Responsible Investing and the use of ESG has become an important topic in the investment industry. There are some misconceptions around ESG, however, and how these factors are integrated into the investment process.

Addressing this, Sue McNamara, Beutel Goodman’s newly named Head of Responsible Investing, joined Marcia Wisniewski, Vice President, Private Client Group, to discuss this topic, focusing on these three key questions:

1. ESG has been on the end of some negative headlines recently—why do you think it’s receiving some backlash?
2. What does Responsible Investing mean to Beutel Goodman and how does the firm integrate ESG into its investment process?
3. Are there differences in how you apply ESG factors across your fixed income and equity strategies?

 

This recording took place on October 20, 2022. The following transcript is edited for clarity.

 

Note: The information in this transcript and recording is not intended, and should not be relied upon, to provide legal, financial, accounting, tax, investment or other advice. This is not an invitation to purchase or trade any securities. Beutel, Goodman & Company Ltd. does not endorse or recommend any referenced securities.

 

Marcia Wisniewski: Welcome to the latest in our 3 Key Questions series. Today we will discuss three key questions on responsible investing. Thank you all for joining us.

We acknowledge the land we are on is the traditional territory of many nations, including the Mississaugas of the Credit, the Anishnabe, the Chippewa, the Haudenosaunee and the Wendat peoples and is now the home to many diverse First Nations, Inuit and Metis peoples.

We also acknowledge that Toronto is covered by Treaty 13 with the Mississaugas of the Credit and the Williams Treaties signed with multiple Mississaugas and Chippewa bands.

I’m Marcia Wisniewski, Vice President of the Private Client Group at Beutel Goodman. Today, we have the pleasure of speaking with Sue McNamara about our 3 key questions. Sue is the Head of Responsible Investing and Head of Credit, Fixed Income here at Beutel Goodman.  Sue joined us in 2006 and has 25 years of investment industry experience.  She is a graduate of the University of Western Ontario and a CFA charter holder.

Following our 3 Key Questions, we will also have a short Q&A with Sue, and we invite you to contribute by typing any questions you may have into the Q&A section at the bottom of the screen

Broadly speaking, responsible investing is a strategy that applies E S G (environmental, social, and governance) criteria alongside more traditional financial measures to evaluate potential investments.

With that in mind, I would like to begin with the first of our 3 Key Questions, which is:

 

ESG has been on the end of some negative headlines recently—why do you think it’s receiving some backlash?

 

Sue McNamara: Great, thanks. It’s a great first question to kick off. You know, in many ways it has been ESG’s summer of discontent and the practice itself has been under fire on numerous fronts, which I’ll try to outline briefly in the next few minutes. I think one of the main problems is really the definition of ESG itself. It’s very broad and it can encompass very diverse and different investing styles, from divestment and negative screening to integration to impact investing. I think a lot (of people) can get confused with the type of ESG investing you’re doing.

So, let’s start off with what’s really drawn a lot of headlines for the asset management community, and this is the sense of greenwashing funds. There are investigations undergoing both in Europe and by the SEC in the U.S. and we know that the Canadian securities regulators are also looking at this. If you have ESG or sustainable or responsible investing or any of those labels on your funds, the regulators are going to make sure that you’re doing what you actually say you are doing. If you say that you have fact sheets in ESG work for every single company in any of your portfolios, they have the rights to ask for that.

So, they’re mining your investment objectives and then going in to make sure that you’re doing the work. There have been some high-profile cases already. DWS has been fined—the cops showed up outside their offices in Europe. Goldman Sachs and Bank of New York Mellon also have funds that have been flagged [by regulators]. So, this has got a lot of headlines, but on one front, I actually think this is almost a positive for ESG.

You know, it is time to bring confidence to the ESG investor. With these regulations and investigations once they’re through, you have some confidence that if a fund says it’s responsible or sustainable, you know it’s been vetted by the regulator and it gives you that level of confidence in investing there.

Another high-profile case has been in the U.S. on the state side, where several Republican-led states have had a backlash against ESG, saying they don’t think that’s part of a fiduciary duty of an asset manager. You’ve seen Texas that has banned asset managers who have fossil fuel-free investments. And you’ve also had Florida, who said they will not hire any investment manager that has anything to do with ESG in their research process.

