Climate Change 2011 - A shorter version of the discussion

Participants

Viktor Andersson, Co-Head, ESG Analysis, SEB Wealth Management

Joost Bergsma, CEO, BNP Paribas Clean Energy Partners

Matt Christensen, Executive Director, Eurosif

Carlos Joly, Chairman, Climate Change Scientific Committee, Natixis Asset Management

Lars Kalbreier, Head of Global Equity and Alternative Research, Credit Suisse

Andreas Knoerzer, Head of Asset Management, Bank Sarasin & Co. Ltd

Steve Triantafilidis, Head of Global Equities, Vontobel Asset Management

Panel Moderator: Elisa Trovato, Deputy Editor, PWM

Elisa Trovato: Welcome to the roundtable about climate change and sustainable investing. The aim for today’s discussion is to assess the impact of climate change on investment decisions. More broadly, we will analyse the integration of ESG factors into the investment process, as well as the opportunities and challenges in distributing responsible investment products in the wealth management space. Carlos, can you outline how tackling climate change is affecting your investment decisions and what investment approach do you favour?

Carlos Joly: The climate change issue brings back nature in a very central way in investment management. It is interesting how throughout history, nature was really very integral to how one did business and how one made investment decisions: think of shipping, agriculture and transportation. Think of storms at sea affecting merchant fortunes, flooding of farms and villages affecting livelihoods, droughts and freezing weather. With the progress of the industrial revolution in the 19th and 20th Centuries, and particularly recently with the emergence of modern portfolio techniques in the latter part of the 20th century, it is as if nature did not matter. There was a redefinition of risk. Real risks got supplanted by technical risks. That needs a rethink and needs to change. We have to begin to seriously consider how nature interacts with how we make investment decisions, and climate is the most evident way. There are various approaches to doing that. What makes sense is to avoid passive approaches that tie you to the broad indices.

At Natixis we have decided to take a thematic approach, with three major thematic clusters. The first is mitigation of carbon emissions; the second is adaptation to the inevitable consequences of climate change; and the third is better management of natural resources: soil and water. These themes help us identify strong companies with solid growth and good profit margins. We apply this approach to various funds, and particularly in our Impact Funds-Climate Change.

Joost Bergsma: The impact of climate change on investment decisions is probably bigger than one thinks. You have to focus on leaders and pick themes, but at the same time, it is an evolution that has been ongoing and is accelerating. That impacts on more or less all sectors, starting with the energy sector, but it is also going into transport, chemicals and steel. You have leaders who are leading the pack and at points will be ahead of the pack, but even the followers will have to clean up their act. I think the energy sector is interesting and at the forefront, also because of the EU 20-20-20 directive. That is a hard law, which makes clean energy tremendously attractive. In these uncertain times with oil, another key driver of clean energy is energy security. I think it is an absolutely major reason why Europe, is investing in clean energy.

Today there are certainly a lot of attractive unlisted, illiquid-type opportunities, which are a barrier for private clients. Product innovation, taking illiquid opportunities such as clean energy and developing simple financial instruments to make them liquid, will help the growing demand from private clients.

Elisa Trovato: Looking at the at the government policies in the clean energy sector, what is the impact of subsidies on market efficiency and how do you take into account of the distortions they generate?

Steve Triantafilidis: Clearly, government policy has had a large impact in the last year or two with changes in subsidies, notably in Germany. It probably has seen some distortions in where, for example, the solar industry has developed. I think that is of concern to investors in this space that a lot of the investing has been driven by subsidies, rather than truly being an alternative to traditional sources of energy. In China, overall the government is very interested in the topic and wants to be a player in new technologies related to alternative. It has simply realised that it cannot use oil and coal in the quantities that a large, industrialised nation would normally. What that may mean is further distortions because they are encouraging these players with a different agenda than in most markets. In the US, although there has been a lot of talk about green jobs and the stimulus package that was announced put a lot of effort in that area, not much has actually happened.

So it may be a function of free markets that you cannot make it that easily, compared to China, which still has a government that can dictate, in some ways.

