Responsibility Matters April 2020

RESPONSIBILITY MATTERS

RLAM’s Responsible Investment Review April 2020

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Responsible investment – materiality matters

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Gas utilities in a net zero economy

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The Big Interview

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Tail(ings) Risks A liability for mining companies that’s hiding in plain sight

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Six common misconceptions about recent changes to pension regulation and the consideration of ESG

FOR PROFESSIONAL CLIENTS ONLY, NOT SUITABLE FOR RETAIL INVESTORS.

Change really is the only constant Piers Hillier, Chief Investment Officer, Royal London Asset Management

The outbreak of the coronavirus is having and will have a fundamental impact on how we live our lives. We expect it to impact how investors look at companies from a responsible investment (RI) perspective as well, accelerating a trend that was becoming more noticeable as we moved through 2019 and into 2020. While environmental, social and governance (ESG) issues have been a core focus for us for a long time, the last 18 months has seen them being increasingly in the minds of the general public, politicians, companies and investors. Although regulations are part of this – with the new rules for pension trustees to outline their approach to engaging with companies and voting their shares the latest example – it is clear that we are seeing a material shift in how society views these issues.

Executive pay is an established point of concern, and remains a key area of activity for us. But RI is now much broader, looking right across the ESG universe to identify and deal with areas of specific interest or influence. The team’s research into tailings dams is covered in this edition is a great example.

It is fair to say that ESG considerations are integrated in different ways across our investment teams. This reflects our belief that ESG will help produce better long-term returns, but that a one-size-fitsall approach simply won’t work. Equities, bonds and property all require tailored approaches, and different regions and countries have different norms that make direct comparisons difficult – so for instance, US, Japanese and UK public companies have different attitudes towards board independence and splitting CEO and Chair roles.

We continue to invest in our RI capability, as this is an area that we have to get right for our investors. In addition, as a mutual, we believe that this is a natural fit for us, and the whole Royal London Group continues to develop its strategy around issues such as climate change, diversity and social impact alongside responsible investment. Just as importantly we’re talking more with clients, so you know what we’re doing and why. This can be seen in recent publications such as our policy paper on Pensions and ESG, our annual stewardship report and the regular inclusion of ESG activity in our quarterly reports.

I hope you enjoy the magazine. If you have any comments – either on subjects you’d like to see covered or the underlying actions we’ve been taking at RLAM, we’d love to hear from you.

Email us at communications@rlam.co.uk

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Responsible investment – materiality matters OVERVIEW Even though responsible investing seems like a new and exciting growth area, the approach has actually been around for more than 100 years. Starting with the Quakers in the 1800s, who made it clear they didn’t want to invest in alcohol and weapons etc, there has been an ongoing evolution in approaches and definitions through to the current day. The evolution has been driven by significant historical events, such as apartheid in South Africa and the global financial crisis, and due to changing social attitudes and regulatory changes.

Along with the changing approaches to responsible investment, we have seen the introduction of varying terms which highlight the slight nuances in each approach as these have evolved over time. While the growth and evolution of responsible investing has been a positive

one, the introduction of a range of terms has created some confusion in the market about what each one means; something that is often exacerbated by many professionals using the terms incorrectly and interchangeably.

These terms can be broken down into ethical, responsible, sustainable and impact investing.

DEFINITIONS

Ethical investing originated in the 1970s and is defined as an investing approach which is based on negative screening, whereby the investor screens out holdings based on ethical or moral principles – for example the exclusion of tobacco. RLAM currently runs one ethical fund, which adopts a broad policy of not investing in companies with significant trading interest (defined as 10% revenue threshold) in certain sectors. These sectors include

gambling, pornography, tobacco, alcohol, armaments etc. Our cash funds also do not invest in armaments or tobacco.

In the 1990s, ‘socially responsible investing’ was introduced as a concept, where investors started to broadly consider the ethical as well as environmental and social implications of their investments, recognising that managing waste and avoiding environmental fines will help to boost overall financial performance.