So, this is a case where I think people are misunderstanding the different parts of ESG. For Texas, not all ESG screens out fossil fuels. In fact, I think fossil fuel divestment is declining as a tool, and more so moving towards engagement and integration. I understand from the Republican-led states’ point of view, they’re saying that the only thing that you should do is focus on returns versus your benchmark, and that ESG doesn’t belong in that sort of analysis. Maybe part of that is just misunderstanding what ESG is. ESG doesn’t mean that everything that you do is investing with an eye for what’s best for the globe—that’s impact investing. ESG integration is looking at ESG through the lens of risks and opportunities. And I would say it blends very well with fiduciary duty, because there are very few companies that score poorly on the ESG front that would add value to your portfolio.

The last thing I would say on this is that the states are saying that decisions on the environment and social and governance belong at the government level. We probably wouldn’t be in the position we’re in right now where we’re relying on the corporate world to move the needle forward on the environment side if governments had been doing a good job from the beginning. I mean, we’re behind on our Paris Accord commitments. So, you need more than government to do this. It’ll be interesting and it’s going to continue to garner headlines in the U.S., but I think a lot more understanding of what’s going on needs to be disclosed to the market.

Also, what’s been very topical this year has been the Russian invasion of Ukraine.

I think that’s brought up two criticisms of ESG. First and foremost, I was very disheartened to see after the invasion, the number of funds that had labeled themselves as ESG or responsible or sustainable that actually owned Russian sovereign debt. I think that is a definite problem for the industry. Part of the social—the S in ESG—is investing in governance and governments and sovereigns where you feel that they are part of the UN global compact and part of that is that they have a certain respect for their citizens and the rights of their citizens. And I think you could argue to a certain degree that Russia does not respect the rights of its citizens. So, I think that was a bit of a black mark against ESG, to see the amount of sovereign debt that was held by Russia in those types of funds.

And second is a bigger issue that’s going to play out over a longer period of time. That is the criticism saying that you have Europe that is at the forefront of ESG, but you also have Europe that is an energy taker and is being really effectively cut off from gas and oil from Russia and requiring a lot of sovereigns to backtrack on some of their renewable energy policies. Now they’re trying to source crude and oil from other places. They’re ramping back up nuclear; they’re ramping back up coal in the extreme cases. And isn’t that just the complete antithesis of what the E in ESG is trying to do? I would agree with that, but you know, I’d also say that I never thought that the path to net zero was going to be smooth and that we were going to be able to reduce our GHG emissions by 8% per annum and smoothly get to that net zero target.

It was always going to be bumpy and disruptive. So yes, in the short term, we’re probably taking a step back, but in the long term, we’re probably going to incentivize governments in Europe to escalate on the renewable power front; to escalate in the adoption and the efficiency of battery technology as a way to store electricity; to look at alternative fuels. So we might be taking a step backwards, but hopefully we’re going to accelerate going forward.

Another area of criticism that I’ll address too is on the third-party ESG rating agencies, There’s a lot of rating agencies that are looking at this, from MSCI, to Sustainalytics, S&P, ISS, Bloomberg and CDP and there’s a lot of criticism, and there’s a lot of differences between those ratings. How can one company be rated highly at one of the rating agencies and at the bottom of the pack at another rating agency? And I think a lot of this has to do with what are they looking at? Are they evaluating the company based on what they disclose, or are they evaluating the company on the quality of that disclosure? Are they weighting things differently for a data security company or a company like Telus who has a lot of customer information. One of the rating agencies weights the protection of that data very highly, whereas another of the rating agencies rates the governance very highly. And so it has very different ratings. So, I think that’s coming out in the differences and part of your job as the investor is to understand the differences between the ratings and what the companies are doing.

Having a background in fixed income, we never relied solely on a credit rating for a company. And likewise, we would never rely on a third-party ESG rating for a company. You still have to do your own due diligence and your own work. Those ratings are there as a tool to help you out and to help you with your work, but they’re not the sole thing that you look at. And this is the challenge for some of the passive ETFs that are out there if you’re constructing an ETF based on that rating. There could be issues with that rating or issues with the way that rating is derived—is the ETF really achieving what you want it to?

