ESG: assessing business practices.

At Lombard Odier, we take a three-tiered approach to understanding the sustainability of a company’s Environmental, Social, and Governance (ESG) practices, considering long-term metrics, short-term metrics and impact metrics.

 

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Source: LOIM. For illustrative purposes only

 

Long-term metric: A multi-lens perspective on long-term sustainability

While simple ESG scoring methodologies can be a useful guide to assessing which companies have more sustainable practices than others, we find they do not generally reveal who is making real, measurable progress over time. They can also naturally favour larger companies with the resources to spend on creating transparency around their social and environmental practices. In order to understand these dynamics better and generate a more meaningful outcome, we introduced our proprietary ‘CAR’ methodology in 2012. 

 

CAR scoring methodology

CAR stands for ‘Consciousness’, ‘Action’ and ‘Results’. It sorts through vast amount of raw ESG data to better differentiate between the talkers, the do-ers and the real achievers. We place a greater emphasis on the ‘R’ when arriving at the final score to give our investment teams a much deeper understanding of genuine corporate sustainability.

 

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Short-term metric: Controversy scoring to understand short-term sustainability risk

Serious corporate responsibility failings tend to materialise, in the short term, in the form of controversies. The impact of these events can be meaningful for investors because they create reputational issues, often leading to lower market performance.

To understand this risk in the short term, we look at companies’ exposure to controversies and gauge the severity of these issues, applying a “Controversy Score” from 0 to 5, where 0 is no concern and 5 is a major concern. Companies with scores of 4 and 5 can be screened out of portfolios as a way to limit portfolio risk. We have implemented an internal policy under which trading in level 5 controversy companies is restricted without further explanation and validation at CIO level. 

We also seek to engage with companies featured on the controversies’ list as a way to mitigate risk.

 

Classification of incidents following standards by United Nations Global Compact Principles 

 

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Source: LOIM. For illustrative purposes only

 

Impact metrics

In analysing how well companies are positioned for the transition to a CLIC™ (Circular, Lean, Inclusive, and Clean) economy, we believe it is important to understand the impact they have from a socio-economic context. The level of opportunity a company faces in terms of growth or competitive advantage will be materially affected by its impact and warrants close analysis. We also believe it is important for investors to easily understand what impact they are accountable for.

We have developed a series of impact metrics relating to carbon emissions and water consumption to address two specific needs: to help portfolio managers pick the right stocks; and to help end investors more easily understand what they are accountable for.

On carbon emissions, we look at the total production and emissions scope of a company including production, energy usage and its supply chain. Our methodology for reporting carbon emissions is aligned with the final recommendations of the Taskforce for Climate-Related Financial Disclosure (TCFD).

For water we look at both how much the company has purchased as well as its direct withdrawal from water sources.

We then calculate two different ratios for each metric: first, the intensity ratio, which is the level of carbon emissions or water consumption per revenue unit which can be used to compare the carbon and water intensity of a company versus its peers; second, we calculate the investment ratio, which is the level of carbon emissions or water consumption per investment unit as a way of identifying a company’s accountability.

 

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Source: LOIM. For illustrative purposes only

 

Carbon metrics

  • Absolute carbon emissions: measures the amount of greenhouse gas emitted by a company over a year. At a company level, we look at its scope 1 carbon emissions and First Tier indirect emissions. At a portfolio level, we look at its scope 1 and scope 2 carbon emissions. When aggregating the carbon footprint of a portfolio, one cannot just calculate a weighted average of the absolute emissions of the underlying companies, it needs to be proportional to the total amount of all investments held in the company (both debt and equity). Therefore, we use the carbon investment ratio.

  • Carbon investment ratio: this is equal to the absolute carbon emissions of a company per unit of market capitalisation + debt (or in other terms: Enterprise Value minus Cash). Therefore, when measuring the carbon footprint of a portfolio, the weighted average of the carbon investment ratios of the underlying companies are calculated. This figure is the carbon emission per million US dollars invested in the portfolio and multiplying it by the amount invested will provide the carbon footprint of the portfolio.

  • Carbon intensity: the amount of greenhouse gas emitted per unit of revenue generated by a company. The intensity of a portfolio is the weighted average intensity of its underlying companies. We consider the portfolio as a company composed of the weighted average of its positions. We look at the direct and First Tier indirect carbon emissions at both the level of a company and the level of a portfolio to avoid any risk of double counting. 

 

However, it is important to recognise that overtime, static measures for carbon emissions - whether they related to absolute levels of intensity - don’t always give the best overview of trajectory. This is why we have developed the LO Portfolio Temperature Alignment Tool. We believe it is vital to monitor the ‘temperature trajectory’ of individual companies to assess how well they are aligned to the decarbonisation pathways implied by the goals of the Paris Agreement, which seeks to limit global warming to 1.5-2°C.

 

  Click here to find out more about the LO Portfolio Temperature Alignment Tool.

 

Sovereign bonds: In order to calculate the impact metrics for sovereign bond portfolios, we calculate carbon emissions at a country level using Bloomberg data. Additionally, we use annual World Bank data to measure the absolute level of carbon emission within a country. We obtain the intensity ratio by dividing this amount by the GDP (current USD). In order to calculate the country’s carbon investment ratio we will apply the following formula:

(Country total CO2 emissions x government revenues in % of GDP) / (GDP x government debt in % of GDP)

 

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