If you are investing based on subsidies, you need to be very careful, because they will change as governments have pressures in terms of meeting lower budget deficit targets. If companies are only surviving because of subsidies, then clearly you should be very careful about investing in them. On the other hand, if there is not some encouragement in some way, then maybe the industry does not get off the ground either. So there is a balance there. From our perspective, we do not want to be only investing in companies that are too heavily reliant on government subsidies and balance with opportunities driven by market forces.

Joost Bergsma: Subsidies have actually worked. The cost of solar, for example, has decreased by almost 100 per cent, and that is mostly because subsidies have stimulated growth in investment volumes leading to declining manufacturing costs. At the same time, you see a significant amount of investment opportunity opening up, which is very attractive to institutional investors; all subsidies do at the infancy stage of clean energy is break the gap between what is the distorted market price for dirty fuels versus, let us say, cleaner fuels. Germany has actually been successful in creating a leading clean energy industry which employs many staff.

Elisa Trovato: Themes, such as those related to water scarcity or clean energy, are easy to understand and to explain, they often incorporate an ethical or responsible investing component and meet investors’ increasing interest in this area. Are thematic funds still the most powerful means to draw investors’ interest in this area?

Lars Kalbreier: Very much so. Investors are moving away from a pure benchmark approach towards targeted, thematic funds. The financial crisis has triggered a move to back to basics and back to transparency. The thematic approach is tangible, it is something that investors can understand. Clients have become much more participative in the investment decisions than they used to in the past, which has brought them and their relationship managers to speak about themes, not only regarding diversification, which did not really work.

Climate change offers a wealth of different themes which not only draw interest from investors because they are fashionable, but because they also present very good investment opportunities. One specific example is resource efficiency, which is very much the low hanging fruit of the whole debate. What is really going to be securing investment in that space is probably less government involvement, and more the prices of different resources. Only then the invisible hand of the market will start to fully work. We just need to revisit the ways we use resources including CO2 emissions, by using them differently and using them in a smarter way. I believe it is very easy for us to reduce our energy consumption by about 30 per cent, just by using them much more efficiently. That is really much easier than revolutionising the whole energy source system.

It is going to take long time before we can start to use proper alternative energy sources. Some innovations are coming from the scientific backgrounds and we will start to see more and more of them in our daily life, such as nanotechnology in solar cells. Every window panel that does not have a transparent solar panel would potentially be just a waste of space and a waste of potential energy source. Right now it is still very expensive, but prices will be coming down and in the next 10 to 20 years it is probably going to be standard.

Viktor Andersson: The product side is going to change the private banking industry. Traditionally the plain vanilla SRI funds have been the main holdings, and this is still the largest part. However, as clients become more sophisticated, they want to see what their money is doing, be it by thematic funds or by impact investment products. For example, the World Bank has issued several Green Bonds, available to the private banking market, which raise money for specific projects in emerging markets in the clean energy and sustainability areas. I think tangible and simple products like that will increase the interest of investors.

Elisa Trovato: Sarasin took the decision two years ago to make clients’ discretionary portfolios compliant with the SRI’s investment principles. Is responsible investing a competitive differentiator in portfolio management in the private banking world? How was it received by clients and advisers? What are the challenges in implementing your decision? Can you actually manage a whole discretionary mandate in a sustainable way across all asset classes, including alternatives?

Andreas Knoerzer: At the end of 2008, the financial crisis was at full strength. We saw clearly that private investors in particular had been looking for more transparent, and fairer products. Sustainable investing is a winner of the financial crisis and it is a way to differentiate ourselves from our peers and we can stay away from benchmarks. Our decision was actually very well received from the very beginning and supported by the relationship managers. We could prove that the performance was better with sustainable investing than with the classical approach. The response from our clients was very positive, too. We gave them the option to opt out if they did not agree. Only a handful out of the 700 accounts with whom we started the business opted out. Since then, we have doubled the number of managed accounts, and we have grown in terms of assets from €1.8bn to almost €5bn in just two years. It is also important to inform, write and report about what we do in a transparent way. Our relationship managers have no other alternative, they sell our products and whenever we use a pooled product from a third party, it is screened against sustainable criteria, too.

