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ESG integration: for a better risk-weighted return

When we determine our risks we take ESG factors into account in order to arrive at a better risk-weighted return. ESG factors can directly and indirectly impact financial results. For instance, climate-related financial risks such as more extreme weather conditions that result in higher claims at insurers. Companies with substandard safety and risk management run greater risks of incidents and accidents, which can subsequently result in an increase in risk or, as the case may be, loss of return.

We do not see ESG risks as a separate set of non-financial factors, but as non-traditional sources of financial risks. ESG factors are a way of analysing financial risk in the long term. The academic literature has since produced a substantial volume of evidence that supports the thinking that attention to ESG factors actually results in better investment performance in a financial sense. For our clients, it is important to see this confirmed in the results of the various programmes managed on the basis of ESG factors, i.e. the CO2 reduction programme and the exclusion policy, at present.

PGGM has been measuring the financial consequences of the aforementioned instruments for several years already. In the past, a great deal of attention was devoted mainly to the question of whether the ESG policy results in higher returns on the investments. Our calculations demonstrate that these instruments have not, to date, had any significant impact on the returns on the investments.

Returns also cannot be viewed separately from the risk of the investments. Academic meta-studies of the impact of ESG policy on investment results suggest that improved performance can mainly be traced back to risk reduction. That is also why measuring the impact of the ESG policy on risk is important. This is difficult to calculate but we continue to devote attention to this since this could help to further refine the programmes.

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Bottom-up ESG integration

Responsible investment guidelines per assetclass

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At PGGM, ESG integration is primarily the responsibility of the different investment teams. Within the limits of the investment mandate, our investors have the freedom to make their own decisions in setting up the portfolio and the duty to report on progress. ESG plays an important role in this, as does financial return. How the investment teams take ESG factors into account and weigh these factors in the day-to-day considerations differs per asset class. This difference is mainly due to the degree of influence which PGGM can exert on the investment process, for example whether management is external or internal. Whether passive or active investment strategies are involved also makes a difference. The effect that ESG factors are expected to have on the asset class, such as risk reduction as compared to improved returns, also plays a role. For the more active mandates, the portfolio manager comprehensively takes ESG information into account in analysing a company, country or project and ESG analysis is consequently an integral part of the investment decision. Genuinely integrating ESG factors is no simple task. There are no clear standards or definitions. There is also much to be gained in relation to disclosure, the data that companies provide on their environmental policy, social conditions and sound governance. Qualitative assessments also need to be made sometimes - how can respect for human rights be expressed in financial models? Further on in this chapter, we show what ESG integration looks like in practice.

Bottom-up ESG integration: Infrastructure

Via the Infrastructure team, PGGM invests directly in infrastructure companies and projects. Because of our long-term focus, improving sustainability in the business operations of our investments is essential and in line with the interests of our clients and their participants. The team takes ESG factors into account when selecting new infrastructure projects. A first step in this process is the ESG Quickscan which looks at the possible ESG risks. For instance, they take the potential for conflict in the region, the labour standards and working conditions in the region, and the relationship with trade unions into account. During the due diligence phase, the identified risks are then managed. Depending on the outcome, they formulate agreements with the companies on managing these risks and on reporting potential incidents. Participation in the Global Real Estate Sustainability Benchmark (GRESB), the online ESG benchmark platform, and ESG KPIs are part of the reporting requirements. ESG factors are also a fixed part of the monitoring discussions and management is asked to devote attention to this, particularly if performance is less than satisfactory.

Bottom-up ESG integration: Long-Term Equity Strategy

The Long-Term Equity Strategy (LTES) team is positioned to invest by means of public equity in solutions for the four sustainability themes: climate change, pollution and emissions; water scarcity; food security and health care. Their investment universe is put together based on impact criteria. That means that the universe could include businesses whose ESG risks do not weigh up against the impact. It is therefore part of the assignment to screen businesses for ESG risks as part of the equities selection process. First, during their due diligence, an in-depth ESG analysis is carried out on a broad range of topics to chart out ESG risks related to the business. The analysis includes an assessment of the existing ESG policy, the reporting and management system, as well as research using independent external sources on the company’s ESG performance. The team uses external data sources such as the Internet, annual reports and specialist databases like Sustainalytics B.V. and MSCI ESG Manager. LTES also explicitly examines the outstanding controversies relating to every business. All these data are weighed in the investment case for the company. They also engage in dialogue with the management of the companies in which PGGM invests. The ultimate result of the ESG analysis constitutes an integral part of the investment case. If portfolio companies are associated with material ESG issues, they try to contact the executive management to encourage risk management and process improvements. They try to exert influence and move the company in the direction of the best practices and international standards that apply for the sector. In a number of cases, our ESG analysis resulted in a company not being included in the portfolio.

Bottom-up ESG integration: Private Equity

Within the Private Equity team, ESG criteria are integrated in the entire investment process. This starts already with the assessment of our investment partners. The PGGM Private Equity team not only wants good returns, it also demands ESG performance from the general partner. PGGM only selects funds with whom agreement is reached on ESG standards. This is important because the private equity parties we work with are responsible for managing ESG issues. The team assesses how they deal with ESG in their investment process by means of our ESG framework. Among other things, data about country and sector risks are examined and these are compared with the general partner’s ESG scores produced on the basis of PGGM’s own assessment. This is then used as a basis to identify the investment partners with whom to enter into dialogue. Incidents, such as accidents involving serious physical injury, major environmental incidents and the legally established misappropriation of funds, are also recorded and discussed. The analysis based on our ESG framework provides a good structure in which to engage in dialogue with our partners on how they set up their process. It is also an instrument for getting a view of which partners are lagging behind and enables us to chart out whether the investment partners’ portfolios involve high ESG risks.