So, that’s a long list and I could probably get into a bigger list of issues that have been plaguing ESG. But, it’s still a fairly new kind of concept. It’s still growing; it’s not the end, it’s just, the growing pains of this type of strategy. And I think knowledge, as with anything, is power. The more people understand this, the better. You can’t look at some of the climate-related events that we’ve had over the past weeks and months, from wildfires to hurricanes, and say that we don’t need to do something on the E (environmental) side.

Also, there is the S (social) that’s involved too. I think a lot of people kind of ignore the S and think that, well, geez, E should be about environment and environment should be about emissions. No, I think, the S is important in that as well. You could have a company that has the best carbon footprint and the best directionality to get to net zero by 2050. But then again, when you start looking on the S side, maybe that company has a horrific safety record or uses labour practices like child labour or slave labour. Or maybe that company has run roughshod over indigenous, Metis or Inuit rights in their pursuit of that. So, the social and the concept of a just transition and an energy transition goes hand in hand.

I think a lot of this is going to come down to investor understanding and asset manager understanding. The asset manager needs to clearly define how they are looking at ESG, how they are integrating it, and how they are applying it across their funds. And the investor needs to read those investment objectives and really understand what the asset manager is trying to achieve. I think there can be some differences in that. The asset manager, if they’re doing integration like we are, is looking at the risks and opportunities of ESG. I think some investors see ESG and the headlines and think, oh, they’re doing good for the planet. I think that kind of understanding, the gap has to close for ESG to continue to go forward.

Marcia Wisniewski: It is an education process. Well, the second question is…

 

What does responsible investing mean to Beutel Goodman and how does the firm integrate ESG into its investment process?

 

Sue McNamara:  So, I touched on it a little in the beginning on the different types of ESG investing. At Beutel Goodman, we’re looking at it from an integration point of view. We do not divest; we do not stay on the sidelines and say we’re not going to invest in fossil fuels or other types of companies like that. The way we look at it is, we integrate ESG into the research we do on the companies that we invest in. We look at it both on the risk side, as well as an opportunity. We’re an active owner and we’re an active manager of what we own. So, on the equity side, we’re active with the use of our proxies. On both fixed income and equities, it comes down to engagement as really the key way that we can forward our ESG objectives.

The way I look at it is, if you divest, you really have no say in anything. You’re sitting on the sidelines watching things take place. As an active manager, you’re in front of management teams; you’re in front of the board; you’re engaging; you’re sitting in front of these teams as a large equity holder. We run very concentrated portfolios on the equity side and fairly concentrated on fixed income too. So, we are pretty meaningful when we’re engaging with the companies that we invest in. You can effect change much more effectively in dialogue with these companies than you can on the outside looking in.

We also participate in collaborative initiatives. We’re a member of Climate Action 100+ that targets some of the biggest emitters globally. We’re one of the founding members of Climate Engagement Canada, taking the principles of what CA 100+ does, but applying it with a Canadian perspective. We are a supporter of TCFD (Task Force on Climate-related Financial Disclosures), and we expect to be releasing our first TCFD report before year end. So, we’re collaborating not just with ourselves, but collaborating with our competitors. The more people that are together, the more powerful we can be in implementing change.

I think it’s always best to give an example of engagement in action. A good example of a joint engagement we did was with Suncor. Suncor, as you may know, was targeted by an activist investor for some of its practices. We spoke with the CEO and the CFO on several occasions. We talked about how on some levels we did support what the active investor was going after. Suncor definitely needs to improve its record on safety. There’s definitely operational efficiencies that have been promised for a long time that weren’t delivered on. But we also wanted to make a point that from the fixed income side, we disagreed with the activist investor that debt should be levered up and all of the proceeds from levering up the balance sheet should be put towards shareholder-friendly share buybacks and dividend increases. We wanted to make it clear that was neither good for us as the debt holder nor really for the equity holder. So, we worked together on the equity and fixed income side in those engagements.

