The ESG Update Episode 15: Not So Risky Business
The relationship between ESG and risk may be more intertwined than you think. From litigations to stranded assets to loss of social license – we dissect the complex world of ESG and risk mitigation. Join us in this week’s episode as we welcome back Andrew Rodriguez, CEO and Chief Investment Officer at Change Finance, and introduce the newest addition to our pod!
Transcript
This transcript has been edited for clarity.
Dan Carreno, Change Finance:
Welcome to The ESG Update presented by Change Finance. We are an ETF provider dedicated to environmental, social, and governance investing. Our mission is to help investors align their portfolios with their values without sacrificing returns. I am your host, Dan Carreno. Today, I'm very excited to announce that The ESG Update officially has a co-host. This is former guest and now the newest team member at Change Finance, Brittany Damico. (Applause) Brittany, how are you? Would you mind sharing a little bit about yourself, how you've arrived at Change Finance, and now co-hosting this rather nerdy podcast.
Brittany Damico, Change Finance:
Absolutely. Thank you so much, Dan. I am thrilled to be part of the team. To give the listeners just a little bit of an update and background on myself, I have been working in the financial services industry for a little over 11 years now. In my academic past, I have undergraduate degrees in both environmental science and chemistry. I have a post-graduate degree in ecological economics from the University of Edinburgh. My specialties are in the realm of ESG communication and education, environmental evaluations, and circular economies. Throughout my professional past, working with financial advisors, going back to school, finding that passion for sustainability and impact investing, all of that coming together has led me to this space in Change Finance becoming Senior Business Development Manager. All of that to say, here I am. I'm so excited to be part of the podcast and part of the team.
Dan Carreno, Change Finance:
Awesome. Well, I am also very, very excited to have you here. I think the timing is good. I suspect that the listeners are now figuring out that I have really no idea what I'm talking about most of the time. I will be more than happy to hide in the shadow of your intellect in the coming episodes. This is great. Okay. In this episode, we are going to be focusing on the relationship between ESG and risk. This topic has come up repeatedly on this podcast, maybe in every single episode. I thought it was worth taking some time to dig into it in a little bit more detail and to really determine, ‘Is there data to back up this assumption that that ESG really does help mitigate investment risk? Or, is it basically a bunch of hype and a sales pitch?’ To dissect the topic today, we're going to be bringing back our returning champion, the CEO and Chief Investment Officer at Change Finance, Andrew Rodriguez. Andrew, how are you?
Andrew Rodriguez, Change Finance:
Well, it's good to be here. I'm super excited that Brittany's joining you on the pod. I can't wait for all the intellectual conversations to begin, starting now. (Laughter)
Brittany Damico, Change Finance:
Great to have you Andrew. So excited to have you on the pod again. I want to get your feedback on an article I was reading earlier, and it was something that Morningstar had published last year. An article titled, ‘ESG Risk Comes Into Focus: Companies Focus on Their ESG Risks to Build Profitability for the Long Term.’ Essentially, the article is looking at ESG investing through a lens of risk mitigation. It introduces the concept of an economic moat or, in other words, a company's sustainable advantage. It states that, ‘a company that ignores these risks or commits a misstep could incur significant economic costs that jeopardize its ability to earn long-term sustainable profits.' If you're looking at risks through an ESG lens, the type of questions that the article says you want to focus on and to look at are things like, ‘Which environmental, social, and governance issues are financially material for each company and or industry?’ How are the companies tackling these material risks?’, and ‘How will these risks affect a company's long-term value?’ One of my favorite references in the article is the famous quip from Warren buffet that says, ‘only when the tide goes out, do you discover who's been swimming naked?’ I think that's really appropriate for looking at risk in the ESG space. The article then goes into breaking down the types of risks under the E the S and the G. Under environmental risks, it looks at things like carbon pricing, climate change protests, and environmental disasters. Under social, it looks at things like losing the public's trust. As we look at governance risks, most of that comes down to just a poor allocation of capital. So, I'd love to get your opinion on just their ideas of risk mitigation, and then maybe we can go into a little more specifics in terms of how that has affected companies in the past.
