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Environmental, Social & Governance (ESG) and PruFunds

Adrian Gaspar, Multi-Asset Investment Specialist at M&GPrudential Treasury & Investment Office (T&IO), reveals the answer to a question that is often asked  “do Prudential’s PruFunds have an ethical stance or indeed are they ethical portfolios?”.

The simple answer is no. However, ESG considerations are embedded in many of the underlying investment processes used to build our portfolios. ESG is not the same as using ethical funds that would generally prioritise the ‘moral’ return over the financial return and would seek to screen out what they consider morally dubious industries. Using ESG factors does not mean that whole sectors or companies are ruled out, but they are used to inform the investment decision making process. ESG is more about engagement as opposed to exclusion.

The concept of responsible investment incorporating ESG factors is not new, indeed a study by Deutsche Bank in 2012 traces early socially responsible investing back to the 1960s.

ESG investing seeks to incorporate three factors in to a fund manager’s investment decisions.

Some examples of each are;

Environmental – climate change, greenhouse gas emissions, renewable energy, resource depletion, waste and pollution and deforestation

Social – working conditions, local communities, conflict, health and safety and employee relations and diversity

Governance – executive pay, bribery and corruption, political lobbying and board diversity

T&IO works very closely with businesses like M&G and Eastspring on a day to day basis and both companies have ESG policies and are also signatories to the United Nations Principles for Responsible Investment (UNPRI). Signatories voluntarily agree to incorporate ESG issues in to their investment analysis and process.

How relevant is ESG?

According to research carried out by M&G and The Wisdom Council, 9 out of 10 ‘millennials’ said they were interested in socially responsible investing and wanted to know more.  Millennials were also twice as likely (64%) than investors over 55 (29%) to invest in a fund if social responsibility was part of the rationale.

M&G approach to ESG

Advisers will be aware that M&G are responsible for stock/asset selection decisions for a large proportion of the segregated mandates and funds held in the portfolios that underpin PruFunds, so in this article we will focus on what ESG means from an M&G perspective while also referencing some examples from the alternatives portfolio.

M&G believes that ESG factors can have a material impact on long-term investment outcomes. Their goal is to achieve the best possible risk-adjusted returns for clients, considering all factors that influence investment performance. Consequently, ESG issues are incorporated into investment decisions wherever they have a meaningful impact on risk or return.

They apply this approach to ESG analysis across all asset classes and sectors in which we invest. While M&G consider it essential to include ESG issues in to investment analysis, they do not make investment decisions based solely on their ESG views. Rather, investment decisions are made after considering all factors that influence an investment’s risk or return.

 

Can you apply the same approach to each asset class?

In short no. An ESG investment process as with any other, can be complex and vary by asset class. For instance, research by MSCI around ESG factors suggested around 20% of companies in the global investment grade market qualify as ESG industry leaders (those with AAA or AA ESG ratings). By comparison, only 5-6% of the high yield companies have an ESG rating of AAA or AA so clearly the process around high yield will need to be adjusted otherwise such a small investible universe would compromise the quality and diversity of a high yield portfolio.

When discussing any investment theme, in this case ESG, I always feel it is valuable to provide actual examples to give readers some context on what ESG means.

 

Equities Case Study – Carnival Corporation & plc

This is an example of M&G engaging with a business on environmental factors.

Carnival Corporation & plc (Carnival) is the world’s largest leisure travel company with more than 100 ships sailing under 10 brands. In December 2016 the company was fined $40m for environmental pollution, relating to an incident dating back to 2013, where Princess Cruise Lines were found guilty of diverting oily waste into the sea.

The subsequent dialogue between M&G and the most senior executives at Carnival and the operational changes made left them reassured that the incident did not a reflect a fundamental cultural issue for the company. They visited Carnival’s state of the art training centre, including sophisticated bridge and engine simulators, to understand the ongoing crew and development training. The centre cost Euro75m to build with annual costs of Euro13m.  This huge investment reinforced the M&G view that health, safety and the environment are key issues for Carnival.

 

Real Estate Case Study – Minster Court, London

This long-term holding in the life fund property portfolio had not had its energy efficiency reviewed since being built in the late 1980’s. This meant there were many opportunities to reduce energy consumption within the building by upgrading technology and management practices.

The approach taken by M&G Real Estate was to implement a lot of very small changes that in combination would lead to significant results. Some examples were; hosting environmental awareness events with tenants, running energy efficiency seminars, an agreement to shorten the period that external lighting was used and an upgrade to the Building Management System (BMS).

These activities led to a 22% improvement in energy efficiency at Minster Court and a significant reduction in water consumption was also achieved. This is a relatively old example as the period in

question was between 2008/9 and 2012/3 but hopefully illustrates that responsible investing in its various forms is not a new phenomenon.

 

Alternatives – Renewable energy

Within the alternatives portfolios in PruFunds there are assets that invest in sustainable and renewable energy, including solar and onshore and offshore wind projects across Europe and the UK, biomass waste to energy generation in the UK, battery storage in the UK and hydroelectric and wind power generation in Latin American. For example, Prudential are invested in funds with interests in over 350 onshore and offshore wind turbines.

The Alternatives team in T&IO committed around £150m to create a fund NextPower II, to acquire and operate solar PV plants in Italy in partnership with NextEnergy Capital. This investment in a highly fragmented market has seen the strategy buy 45 plants with a capacity of 85.5MW, making NextPower II one of the top ten owners in Italy.

 

Summary

Behind the headlines, ESG is a very complex subject with no industry wide definition of what it means, so most companies have their own interpretation and ways of implementing each factor in to their investment process. At its heart ESG is about long-term investors looking past the numbers and understanding all of the non-financial risks and opportunities that investee businesses are facing. Making investment decisions in this way should also be positive for policy holders over the long-term.

While there is no one definition of what ESG is, the whole subject of responsible investing is a huge theme globally. To put this in to context, the Global Sustainable Investment Alliance produced a report which suggested that there are $22.9trn of asset globally that are run in some form of responsible investment strategy, an increase of 25% since the previous review in 2014.

The subject of ESG is going to become more prevalent and attract the attention of more of our policyholders so we feel that it is important that they understand that whilst PruFunds do not have an ESG outcome, environmental, social and governance considerations are important and are ingrained in a lot of the underlying investment processes.

Learn more about T&IO and Prudential’s latest risk managed solutions.

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