We have two offerings. One is a pure solution, where we do not have commodity investments. The clients do know that and they sign up to the contract which informs them what they can expect and what they cannot expect. The “standard” offering means that at least 75 per cent of the money invested is sustainable, but we do allow a classical asset allocation, investing in commodities. We have launched and looked at products in emerging markets in real estate and equity. Nowadays, that can all be done in a sustainable way. Bank Sarasin, in early 2008, moved out of the hedge fund advisory business entirely. In terms of private equity, our involvement is only selective; even within the climate change ideas you will find alternatives which have a certain sustainability angle to them. The next challenge is to make sure that more and more of typical private banking asset allocation can be done in a sustainable way.

Elisa Trovato: The sustainable investing space is still largely dominated by institutional investors. What are the key barriers to the further growth of sustainable products in high net worth individuals’ portfolios?

Matt Christensen: Investors generally want something tangible and so the thematic approach has been a practical way to sell the sustainability idea. One of the findings from the 2010 Eurosif HNWI & Sustainable Investment Study is that once investors start doing an investment in, say, a thematic fund, they then start to learn around the field; the study showed that their interest in sustainable producs grows over time, to then say, ‘Well, let us look at it across a different asset class, or across what we can do within equities.’

Institutional investors remain the biggest source of financing when it comes to sustainability, but nevertheless, the wealth management space is an important growth area; it is just coming from a lower base. Part of that is due to the need for continued product innovation. For example, when HNWI’s are approached with a best-in-class fund, which is the way it really started in many parts of Europe, potential investors struggled to understand how this approach was different from a typical mainstream financial product. With thematic funds and other newer products in the sustainability space, you will see increasing appetite from HWNI investors.

Viktor Andersson: The main barrier in any organisation, is sales people and relationship managers. The reason for this is that the amount of time relationship managers can spend to learn about every new product is limited... In addition to that they have to learn about sustainability, because they would never want to go into a client meeting and present a product they do not understand. This has to be a strategic decision from the management, and it needs to be incentivised. At SEB we are not incentivising the relationship managers yet, but I am dealing with those that have a personal interest in it who can become our ambassadors. When there are a couple of success stories, the word spreads to others. Financial incentives are the most effective, but there could also be a mandatory element for relationship managers to present a sustainability product as standard part of the offering, even when clients do not ask for it specifically.

Elisa Trovato: Is that any clear evidence that can explode the myth that sustainable investments under-perform?

And how important is the feel-good factor for clients to invest in sustainable investments?

Lars Kalbreier: The feel good factor must be correlated with the performance in the long run. Otherwise we would be a charity. Thematic funds do well and tend to, in some cases, outperform the benchmark. At Credit Suisse we use a core satellite approach. In the core part, the focus is close to the benchmark and general markets. In the satellite part, the juicier bits are in the targeted thematic approach. But it is very difficult, from a statistically significant level, to show that high scores from an SRI perspective lead to outperformance. If you are after alpha, you cannot invest using only sustainability criteria without having a thematic overlay.

Carlos Joly: One mistake that is repeatedly done in the discussion as to whether there is SRI outperformance or not, is to start with the assumption that there is a “sustainability or ESG or SRI asset class” that in itself guarantees outperformance, as if sustainability or ESG criteria in and of themselves could completely determine financial performance. And that is no more true than the proposition that says investing in a “value” asset class will outperform or investing in an “income” asset class is going to outperform. Much has to do with the quality of the investment process and much has to do with the talent of the asset manager. A lot also has to do with the geographic distribution of a portfolio and a lot has to do, nowadays, with currency volatility. Don’t forget that ESG is an important complement to financial analysis, but does not replace paying attention to the quality of the balance sheet, debt structure and to financial ratios.

Elisa Trovato: What does ESG integration add to the investments process? Has it become mainstream?

Viktor Andersson: With ESG integration you get a more accurate, more fair value of the company. ESG integration is not mainstream yet but all is pointing in that direction. Studies indicate that 80 per cent or so of European assets have integrated ESG, but I would say they have not. In order to properly integrate, the portfolio manager has to be able to say, ‘For this particular company, in what way is sustainability integral to the business model? Which sustainability factors are they making how much money from?’ This would obviously impact the valuation. Very few players have the skills to do that today, even on a global scale. Sustainability factors are in general not fully priced into a company’s evaluation. If they were, then there would be no added value for ESG integration and thus no business case for it, and I am absolutely convinced there is one.