That has now evolved, and responsible investment as a term is still used widely today. At RLAM, we use responsible investment to describe our overall approach to how we manage our clients’ assets. This includes our commitment to be a responsible long-term steward, vote our shares, and actively engage with the companies we invest in on environmental, social and governance (ESG) issues. It also includes how we manage money,

The impact economy Traditional

Ethical

Responsible

Sustainable

Impact

Philanthropy

“I’m aware of negative impact but I don’t consider it in my investments.”

“I want to avoid investing in harmful companies, i.e. tobacco.”

“I want to act responsibly, and integrate ESG factors into my investments.”

“I want to invest in companies contributing to a sustainable future.”

“I want my investments to help tackle issues like climate or education.”

“I want to give back to society.”

RLAM’s current focus

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by considering material ESG issues when making investment decisions. We think taking this approach helps create better outcomes for customers and beneficiaries.

The concept of sustainable investing is one that has been introduced in the past twenty years. The focus here is on directing investment to companies that contribute to a sustainable future e.g. an energy company with significant renewable energy assets and plans for further expansion. RLAM currently operates a number of sustainable funds, where our processes ensure we select companies for the funds which either demonstrate clear ESG leadership and/or which offer a clear net benefit to society.

The evolution of RI has been driven by significant historical events Most recently the term impact investing has been introduced to the market and is starting to gain increasing momentum.

Impact investing enables investors to invest with the intention of creating social or environmental benefits and also allows them to measure these benefits (impact).

Quakers & Methodists No weapons, alcohol or tobacco investment

1800s

Impact investing is still a reasonably new concept and often causes a lot of confusion for clients. The main difference is that the primary aim is to generate a social or environmental impact, and this is often best achieved through very focused private equity style investments. Measuring these ‘impacts’ is also more of an art than a science, and the methodologies around this are continuing to mature and evolve. It is likely the investment options currently available will adapt over time, as expectations are honed and investor expectations catch-up.

THE EVOLUTION As with the evolution of terminology and investing approaches, expectations of investors are changing and shifting and changing. Regulatory changes, increased customer demand and awareness and the acceptance that ESG integration has no detriment on returns means these concepts continue to gather momentum and the terminology will continue to evolve. The advice we like to give our clients is to not get too caught up in terminology when choosing a fund or fund manager because language will change over time. Rather, focus on their investment process, the core aim of the fund and their track record, and whether this aligns with the ultimate needs and requirements of the end customer.

Principles for Responsible Investment – now $85 trillion, >2,200 signatories

Chernobyl, Exxon Valdez (Corporate Social Responsibility)

1970s

Growth of ‘SRI’ funds

1980s

1990s

South Africa divestment, Kyoto Protocol on climate change

2006

UN Sustainable Development Goals

2008/9

Global Financial Crisis

2015

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GAS UTILITIES in a net zero economy

In June 2019, the UK committed to a legally binding target of net zero carbon emissions by 2050; an ambitious aim which will impact every sector of the economy, as well as closer to home.

2018 was the first year in which the UK’s households emitted more CO2 into the atmosphere each year than its power stations, according to provisional government figures. Much of this comes from burning gas in order to heat our homes, our water and our food. A relatively small number of companies are involved in moving this gas through the nationwide transmission network, into the local distribution networks and, finally, into our homes.

Whichever strategy is chosen, we would expect to see much lower demand for gas To gain an insight into what net zero would mean for the sector, RLAM engaged with the companies which transport this gas in local areas.

Conventionally, the bonds issued by the UK gas networks are seen as relatively low risk investments by the credit market, underpinned by a stable regulatory framework and an expectation that the pipes on which they earn their returns are here to stay. We wanted to ensure that this thinking still held true in a world of net zero.

GETTING TO NET ZERO Burning natural gas might produce less CO2 than coal or oil, but the contribution it makes to emissions is still substantial, representing half of all emissions in the UK. The UK will need to overcome several challenges in order to get to net zero, but ultimately we assessed the implications of three potential scenarios: • Fully electrify – phase out gas networks and expand use of renewables. However, phasing out gas altogether would require a huge increase in capacity to meet peak demand as current capacity is nowhere near enough.

