This decade would probably be recognized in history as an era that transformed the world of investing for good. The capitalist model of looking at returns and financials in isolation is now broadened to look at other meaningful aspects that touch multiple stake holders and finally include the society and the environment in which companies operate; the so called taken for granted “social license to operate” is being challenged.
Sustainable investing is moving from just being a lip service to real action in a bid to achieve the triple bottom line of Planet, People and Profit. For companies, rather than being onerous, it’s a welcome move towards building better businesses. This is because ESG advocates an active ownership which drives investors away from activism and divestment actions towards more constructive engagement. This is an opportunity for companies to tell their story, show their willingness and align investors to their sustainability agenda.
Engagement is that feedback loop that keeps the ESG momentum going. The notion that successful engagements lead to meaningfully improved financial and share-price performance, alongside better governance is fast gaining traction. For long term investors, it is becoming an important pillar of their stewardship agenda.
In earlier days, corporate governance and shareholder engagement had been a “back office” phenomenon. Now regulators are pushing institutional investors to be more judicious while exercising their voting rights and thereby be more prominent and have an active role in shaping companies. Still many would outsource such an important tool that could be wisely used to influence companies. Also many companies lack action, drawing many cynics to conclude that it’s nothing more than a talk shop.
For companies, it is important to understand investor concerns on ESG issues and start disclosing relevant data despite it not being mandatory, they need to get ahead on the ESG curve. Those that fail to tell their own ESG story will now be at a significant risk. Even for investors, it all boils down to intent. It is easier for investors to dump controversial companies in a bid to showcase a clean portfolio. However, such a strategy could prove detrimental to long term performance. It is important that investors attempt to engage with companies to understand the issue at hand and take a learned decision for any portfolio action they take. However, active investors score over passive ones where divestment acts as that edge that could lead to a more productive engagement.
Investors Need to Be Patient While Companies Showcase Intent
In the evolving world of ESG, investors, companies and regulators all are learning every day. There is no perfected science behind many of the ESG aspects. Investors would do themselves a favour to adopt a “comply or explain” model which gives them a chance to engage with companies. Through a two way dialogue, Investors can draw management’s attention to new issues that are particularly important for embarking on a path of improvement from an environmental, social and governance standpoint.
We at Quantum have made a commitment to be constructive partners of our portfolio companies. We engage with our holdings on the most pertinent issues in an attempt to steer them towards both improved disclosure and practice. These company interactions in turn deliver new insights that help improve our understanding and thus completes the circle. Our long-term investment horizons provide us with the opportunity to use this iterative process to drive positive change in the companies in which we invest, ultimately to our mutual benefit.
Not surprisingly, we have had mixed results on our engagement efforts. In the initial stages, our engagement focused more on understanding the preparation and oversight of the company’s senior management and Board on key environmental issues. At times we have also engaged with the company when certain disclosures were not forthcoming or the company was in the midst of some controversy.
Our Engagement with Cement Companies
We engaged with cement companies in our portfolio to understand their long-term targets on emission reduction and what are some of the key challenges to mitigating the environmental impact of their operations. In comparison with global peers, Indian cement companies perform better on parameters such as energy efficiency, water stewardship and use of alternate raw materials to reduce the clinker factor. However, we observed that Indian companies’ use of alternate fuels i.e. the Thermal Substitution rate (TSR) at 4% was lower than their foreign counterparts which were at ~20%. In addition, we had concerns on the health and safety record of one company and disclosures around water consumption of another company.
Our interaction with the management on the above issues provided us with the insights enumerated below –
There were a couple of reasons for the low TSR rate. The chief reasons for the low TSR were the lack of “polluter pays” principle in force in India and lack of scientific practices of waste management and segregation. Majority of the waste currently used in cement plants is refuse derived fuel (RDF). In India, only 70% of the daily generated municipal waste is collected and nearly 80% is dumped without proper treatment. In developed countries, the generator of waste has to pay a certain price if the waste is disposed in a landfill whereas in India, the waste generator expects to be compensated for selling waste to the cement manufacturers.