Matt Christensen: ESG integration adds, potentially, risk minimisation; better performance returns over time, identification of future opportunities; anticipation of future ESG regulatory costs. Those are just examples.

ESG integration has certainly become more mainstream over the past five years, but this is still early days in the growth of this sector. It might be helpful to compare it to where hedge funds were twenty years ago - the hedge fund industry was struggling in Europe with how to define itself, aside from their typical fee structure of ‘2 plus 20’. There were many questions about the how to distinguish a hedge fund such as ‘merger arbitrage’ versus ‘macro’ versus other areas? Overver time however, it has become much easier to categorise a certain type of hedge fund.

I believe that a similar phenomenon is occurring with ESG integration. Over time, investors will specialise in the type of ESG integration approach they utilise. Related to ESG integration, you will increasingly here things like: ‘I am an impact investor or I am a thematic investor across these asset classes.’ I think the conversation around performance and around what ESG is and how to define it, is going to actually become more granular based on the specific investment approach. I can see it happening now over time, as categories start to be created and understood so that interested customers can actually say, ‘Let us speak about what you as a fund manager actually do in that sub category of ESG integration.’

Elisa Trovato: In emerging markets, is there enough data available for identifying companies with high standards of sustainability, in order to limit the sustainability risk? Asia is a particularly policy-driven market. So does that mean that the key to success is identifying a company which can benefit from government policies?

Steve Triantafilidis: We have been looking at that and started with Asia a couple of years ago, and launched a specific fund. I think it is true that data is an issue, and some of the traditional sources of information available in the developed world are not available in Asia or in emerging markets. This means a lot more effort from analysts to get information from companies, who we found initially were not well equipped to provide answers. But they are starting to at least think about it and starting to develop efforts in that area. So, in integrating ESG, we have had to have the analysts directly look at these companies and look at whatever reporting there is. However, especially in some countries like China, for example, you may not even get normal financial reporting at a high quality. But I think it will develop there, as it has in other countries. The problem with emerging markets is that you cannot generalise. So, there are different levels of government involvement and government direction and different levels of regulations that apply.

Joost Bergsma: Asia should offer a sizeable investment universe. In 2010, Asia was the second largest region (after Europe but ahead of North America) in terms of net new investment in new energy, with around $50 billion of new invested capital in clean energy. Many leading the solar manufacturers are based in China. A number of the leading Chinese solar manufacturers are listed on the New York Stock Exchange and comply with international disclosure and financial regulations. So is Asia certainly a growing universe of investment opportunities from which private individuals can benefit. Asia is doing its part in hard dollars to comply with clean energy standards.

Carlos Joly: Based on the success of its global Impact Funds-Climate Change fund, Natixis is working to launch a similar fund just focused on emerging markets. We find that there are a sufficiently large number of names to invest in, in a sufficiently broad spectrum of sectors throughout the array of emerging markets. Combined with the fact that most economic growth is happening in emerging markets, that provides a very, very compelling investment proposition, because you combine two long-term trends in the world, economic emergence and the inevitable consequences of climate change, and you figure out how to integrate them in an investment portfolio.

Developing countries have not closed their eyes to the environmental issues, as is sometimes popularly misconceived. If you look at the national industrial policy of China, for instance, you see that they are determined to become a leader in car batteries, in wind turbines, in high speed trains and in mass transit and are becoming so. If you look at the environmental reports of the large trans-national based companies in Asia, Brazil, Argentina and at their CSR reports, they are of a not dissimilar quality than that of large trans-nationals from mature markets. So among the large companies, the quality of the reporting has increased dramatically over the last five years and you do not find notable differences amongst the leaders. Where we would like to see more information, of course, is in the mid-cap companies. But that is also a problem in mature markets.

Andreas Knoerzer: We launched a fund last year to access the domestic growth of these markets. Our research shows that the leaders are pretty close to our leaders. On average, they are below, but they are progressing faster. And we think that it makes perfect sense to have not just the growth of the emerging markets, but growth in a sustainable way in order to avoid the mistakes of the past.

We obviously all know that the data is not perfect, but it is improving. We do not have a different rating or scoring methodology for emerging market companies, because most of these companies are global competitors. They compete with our companies, so why should we rate them differently? However, in order to come up with a product which is diversified enough, we are more flexible with our investible universe and will review that in two year’s time. It is very transparent where those companies are positioned in our sustainability matrix. Hopefully, more companies will come to qualify within our stricter investment area.

