In this episode of Markets in Focus

Governance, the “G” in ESG, is about “seeing how deeply embedded these issues are in a company's strategy and ultimately their operations,” says Joy Facos, Head of Sustainable Investing and Corporate Responsibility. Joy joins Matt Orton, CFA, to talk about how environmental and social issues — the “E” and “S” issues — are guided by the “G.”

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Transcript

Matt Orton:
Sustainability matters for all investors, whether you're primarily focused on financial returns or seeking to drive sustainable outcomes. Environmental, social, and governance considerations can highlight recognizable risks and present new investment opportunities. And in the wake of the COVID pandemic, there's an increasing realization by corporations and their stakeholders that capital markets, economies and environment and social constraints are all interconnected. But there's still a lack of formalized implementation, which is likely the result of the complexities in evaluating ESG considerations and their impact on risk and return.

Today, I'm lucky to have Joy Facos join us again to help break down some of the key aspects of ESG. Joy is the Head of Sustainable Investing and Corporate Responsibility at Carillon Tower Advisers. And today we're going to focus on the G within ESG and why Joy believes it's the glue that holds the S and the E together. This is Markets in Focus from Carillon Tower Advisers. I'm your host, Matt Orton. Join me and my colleagues as we discuss the latest trends and developments driving the markets. Visit us at marketsinfocuspodcast.com for additional episodes and insights. Joy, thanks so much for joining us.

Joy Facos:
Thanks so much, Matt. I'm really happy to be back.

Matt Orton:
Great. And to kick things off, I think it makes sense to start very basically and level set things. Perhaps you can start by just defining governance, that G within ESG and providing some color around the role that it's played in traditional investing.

Joy Facos:
Great. Thanks. That's a great place to start. So governance in this context is the leadership of a company: the structures in place for setting direction, establishing policies, and providing oversight, namely the board of directors and executive management. In traditional investing, the board and executive management are evaluated on the quality of a company's strategy and management's ability to execute on that strategy to drive shareholder value.

Matt Orton:
Thanks, Joy. It's interesting to think about the role of governance in traditional investing, because it highlights why it's so tangible within the investment research process. So as we broaden the scope of the discussion, it would be great to get some context as to how the role of governance in traditional investing has grown and taken focus within ESG.

Joy Facos:
Yes. I mean, absolutely. Within the context of ESG investing, the scope of responsibility has really widened beyond simply increasing shareholder value. While that's still clearly important, corporate leadership must also take into account environmental and social considerations when setting strategy, particularly as we move to a lower carbon economy. I really want to stress here that these considerations are not mutually exclusive – that one does not necessarily come at the expense of the other over the long term.

In fact, by incorporating environmental and social issues into business strategy, a company is positioning itself for future success, especially in light of climate-related risks and opportunities. We see a lot of attention focused on the E issues. However, it's important to note companies that take seriously their S or social responsibilities, and incorporate them into their strategies and practices, are also positioning themselves for future success. A company's approach to employee health and safety, diversity, fair employment practices, employee engagement, respect for human rights, and community involvement speaks to its commitment to its employees, its customers, and the wider community. A positive, consistent approach to these issues can be a source of significant competitive advantage for a company over time.

Matt Orton:
So I think that's a great point. You mentioned that they're not mutually exclusive because I think that often gets overlooked by the broader investment community. And just to dive a little bit deeper into the G, can you maybe share some examples of just how we as traditional investors might look at something that's really considered a part of the governance area of ESG, but we might not even realize it?

Joy Facos:
Sure. I mean, I think one of the first places you can look is the structure of the board of directors. Many corporations now are building into their board of director committee structure, a committee devoted to E and S oversight that really shows that there's a commitment to these issues in helping drive a company's strategy. Another place to look is to see whether E and S metrics and targets are incorporated into a valuation of executive management and are actually factored into the compensation structure. So it's seeing how deeply embedded these issues are in a company's strategy and ultimately their operations. The other thing I would say around this is, you can find this information in a company's proxy statement. And while neither one is considered standard yet, we are seeing more and more companies, particularly larger companies putting these practices and structures in place. It really is interesting to see where they're going with this.

Matt Orton:
Well, that's great. And maybe to dive even a little bit deeper then into this idea that sustainability is starting to permeate governance, leaders are becoming more accountable for environmental, social and economic performance. Now as an investor, how should we think about the role of the board and executives with respect to implementing and directing these considerations? And how can we engage them? You've been seeing, I think a lot of companies, especially large passive investors start to get a little bit more involved and vocal. Now, how should we, as investors start to think about how we might evaluate all of this?

Joy Facos:
Yeah, it does kind of feel like a daunting task. I've got to say. But with respect to engagement, it's clear institutional investors in particular are well positioned to raise ESG issues with portfolio companies. For Carillon and its affiliates here, many of the issues that we raise for engagement are identified through fundamental analysis, and it's important to keep in mind that engagement can take many forms. It can be a call to management, it can happen through emails, it can be through letters. It can happen on quarterly calls. Just raising these issues with management is an important part of letting management know that investors are finding these issues really important. And so for direct engagement, that really is probably the realm of the institutional investor, but beyond direct engagement, and this is true for equity investors, whether institutional or individual, they're able to have their voice heard through proxy voting, at a company's annual general meeting.

And they can vote on these issues that are of importance to them. Again, this information can be found in a company's proxy statement, as well as the company's website. And another aspect of corporate governance that sometimes gets overlooked is responsiveness. How responsive is management to engagement efforts? And how responsive is management to vote tallies? Even though an issue might not necessarily get a majority vote at a shareholder meeting, if there's enough momentum behind it, if it's just shy of the majority threshold, it would really behoove a company management to take a listen to that statement. Again, even though it's not majority, it's a pretty loud call to do something. So retail investors, individual investors, institutional investors, all have a say.

