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ESG Reporting: Cambridge Associates Interview

Jackie Bennion

10 May 2019

Chris Varco is based in London and is managing director of sustainable investing at . The Boston, Massachusetts-based asset manager has traction in the sustainability space and applies ESG criteria across all its investment platform. This publication spoke to Varco about the due diligence that goes into integrating ESG components and measuring their impact, and what elements of the "50 shades of green out there" are being driven by private clients and basic economics. His advice is "drop the idea of the starting point being what is this going to cost me?" (This item is part of a series of articles examining ESG. To see the editorial analysis of the subject, see here.)

Covering this topic for wealth managers it has reached a diluvian moment, where we are inundated with ESG proclamations, and knowing what is genuine and what is less so is difficult. So can you explain your role on the research and implementation side of ESG investing?
I head up all of our work in London on thinking about ESG and building private clients portfolios, where that is a key lens, then doing due diligence on managers where there is a very heavy ESG component. So it is a dual role between finding the investments and then building client portfolios.

How do you set an ESG portfolio? How do you assess the companies, the managers, and reach certain decisions?
It is a good question. I think your point about there being an explosion of products is entirely true. There was a Times supplement last week about ESG investing. There are definitely 50 shades of green out there. The starting point was originally the ethical beliefs of investors, which stems right back to the 1980s, whether it is avoiding apartheid in South Africa or tobacco. So if it is avoiding those in your portfolio, then there is a sideline in "let’s actively create good outputs", which would be impact investing.

When do you think the switch began from just screening out to investors being more proactive?
It is gradual, and we work on both. Certainly with private clients that proactive aspect is what is gaining traction. I think the switch is just driven by an economic basis. We are not about labelling ethical funds. We are genuinely not using the “ethical version” of a UK equity fund that is a negatively screened version of something else.

How do you differentiate?
We are really trying to find those managers who are proactively looking at massive sustainability issues like climate change, transferring to a low carbon economy, what we call a multi-stakeholder society, where externalities get internalised really quickly, so that you can’t behave in an unsustainable way without it being on Twitter and the greater accountability attached to digital and the massive issues being raised around resource scarcity.

There is a growing economic basis behind this and a growing economic basis behind the solutions. It is amazing in a decade how we have gone from the situation where wind and solar were multiple times more expensive than gas or coal-fired electricity. And now they are falling below them in cost.

We have funds seen through the ESG lens that have been number one in our database since their inception for emerging markets, and global equities, so we can move beyond the idea that this is a discussion about ethics and tradeoffs and think about a choice that makes economic sense.

From your assets under management what share are in impact investing?
That is a difficult question. We have about 200 clients who are very proactively pursuing those strategies, and all at different levels between that. There are investments doing this as a main strategy, in depth, but the key for us as a firm is that we are now collecting ESG data on every single fund we do due diligence on. That is the big real change over the last five years. We are asking those questions to hedge funds, to private equity and to venture. The move to this focus is just becoming ubiquitous. That doesn’t necessarily mean labelling.

What do performance benchmarks mean to investors?  As it is not standardised yet, how do you judge what is credible?
Yes they are really confusing because there are basic ones that exclude a few things – arms, tobacco – then there are the more funky ones that actually tilt the weight more towards positive companies, and there are the low carbon ones …

Which indices do you favour in terms of ESG becoming more standardised?
We have done lots of work with clients on climate aware indices. You can reduce things like carbon emissions and exposure to fossil fuel companies and things that may well be at risk over the next 20 years, for obvious reasons, with minimal tracking error. That is an example. We have worked with managers to create a very interesting new global equity low-carbon indices.

Is climate where there is most appetite? How do you narrow it down in terms of investor alignment?
Climate is a big one. But lots of private clients and families are looking at investing in social impact as well and investing back in their own communities. With climate there are lots of ways to invest in solutions. You can be investing in renewable infrastructure, but we also look at education and healthcare strategies. There is a whole mix and climate is a big deal but increasingly a lot of European investors are looking at the United Nations Sustainable Development Goals (SDGs) and there are lots of managers trying to align around that social and environmental framework.

But it is incredibly broad.
It is very broad. I think goal eight is economic growth, which is incredibly broad, and some managers shoehorn any company into that category on the basis that it is growing. Again, you need to be very wary of green washing.

When you look at asset allocation, what do you ask managers to report on that show these global issues are being tackled?
We assess the manager’s investment strategy on two levels. We look at the firm level, so what policies they have in terms of ESG considerations. And how they are thinking about climate risk, and importantly, how they are thinking about stewardship. So how are they voting with their shares and thinking about environmental, social and governance issues, and how are they engaging with underlying portfolio companies on areas like gender, climate risk, all manner of things. Are they an active owner? Policy can only get you so far. You can have a policy on absolutely everything but the question is what are people actually buying?