As I said, proxy voting is very important. And a great example of how we used that power was with AmerisourceBergen. A long story there, but in a nutshell, the company had been subject to opioid legislation, lawsuits and investigations that they had to pay fines on. The management decided that when they were going to calculate their executive compensation, they were going to exclude the amount that they had to pay for those lawsuits and those fines from consideration. We strongly disagreed with that—you own what happened and the fact that the business that you are in, and your business practices, puts you in the line of fire and exposed to those fines, that should be taken into account for your executive compensation calculations. And if it led to lower bonuses, so be it.

So, we discussed it with the CFO that we disagreed with this. We discussed it with the compensation committee of the board of directors. We wrote a letter to the entire board and in the end, we [voted against the proposed executive compensation]. That’s the kind of escalation of views put into action. As the equity holder, you do have the ultimate power in proxy voting and you can escalate in that way. That in a nutshell is how we do ESG at Beutel Goodman.

Marcia Wisniewski: Excellent. Well, you have spoken about a little bit about the equity and fixed income strategies, but I want to drill down a little bit further.

 

Are there differences in how Beutel Goodman applies ESG factors across its fixed income and equity strategies?

 

Sue McNamara: I think there’s three main differences to look at. The first comes on the proxy side. Unfortunately, on the fixed income side, we can’t vote on proxies for management; we get to vote on proxies when there’s a covenant change, but that’s procedural and really has nothing to do with the running of the company. So, we’re kind of powerless on that front. We really have to focus on engagement as our main tool. The good thing for fixed income is that usually companies are issuing debt more frequently than they’re issuing equity. It puts management in front of us as the debt investor a lot more often than on the equity side. They need our money, so they do have to—to a certain extent—listen to us. I mean, what we’re really looking at from the fixed income side on governance is that there is balance between the motivations of management between debt and equity management.

Teams aren’t compensated in bonds; they’re compensated for the most part in stocks. So, we do understand that to a certain extent their motivations are driven to increase their stock price. A lot of our engagement with them is probing management to make sure that we understand that they want to drive the stock price up, but they do have to show some love and appreciation for the balance sheet because that is equally important. Don’t raise debt to where the sole use of proceeds from that debt raised is to pay a dividend or to do a share buyback. My job is not to lend money to enrich the shareholder possibly at the expense of the debt holder. So that’s a lot of the work that we do in the engagement side.

Another way that bonds are a little bit different than equities, and is maybe the most exciting part for me, is the concept of sustainable finance. In the bond market, you can buy green bonds, you can buy social bonds, you can buy sustainable bonds, and you can buy a fairly new product called sustainably linked bonds (SLBs). You can directly participate in the energy transition by buying bonds where the use of the proceeds is 100% dedicated to that goal. If it’s a green bond, it could be used for renewable power projects, or it could be used for converting a building to LED lighting.

Some banks have been issuing social bonds where the proceeds create a pool of lending for people who wouldn’t necessarily have been a high priority for the bank.  Female entrepreneurship, Black, Indigenous and People of Color (BIPOC) entrepreneurship, those types of lending programs can come through social bonds. A lot of social bonds are issued by sovereigns or municipalities for affordable housing or other projects like that.

Sustainability linked bonds are interesting. It’s a concept where you can actually use the proceeds for general corporate purposes. But what you’ve set in the structure of the bond is a key performance indicator. Say, the company will reduce GHG admissions by X percent by a certain date. Or, they want diversity on their board. There are a number of key performance indicators that have been identified by the International Capital Markets Association, which is one of the watchdogs of the sustainable finance industry. You put these in place and if it comes to the date you said you were going to meet those key performance indicators (KPIs) and you don’t, you actually end up paying a penalty. The penalty is from the observation date to the maturity of the bond. It’s usually in the form of a step up in the coupon that you pay.