Matt Orton:
I think that's a really important point because I think you're starting to see more responsiveness or at least those who are not responsive, tend to be criticized even a little bit more in the media. And especially, maybe you can share your thoughts for companies that are out of the limelight, maybe smaller companies, midsize companies, how can fundamental investors or any, just the average individual investors, you're going through doing your research. How can you evaluate that sort of responsiveness?

Joy Facos:
There are a couple of ways of doing that. One, is seeing what the vote tally is following an annual general meeting, this is publicly available in something called form 8-K. Typically, if you go to a company's website, look at their SEC filings and look for the 8-K, which is a recent development report that is closest to the annual general meeting. There you can see what the vote tallies were for each of the issues brought to vote. And a lot of times a company will talk about their response to it and kind of see where it goes from there. If it's not in that particular report, a company may come out following the annual general meeting and just say, okay, we will be addressing this issue, whether it's greater diversity on the board of directors or publishing a sustainability report, you'll know about that relatively soon.

If there's absolutely no change and the company stance is pretty much “talk to the hand,” you know where management stands and then you can decide from there whether or not you want to continue holding that company and, or engaging with that company. For smaller investors, or I should say investors in smaller companies, I will say data availability is kind of a challenge, but if companies are making a concerted effort, even if they're saying that they're starting and providing information or they're working on issues, they should be given the benefit of the doubt and you want to see it over time. And it actually goes back to that traditional investment stance, which is how well is management executing on strategy? Are they doing what they say they're going to do?

Matt Orton:
That's incredibly helpful.

Joy Facos:
Does that answer your question, Matt?

Matt Orton:
Yeah, it certainly does. I think that's a really helpful insight to think about it. And maybe continuing down this line you had mentioned, data availability. What are some other ways that we, as investors can go about collecting data and framing it within the context of ESG? Are there any specific resources dedicated to helping do that?

Joy Facos:
Sure. I mean, there are a lot of resources out there, but again, it's probably best to start at the beginning with a company. And that information can be found, particularly around strategy and risks, can be found in a company's annual report, also known as the 10-K. A lot of this information as I mentioned earlier, is available in a company's proxy statement. Sometimes you might see that under its SEC form name of DEF 14. And for many companies today, you can find this information in a corporate responsibility report or sustainability section of its website. Now here's a note of caution: Currently in the U.S., ESG data are reported by companies on a voluntary basis. This may change in the near future as the SEC considers new ESG reporting rules. So while this information may feel overwhelming and without set standards at the moment, there are frameworks that are becoming more widely adopted.

I think the first that is probably most helpful, particularly in the context of climate change is the Task Force on Climate-Related Financial Disclosures. A lot of times you'll hear it talked about as TCFD. And they came out with a series of recommendations and are using a framework based on four pillars. Not surprisingly, the first pillar is governance. The second pillar is strategy. The third is risk management and the fourth is metrics and targets. So companies are encouraged to report using that framework and addressing how the board and executive management is thinking about the transition to a lower carbon economy. What is their strategy and how are they taking into account what a lower carbon economy might look like and what it might mean for their business. In terms of risk management, the third pillar, it's really looking at both the physical risks that climate change might pose for the company, not just for its operations, but also its supply chain in terms of risks of extreme weather, disruptions in the supply chain caused by extreme weather or rising sea levels.

Another risk is known as transition risk. What are the risks to the company's business as we transition to a lower carbon economy? How much of their revenue is predicated on fossil fuels, for example, and the use of fossil fuels. What is the cost of transitioning say to renewable energy? So those are the kinds of things that they're looking at in that third pillar of risk management and looking for companies to report. And finally, and this one is a little slower to come around, is a company's reporting on its metrics and targets. You might be seeing companies say, “okay, we're going to be net zero by 2050.” Okay. So that's their target. You want to see how they're going to get there and over time, be able to analyze what they are disclosing in terms of metrics towards that target. So the TCFD framework is very helpful there.

Another framework, which is really wonderful and it's a little broader in scope, is the framework that was established by the Sustainability Accounting Standards Board or SASB. And they have a materiality mapping approach, which really breaks down 77 industries and sub-industries by what are the most important or material metrics that an investor should be looking at. And therefore, a company should be reporting to understand more about their ESG approach. And honestly, because I haven't thrown out enough letters, SASB has recently merged with IIRC, the International Integrated Reporting Council to become the VRF, the Value Reporting Foundation. So what they're doing is really putting together the foundation for future reporting.

Now, whether or not those standards are officially adopted by the SEC, we'll just wait and see. There might be some combination there in terms of what the SEC might be thinking about going forward. So TCFD, SASB, VRF and the SEC are all excellent resources, really to learn more about this. And again, these resources are available to all investors, it's all publicly available. So it might take a little time to understand everything, but again, all of these resources are super helpful. So I just want to say, regardless of the framework, it's really important to remember that corporate governance is the key as it sets the tone from the top. The G provides the guidance that really drives the E and the S. And as we started off, it really is the glue that holds it all together. So do you have any other questions or have I addressed your questions, Matt?

Matt Orton:
Yeah, I think I'm still working through the alphabet soup of acronyms, but if anything, it speaks to our industry at being great at coming up with new nomenclature for titling things. But I think, like you said, really the main point is just to convey that once you get the G right, the E and the S are going to follow. So I think this has hopefully been incredibly valuable for all of our listeners. We certainly appreciate all of your support and until next time, take care.

Joy Facos:
Great. Thanks so much, Matt.

Matt Orton:
Thanks for listening to Markets in Focus from Carillon Tower Advisers. Please find additional episodes and market insight at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple podcasts, Spotify, or your favorite podcast app. Until next time, I'm Matt Orton.