Interview with John McKinley, Director, BlackRock: Just what is ESG investing and how far has it developed beyond ethical investment?

Pádraig Floyd, Consultant Publisher: For years, there have been misconceptions around what exactly sustainability and ESG investing means and the narrative has evolved quite a bit from where it started with ethical investing. What does it mean to you?

John McKinley: We use the term sustainable investing to refer to investments that incorporate social and environmental considerations alongside financial goals. We’ve seen a shift over the last few years from what has been a niche, values-based or ethical investing approach to a more mainstream value-driving approach as more investors recognize that environmental, social and governance (ESG) factors can mitigate risks and identify drivers of long-term value.

We define sustainable investing by three core approaches, which reflect the evolution in motivations and investment tools investors can use to meet their social, environmental and financial goals.

The first approach is using exclusionary screens to remove certain sectors or companies that are not aligned with investors’ values or investment goals. This could involve removing controversial companies or divesting from fossil fuels, for example, to decrease carbon risk. Exclusionary screens remain the most widely used approach today.

The second approach – ESG investing - is focused on using ESG criteria in the investment decision making or portfolio construction. In this approach, investors often seek portfolios that specifically target companies that perform strongly on ESG metrics. Increasingly, investors choose this type of approach on the premise that higher ESG scores can identify stronger fundamental companies which could achieve better long-term performance.

At BlackRock, we articulate three key ways investors can incorporate ESG considerations. The first is ESG integration, which refers to including ESG metrics alongside traditional risk metrics in the standard investment decision process to improve long term outcomes.

The second approach is what we call “ESG best In class,” which is reflected in our iShares MSCI SRI ETF range, using ESG metrics to identify the highest performing companies by sector for those asset owners who want to maximize their exposure to higher ESG rated companies. This particular approach also includes some exclusions, such as tobacco, alcohol, gambling and firearms.

The third approach within ESG Investing is “ESG optimization.” This approach is for the more benchmark aware investor looking to maintain a targeted tracking error as close to the parent index as possible – within 30 to 50 bps – while optimising for higher ESG exposure or in some cases, optimising for lower carbon exposure. We’ve found you can have big impact with small tweaks. Within 30 basis points of tracking error of the MSCI World index, for example, you can reduce your carbon exposure by over 70%.

The third and most recent segment within sustainable investing is Impact Investing. BlackRock defines impact investments on the basis of three core characteristics. First, a fund should clearly define targets for delivering positive social or environmental impact. The objectives should be transparent and clear. Second, the fund should measure and report the impact performance alongside financial performance. Any impact fund at BlackRock, for example, will provide transparent post-investment impact reporting to end investors on a regular basis. Third, these funds should target a positive financial return. We are focused on delivering strong financial performance and finding innovative ways to deliver targeted social and environmental impact across asset classes.

Pádraig Floyd: How is ESG developing to balance the different components (E, S and G) and which are currently most important?

John McKinley: Simply put, we have found companies that effectively manage ESG factors that are material to the operation of their businesses are more likely to create value than those that do not. As such, we expect companies that successfully manage ESG factors to deliver stronger financial performance over the long term. And it makes sense – companies with strong ESG practices tend to quickly adapt to changing environmental and social trends, use resources efficiently, have engaged (and, therefore, productive) employees, and face lower risks of regulatory fines or reputational damage.

There has been increased focus on the environmental risk and opportunities posed by climate change and more institutions and individual investors are more aware of those risks. The market often underestimates and undervalues climate risk as the impact of climate change is not always visible in the near term. We often say that markets tend to respond to the “shark closest to the boat.” Political referenda, changes in monetary policy, and political elections tend to capture investors’ focus. But this is changing as the effects of climate change are becoming more visible, including a marked increase in extreme weather events resulting in more than $1B of damage as well as technological disruptions, including the rise of electric vehicles for example. Investing in renewables is becoming increasingly attractive as solar and wind are becoming cost competitive and in some parts of the world cheaper than coal with 62% drop in cost of solar since 2009. With increased awareness, more investors are mitigating the risks and exploiting the opportunities associated with the transition to a lower carbon economy.

Pádraig Floyd: To what extent has ESG been incorporated into the businesses and investment strategies of asset management companies (there is a lot of scepticism about this). How would you articulate how it has been achieved in BlackRock?

John McKinley: From our perspective it starts from our role as a long-term investor and fiduciary for our clients. In our CEO’s annual corporate governance letters, for example, we’ve made the point as clearly as possible that as a long-term investor and fiduciary, we increasingly recognise the ESG issues - whether it’s global challenges like climate change, resource scarcity or governance issues such as board composition – can and do often have a financial impact at the portfolio level.

We therefore proactively take a view on these factors across all that we do. There are three key ways we address the risks and opportunities associated with these factors.

