world, the pension funds can play a key role to ensure that the companies, industries, and sectors that are taking steps to ensuring a resilient, sustainable economy have the long-term capital support to do so. Engagement with investee companies must therefore transition to a more “strategic engagement” model which will in some cases, require engagement for complete industry and sector transformations, effectively refocusing engagement activities on the Beta returns of the industry or sector as opposed to the Alpha returns of any one investment.
There are so many challenges to responsible investing and I truly wonder if each of the large pensions has thought things through carefully.
Moreover, it is concerning that Responsible Investing teams at Canada's large pensions have little to no investing experience.
"Well, that doesn't matter Leo."
Well, it kind of does, especially since we are headed to a very deep and prolonged recession and bear market and my instinct tells me nobody is going to care about ESG when their job is on the line.
ESG, Impact Investing, all that stuff was nice is a rising market, in a bear market, there is going to be a lot more soul searching going on.
This is actually a good thing, I welcome it because I can't stand ESG fluff and BS, it pisses me off.
Just like I can't stand DEI window dressing where everyone takes diversity & inclusion seriously but only in words, not really in actions.
That really pisses me off.
So I'm going to start calling out BS when I see it .
As for Tamara Close, I really thank her for shining a light on important issues and think every Canadian and international pension should reach out to her, she really knows her stuff (follow her on LinkedIn here).
I would also recommend you read more insights from The Close Group here and really get into the important issues.
Lastly, I didn't ask a penny from Tamara to write this comment and post it because she is providing al of you with a service, trust me on that.
Below, Katharine Preston: VP, Sustainable Investing (OMERS) and Vishal Bane: Associate Portfolio Manager (AGF Investments) discuss how Canadian pension funds can build sustainable portfolios. Great discussion, take the time to watch this.
Also, the EU platform on Sustainable Finance launches and new criteria for all six taxonomy objectives.