The rise of ESG as an investment theme - IMAP Independent Thought

By Jayson Forrest

The appetite by Australian investors for portfolios that meet their personal values, continues to rise steadily. And sitting at the heart of this is ESG. Leah Willis (Australian Ethical), James Harwood (Russell Investments), Michael Salvatico (S&P Global Sustainable1), and Deanne Baker (Lonsec) share their thoughts on how advisers can meet this demand, while still satisfying the financial goals of their clients.

With one in two advisers providing environmental, social, and governance (ESG) advice in 2021 - up from one in five in 2016 - the interest and growth in ESG remains one of the key trends in portfolio construction today. And it’s easy to see why. According to the Responsible Investment Association Australasia’s (RIAA), Responsible Investment Benchmark Report 2022 Australia, Australia’s responsible investment market reached $1.54 trillion in 2021, which is up from $1.28 trillion in 2020.

Speaking at the IMAP Independent Thought Conference in Melbourne, Leah Willis - Head of Client Relationships at Australian Ethical - says Australian investor assets under management now give responsible investment a 43 per cent share of the total market - up from 40 per cent in 2020.

“Investors are increasingly realising that they have an ability, through what they buy and invest in, to have a beneficial impact on the environment and society,” says Leah. “This is being aided by advisers who realise the benefits from engaging with responsible investing.”

Citing the findings from the Australian Ethical/Investment Trends 2022 ESG Adviser and Investor Reports, Leah says ESG investing is not only providing benefits to clients - such as potential higher returns over the long-term - but significantly, yielding benefits for advisers and their practices.

The research found that of current ESG advisers:

• 57% - have seen an increase in client demand for responsible investments over the last 12 months;
• 53% - say that ESG has enhanced their value proposition;
• 36% - report that their ESG advice has attracted more clients; and
• 45% - claim that ESG has helped to build a better rapport with existing clients.

“Consumer interest in sustainability-themed investments is high,” says Leah. “RIAA confirms that consumers using its Responsible Returns online tool (1 January-31 December 2021) are searching  for a variety of ESG investing options, such as renewable energy and energy efficiency (16 per cent), sustainable land and agriculture management (12 per cent), and sustainable water (10 per cent). And investment structures, like managed accounts, provide advisers with a great solution to be able to engage in the ESG and responsible investing space in a scaleable way.”

Lonsec is one such manager that takes a serious approach to ESG, recognising the demand for ESG from both clients and advice businesses. At the 2022 IMAP Managed Accounts Awards, it took out the ESG category with its whole of portfolio solution and approach to ESG. According to Lonsec Portfolio Manager - Multi Asset, Deanne Baker, Lonsec’s Sustainable Managed Portfolios are a multi-asset solution that incorporates ESG and sustainability principles across the major asset classes.

She says the aims of the portfolios are not only to deliver strong risk-adjusted returns but to also make a real world impact. This is achieved by making a positive contribution to the key environmental and social challenges facing society, as measured by the United Nations’ 17 Sustainable Development Goals (SDGs).

“The market has evolved considerably over the last few years and now we’re really seeing clients demand a whole of portfolio solution. They want to know that the impact they’re making is occurring across the entire portfolio,” says Deanne.

“So, what we are seeing is a move towards more holistic portfolio construction, where ESG and sustainability is incorporated across each of the major asset classes. The good news is there is enough quality products available in Australia now, where you can build a fully diversified portfolio, while still generating impact.”  

Sharing Deanne’s views, James Harwood - Senior Portfolio Manager, ESG Strategies at Russell Investments - expects to see a merger of some of the different approaches to portfolio construction, as a result of client demand for a whole of portfolio solution.

“We’re starting to see a lot of core portfolios increasingly having some kind of ESG integration. At Russell Investments, that’s definitely what we do for some of the asset classes in our ESG managed accounts that aren’t in the equity space. I think you’ll see a lot of funds moving in that direction,” says James.

Leah adds that an interesting aspect of ESG investing is the increasing ability of investors to access unlisted private assets for impact investing. She says advisers can expect to see more product coming to market that will allow for greater portfolio diversification, allowing investors to achieve deeper impact outcomes with their investments.

Deciding what investments should and shouldn’t be in an ESG portfolio really depends on the individual preferences of clients, says Deanne.

“It’s really hard to design a portfolio when you’re considering an individual’s values and ethics. For example, what’s important to me might not be important to someone else. So, it’s essential you understand your clients’ values and goals, and have a conversation with them about that, in order to work out what sectors and companies they want to be invested in.”

As a portfolio manager, Lonsec is designing managed accounts for a broad range of clients. It has a bottom-up process with its Sustainable Managed Portfolios, where it seeks to make a positive contribution, while limiting exposure to controversial sectors - like gambling, alcohol, tobacco, coal mining, nuclear, adult entertainment, and weapons.

“We believe ESG and sustainability are different, so we assess these risks differently, just as you would with other types of risks in a portfolio,” says Deanne. “We have a range of exclusions in terms of activities we think are fundamentally misaligned to our objectives, which are aligned to the United Nations’ SDGs.”

