Climate change, income inequality and the way we engage with public versus privately-owned companies were some of the major themes we encountered over the past year. We share our insight about the impact these themes have on investment analysis and portfolio management. This section includes: • Climate Change • Income Inequality • Public vs Private Company Engagement For investment professionals only. Not for further distribution
ESG THEMES: CLIMATE CHANGE
In 2019, there was a dramatic increase in concern over climate change, from an investment perspective as well. However, aside from select sectors facing extremely elevated transition risk – e.g. fossil fuel producers – there has not been significant impact on company valuations to date. In our view this is because climate change has not particularly impacted the near-term cash flows for the broader market.
The science behind climate change
For the world to have a chance of at least minimizing the impact of climate change, it is necessary to keep global temperatures to within +1.5°C from preindustrial levels. To experience less severe impacts from climate change, global temperatures need to stay within +2.0°C.
Viewing Our Investments Through a 1.5°C and 2.0°C Lens
We believe it’s highly likely that our investments will need to be capable of adapting to either of these temperature scenarios. Even keeping global warming within these parameters means there will be climate change impacts that will affect the investment landscape, such as rising sea levels, increased storm frequency, hotter and more frequent heat waves, and shifts in growing seasons.
Climate Change in Our Investment Analysis
We believe almost the entire investment universe will feel some impacts of climate change. Creating economic value with a low or zero carbon footprint will enhance a company’s positioning against their peers, in a world of rising environmental regulation. Fundamental analysis, alongside our Responsible Investing Indicator Model’s (RIIM) evaluation, is crucial to help us compare how entities stack up against each other on a range of climate-related issues. RIIM portfolio analysis enables portfolio managers to quantify the amount of climate-related risk they’re taking across the portfolio.
In addition to our RIIM analysis, the responsible investing team works closely with our sector analysts in evaluating climate change factors. This collaboration helps the team with work on company-specific climate analysis, to more thematic work, such as creating a carbon tool to aid rigorous research.
The gap between science, policy and corporate reporting
As we pointed out in our previous ESG annual report, there is a profound disparity between science and policy regarding climate change. While climate change became more topical for society over 2019, there has only been varying levels of commitment from governments on combating rising temperatures.
Various climate change-oriented regulatory measures that have been passed are aimed at financial markets. While moving policy in the direction of science is a positive, the fact that regulation on financial markets have moved faster than that on corporations creates a problem with the quality of ESG reporting we can provide to our clients. This is an area of continuous development, which should lead to better outcomes for ESG integration in investments.
ESG THEMES: INCOME INEQUALITY
Income inequality is one of the defining socioeconomic issues of our time. The Gini coefficient, which measures income distribution and inequality, suggests that, globally, the average person has lived in a country where income disparities are widening.
If this continues, it will likely lead to increased indebtedness, steeper yield curves, inflation, higher corporate taxes, and tighter trade restrictions. It will also create sectoral opportunities as consumption patterns change and the demand for cheaper goods and services grows.
This is mainly due to lower distribution of taxes and transfers, more concentrated industries and changes in labour markets.
Wage Disparities Fuel Populism
It has significant implications for investors, by constricting growth and creating inequality of opportunity when lower-paid people are denied the chance to invest in their health and education.
Crucially, income disparities lead to struggles over government resources, which creates political volatility that can fuel the rise of populist causes – alongside higher public spending – and deepen social divisions. Blue-collar workers who feel that they have not benefitted from globalisation increasingly support closed economies.
Changing Consumption Will Create Sectoral Opportunities
Income inequality will likely negatively affect luxury good manufacturers, but it will create opportunities elsewhere, e.g. affordable leisure and accommodation. It should also encourage innovation to provide affordable education and healthcare, as well as accessible financial services.
How Income Inequality Influences Our Investment Decisions
Our ESG specialists support the sovereign investment teams throughout the investment process. Income inequality is a key consideration in the social component of ESG, which has a strong influence on our sovereign debt investment decisions, through the use of our Responsible Investing Indicator Model.
We anticipate further policy changes as governments continue to respond to demands for wider access to affordable services and better protection for workers. As companies respond to these changes, sector-based opportunities will continue to arise. We will continue to monitor income inequality around the world and incorporate it into our analysis in striving to maximize investment performance for our clients.
ESG THEMES: PUBLIC VS PRIVATE COMPANY ENGAGEMENT
We have specific investment processes for privately held companies, versus those that are publicly owned. Here we give some insight into the main principles.
Why Does T. Rowe Price Invest in Private Companies?
When we consider private company investments, we aim to identify innovative businesses that can compound wealth as they transition from fledgling to durable growth companies. It offers insights into potential industry disrupters, as well as the opportunity to assess companies before they go public. However, these investments are always challenging, as the securities are more illiquid and carry greater risk than investments in more established, public companies with longer track records.
Private Investment Stewardship
Private company investments have some unique aspects that require a slight change in our approach to stewardship activity and oversight. For example, while privately held and focused mainly on operational matters, companies’ boards often comprise a few key investors and business partners. However, as they move closer to listing publicly, boards have a fiduciary duty to many more stakeholders, including more attention and oversight. This requires independent director representation, free of any ties to the company.
Proxy Voting for Private Companies
Instead of annual general meetings and proxy voting, private companies use written consent to seek shareholder approval for corporate matters, e.g. director elections. Unlike with public shareholder meetings – which involve appropriate meeting notice, upfront information about voting items and the chance to express a view publicly – private companies simply ask for consent from certain investors, one by one, until they reach the 50% needed for approval. Written consent enables companies to get efficient stockholder approval, but reduces transparency.
As responsible stewards, we apply the same governance standards to private and public companies, but written consent limits our ability to effect change at private companies.
A Potential Turning Point
After a long period where private companies had their pick of investors, leaving little room for capital providers to negotiate better shareholder rights, there are signs this imbalance is shifting. Investors are demanding more stringent requirements from companies seeking funding and recent market volatility has only accelerated this trend. If our prediction is correct, we should see a healthier and more balanced dynamic emerge in the market for private, growth-oriented, companies.
ESG Themes – read more
Factoring in rising climate risks Impacts of growing income inequality How we approach governance
Read more in the full report.