• Burn something cleaner – burning hydrogen has only water vapour as a by-product, while around 75% of distribution networks can already carry hydrogen. However, the cost of producing hydrogen would still lead to increased costs for consumers. This switch would also lead to new boilers and other appliances being required in every home.

• A blended option – most of the gas companies envisaged a future in which networks used a variety of methods to meet their decarbonisation targets, for example by using more bio-gas or partial injection of hydrogen up to levels which existing appliances can tolerate. However, this focus on localised solutions can hinder national solutions, for example in the case of extreme weather events in one part of the country, and make it harder to balance national energy supply and demand.

IMPLICATIONS FOR INVESTORS There are clear investment implications and conclusions to be drawn from this engagement and analysis. No single scenario offers a perfect solution, and with the clock ticking towards 2050, it is still not clear what strategy the gas networks will adopt. However, whichever strategy is chosen, we would expect to see much lower demand for gas.

As providers of long-term financing to the gas network, understanding the potentially enormous impacts of decarbonisation is vital, particularly when this sector is viewed by many as very stable in a longterm context.

This project is a further example of how effectively integrating ESG and credit analysis better informs evaluation of credit risk, providing our credit team with increased opportunity to build more sustainable portfolios for our clients.

For a more in-depth article on our analysis of the gas or water sectors, please go to Gas utilities in a net zero economy: avoiding Ofgem’s death spiral

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THE BIG INTERVIEW ‘ It isn’t simple, but it is essential’ Azhar Hussain, Head of Global Credit at Royal London Asset Management (RLAM), explains what ESG (environmental, social and governance) means to him.

Azhar heads up RLAM’s global credit team, a responsibility that includes the management of several portfolios, including RLAM’s two global high yield funds and multi asset credit strategy. These funds invest in less well-known parts of the fixed income universe – high yield bonds and loans. Azhar created the team on joining RLAM in 2012. Collectively the team has a wealth of experience.

“The emphasis has been to create a team of diverse experience and expertise, as I think this brings a greater variety of views and a better challenge,” he says. “But we do share an underlying view that you have to research and understand every bond or loan that you are going to add to a portfolio. And to do that properly, there are no shortcuts. That’s something that we’ve all done throughout our careers”.

A lot of high yield bonds and loans originate from companies that are not listed on equity markets. So the ‘off-theshelf ’ research that is available for many listed companies just isn’t available.

“We’ve always placed an emphasis on governance. When you’re looking at a company that isn’t quoted, you want a degree of trust in the numbers you are looking at. The quality and integrity of management and owners cannot be understated here.”

As a bond investor, my upside is almost always less than the downside

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A TAILORED VIEW The high yield market is less homogenous than the investment grade universe. This means that research has to be bespoke.

This applies to ESG analysis as much as traditional financial analysis. And while Azhar and his team are comfortable doing some aspects of ESG research, there are changes in this area that make having a specialised team essential.

For example, RLAM’s Responsible Investment team have carried out a review of all the bond holdings in the energy and chemical sectors.

“The difference between the best and the worst ESG performers can be very marked – so for instance, when looking at oil exploration companies, we see some that are trying to reduce the impact of their operations by running their rigs on renewables where possible and are transparent about boardroom pay and the like. Others are trying to drill in more controversial areas such as the Arctic and are less willing to discuss governance with investors”.

We’ve always placed an emphasis on governance “The oil sector research was a good demonstration of how ESG factors are a key element in our investment process. It highlighted that there is a real difference in terms of what companies are doing to address ESG factors and hence the risk that bond holders are taking. As investors, we want to make sure we are properly rewarded for this risk in each investment.”

Tailored research is also useful as it can show where ESG progress is real or cosmetic. Instances of ‘green washing’ –

The emphasis has been to create a team of diverse experience and expertise where PR and marketing can suggest that a company’s ESG credentials are stronger than is the case – are not widespread, but are nonetheless something to look out for.