Andrew Rodriguez, Change Finance:
Sure. I think this is a great start. I don't think anybody should consider this list of risks that they call out to be sufficient. I think there's more being clear every day. Back in the early days of this work, when we were doing SRI investing, it was very limited what we consider to be material. Folks were looking at things like tobacco, alcohol, gambling, and things of that nature and then trying to draw the link. Today, I'd say there are so many more risks in terms of how you behave, just generally speaking. A lot of that comes down to this category. You mentioned the social risks. We call this the risk of losing your social license. We see that all over the place. McDonald's is an example. After Supersize Me came out, millennials don't eat at McDonald's at the same rates that generations before them did. They're still looking to figure their way through moments like this. So, in fact, any poor behavior when you're not taking care of your stakeholders can come up in this way, especially with how fast we have access to really deep and detailed information, all across the globe in how companies are touching the world.
Brittany Damico, Change Finance:
Absolutely. When we were looking at the article, one of the main highlights that they referenced in terms of losing public trust was the Equifax data breach in 2017.
Andrew Rodriguez, Change Finance:
Yeah, I completely agree. These sorts of things are happening all the time. They're happening this year. A big example of a company really dancing on the line of social license risk and/or the loss of their social license is Amazon. It's been true of Amazon for years, but even in the middle of a pandemic where their service was more essential for human beings than ever before, the conversation about breaking them up is still loud, if not louder. I think a lot of that plays into their employment practices and their practices around packaging. Basically, one of the main things that I saw last year that I think is going to be a big part of this push is when there was a labor dispute in France during the pandemic. They said, oh, shoot, we might not be able to continue shipping if we can't solve this labor dispute in a way that's good for Amazon, basically holding a country at risk, over their ability to distribute to all of their people, everything from toilet paper to Lego blocks for their kids. It seems like there's big social license risk even for a company as big as Amazon.
Dan Carreno, Change Finance:
I love the quote from Warren Buffet. I would say 2020 seemed like a year when the tide went out and there was a whole bunch of naked folks standing on the beach. Between the conversation on social justice, which placed a lot of focus on racial and gender pay equity in 2020, and the conversations around climate change, following the massive fires and an unusually active hurricane season, it certainly put the focus on that level of ESG risk. We had the energy sector by far being the worst-performing sector in the market last year. So, it seemed like the year that the tide went out. To keep it moving along, Andrew, I feel like you've been mentioning this loss of social license, and obviously, that's one aspect of the way that you think about risk and ESG data. Could you elaborate on some other risks, and what is your thought process when it comes to insulating investors from these types of risks?
Andrew Rodriguez, Change Finance:
All sorts of risks alongside social license. I'd say probably one of the main ones I would like investors to be paying attention to, because it went from theoretical to real last year, is the stranded asset risk in the fossil fuel industry. For folks where that's a new concept, we're talking about the assets on the books of fossil fuel companies, the assets that are in the ground, not the assets that they pulled out and sold already. We know that over 80% of what's on the books of just the publicly traded fossil fuel companies can't get pulled out of the ground and we keep ourselves below two degrees of Celsius rise. We're actually all having conversations about how our models are probably wrong. We're probably a lot closer to one and a half degrees than we thought. A 20% number might actually be closer to 10% or 15%. Whatever the number is, we were hosting a conversation with Mark Campanale of Carbon Tracker. Their new data suggests that any price above $35 a barrel in operating costs is actually stranded today. So that is every sideways driller in the Dakotas, all tar sands, and any of the more complex drilling, can't be pulled out cheaper than that. It leaves the Aramco's of the world fine for now, but that means that 80% or 90% is not worth any dollar figure. It's worth $0, but it's on their books as worth something. All of these companies are valued in part off of assets that they'll never be able to pull out of the ground.
Dan Carreno, Change Finance:
If I could compliment that in terms of some research that was conducted by Bank of America, where they found that between 2005 and 2015, 90% of the bankruptcies that occurred within the S&P 500 could have been avoided if investors had basically looked at the ESG ratings of those companies leading up to those bankruptcies. That really speaks to the fossil fuel industry in particular because that is where the majority of the bankruptcies have come from.
