ESG takes an equal role at Nikko
Nikko Asset Management has revamped its environmental, social and governance (ESG) process by splitting it out of the credit function. Each corporate and bank issuer the investor looks at must now satisfy separately assessed ESG and credit criteria rather than having the decision tied up in a central area.
Why did Nikko elect to revamp its ESG process and how long did it take to plan and implement?
RANDS This has been a substantial piece of work that we started half-way through 2020. It took six months to work through thoroughly, by sector and issuer, to overhaul our existing process entirely.
There were two main end objectives. We wanted to separate the ESG decision from the credit decision, thereby enabling us to focus more directly on the ESG elements and ascertain their impact on the fund. ESG has always played into our credit processes but it was previously tied up in credit decisions, making it hard to see where the credit decision stopped and ESG came in.
We also wanted to ensure we were placing an appropriate level of importance on each individual issuer. Sometimes appreciation for a credit can cause one to overlook some of its blemishes. We wanted to be able to pull apart what we liked about the credit from its ESG factors.
LUO One of the fundamental components of the new process is thinking about the sustainability of a business. We effectively created a distinct framework to consider business longevity. The new process also enables us to ascertain how a company is addressing ESG issues – for example, whether it has set appropriate goals and is achieving them.
One could argue that this is already part of the credit process. But we wanted further to draw out ESG issues and assess how companies are thinking about things like active engagement and managing stakeholder concerns.
LANGER It is clear to me from having been in the market for many years that some market participants continue to view ESG as a gimmick. I wanted to ensure the people driving and shaping our new ESG process really cared about it – which was my reason for picking Linda and Chris for the work we did last year.
This is purely a fixed-income development: our equities team has its own process and ours is unique to our part of the business.
RANDS Most of the teams across Nikko globally are incorporating ESG into their processes in their own ways. The research for fixed income shows different outcomes from equities. Fixed income needs to be different.
Why is the new approach focused only on banks and corporate credit? In particular, was any consideration given to incorporating high-grade issuance?
LANGER For the most part, supranationals and sovereigns already have robust ESG credentials. By and large their modus operandi is to do social good and most have specific social or green bonds. ESG is not a contentious area for this issuer set.
Our focus is on portfolio risk. With a remote chance of default on government or quasi-government bonds, there is very little downside risk. In addition, governments do many different things and it is hard to separate what they do well from what they do poorly – and, in reality, trying to do so adds very little value. The value is very much in the default space, and this is what our process is helping us avoid.
RANDS Because the index is 90 per cemt comprised of government bonds, we think making an allocation to the index is effectively allocating to government bonds. To screen these out would be counterintuitive.
Is it fair to describe the ESG analysis approach itself as a negative screen? If so, how does Nikko’s approach integrate with other ESG strategies, for example positive screening and the role labelled product plays in portfolios?
RANDS It is fair to say that our approach is an enhanced negative screen. We are working to ascertain whether a company stacks up on ‘E’, ‘S’ or ‘G’ concerns and screening it out of our universe if appropriate.
There are two reasons for this. The funds we run are not labelled as sustainable or ethical so, unless we have a valuation concern, we do not have a natural bias for positive ESG companies. We are trying to avoid negative ESG factors and companies that are clearly behind the eight ball.
The second part is that we use the negative screen to ensure we are identifying companies with poor practices and benefiting the fund by avoiding them. Our investment criteria require strong credit quality and adequate or good ESG practices – and anything that does not meet these criteria will drop out of our investment universe.
LUO We do not incorporate positive screening but we are making a point of looking to see whether a company is positively addressing negative ESG practices. We are particularly supportive of issuers with a positive ESG trajectory and will view more favourably issuers that are aware of ESG issues and addressing them appropriately.
In the context of COVID-19, social issues like labour management or health and safety have become forefront considerations for all businesses. As such it makes sense for us to home in on these types of factors as well.
RANDS Now we are scoring these companies, high ESG scores are quick and easy for us to see. While we might not screen only for positive companies, a strong underlying credit with a positive ESG overlay and a valuation that stacks up is credit that is ticking all our boxes and one that we would want to put in the fund.
“We still very much believe in active decision-making and management, but we also believe in using quantitative tools more easily to facilitate the decision-making process. Our ESG process follows the same philosophy – it is all about using data to make better decisions, not using data to make decisions for us.”
There is a lot of talk about investors integrating ESG in the credit process and that ‘ESG risk is credit risk’, yet Nikko’s approach is formally to separate ESG and credit analysis rather than integrating them. On the other hand, presumably the goal for Nikko is to enhance the significance of ESG in the overall process. Is the Nikko approach unique or unusual, and why does it make sense to do it this way?
RANDS Without a doubt the goal is to enhance the significance of ESG in the overall process. Our aim is to focus on the components that matter and give each the attention it deserves. We have done what we think makes sense.
