A Sophisticated Investor's Approach To Climate Change: The Case Of LGIM

Most major asset owners and asset managers now recognize the deleterious effects climate change can have on their overall portfolios. Climate change represents a system-level risk that very large, long-term investors cannot diversify away from. Exclusions or divestments can make sense in economic terms if an investor thinks a sector or company’s value is going to decline over the long term, but it does not solve the system-level problem.

What does help address this problem is active engagement through which investors encourage and pressure companies to improve their carbon performance and, in some cases, to dramatically transform their business models. One group of investors taking this approach is ClimateAction 100+, a coalition of investors with around $33 trillion in assets under management (AUM) They are focused on the world’s largest 100 “systemically important emitters” who account for two-thirds of annual global industrial emissions, along with 60 other companies who present significant opportunities to drive the clean energy transition.

One of the members of ClimateAction 100+ is the U.K. based asset manager Legal & General Investment Management (LGIM), the world’s 11^th largest asset manager with around $1.3 trillion in AUM. Under the leadership of Sacha Sadan, Director of Corporate Governance and Board member, they have developed an interesting and sophisticated approach to climate change which combines elements of both engagement and divestment. They announced their “Climate Impact Pledge” in November 2016 in “ESG SPOTLIGHT: Time to act on climate change” by Meryam Omi, Head of Sustainability and Responsible Investment. Through a proprietary methodology they evaluate 84 companies in six sectors: oil and gas, metals and mining electric utilities, automobiles, banks and insurance, and food and retail distribution). Companies are evaluated in terms of five criteria:

• Statement on Climate Change: Formally recognizes climate and energy impacts
• Transparency: Transparent disclosure of key indicators to investors
• Board Governance: Diverse and robust board that is equipped to drive innovation and market changes
• Business Strategy: Robust strategy that embraces current and future climate related challenges for the company. Investments into new technology/products
• Public Policy: Disconnect between public statement and collective advocacy

They rate all of these companies and then engage with them to help them improve their performance on climate issues in order for these companies to deliver sustained financial returns. Those that fail to meet a minimum threshold and improve will be disqualified from their family of Future Word funds which “have been designed to take advantage of the opportunities posed by the transition to a low-carbon economy.”  In some cases, LGIM divests from the company. When it cannot do so they vote against the chair of the board.

Since their preferred outcome is for companies to change rather than just getting divested (which still sends strong signal but alone will not create the system-level changes that are necessary), LGIM also recognizes companies that are leaders and “improvers” (faming) and those that are laggards (shaming).

Yesterday LGIM published “LGIM’s Climate Impact Pledge: The results so far,” also by Omi, and very interesting results they are. Since they began their engagement process in April 2017, LGIM found that the scores of U.S. companies have improved, “dispelling concerns over the knock-on effects of President Donald Trump’s decision to withdraw from the Paris climate accord.” They also found improvements in the average scores of Australian, Japanese, and Korean companies. In contrast, average scores for companies in France, Germany, and the United Kingdom have decreased. LGIM attributes these results to the fact that investments in clean energy in Asia have increased but have slowed down in Europe.

The leaders by category are:

• Statement on Climate Change (Nestle)
• Transparency (Bank of America Merrill Lynch, BNP Paribas, and Statoil)
• Board Governance (BHP Billiton)
• Business Strategy (Total)
• Public Policy (Iberdola)

Companies that have shown notable improvement include Daimler AG (statement), Kraft Heinz (transparency), Toyota (governance), Commonwealth Bank (strategy), and EDF (public policy).

LGIM also announced that it had excluded the following companies from Future World funds due to their low scores and lack of responsiveness to LGIM’s concerns: China Construction Bank, Dominion Energy, Japan Post Holdings, Loblaw Companies, Occidental Petroleum, Rosneft Oil, Subaru, and Sysco Corp.

LGIM’s overarching objective is to improve the scores of all the companies the rate. “The more company scores go up, the higher the chance of temperatures not going up.” Engagement is the foundation for this, combined with carrots (calling out leaders and improvers) and sticks (calling out laggards and eventually divesting from them or voting against the chair).  In conclusion they say, “Let us work to make this happen.”

I think this sophisticated approach can be applied to other system-level issues where improving a company’s performance on a particular issue will enhance its ability to deliver sustainable returns to shareholders over the long term, as well as a sustainable society. Other topics where this approach would be useful include gender and income inequality, plastics and packaging, artificial intelligence, and cigarette smoking. On all of these topics there are companies which are working hard to address the issue, as well as those that aren’t addressing it at all or are making the problem worse.

Engagement with the leaders and those who want to improve is the right approach. For those unwilling to improve, divestment and exercising shareholder rights such as voting against the chair of the entire board sends a strong signal. If it results in a “wake-up call” to the company, the investor can then reconsider whether to purchase some shares and try engagement again.