Our investment teams have elaborated their own guidelines for responsible investment and published these on the PGGM website. See the website for more details on how they integrate ESG factors.

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Determining the materiality of ESG factors

In order to assess whether ESG factors are material for our investment position for a specific investment, PGGM establishes processes which operate as part of investment decisions. We strive for consistency in this context by using a single system. We therefore weigh ESG factors as an integral part of the investment process.

Drawing up an ESG framework

Drawing up an ESG framework
PGGM periodically assesses the ESG framework for each asset class. This framework shows which ESG factors affect the financial performance of underlying investments and to what extent.

Integration in the investment decision

We then determine how financial and other ESG factors start or continue to play a role in the overall investment selection process. This can involve, for example, addressing ESG factors in due diligence, incorporating ESG factors in valuation models and/or developing policy or tools to assess external asset managers.

Monitoring and reporting tools

We also determine how ESG factors are regularly discussed with internal and external managers, which assessment criteria apply to internal and external managers, what reporting requirements and KPIs are laid down and how the ESG performance of the underlying investments is monitored. The status and development of the implementation of the above stages may differ in each asset class.

It is essential that those factors that potentially have a major impact on the future performance of the investments are charted out.

With the processes above, it is firstly essential that factors that potentially have a major impact on the future performance of the investments be charted out. These factors differ per industry/sector and per geographical location and activity.

In order to assess materiality, it is therefore necessary that the investment teams that have knowledge of the investments determine which ESG factors are relevant. In doing this, the teams use various data sources and the publications from the business or manager which is invested in. The investment teams must then systematically screen the factors. Investment teams draw up requirements for this, with support from the Responsible Investment team. Sector associations have also set up frameworks to create uniformity in the reporting on important ESG data. Our property and infrastructure teams make use of the Global Real Estate Sustainability Benchmark (GRESB) to measure sustainability performance, for instance. The advantage of these kinds of standardised methods is that the investment teams at PGGM use the same structure in which materiality risks can be assessed.

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Challenges of ESG integration

ESG integration requires a weighing of various ESG factors but also of ESG factors in relation to financial performance. This requires estimating the time period in which ESG factors will become financially material. This consideration can often be difficult. The longer the investment is expected to be in the portfolio, the more important this consideration becomes and the more research that is required. This has an effect in the due diligence. What is essential in this is a clear vision on how ESG factors could be improved during the term of the investment, making it possible to lower the identified risks. We expect this to have a positive effect on performance.

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Results of ESG integration

The primary objective of ESG integration is to improve the performance of the investments. Actively determining and managing the risks means they can be lowered. The result of this is quantitatively visible to some extent because the investments can perform better if factors are given the right attention. Compared to other investments, this results in a headstart that is measurable.

The effect is also to some extent invisible, because managing factors well in fact prevents problems from arising that result in loss of performance. This result is more difficult to determine because the activities are precisely aimed at events not arising, which events therefore cannot, by definition, be measured. How we deal with this is increasingly focused on establishing connections between the ESG factors and the effects that arise in the portfolio, so that we are able to track down and mitigate the key predictors of weaker future performance. To do this, we investigate the quality and authoritativeness of data in order to draw conclusions. This quantitative research is a field that is changing and evolving.

In order to carry out this research, we have a growing need for data in order to reach an opinion. At the same time we see that as a result of the various requests, the companies in which we invest are suffering some ‘reporting fatigue’, because there are too many similar initiatives under way all trying for the same aim. Firstly, this has the disadvantage that the companies do not know where they stand and secondly, much time and energy has to be put into duplicating something that has already been done. We would prefer to see this energy consolidated and put into improving the frameworks already in place. That is why we opt to tie ourselves to just a limited number of specific frameworks in which we want to actively play a role so as to make these better and more broadly applicable. Towards the companies, we are clear on what frameworks we use and we are transparent about what we do with the information.

ESG integration is about enhancing the investments.

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ESG integration in figures: effect on the portfolio compared to the reference index

It is crucial for us and for our clients to be able to properly understand and monitor the actual effects of the policy on the performance of the investments. This applies both for the impact on the return and on the risks, therefore. It does not suffice in this context to determine the height of this impact alone. We also want to better understand whether the impact on the returns follows a certain pattern, for instance whether the instruments for responsible investment result in less drastic negative outliers. These are difficult calculations. Years of data are moreover required. As more data become available over time, these effects become clearer. This enables us to increasingly better substantiate the effects of the ESG policy on the investment results and our clients can make more focused choices in their policy in this regard.

The figure below shows that our instruments for ESG integration have not, to date, had any significant impact on the returns of the investments.

Our ESG integration has not yet had any significant negative impact on the returns of the investments.

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ESG integration from 2020 onwards

Over the past ten years, the requirements stipulated for responsible investments have increased, be it through regulations, voluntary standards or simply because of stakeholders’ expectations. ESG integration is a constant process aimed at ensuring that all decisions and changes on the policy level are implemented by all of PGGM’s investment teams. After all, this is where it is put into practice and it is a crucial process if we want to prevent ‘green-washing’ and empty promises.

Every year, we use an internal system to gauge the capacity of the investment teams to integrate ESG factors in the investment process (the Maturity Matrix). In 2020, a transparent weighing framework (for ESG versus other investment factors) will also be worked on, along with specific criteria for the integration of material and/or normative ESG factors. The first is determined with reference to the ‘materiality map’ of the Sustainable Accounting Standards Board (SASB). A database is being set up for the various asset classes. This will compile key data that allow us to monitor material factors, test data and learn from experiences. It will also strengthen the consistency of the execution of ESG integration among the various investment teams, allowing knowledge amassed to be used across the board. The second, normative ESG topics will be dealt with in guidelines.

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