I think these are exciting bonds and good for the industry, but unfortunately they’ve come under a lot of scrutiny of late. Just as with asset managers who could be bad actors, there’s been some issuers who have been bad actors on this front. A recent study by Bloomberg looked at about a hundred financings of SLBs, mostly in Europe because Europe is a little bit farther ahead than North America on this front. They found that the majority of the targets were pretty weak or irrelevant. And in some cases, they’d actually already achieved the target. This is a kind of trick where a target is set say for 2030 based on a 2019 baseline, or 2022, so you have a good sense of where the company is. Some companies have been issuing SLBs where they’ve already achieved their objective—that doesn’t make sense. I’ve been working really hard with a lot of my colleagues on this, reinforcing the fact that the KPIs have to be meaningful to your business. There was one bond issued in Europe where the company was targeting its Scope Three emissions, but its scope one and two emissions were 98% of its carbon footprint. So it doesn’t matter if you’re reducing your scope three emissions, that’s great that you are, but it’s really not moving the needle for what a company is doing towards its energy transition and towards its decarbonization. The KPIs that you set have to be material to what the company is doing. They have to be ambitious. It can’t be easy to be able to achieve these goals, and they have to really move the needle. Don’t use energy intensity as a goal—use your absolute reduction of emissions because if you want to get to net zero by 2050, that’s what you have to reduce. Make sure that the observation date—the time between when the penalty kicks in and when your maturity date is—is meaningful. It has to be a few years. It can’t just be a few months because then what’s the point? And also, a coupon step up of 25 basis points in a company that has billions of dollars of revenue is nothing for that company. What is the incentive for them? I think coupons have to get a lot more meaningful.

Going back to the issues about sustainable finance, and if you’re running a sustainable fund. We run a BG Sustainable Bond strategy, but we don’t buy anything that’s labeled green or social or an SLB just because it’s labeled that way. No, you use the same due diligence that you do when you’re looking at credit. Then there are companies that have issued green bonds and I’m not against the fact that they’ve issued a green bond, but their whole business is green. You don’t need a green bond for that because what you do is green. I would hold that company in my portfolio if the credit quality was good because I’ve assessed that their business is green, like a renewable power developer.

Then there are other companies that are asking for a greenium. This is the concept that because your bond is sustainable, or social, or an SLB or green, you can issue it at a better price than if it was just a generic bond. Okay, that’s fair to a certain extent, but earn your greenium. If it’s ambitious, if it’s material, I’d be willing to pay a small greenium. But if you don’t, or if you’re already doing what you say you’re going to do, then you don’t get a greenium, I think that’s going to start to shake up the market, this new level of due diligence that has to be done on sustainable finance, and that’s going to get pushed back to the investment dealers and to the issuers and hopefully that’s going to bring a lot more credibility to this industry.

I would also like to just touch on another point related to this. When you’re constructing a portfolio that is committed to net zero or sustainability, it’s really easy to go out there and select a group of bonds that are just inherently green and have low emissions and your portfolio looks really great versus the index. But are you really contributing to the energy transition? Especially in North America where we are producers of energy for the most part and not takers of energy. So in the beginning, we may have to get dirty to get better, and that means investing in companies that produce natural gas, that produce crude oil, that are midstream companies, that are transporting the oil, or coming up with carbon capture and storage solutions or other types of solutions. You may invest in these companies if you have done your work and if you’ve engaged with the company and think that that company has a credible path to get to net zero by 2050. You’ve engaged and see that they have interim targets, that their targets are science-based and the executive compensation is tied to those targets. If you’ve done due diligence and you feel like the company is on the right path, and you keep on checking back on them and if they fail on their target, then there’s going to be more difficult conversations—you should be able to invest in that. I mean, we have an opportunity as investors to help with the energy transition and with the pathway to net zero and sometimes that means getting a little more dirty than maybe you would’ve liked to.

Marcia Wisniewski: You learn something new every day, the green premium, that’s very interesting. I want to thank you Sue for going into such detail and explaining the complexities of responsible investing in ESG.

We’re moving on to the Q&A portion of our webinar and we’ve received a number of questions from the listeners today. But in the interest of time, I’m going to have to just select a few…

 

Are there any industry benchmarks for ESG investing or is it subjective to each investor based on their own priorities?

