ESG integration

Environmental, Social and Governance (ESG) integration can be described as the identification and mitigation of material ESG-factors in investment activities and -decisions. ESG integration is aimed to improve better risk-weighted return, since ESG-factors can directly and indirectly impact financial results.

For instance, climate-related financial risks such as more extreme weather events can result in higher claims at insurers, or energy companies sued for complicity in human rights violations can lose drilling rights.

Our investment teams are responsible for the integration of ESG-factors in investment decisions. The Risk departments perform a parallel ESG risk analysis and challenge the assessment of the investment teams. The Responsible Investment team assist the investment teams by providing guidance, training, and coordination. The role of the Responsible Investment team is to help ensure that the investment portfolio contributes to the responsible investment objectives of PGGM Investments and its clients, and also complies with ESG-related regulation.

ESG integration in practice

A first step to ESG integration is the identification of ESG-risks. To be able to identify these risks, ESG related data are essential. The available data is limited due to subjectivity, estimations and modelling of the data. Improvement of data quality is therefore an important objective of our ESG integration activities. We have insourced ESG data from several specialised data provided for many years, attempting to overcome data limitations like subjectivity, estimations and modelling of data. In 2022 we expect our internal ESG database to be operational. This database will enable the investment teams to easily access, use and report the most relevant ESG-related data for ESG integration purposes, but also to meet the requirements from regulation, voluntary initiatives, and client policies.

In 2021 we started using a tool provided by the environmental, social, and corporate governance data science company RepRisk. With this tool it was better possible to specifically identify ESG risks relating to the OECD Guidelines for Multinational Enterprises and involvement in thermal coal and tar sand exploration in our private investments. This enables us to better comply with the requirements of the IMVB covenant, which some of our clients signed.

We expect good direct or indirect results from an improved integration of ESG-factors. Better reporting of ESG-related data will therefore remain one of the key priorities for our dialogue with and monitoring of external investment managers. Especially in private markets, we see exciting potential for reporting on risks and of mitigation strategies.

To identify and assess ESG-risks, our Responsible Investment team developed a structured process, based on the Sustainable Accounting Standards Board (SASB) framework. The assessment process will be further refined and in 2022 we expect it to be tailored and presented to most investment teams.

Additional support is provided through internal Responsible Investment Guidelines, which discuss topics like biomass, hard to abate sectors and biodiversity. The number of these guidelines will be further expanded in the coming years.

A day as an investor: Rui Chang advising on ESG integration
A day as an investor: Andrea Palmer about ESG integration in Listed Real Estate

Rui Chang (29) is an advisor of our Responsible Investment (RI) team and has worked at PGGM Investments for four years. She obtained an LL.M. in Public International Law from Utrecht University, with a specialisation in environmental law and law of the sea. About her team, Rui says: ‘The RI team is the centre of sustainability within PGGM Investments. Our work covers multiple aspects, including ESG integration, stewardship, and impact investing.’

Read: Advising on ESG integration by Rui Chang

Andrea Palmer (30) joined PGGM in November 2020 to oversee ESG integration for PGGM Investment’s Listed Real Estate Fund. The fund invests in global real estate securities such as REITs and listed property developers in developed markets. Andrea has worked in real estate and ESG investing for nine years, previously at Triodos IM and GRESB. Andrea graduated from Aurora University outside of Chicago with a Bachelor’s in Marketing Research. She holds a Series 7 general securities license (U.S. Financial Regulatory Authority) and the Sustainability Accounting Standards Board FSA Credential. Andrea: ‘The great part about my work is that each day looks different. Most of my time is spent on things such as engaging with management teams to understand and evaluate their approach on managing ESG issues, developing our climate risk and impact management frameworks, and working with various ESG data sources to enrich the team’s investment process.‘

Read: A day as an Investor by Andrea Palmer

A day as an investor: Rui Chang advising on ESG integration A day as an investor: Rui Chang advising on ESG integration

Read: Advising on ESG integration by Rui Chang

A day as an investor: Andrea Palmer about ESG integration in Listed Real Estate A day as an investor: Andrea Palmer about ESG integration in Listed Real Estate

Read: A day as an Investor by Andrea Palmer

Biodiversity

The attention of governments, corporations and investors is increasingly turning towards the topic of biodiversity and nature loss, a threat potentially equal to climate change. It has also become evident that the two share common causes and common solutions. And experts are clear: either we solve both or we solve neither.

PGGM Investments and other investors are already exposed to nature-related physical risks. In 2020, De Nederlandsche Bank (DNB) assessed that the exposure of Dutch investors to such risks was at least € 510 billion. The expectation is that regulators will soon be asking PGGM Investments and its peers to find ways to manage these risks. Like the climate crisis, we simply cannot ignore the biodiversity crisis.