Elisa Trovato: Lars, are high net worth individuals interested in gaining exposure to these growing economies through traditional funds, or are they also looking at sustainability themes?

Lars Kalbreier: Investors are definitely interested in emerging markets. As to the SRI, it really depends. Asian investors are open to ideas or trends, but they are very short-term oriented. It needs to be a long-term sustainable but it should generate performance within one month; that is almost impossible to reconcile. The European client base is much more open in investing in specific trends within emerging markets, also in the sustainability area, because they have more of a long-term approach. Many sustainability issues are affecting emerging markets to even a greater extent than the developed markets. Water is a very popular theme. Many engineering companies are European or US companies, but they have big exposure to emerging markets. Since the universe is fairly limited, especially in the large cap area, you will find the usual suspects in many funds. Many companies are still in the mid-cap arena, but they are growing. The universe itself is probably not yet complete in emerging markets.

Elisa Trovato: How do you reconcile the fact that sustainability themes tend to generate good performance over the longer term but investors are focused on short to medium-term performance?

Viktor Andersson: I do not see that there is a conflict, because the leading companies from a financial perspective are the leading companies from a sustainability perspective too, the blue-chips of this world. Best in class for developed markets is irrelevant in many cases, because the absolute difference between leaders and laggards is so small; whereas when you do it for emerging markets you get huge differences and can pick winners based on that.

Elisa Trovato: Matt, from a regulatory standpoint, what have been the most successful initiatives that have been taken by the European Union, and which ones should be implemented in the future?

Matt Christensen: The EU has not done anything particularly helpful for ESG yet, so I cannot point to one. The easiest way for a regulator to approach this area is on the transparency side, because the minute you start working through definitions like ‘sustainability investing means x from a regulatory perspective’, you destroy the sector. Doing it through disclosure regulation is a nice way to make a gentle push that alerts people to become more engaged on these issues. Additionally, regulation through combines disclosure with business strategy will ensure that ESG content remains a strategic issue, not a compliance issue.

The other point related to that is that people often talk about the challenge in this space: how do you define sustainability and ESG etc? It is very difficult. What can be done, though, and should be at least tackled, is common language. Whether you can develop common language across different cultures and values is still a question mark, but that could help in addressing clarity for everyone – regulators, investors and family offices/HNWI investors – because there is still this overall question of, ‘I do not understand the terminology. A lot of terms are used in different ways in different countries’. Eurosif is embarking on that this year. We are leading a consultation convening investors across Europe to have meetings to discuss it.

Elisa Trovato: What are the key growth drivers for sustainable investing, and what are the barriers to overcome?

Carlos Joly: The investing public intuitively understands that environmental issues, and particularly climate change, are important to investment decisions and to the future of their investments. The reason uptake is not more widespread has to do with two factors of our investment business: one has to do with what I call the investment technology. We are still too wedded to using and promoting passive and near index investment strategies, rather than promoting real conviction funds that are not tied to tracking error. The other barrier is that, in many cases, senior management is not making the right decision, which is to put the marketing budgets and sales forces behind the promotion of ESG-type funds. Like most things, these funds do not sell themselves, they have to be sold. When that happens, I have no doubt that there will be exponential growth in ESG-type products.

Steve Triantafilidis: In terms of barriers, there are also difficulties in introducing other asset classes into the alternative space. Commodities are a big area of investing, but what does it mean when we look at it there?

In most markets generally, hedge funds account for as much as 50 per cent of trading, which is disproportionate to their asset size; therefore, they are a key driver in terms of what happens to share prices even longer-term as well. But I have ever heard hedge funds talk about sustainability when they present their investment approaches. If a large category of trading is being done by hedge funds that are not even focused on that, that will be a significant barrier to the adoption of sustainable investment.

Andreas Knoerzer: With reference to private banking, I do not believe that legislation is a driver. On average, the products are there, although there are a few gaps. I do not believe that, for private individuals, definitions matter. There are different methodologies that should be applied, but ultimately, it is about us building up a track record. If you have a track record, you have a story to tell and to sell.