Andrew Rodriguez, Change Finance:
Not a surprise to notice that companies who are doing better on ESG are managing to on so many other variables. They're paying attention, looking into the future for their companies out 10, 20 years on a number of different measures and then improving upon them ahead of time. Every other company who's not looking today at their ESG metrics is probably behind. They're probably already at risk and they have a lot of catching up to do so. In fact, I think ESG companies represent better overall run companies, generally speaking. Another risk I think investors should pay extra attention to is litigation risk. Maybe not for the obvious reason. It's not just the fine itself. Today, the fine isn't even as much as the revenues drawn by that bad behavior. Volkswagen is the big example here. They had huge fines, but not in relation to the revenues that they drew from it. So, in fact, bad behavior is just a tax in our fining system that we've created globally. At the same time, there were other places where that's true. In part, these companies put a lot of resources into defending themselves that they have to draw away from their businesses. And at the same time, there's the social license risk because there's a key moment where we all see their bad behavior. Others don't want to collaborate as fast and customers choose other partners while they can. It takes about 12 months for the stock price to recover from litigation risk that shows up for a company.
Brittany Damico, Change Finance:
Yeah, absolutely. The Morningstar article references AstraZeneca. They had made a shift from primary care treatments to focusing on cancer drugs. The shift was expected to lower their litigation exposure to only 1% of their annual income, which was significantly lower than their historical rates.
Andrew Rodriguez, Change Finance:
Fascinating.
Brittany Damico, Change Finance:
So just another example of how that comes into play. Well, great. Thank you for all of that. I would also love to hear about how Change Finance uses ESG data in terms of risk mitigation.
Andrew Rodriguez, Change Finance:
We as a company go beyond ESG. We certainly use the terminology as it's the topic of the day, but ESG is insufficient. It's not saving the planet for everybody, full stop. We've got to get to work on something that's far past just saying what companies are good enough. If ESG is still saying that there is a best-in-class oil company, I don't know if ESG is sufficient to tell us what's good enough. It was a couple of hundred years ago, but there were publicly traded slavery companies. And, if we had an ESG standard, there'd be a best in class one. So what we do is we go significantly past ESG. We set an ESG filter to start. Usually, that's where most folks end, but we really want to get a sense, first of who's good enough, and then we go beyond in all the other areas we consider material that getting a good ESG score is insufficient. We’re using about 125 of those today, because we are nerds in this space. Take a company in the transportation industry, for example, they have to get a good ESG score and then have a certain level of score that's pretty far along and their renewable fuel program and pass our NOX, SOX particulates, VOC emissions, along with our carbon footprint emissions, before inclusion. So that makes the list significantly smaller of who's acceptable to us. This does end up covering these sorts of risks we're talking about.
Brittany Damico, Change Finance:
Well, perfect. It sounds to me like we're just setting the bar for everyone else to meet our level of methodology in terms of ESG criteria and what we're looking at.
Andrew Rodriguez, Change Finance:
I'd absolutely agree. I don't have any interest in managing a dollar that's half-assed ESG. What's the point. What's the point? It turns out that investing with more of your values can work just as well, if not better. So why wouldn't you invest with all of your values, if you're going to make a hundred bucks either way? I think most people would choose as many of their values as possible.
Brittany Damico, Change Finance:
I agree. Well, perfect. Thank you so much, Andrew. As we begin to wrap this up, I have one more question for you. What would be your advice to investors that want to maximize the risk mitigation benefits of ESG in their portfolios?’
Andrew Rodriguez, Change Finance:
Great question. I'd say go hard at ESG and do your research about what the results are on the other side. There are plenty of funds out there that say they are ESG, say they are fossil fuel free, and many times they don't reflect any of those. Folks have to do their research and dig deeper into these sorts of pieces to understand who the manager is and what their commitment level is to this space. Are they just taking an ESG rating, slapping it on a fund, putting it out at a low basis point fee, and then voting with management with their proxies? Or is this a firm that’s committed deeply to this space, doing proprietary research, shareholder advocacy, and pushing the needle on what ESG can be, so that we can save the planet and we can save it for everybody, this decade, while we still have time.
Dan Carreno, Change Finance:
Excellent. Let's wrap it up there, Andrew. Thanks so much for coming on again and sharing your insights with us. Brittany, wonderful to have you co-host. I look forward to doing this together moving forward. For those listening, if anyone wants to find articles or resources that we referenced during the podcast, you can always go to www.change-finance.com. Our podcast library can be found under the insights tab, and links will be provided within the podcast transcript. Of course, if you have questions or feedback for us, you can always get in touch with us through the website. So thank you for listening and tuning in today. And we will be back soon with another episode of the ESG update.