And while Lonsec’s portfolios may not have the lowest carbon footprint, the portfolio manager continues to work diligently for alignment with the Paris Agreement to limit the impacts of climate change. However, when it comes to nuclear energy as an exclusion, Deanne concedes it’s an interesting area of discussion, although many investors still find it an unpalatable sector to invest in.

“That’s because Australia can become a renewables super power - we have lots of wind and solar, and other sources of energy we can use. In comparison, nuclear is expensive and not zero carbon, particularly when you take into account, for example, the amount of concrete that is needed to go into building the reactors. But if you’re in Europe and don’t have access to renewables, then nuclear becomes a much more viable source of energy. So, we’re finding in many European portfolios, even if they are ESG-related, they do have some exposure to nuclear.”

James agrees that the ‘exclusions’ side of ESG portfolios can be challenging for both investors and portfolio managers.

“In Australia, we have a big mining sector. However, most ESG funds and investors seek to have no exposure to coal or perhaps, no more than 10 per cent of a company’s revenue coming from coal. When we’re building products, we’re looking to develop products that get the balance between ESG and risk right. Therefore, I don’t believe excluding all mining is the way to go. We know there are critical metals, which are a big part of the decarbonisation solution, that will need to be mined.”

James also agrees that nuclear is a polarising topic. Russell Investments regards nuclear as a ‘grey’ source of power - it’s neither renewable or a fossil fuel. And while the manager doesn’t look to tilt towards nuclear, Russell also doesn’t look to exclude nuclear from all its strategies.

“While we would exclude nuclear miners, we acknowledge that nuclear power is still required by many countries, as they transition to renewables and a low carbon footprint,” he says.

Michael Salvatico - Head of Asia Pacific, ESG Business Development at S&P Global Sustainable1 - agrees that energy transition is an incredibly important part in how we deal with climate change.

“I often get asked about nuclear energy and green hydrogen. We believe every energy source plays a role in the future decarbonisation of the planet. For example, our research indicates that green hydrogen will contribute 7 per cent to global decarbonisation, and that will largely be through its role in decarbonising transport,” says Michael

Looking ahead to the next two years, Leah is confident the market will see more advancements in social equity, human rights, and animal welfare, which she says are the types of issues that are constantly raised by investors.

“Once we have more leadership from the Federal Government on the environment and climate, and we start to see this transition costed into the economy, then that will throw open many opportunities for investors,” she says.

“I believe managers and portfolios will have to fundamentally keep up with the transition that the Australian economy will undergo. At Australian Ethical, we are already thinking critically about how we navigate the pros and cons of this transition.”

James maintains that the growth of ESG will continue unabated, even in core strategies. He also anticipates improved ESG reporting across asset classes over the next couple of years.

“My advice to advisers is ESG can be a complex space but the key to unlocking it is understanding what’s important to your clients. The ESG beliefs of individual clients is quite personal, so I don’t believe blanket exclusions are the way to go. I’m definitely a firm believer in the increased use of corporate engagement as the way to effect change.”

Deanne agrees that climate change is here and is not going away. She says it’s something advisers need to be across, including having investment solutions ready to roll out for clients. She believes issues around gender diversity, modern slavery, and nature-related financial disclosures and biodiversity, will also increasingly become prevalent.

“We’ve already got the Task Force on Climate-Related Financial Disclosures (TCFD), and moving forward, there are nature-related financial disclosures coming, which will be more aligned to ESG.”

Michael agrees that biodiversity will be a huge issue in the coming years, with a potentially bigger focus on it than climate change.

“We can expect the same type of framework for biodiversity as we currently have with the TCFD,” says Michael. “The TCFD came out in June 2017, and the number of supporters of this framework continues to grow globally. It ties in very well with net zero commitments by countries, companies, and investors, and it also provides a great framework to understand the governance, strategy, risk management, and metrics.”

In order to transition the entire economy to a low carbon footprint, Michael agrees that corporate engagement will become increasingly important.

“To transition companies, like AGL, from being 10 per cent renewables and 90 per cent fossil fuels focused, to being 90 per cent renewables and 10 per cent fossil fuels focused, investors will need to actively engage with these companies,” he says. “Over 50 per cent of Australia’s carbon emissions are coming from companies in the ASX 200, so it’s important that investors engage with these companies and encourage them to reduce their carbon output.”

Leah Willis is Head of Client Relationships at Australian Ethical;

James Harwood is Senior Portfolio Manager, ESG Strategies at Russell Investments;

Michael Salvatico is Head of Asia Pacific, ESG Business Development at S&P Global Sustainable1; and

Deanne Baker is Portfolio Manager, Multi-Asset at Lonsec.

They spoke on ‘The rise of ESG as an investment theme’ at the IMAP Independent Thought Conference - Melbourne.

The session was moderated by Neil Rogan - Head of Adviser and Intermediary Solutions Australia at Russell Investments.