The first is the BlackRock sustainable investing team which is focused on developing innovative strategies and solutions that by design incorporate social and environmental objectives into the investment strategy. This can range from broad based passive ESG strategies to more thematic funds including a green bond index fund as well as an actively managed New Energy fund and our Scientific Active Impact strategies.

The second pillar is ESG integration – which refers to the entire asset base at BlackRock. We’ve integrated ESG data into our portfolio risk management system, Aladdin. Today, our portfolio management teams have access to E, S and G metrics as well as carbon intensity metrics relative to the benchmarks of the funds they are managing. Leveraging the power of Aladdin our portfolio management teams can assess their portfolios relative to their respective benchmarks with regard to carbon and ESG factors to inform their investment decisions.

The third pillar is our Investment stewardship team, which is now more than 30 individuals globally who engage daily with companies on behalf of all our shareholders, whether they are in passive or active funds. Through private dialogue and proxy votes, this team engages companies to generate more value over the long-term.

Using one BlackRock voice, we often have unique access to senior management and board members to engage on climate risk, for instance, to improve companies’ management of material risks that can deliver long-term value.

Pádraig Floyd: To what extent does ESG deliver better performance? Can it be shown to be an effective investment strategy that makes a difference not only to lives, but returns?

John McKinley: We often say as a starting point that we believe that companies who manage ESG matters that are material to their businesses will create more Long term value than those who do not.

The positive impact of integration of ESG into the business may not be immediately apparent, but it will drive long term financial results.

This is a big focus of ours driving deeper into the research. One constraint has been the lack of data that shows this correlation and as we have the data to expand we will have more data to be able to disaggregate the facts and better understand which factors are most correlated with stronger, long term performance. But overall, we see it is a smarter long term decision to use ESG factors to identify fundamentally stronger companies and to mitigate risks.

Our active equity and systematic modelling teams – investment teams filled with data scientists who have come from places like NASA and Google – have historically used big data to identify alpha signals. Over the past few years, they have used their access to big data to examine the relationship between carbon efficiency and performance and within the available data sets. They found that those companies that can produce more revenue while using less carbon are oftentimes stronger fundamental companies, as they are more operationally efficient and have stronger management practices. That bears out looking at the performance over time between companies that are carbon efficient are outperforming the carbon cutting laggards.

The team extended the analysis beyond carbon to look at climate efficiency, developing 17 different indicators in a model and scoring a universe of companies based on how climate friendly they are in terms of climate opportunities, climate risk and their own investment in these technologies. They tend to be the ones managing their ESG risks and outperformed the market by about 7%.

Increasingly, we’re finding that being more climate aware can have a positive impact on performance across your portfolio, rather than any negative ones.

Pádraig Floyd: How should ESG be measured, as it is often difficult to contain it within a benchmark, and many investors are moving away from their use in any case. How should they be addressed?

John McKinley: The specific approach will depend upon the asset class and investment style, but we think it’s important to be as transparent as possible about the objectives, whether broad based ESG exposure, or to generate a targeted social and environmental outcome.

For more thematic or targeted approaches, for example, we have developed specific impact reporting relative to those targets. We’ve done this in our renewable power fund for example, and aggregated systematic data for investors concerning the overall production of renewable power by megawatt, the overall reduction of carbon, water usage stats – often information gathered during the deal stage – and translating this data into more easily digestible metrics. So, instead of reporting mega watts of renewable energy produced, for example, it could be most useful to translate that metric into the number of households powered by energy from renewable sources.

Ultimately, we show how they are meeting these objectives in a measurable and credible way.

Pádraig Floyd: Where will ESG be in five years time? What will be the key drivers to influence its development?

John McKinley: We see an increased trend in mainstreaming the integration of ESG factors in the investment process, as ESG becomes a tool that investors can use to make better long-term decisions.

There are a number of macro factors driving increased and adoption of sustainable investment solutions.

One is the transfer of wealth to two key demographics: millennials and women. Both will take control of the majority of assets and already seek to align capital with companies that are driving positive social or environmental impact.

Millennials, for example, are expected to inherit $30 trillion to $40 trillion over the next 30 years and are already twice as likely to invest in a company that has a net positive impact upon society. They are already driving adoption and we expect that to continue to grow.

Organisations are also responding to constituent pressure. Institutional investors are under pressure to take action in line with their fiduciary responsibilities and increasing ESG disclosure regulatory requirements.

Foundations and endowments are also looking to align their portfolios with their organisations’ missions. An environmental foundation for example by design will seek to advance positive sustainable outcomes is placing more pressure on CIOs to align investment strategies with the mission of that organisation. And companies are under pressure from their investors and consumers to use more sustainable practices up and down their supply chains and consistently disclose how they are managing material ESG risks and opportunities across their operations.

Sustainable investing is no longer a niche pursuit or a feel good exercise. It’s an increasingly important component of smarter long term investing.

This interview is part of the Investing in a Sustainable Future 2017 report - you can download your free copy, simply enter your details online.

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