Some companies are now issuing green bonds – which state that the proceeds raised will be used for green activities, such as the generation of renewable power. But a convenient label cannot replace bespoke bottom-up ESG analysis. We are also cautious about the financial attractiveness of some green bonds given that there is high demand and low supply. This is why we like to use our in-house team to search out other green opportunities that may not have the convenient ‘green’ label.

MORE TO COME ESG factors are still not universally looked at or talked about. Companies are generally offering more information and clarity – both on what they are currently doing and what their plans are for the future – but there is more to come. With increased client demand, both the Global Credit and Responsible Investment teams have grown in recent months, bringing in more expertise and offering more scope with collaboration.

“When I’m asked why we brought ESG analysis closer into the investment process, my answer is always the same: why wouldn’t you? I know there are managers who believe that ESG is just a ‘tree-hugging’ exercise, or

that this is a fad, but I disagree. An oil company with lax health and safety protocols is more at risk of a spill that could cost billions of dollars in clean-up and fines.

A retailer reliant on child labour could see demand for their products crash overnight.

“As a bond investor, my upside is almost always less than the downside – if a company goes under we lose everything, but if a company does really well, we still only get the coupons and repayment of principal as promised. So looking for those risks that can really hurt a company makes a lot of sense to me.”

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TAIL(INGS) RISKS

A liability for mining companies that’s hiding in plain sight Tom Johnson – Responsible Investment Analyst

Mining companies are consistently assessed by financial analysts on the prices achieved for the metals and minerals they extract from the earth. Less thought is usually given to the other substances used to dig the metals out of the earth, or the chemicals which are used in the extraction processes to remove the ore from the rest of the rock.

MINING COMPANY FAILURES CAN HAVE SERIOUS EFFECTS Tailings dams, which tend to be located close to the mines, create an easy place to store the by-products of this mining activity. These dams, which are filled up over time, tend to use existing natural barriers or man-made walls, into which in millions of tonnes of ground up slurry and water from the extraction processes are introduced over time. Depending on the chemicals and methods used to extract the ore, this slurry can become toxic and therefore the collapse of a dam can have serious consequences. In Brazil, first at Samarco in 2015 and most recently in Brumadinho this year, dam collapses lead to a loss of life in workforces and local communities, along with severe environmental damage. The impact for companies who own and operate the dams has been significant clear up costs, fines and even criminal prosecutions for those managing these sites.

UK investors might be surprised to learn how exposed they are to the risk of a tailings dam collapse. Shares in the four largest mining companies in the FTSE 350, who supply the world with everything from coal and copper to diamonds and

gold, make up around 6% of the index.

Between them, these four miners are actively using over 200 dams to store waste from their operations every day. They also have exposure to around 350 other closed or inactive dams.

LOOKING FOR A DIFFERENTIATED APPROACH Following the Brumadinho disaster, RLAM decided to take action in order to better understand the potential risks of a further collapse which our largest mining holdings faced. Historically, disclosure around these risks has varied from company to company, with some mining businesses much more open to sharing specific information about their dams.

Therefore, our first action was to co-sign a letter, authored by the Church of England investment arm, along with a number of other institutional investors, asking mining companies to provide more standardised disclosures of their tailings dam exposures.

For the companies where RLAM holds material stakes, our efforts in this space were successful and we now expect our leading mining companies to share these disclosures on an annual basis.

The data also offered us a chance to understand where our holdings differed.

While a Norway-based foundation is still working on an open-source database which aims to record every dam globally, we built our own with a narrower focus on the companies which we held material stakes in. Even at a first glance, the differences in construction exposures, stability certifications and operational practices were immediately apparent.

After comparing the responses, we then reached out to each of the four companies where we currently have material stakes, working to ascertain how they managed

the physical assets, the governance and organisational procedures, and how they thought about their dams from a financial perspective (both the consequences of failure and the costs of operational running of the sites). We also covered an under-appreciated area in many businesses

UK investors might be surprised to learn how exposed they are to the risk of a tailings dam collapse focused on physical assets, the crucially importance role which staff, training and culture play in maintaining safe sites.