We are very conscious of this topic and are addressing it within our investments. This includes divesting from companies that have a severe negative impact on biodiversity. An example of this is SLC Agricola SA, a Brazilian agricultural producer, who was added to the non-inclusion list due to its involvement in illegal deforestation.

Also, PGGM Investments engages with companies regarding biodiversity. For example: we are engaged in discussions with food producing and retailing companies on deforestation, which is a major driver of both climate change and biodiversity loss. Together with peers we are using tools such as satellite technology to engage in conversations with companies on how to improve their sourcing practices for cattle, soy and palm oil. We have joined peer networks to agree on standardized metrics and tools (i.e., the Taskforce of Nature-related Financial Disclosures, the Partnership for Biodiversity Accounting Financial).

There remains a lot to do, particularly the translation of these complex topics into usable metrics during the investment process. Yet, thanks to the growing attention, a lot of development in terms of metrics standards and regulation is expected in the coming years. In the meantime, asset managers like PGGM Investments can already take action to manage their exposure and their negative impact.

PGGM Investments supports Private Equity ESG Data Convergence Project

In recent years, we see a proliferation of sustainability-related initiatives. These often focus on public markets, and it is becoming clear that private equity (PE) needs to catch up. In 2021, PGGM Investments participated in the ESG Data Convergence Project, the first partnership in the PE industry between private equity firms (so called ‘general partners’ (GP) and its investors that commit capital (so called limited partners (LP). These project aims to standardize ESG disclosure metrics. The convergence starts with six metrics, including Scope 1 and 2 greenhouse gas (GHG) emissions, renewable energy, board diversity, work-related injuries, net new hires, and employee engagement. This will help PE to achieve our clients’ climate ambitions. After having collected GHG emissions data across the PE portfolio, we faced a clear gap in terms of data availability in the PE industry. By supporting this LP-GP partnership, we are committed to further collaborating with LPs as well as engaging with our GPs to achieve full ESG transparency.

ESG integration in numbers

What is the financial impact of ESG integration on our listed equity investments? PGGM Investments uses standardized measures and deviation analyses to measure this. The size of the difference between return fluctuations of an investment portfolio against return fluctuations of a benchmark is measured by a tracking error.

A tracking error is a measure of the size (not the direction) of performance differences.

The benchmark is the FTSE All World Index, a broad market index reflecting the global stock market performance. A large tracking does not necessarily imply underperformance of a portfolio compared to its benchmark but a higher chance that the performance will be significantly different.

With our ESG integration policies we want to achieve the best ESG performance while achieving market-level returns. Therefore, we strive for a low tracking error in all our ESG integration policies which represents reduced risks. To understand the impact of ESG integration, we compute the tracking error of each ESG integration policy separately and the total tracking error due to ESG integration. The graph below shows from left to right the tracking errors of individual ESG integration policies and the total tracking error due to ESG integration. Our CO2 reduction strategy has the biggest impact (0.36%) followed by our allocation to impact investing (0.26%). However - overall - we can conclude that our ESG integration policies do not have a significant impact on the financial performance of our listed equities portfolios. The total tracking error of ESG integration, after correcting for overlaps in policies and accounting for country and sector effects, is only 0.52%.

Research: The attractive risk-return trade-off of SDIs

Impact investing becomes an increasingly important instrument to classical ESG integration.

Environmental, Social and Governance

While ESG integration emphasizes investment risks resulting from ESG factors, impact investing seeks to align investments with opportunities generated by solutions to sustainability challenges. Our new SDI AOP dataset allows us to explore and research to what extent companies contribute to SDG solutions through their core commercial activities and to link that information to financial performance at the company and portfolio level. This helps us in empirically evaluating the merits of “3D investing” in listed equities. It is an extension of the traditional risk-return considerations to include the positive contributions that companies are making to environments and societies through their core business alongside their financial risk and return profile.

Our empirical research shows that SDIs provide an attractive risk-return trade-off. In our study, a pure-play SDG-aligned portfolio yields a risk-adjusted performance over a five-year time horizon that is on par with a broad market benchmark. Our results show that investors can accommodate SDG tilts in diversified listed equity portfolios without compromising financial performance. Attention to industry exposures resulting from a closer link of some industries to specific SDGs is an important consideration in SDG-aligned portfolio construction. The research results have been presented at a webinar of the International Center for Pension Management (ICPM) and help PGGM Investments and other members of the SDI Asset Owner Platform in gaining a better understanding of 3D investing.