 

Sue McNamara: There are ESG benchmarks—Bloomberg produces a set; FTSE produces a set. I think you have to do the same amount of work on investigating the benchmark, the same way that you would investing in a fund. When I discussed about the issues with third-party ratings on ESG, a lot of the indices decide what goes in the index. So MSCI’s indices are based on MSCI’s ratings. The companies that end up in the MSCI Leaders ESG Index are its top rated companies. So, the benchmark can be flawed by the way they decide who is included in the benchmark and who is excluded. We’ve decided for the BG Sustainable Bond strategy to benchmark it against the FTSE Overall Bond Universe, the benchmark of all benchmarks for fixed income, because some of the bond indices are green bonds only. Well, I don’t want to be measured against a green bond index because I can buy sustainable bonds and social bonds and SLB bonds. So we’re going to continue to monitor the space, but there are choices there, and there are ETFs that are based off those indices, but you have to understand what the criteria is for inclusion in the index.

 

Given the importance of Canada’s energy sector to the overall economy, what are the implications of a greater focus on ESG factors in this country?

 

Sue McNamara: It’s interesting. In Canada, we’re borrowing a lot from Europe as the leaders on this, but Europe is an energy taker and Canada is an energy producer. So, we have a different role to play, but it’s not necessarily an opportunity lost. I think it could be opportunity gained for Canada and advantage Canada. It goes back to my comment on getting dirty. We could be a leader in carbon capture and storage. If we can get the technology right, we could be a leader in hydrogen. Again, that’s a long path. That’s a lot of technology to be put in place. If you even think of the magnitude of investment that’s going to be required if we are going to really get to net zero by 2050. I mean, you can blend hydrogen in the gas stream probably up to 20 to 30%, but to go further means that every appliance in your house has to be replaced by an appliance that could run off hydrogen.

So if you’re going to run hydrogen through a pipeline, you need new pipelines, you need a different way of running pipelines. Hydrogen is lighter, it moves faster, it’s more flammable. So thinking of those microcosms of how much capex and how much infrastructure spending is required to do this—we can choose to invest and fund this and be a leader, or we can choose to not, for lack of a better word. I think there’s a huge advantage to Canada, but we have to get it right and we have to make sure that we hold our companies’ feet to the fire to make sure that they’re not just making a blanket empty promise to commit to net zero by 2050, that they’re really committed there and that we continue to engage and push them forward.

Marcia Wisniewski: I think we just have one time for one last question.

 

Should ESG really just be the E and shouldn’t the E refer to emissions specifically?

 

Sue McNamara: I have sympathy for that—when you think about ESG, you think about the environment; you think about commitments to net zero. We probably have an oversized conversation when we talk about ESG, that it’s weighted to the E, and then you realize, oh, I’m talking about ESG and there’s an S and a G here too. If you look at infrastructure projects; if you’re building an infrastructure project in Canada, there’s not one piece of land that doesn’t touch indigenous, Metis or Inuit rights or treaties. So they have to be part of the conversation. They have to be part of the process, training, education and employment on those projects. Social means looking at the treatment of workers, the sourcing of raw materials through a supply chain that may come from countries that engage in slave or child labor.

You have to look at that as part of your investment because nothing can destroy value at a company more than a bad headline or a controversy. You can take the example of SNC with the bribery and corruption scandals and the destruction in value of that stock. You don’t want to have a company that you’ve invested with, engaged with and vetted to be on the front page of the paper for having done something like that. So, social plays a huge part. Governance is maybe the trickiest part because really you should be always looking at governance whether you’re got ESG or not. But as I spoke about before, the governance is really about active ownership—taking what you have researched, and engaging with companies, and then voting in your proxies.

Marcia Wisniewski:  Thank you Sue for all your insights on this very important topic.

There are a number of questions we are not going to get to, so if you have a question that we did not get to, your Beutel Goodman representative will be pleased to follow up directly with you. Also, for those of you who would like to learn more about Beutel Goodman’s approach to responsible investing, please feel free to reach out to your Beutel Goodman representative to receive our regularly published responsible investing reports.

You can also visit our website at www.beutelgoodman.com. There’s quite a lot of information there as well. Thank you all for joining us and I hope you have a great day!

 

 

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