ESG and the UN’s Principles for Responsible Investment

Knut Kjaer, Chairman of FSN Capital and founding chief executive of what is today the world’s biggest sovereign wealth fund, in a recent Bloomberg article, which reappeared in my local newspaper, The Globe and Mail, describes the climate crisis as the “biggest market failure of all time.”

Back in 2005, the United Nations began a working group with the goal to draft aspirational principles for responsible investments. Kjaer was a co-author. The end result, published in 2006, includes the following six expectations:

1. Incorporating ESG into all investment analysis and decision-making processes.
2. Incorporating ESG into ownership policies and practices of investment firms and the companies in which they invest.
3. Disclosing in full all ESG issues where investments are placed.
4. Promoting acceptance and implementation of ESG principles throughout the investment industry.
5. Working collectively to enhance the effectiveness in implementing ESG principles.
6. Reporting on activities and the progress in their implementation.

If unfamiliar with ESG, it is an acronym that stands for Environmental, Social and Governance, the factors to be considered by investment managers in determining who is good versus who is a bad company in which to invest.

FSN Capital under Kjaer has a clear understanding of who is bad. He told Charles Daly of Bloomberg News, FSN won’t touch fossil fuels describing them as “brown companies.” The notion is not to invest in companies whose over-the-horizon views, that is ten years and beyond, are clearly missing in action on the environment and climate change. He notes “We normally don’t take a bad company and make it good.” That means companies that practice greenwashing are seen as irresponsible when measured against ESG principles. And that’s why Kjaer sees fossil fuel investment as a don’t touch issue.

What are ESG principles?

According to James Chen of Investopedia, ESG is a set of criteria that measures a company’s operations through a set of environmental, social and good governance lens. In his words, “Environmental criteria consider how a company performs as a steward of nature. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights.” Note that sometimes the S in ESG is referred to as “sustainable” rather than “social.”

A deeper dive on the E of ESG looks at how a company manages energy use, waste, pollution, and natural resources including conserving the planet’s biology. The E looks at how a company is managing environmental risks, land use, hazardous waste, carbon and other emissions, and compliance with environmental regulations.

And last but not least is the G of ESG which stands for governance, how the company operates both internally and externally. Are its accounting methods accurate and transparent? Are shareholders consulted and allowed to vote on important issues? Are board members free of conflict of interest? Does the company seek political favours through corporate donations to change the laws? Does the company do illegal things?

In every sense of the acronym ESG, fossil fuel companies do not fit. They fail on the environment. They fail on social. And they fail on governance.

Kjaer says we are in for a big shock this next decade and need to prepare for it. Our “persistent mispricing of carbon” has led to its overuse and our “irrational human behaviour” is creating a mess for the planet and humanity.

One of the prime backs of ESG-based investments, FSN is one of a number of companies in the financial industry responsible for creating a $35 trillion US ESG market. But Kjaer isn’t convinced that the industry can on its own steer the world away from the disaster of climate change. That’s because the mindset of investors and the financial industry has always been short-term in thinking: the next quarter, the next annual report. ESG requires strategies with long time horizons, in fact over the horizon views of companies and their place on the planet.

FSN isn’t alone in chartering a new responsible path focused on conserving the planet. In its field, Munich Re, the global leader in reinsurance, is similarly inclined. It recently launched its Ambition 2025 Group strategy through the issuance of a green bond aimed at incorporating sustainable investments that meet the reinsurer’s climate change focus.

The Munich Re Green Bond has been designed to focus on sustainable transitional initiatives to a low-carbon economic future. Initial capitalization is 1.25 billion Euros with a fixed interest payout of 1.25% annually, maturing in 2041.

In its launch, Christoph Jurecka, CFO of the Munich Re states: “[The company] commitment to climate goes beyond this inaugural green bond and…has taken a holistic approach and…set itself challenging decarbonization targets to underline our ambition to be a climate leader.”

Munich Re’s corporate responsibility statement reads like ESG but in reverse, GSE. Here is my restating of its holistic approach:

• Responsible corporate governance is only possible on the basis of impeccable ethical and legal conduct.
• A social and sustainable approach to our core business involves proactively considering environmental, social and governance aspects along the entire value chain in our core business activities.
• Environmental and climate protection involves an ambitious strategy across liabilities,
  assets and our own operations.

Both Munich Re and FSN are very selective in their ESG strategies. For FSN the results have been encouraging: an 11% jump in corporate revenues, and a 35% increase in operating profits. FSN’s investment focus is on companies implementing targeted transition and adaptation strategies for dealing with climate change.

Kjaer told Bloomberg, “for every investment we do and every action we take in a portfolio company, we must have a 10-year-plus horizon” that aligns with the goals of the Paris Climate Agreement, to limit mean global atmospheric temperature rise to 1.5 Celsius degrees.

Munich Re is similarly inclined with its insurance and actuarial eyes also looking over the horizon as it contemplates a world 1.5 Celsius warmer. The reinsurer sees the rising cost every year in claims for extreme weather events.

Kjaer notes that we need to be prepared for a “huge worsening of the climate compared with today.” Hence FSN has made adaptation strategies a paramount consideration in its investment calculations.