Explain enforcement and accountability.
Exactly. We do a lot of work assessing underlying portfolios. We have tools to screen portfolios for controversies. Are they breaching globally accepted norms around environmental issues?  For example, we have screening tools for compliance with the global compact, which are norms about good practice in business. We screen underlying holdings for poor ESG performers generally. Are there any red flags we can screen for over carbon emissions? We can screen portfolios for positive revenues that are aligned with the UN Development Goals and investing in things on the positive side of the equation. So you have to look at the manager level and the holding level.   

What do you do when you find laggards? How do you make them change?  
Every client has their own approach to ESG. It is very tailored to how the client does things. I have worked with clients where the ESG work of the last four years has involved finding laggards and replacing them with proactive managers.

So they just get kicked out the club?
If you look at most UK fund managers, especially long-only ones, hedge funds can be more variable, they have probably signed up to the UK Stewardship Code, and reporting on ESG and voter engagement. We have engaged with managers and said, ‘Look, you don’t have a policy around ESG and you are not reporting it, and we have positively worked with managers to change their behaviour. In some cases you just find better managers.

Let's talk about implementing ESG and creating and tracking risk frameworks and costs. How is all this internal compliance and active management reflected in fees?
I don’t have much sympathy for ESG managers charging a premium. It is like a factory shouldn’t charge a premium for its products being safe. At an institutional level we don’t expect to pay a premium for ESG funds. In fact, because we have clients we have often helped feed in ESG funds when there is a gap in the market, we have negotiated discounts for clients, because it is a new and evolving space. We are totally independent from managers and, generally, we would not expect to see a premium on an ESG product at all. I think it is a basic compliance function. These are becoming material issues. If you are paying 4 basis points to track the S&P 500 then any ESG product might be one or two basis points more. Maybe it is that they subscribe to a slightly more expensive index, an ESG index, but it is marginal. Even passive ESG approaches, we have been quite successful at including the ESG fund in the negotiation.  

Do you see this institutional drive toward more SRI and impact investing having an affect on traditional philanthropy?
Not in a negative way. There are lots of foundations that have started to develop investing programmes as a complement to their grant programmes. I have been involved in that space and it is just another tool. A grant effectively is an investment in a social and environmental outcome where 100 per cent of the return is the philanthropic benefit. If that same charity gives a super low interest loan to a social enterprise doing the same thing and it has half the benefit of the grant but gets 100 per cent of the capital back and can do it again and again every three years it is just a different level of impact.

At a philanthropy event recently, it was notable how much the financial sector is commoditising social investing, which could leave parts of the charity sector struggling with the implementation costs of putting a whole new level of performance metrics in place. What is your view?
Yes I agree with you. There are always things where there is going to be an investment solution. There are massive areas of philanthropy where it is hard to build a business model and you wouldn’t want to frankly. I am sure we could list plenty. We work with some leading foundations and they don’t want to be in their main endowment generating the money for the grant programme and investing in things that are actually then canceling out the benefits of their amazing grant programmes. That would be insane. So increasingly foundations are just putting the whole net benefit for society of everything they do, from their passive equity investment through to their main grant programmes, and ESG is a part of that. We have clients who are increasingly viewing the whole thing as one engine and spending pool.

Foundations are a huge part of philanthropy and policy drivers in the US, how do you see them in any way driving ESG adoption and changing financial institution approaches?
Our foundation and endowment clients have been awesome for being vanguards for demanding change. Lots have certainly been signing up to the UN PRI to improve their own consideration of ESG. That drives us to seek better information from managers who, hopefully, in turn, will seek better information from companies. Part of the Task Force on Climate-related Financial Disclosure is to try and glue that whole value chain together.

The head of GIIN released a statement recently claiming that ESG is reaching a tipping point and could go either way. Do you have a sense of where ESG is in that evolution?
There are a growing number of really exciting specialists and then there is just more ESG integration by industry, and the whole of the two probably meet somewhere. We have been going to GIIN’s conferences every two years and the exponential rise in the number of people attending ... Last year’s was insane, it was like attending Wembley Stadium in terms of the enormity of it.

As a wealth manager, what are you flagging up for clients new to sustainable investments? What guidance would you give potential investors?
This is more at an institutional level, but we have lots of clients who come to us wanting to engage on this. So we always start with an order of what they are in already, how to look at your existing portfolio and where some of the risks might be and then think about the potential opportunities. There is a whole menu of high-performing alternatives. I would say drop the idea of the starting point being what is this going to cost me? There are lots of high-performing fund managers out there, especially in public equity, and bonds, in green bond funds, and obviously there are loads of opportunity in alternatives and private equity, which is what we do a lot of.  But that comes at a more institutional scale.

What is the sustainable investing landscape like for retail investors?
There are clearly good out-performing sustainability public equity managers that definitely have retail share classes and in fixed income as well. I will admit investing in key venture capital funds in Silicon Valley is a lot harder for retail investors for sure.

Where are we learning from other markets on this?
Scandinavia and Holland are advanced. Europe generally, and the UK. The US is probably leading on market rate impact investing solutions in private markets and venture capital, so yes innovation is happening everywhere really.