USING OUR FINDINGS Our meetings revealed some clear similarities between the firms, particularly in what was considered best practice. The role of independent oversight, rigorous external auditing and a need to have solid technical asset level knowledge cropped up again and again. More limited adoption of best-practice tailings standards at sites where they have equity stakes but don’t physically operate the mines (but with governance efforts to try and drive these through) also featured at a number of firms.

However, what was more startling were the differences. One mining company had routinely been collecting a wealth of data about its non-operated sites for several years, where another admitted that they had found filling in the survey a challenge.

Some had much clearer views on the financial consequence of collapse. And despite all being large mining companies, some simply had far more dams than

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others, including much greater exposure to the upstream construction method used at Brumadinho and Samarco.

Both as an understanding of the hidden risks in a miner’s portfolio that might not appear directly on their balance sheet, and as a proxy for understanding how mining companies approach material environmental risks and manage operational assets, this engagement allowed us to identify the companies in the sector which were better managing their risks within the sector. A number of companies also showed industry-leading practices within their own operations, compared to international peers.

This engagement won’t be the end of the road however. Next year, the International Council of Metals & Mining (ICMM) will be publishing its new standard, which should set a solid base line for how miners should manage their tailings facilities going forwards. And once the businesses publish next year’s disclosures, we’ll be able to get a sense of whether they’ve made good on the remedial actions that they’ve promised. In the meantime, the analysis has provided us with a clear case study for how different mining companies manage their operations and think about their physical and environmental risks.

So as investors in these businesses, this engagement has provided us with an even greater understanding how the companies we hold approach these challenges, becoming crucial to our analysis of the sector.

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SIX COMMON MISCONCEPTIONS

about changes to pension regulation and the consideration of ESG

This is just a fad The momentum around ESG matters has been increasing for some time due to growing public pressure and a greater focus from policymakers and regulators.

On the issue of climate change, the direction of travel is clear following the Paris Climate Agreement. Most major economies, led by the UK and the European Union, are committed to moving to low carbon economies. This will inevitably impact the flow of capital and the sustainability, or otherwise, of certain business models. An increase in extreme weather also poses a threat to business’ infrastructure and supply chains.

Therefore, trustees and pension providers should be taking climate related risks into account in the allocation of their capital.

Other matters, such as corporate governance, workforce practices, waste generation, energy usage, resource availability and corporate culture may also impact the performance of investments and should, where relevant, be factored in to investment decision-making.

We can’t change the world, we are just a small scheme

But we only invest in passive funds

Small shareholders can sometimes be the most effective in bringing about change within a company. Size doesn’t always dictate power. Trustees can also act collectively with other investors to influence behaviour. For example, 360 institutional investors from around the world have signed up to the Climate Action 100+ Group, which is an investor initiative to ensure the world’s largest corporate greenhouse gas emitters take necessary action on climate change.

Trustees can also collaborate through other organisations such as the 30% Club’s Investor Group and the PRI. “But we only invest in pooled funds” There are more and more options for investors in pooled funds.

The key thing is to pick a manager that integrates ESG as a matter of course into its investment process and take their voting and engagement commitments seriously.

Trustees can also select pooled funds with exclusions that match their ESG investment beliefs and they can also push for certain types of asset to be excluded within pooled funds in which they are already invested. Ultimately, the message to trustees is “if you don’t ask you won’t get”. The best time for trustees to exert their influence is when they are making decisions about which funds to invest in or reviewing their choice of fund.

There are some interesting innovations happening in passive, such as ESG or carbon tilted funds. If you’re in mainstream passive funds, check that your fund manager votes its shares at annual meetings and undertakes engagement with issuers. The EU is also drafting legislation to drive the creation of ESG indices which should make it easier to find ESG-friendly passive funds in the future.