A standard approach elsewhere appears to have been to roll ESG into credit risk. But our view is that there are times where this is not necessarily the best approach. A good example is tobacco companies, which may have strong credit metrics but could also have very weak ESG profiles. Our process is designed to screen out these types of companies.
The idea is not to take ESG completely out of the credit decision. If the credit team spots a credit issue owing to an environmental concern, this would still be noted in the credit analysis. However, the credit team deciding that a company is a positive issuer does not by default mean that it has all its ESG components lined up as well.
LANGER It is not always company specific. Quite often the factors are industry or sector specific. A company might have strong credit fundamentals but may also be in a poor sector. This was another reason to remove the emphasis from looking purely at company credit in our process. We wanted to examine at sector level first, to support a more comprehensive decision around a company’s inclusion.
What has end-client feedback to the new approach been, and how much uniformity is there in client preferences in this space?
LANGER The process is predominantly for our client-facing unit trusts, although we have extended it to our mandates. Most clients will have their own views on ESG and we can incorporate these into this process. We tend also to use negative screens in this instance and we will carve out some sectors for clients where there is a specific preference to avoid them. However, it still comes down to a discussion with each individual client. Clients have unique views, and we try to accommodate these as best we can.
RANDS This was a point of much discussion through the process. It is a hard yes or no with a negative screen that says there is no price at which we would participate – avoiding the possibility of a company adding a factor down the line that we just don’t think stacks up.
What impact will the new approach have on Nikko’s investible universe?
RANDS As of early 2021, we are screening out about 5 per cent of issuers from the credit universe. Credit is at present a relatively limited component of the Bloomberg Composite Bond Index because there is a high volume of semi-government issuance. This means that when we screen out 5 per cent of credit issuance it becomes 0.5-1 per cent of the index.
My view is that we can screen out companies without appropriate ESG criteria because we can still construct a strong portfolio when we are only removing such a small percentage of the investible universe.
“We spent six months collating information, from central sources and from issuers themselves. Now I find comparisons far easier to make. While handling the data may become more onerous, we will have extra time for the qualitative part of the decision-making process – which is the more important bit.”
Companies’ sphere of influence is becoming a focus in ESG finance. How far does Nikko’s ESG analysis go in this respect? Does the firm look at supply chains, investments and the like – ‘scope three’ emissions, as they would be called in the environmental space?
LUO We concentrate on the more pertinent issues within a sector. For example, with a supermarket chain modern slavery is currently a big concern and a key focus for our research. In some industries, though, the data is inconsistent and we need to take a step back to understand how each company has responded.
RANDS For each sector we typically aim to look as deeply as we can where it makes sense to do so. If we are talking about an energy company, we will consider its response to scope-two and scope-three emissions concerns. In the supermarket space, we are more focused on modern slavery and what the supply chain looks like. We do not want to adopt a blanket approach, but one that starts at the sector level and gives us the flexibility to go deeper if necessary.
LUO Using this approach through a company’s response we can see how serious it is about addressing an issue. We will keep this in mind as we look at each name.
Where is the data Nikko uses coming from and how much qualitative overlay is involved?
RANDS At the moment, most of our data come from MSCI and Bloomberg. We aim to compare standardised data – whether a score or a rating – and look for outliers. If we see that a company is ahead in governance but behind in environmental score, we will raise this in our next meeting.
If a company is scoring highly across the board, we may still do our own additional research. But it will likely be less than for a company with poor scores where one or more elements are clearly lagging.
LUO It was a considerable process to start with. But we have now completed the bulk of the work across sectors and specific issuers so adding a new name or revising the score line is not as onerous as it may seem.
LANGER This is where our new process is absorbed into our standard credit processes. If our credit team has issuer-specific questions, Linda can oversee these – meaning a much more direct line of approach because we go into meetings knowing exactly what information we want.
It sounds like the dashboards Nikko has built help to automate much of what might otherwise be a time-consuming process.
LANGER We still very much believe in active decision-making and management, but we also believe in using quantitative tools to facilitate the decision-making process.
Our ESG process follows the same philosophy – it is all about using data to make better decisions, not using data to make decisions for us. It is also about having a framework. Once the framework is in place, decision-making becomes a lot easier.
RANDS We spent six months collating information from central sources and from issuers themselves. Now I find comparisons far easier to make. While handling the data may become more onerous, we will have extra time for the qualitative part of the decision-making process – which is the more important bit.
Is it possible to provide any live examples – of themes, even if it is not possible to mention specific issuer names – where the new Nikko process has already been used effectively to benefit its fixed-income funds?
RANDS In the past six months we have seen some universities in the news because of wage underpayment. Our ESG process has enabled us to look for issues in other sectors and gather some credible data – for example, the percentage of total wages and how it compares across sectors and data providers – to make a comparison relative to other companies we have seen.
LUO Then in our subsequent conversations with universities we will raise this issue. It would raise a red flag for us if their response was to skirt around the problem.
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