Jennifer: There’s definitely been an evolution in terms of how we integrate ESG on our fundamental equities team in Canada. It started with us acquiring data from a third-party service provider, and our London-based RI team would generate their own score based on their expert views. And although we still use this score in our analysis, previously it was used as a springboard for follow-up discussion, whereas today, we focus on ESG risks and opportunities, and consider all stakeholders. Our five-stakeholder lens includes not just shareholders, but also customers, employees, suppliers and the industry in general, and examines the relationship and role within all five of these groups. It’s still qualitatively-based, but there’s also a quantitative component which is integrated into our evaluation. And finally – the last piece – which is incredibly important to our process, is engagement, and directly helping management improve long-term outcomes through the consideration of key ESG issues.
David: Our investment process is somewhat different from Jennifer’s in that we’re more quantitatively driven, in combination with fundamental analysis as it relates to ESG. Over time, we’ve moved from an exclusionary approach to a full integration approach, and the other big thematic change is the move from external data sources to relying on our internal London-based RI team, which is differentiated from other managers.
Adam: There are a couple of different factors at play for us in fixed income. The first is that even the idea of ESG integration itself is a little bit newer compared to equities, and hasn’t fully permeated the market yet. There’s this notion that fixed income is secondary in the RI field to equities, where an investor can vote proxies and opine on the direction of the business. However, that is not our view at BMO Global Asset Management, as we believe ESG is very much a fixed income consideration – as it is across all asset classes. As a bond investor, you’re funding a company’s new initiatives and that means you have the ability to impact their actions. If we reflect on ESG as a factor in our evaluation of credits, then it can have a significant impact on the cost of capital for a given security. While there is now growing acceptance from the broader market in our asset class, this wasn’t always the case. But on our fixed income team, we’ve weighed these considerations as a distinct factor within our credit analysis dating back to 2014, complemented by BMO’s rich history in the RI world. It’s incumbent on us to continue to be active on this front and stay ahead of the curve.
Adam: In our credit research process, ESG is incorporated as a distinct standalone factor in analyzing the fundamentals of a company. This is important because ESG can identify additional risks and rewards as we think about what their ability and willingness to repay debt looks like. If a company has poor ESG metrics, that can be a crucial determinant in them having difficulties repaying their obligations. For instance, this is clearly evident in terms of governance, and in some ways that’s the most common, but you can also see this reflected from an environmental standpoint if a company takes on a huge liability, and sub-standard environmental practices impinge on their ability to execute on business plans. It’s a similar story if a company is not meeting guiding social principles; they can quickly fall out of favour with the market and rising reputational risk could impact their market share. . Sometimes, ESG is viewed as an outside factor, but really it poses fundamental risks, and it is an integral component to the evaluation of credit risk to our team. Importantly, our process is oriented around relative value. We believe we can understand the risks on specific issuers better than the market and third-party providers, which allows us to buy mispriced bonds and capture potential upside and additional value for our clients.
David: In Disciplined Equity, there are now four parts of our process where we fully integrate ESG, including stock analysis (where we use a proprietary quantitative model to which we’ve recently added additional factors); portfolio construction (where we look at portfolio-level ESG exposures); overall portfolio monitoring and automated review of whether any companies have been downgraded on their rating, which would ultimately impact our buy/sell decisions; and active ownership in relation to proxy voting and engagement with management. The difference vs. the Fundamental Canadian Equities team is that we centralize this latter part through the RI team in London – we don’t do the engagement ourselves because of our largely quantitative approach.
Adam: As David mentioned, we similarly incorporate our own research into our proprietary scoring system, and don’t rely on third parties for what they believe are the fundamental risks of an issuer. We’re aware of their views because of the potential technical impact, similar to how we view credit ratings from the ratings agencies, but our scoring is based on our own work and input from our RI team, which has certainly been additive to how we think about ESG within credit.
Jennifer: A good example is Waste Connection, the third largest solid waste company in North America. Workforce turnover is very high for the industry because hauling garbage is hard work. Particularly, before COVID, there were many years where competition for labour was fierce, specifically in the U.S., which only exacerbated the turnover problem. Five years ago, the company took a hard look at their practices, and improved employee retention through hiring processes and creating an accountable environment where people could provide feedback on their managers. As a result, their turnover percentage lowered significantly and is now less than their peers, which has a huge impact not only socially, but to the bottom line.
Adam: I think a great example from my perspective is Volkswagen, which went from the darling of ESG while they were falsifying data to a company with the absolute worst scoring after they were caught. What’s interesting is that our RI team engaged with them after the scandal, and observed they were doing the right things on the margin to improve their forward score, which is a factor to consider, and exemplifies our approach of relying on our own research rather than third-party data. This was a company moving forward in the right direction, which gave them a better score in our books.
David: A company that we hold in several of our portfolios is CMS Energy – a Michigan-based utility business – and we like it because of its history of peer-leading growth, profitability, and consistency, with a long runway for that to continue. Not coincidentally, ESG integration is integral to its strategy and helps to bolster the investment case, no matter the target audience. It has committed to reducing carbon emissions by 90% over the next 20 years, with tangible near-term evidence they are moving in that direction. I expect ESG-focused investors will gravitate towards companies like CMS in the future, especially in the utilities sector where U.S. companies are far behind their European peers in working towards energy transition. But you don’t need to be ESG-focused to value its industry-leading financial characteristics.
Adam: In the context of fixed income, there have been a lot of issuers realizing that there’s now an active bid for green and sustainable bonds, so there is an incentive for companies to label their debt that way. We have to acknowledge that money is fungible, so if a company issues a bond, it may in one pocket be achieving something sustainable while not adhering to ESG principles in another pocket. There isn’t really consensus on green bonds yet. There is nuance that has to be applied, and really examining the issuers and the bond – and not just accepting what they say at face value – is key, in the same way we wouldn’t accept financial projections without doing our own homework.
Jennifer: I think greenwashing has definitely impacted our conversations in the Canadian equity market. Institutional investors are digging deeper to understand processes and to weed out those managers who are using a green spin for marketing purposes. It’s really important to look under the hood, and how managers define ESG integration. What exactly does it mean? I think if you’re only looking at ESG, and not at the investment characteristics, whether it’s from a fundamental, or disciplined equity, or factor-based lens, it’s doing a disservice because ESG is one input into the investment decision.
David: I agree – on the one hand, asset owners are wanting to understand how we achieve ESG investing, but I actually think we see it even more on the consultant side. Many have recently said they’re going to include a formal ESG rating framework, where they rate managers according to their team, process, performance, vehicle lineup, pricing and all these different dimensions. Anecdotally, they’re also asking, “How do you integrate ESG?” What data sources are you using?” “How does it affect your buy/sell decisions?” We’re also receiving requests to talk through our fundamental hypothesis as to why a company with a good ESG rating should outperform the rest of the market. They want to hear our thinking behind why we think it makes sense.
Angus: In the context of real estate, it’s about looking forward and understanding that when you’re building assets, do you have the metrics in place to capture performance? It’s not just paying lip service – it’s thinking about what will be important in the future and ensuring your assets are on the right path to engineering, procurement and construction (EPC) strategies. And not just that, but within the context of a zero carbon strategy, how can you assess your approach to ensure you are in line with the strategic objective? We align to real estate industry association requirements and have received independent awards for the standards of disclosure met, which is crucial to providing investors with the confidence they deserve. This philosophy of building the good and the accountability it comes with is ingrained in BMO’s culture of honesty and integrity. It’s a natural fit with our bottom-up approach at BMO Real Estate Partners.
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