Ultimately, the message to trustees is “if you don’t ask you won’t get”

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But we have a duty to only invest in our members’ best financial interests Yes, trustees are under a legal duty to invest in their members’ best financial interests.

However, ESG factors may impact the financial performance of an investment.

Trustees are required by law to take these “financial ESG factors” into account when making investment decisions. How they decide to do this is a matter for trustees to determine working together with their advisers and asset managers. Their approach must form part of their policy on how they take account of financially material considerations in their investment decisions, which must be included in their scheme’s statement of investment principles from 1 October 2019.

The Law Commission has also concluded that trustees may, if they chose, also take account of non-financial factors (such as members’ moral or ethical concerns) in their investment decision making: • if they have good reason to think that scheme members share a particular view, and • their decision does not risk significant financial detriment to the fund. Although not all lawyers agree with the Law Commission’s conclusion on the extent to which non-financial factors can be taken into account, the Pensions Regulator has endorsed this approach. Therefore, some trustees may decide to take account of non-financial factors where the Law Commission’s tests are met.

Isn’t that our asset manager’s job?

Trustees are primarily responsible for how their scheme’s assets are invested, as legally, they are the asset owner.

Trustees are also required by law to take account of factors which may impact the financial performance of their investments, including ESG factors, when making investment decisions.

Most trustees will delegate day-to-day investment decisions to one or more asset managers. Therefore, in order to fulfil their legal duties, trustees should ensure that their asset managers have appropriate systems and processes in place to assess and monitor any ESG risks that may impact the performance of their investments. Trustees should also ensure that the approaches adopted by their assets managers are consistent with their own ESG related investment policy and beliefs.

Trustees also play an important role in driving change. Therefore, it is essential that they press their asset managers on ESG matters and that they understand the different approaches that may be adopted by different managers. Trustees should also be willing to push for change by engaging with their existing asset managers or by selecting new managers where their existing asset manager’s approach does not go far enough or is out of step with the trustees’ policies and beliefs and their existing asset manager is unable or unwilling to change.

ESG risks have already been factored in by the market ESG risks are not fully reflected on financial markets. For example, in relation to climate change, the Bank of England has estimated that the reduction in capital allocation within the fossil fuels sector to meet a 2 degree scenario is in the region of US$15 trillion. In addition, the very nature of ESG risks is they are often long-term, idiosyncratic and difficult to measure. Today’s ESG risks won’t be tomorrow’s risk, so ESG risks must be kept under regular review and there also needs to be a constant horizon scanning.

This is an excerpt from the Royal London Policy Paper ‘Pensions and ESG: the Evolving Legal and Regulatory Landscape’ This includes information on what trustees, pension providers and asset managers are required to do.

ESG are often longterm, idiosyncratic and difficult to measure

The views expressed are the author’s own and do not constitute investment advice.

All information is correct at April 2020 unless otherwise stated.

Issued by Royal London Asset Management Limited, Firm Reference Number: 141665, registered in England and Wales number 2244297; Royal London Unit Trust Managers Limited, Firm Registration Number: 144037, registered in England and Wales number 2372439; RLUM Limited, Firm Registration Number: 144032, registered in England and Wales number 2369965. All of these companies are authorised and regulated by the Financial Conduct Authority. Royal London Asset Management Bond Funds Plc, an umbrella company with segregated liability between sub-funds, authorised and regulated by the Central Bank of Ireland, registered in Ireland number 364259. Registered office: 70 Sir John Rogerson’s Quay, Dublin 2, Ireland.

All of these companies are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and Wales number 99064.

Registered Office: 55 Gracechurch Street, London EC3V 0RL. The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The Royal London Mutual Insurance Society Limited is on the Financial Services Register, registration number 117672.

Registered in England and Wales number 99064.

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Contact us For further information about our responsible investment capabilities, please contact: Royal London Asset Management 55 Gracechurch Street London EC3V 0RL 020 7506 6500 communications@rlam.co.uk www.rlam.co.uk

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