On the health and safety aspect, we realized that the company with a “poor” safety record had a stricter interpretation system in place. They also used to include accidents of the truck drivers who were transporting cement and this led to the safety record being higher than other peers who were providing only plant level data.
On water consumption, we asked for the company to provide granular disclosures. Initially we had penalized the company since the water intensity was significantly higher than peers. During our initial interaction with the company, we were made to understand that the high consumption was due to inclusion of water consumption by the housing colonies of the company and the captive power plants. After the company provided better disclosures, we removed the penalty in our rating.
Our Engagement With an Agrochemical Company
We engaged with an agrochemical company to understand the low female representation in its workforce. The reason provided was that majority of the workforce (70%) comprised people in sales who had to work in remote rural locations and in manufacturing plants. At offices, gender diversity was at ~17%.
Engagement With a Healthcare Diagnostic Company
We engaged with a healthcare diagnostic chain when the company's operations suffered a data breach. Our engagement efforts focused on the cause of the breach, the likely liability on the company and the mitigation measures undertaken by the company to prevent future occurrences.
The lapse occurred at a facility managed by a third party. The files that were uploaded on the server were not password protected. The files were temporarily stored on the platform and should not have been in the public domain. In all 0.5% of patient records were impacted. No penalty was imposed on the company. The law on personal data protection (PDP) is not yet enacted and is in discussion phase. The likely liability prescribed by the PDP bill for such breaches is approximately INR 150 million.
The company has recognized the need to strengthen its data privacy and protection practices and hired an external agency (E&Y) to advise them on this matter. The company also acknowledged the need to hire a Chief Information Security Officer and the hiring was completed in Feb 2021. The in-house team is being further strengthened and a lot more people with expertise in data protection and privacy are expected to be recruited.
We continue engaging with them on this matter and other relevant aspects.
Overall, not all companies will engage with us in detail but the trend is slowly improving. Those that are in sectors which are under scrutiny for their large environmental footprint tend to have better disclosures and dedicated teams to handle our queries.
Stewardship – The Way Forward
Stewardship is all about exercising your rights as a shareholder. Two essential ways to do this are proxy voting and constructive ongoing engagements with companies. Responsible investing has spurred a major reworking of the relationship between shareholders and companies. Many Institutional shareholders are working to define their relationships with companies, and in turn companies are being forced to reciprocate and engage directly. Using engagement as a means to exchange information is not only a legitimate exercise but can be crucial in gaining a fuller understanding of the risks and opportunities faced by the investee companies.
Quantum’s multi-faceted engagement approach intends to focus on these areas:
Our proprietary ESG scoring provides good insights on areas where companies lag on material ESG areas of their operations. This provides us an opportunity to directly provide a ready feedback for the company to focus on, a simple letter to the management or the Board is a good starting point
Comply or explain - Meet company management / sustainability team to understand their approach and targets
Escalate issue to the board level where necessary
Guide companies on best practices / benchmarks that help them shape their sustainability agenda
Engage with multiple stake holders like employees, suppliers, customers, NGOs etc to get more information and also verify the tall claims made by the company
Continue to exercise proxy voting judiciously
Take portfolio action as may be necessary
We are active investors, and obviously we may sell shares where we see deteriorating conditions, we do look to encourage positive long-term behaviour while we are owners, and our long investment time frame provides some room for tolerance provided we see intent, an action plan and progress. It is in the interests of our clients for us to encourage long-term sustainable behaviour in the companies in which we invest on their behalf. Over time, we see these efforts result in better management, which can lead to better returns for clients and improved outcomes for society in general.
It’s clear that engagement with management teams doesn’t always achieve desired outcomes or even facilitate much change in how that company does business. While those instances are unfortunate, we continue to shine the light on corporate governance abuses and will hold companies to the highest standards. It can only be a good thing that more and more eyes around the world are beginning to tune in to the importance of non-financial E, S and G factors in investment management, and we look forward to fruitful engagements in the future.