Saintly Central Bankers

The legal mandates of central banks (CB) typically include responsibility for price stability, financial stability and the safety and soundness of financial institutions (e.g. our banks and insurers). So they’re effectively tasked with scanning the horizon to identify and understand those structural issues that could impact our financial systems …. and the economy. Importantly, they are also generally autonomous from our political systems.

Climate change is a market failure; carbon isn’t assigned its necessary economic cost.  Which means CB’s, led by the Bank of England Governor Mark Carney, are increasingly discussing the financial stability implications of climate change and the required appropriate response. Many are concerned that without further mitigation, cumulative emissions pose significant risk of economic disruption.  CB’s views on what constitutes an appropriate time horizon for considering risks seem to be changing.

For instance, historically, weather related ‘shocks’ to the financial system have been short-term, the impact on output or inflation has been temporary and policy-makers have been able to ‘look through’ them. However, some are now beginning to think that the increased frequency and amplitude of adverse weather shocks can no-longer be ignored if we are to avoid more extreme outcomes, the financial impacts of which would be difficult for central banks to manage. Separately, the impact of climate related employment shifts on wage inflation or energy price shocks as we shift to renewable energy are other considerations which could make CB inflation targeting more difficult in the future.

In their regulatory role, CB’s perspectives are also changing. Insurers have long been on the front line of dealing with the weather related impacts of climate change. They have adapted their modelling and pricing accordingly. This is less the case for banks. Late last year, the ECB indicated to the Euro-zone banks it regulates, that it had identified climate-related risks as being among the key risk drivers affecting the euro banking system. Similar messaging has come out of the Bank of England.

What are these risks? Both the banks and their regulator are still exploring this. But basically they are either physical risks e.g. mortgages of homes at risk of flooding or consumer loans on diesels cars etc., or transition risks i.e. those relating to the shift to a low-carbon economy. Responses to a Bank of England survey last year suggested that relatively few of the UK banks are managing these risks in a strategic fashion, principally because their business planning horizon only stretches to a few years out.


Examples of climate-related financial risks to bank assets
Source:Transition in thinking: The impact of climate change on the UK banking sector, sept 2018.

Time horizon is the common link between a lot of these considerations for CB’s and the financial institutions they regulate. Think short-term and there is little incentive to address climate change. Do too little, too late and you might not be able to manage the impact. But do anything too radical in the short-term and you risk materially damaging your business or the systems financial stability. This is the balance that our national and central banks must find. However, they are now undoubtedly giving more consideration to using the tools they have to address climate change.

 

About the author

Ryan Smith is Head of ESG Research. He joined Kames Capital in October 2000 as an SRI analyst and was appointed to his current position in September 2002. He has 18 years’ industry experience*. His role involves managing the team that conducts the ESG screening process for our Responsible Investing funds. Ryan’s team also provides corporate governance screening and research for all equity investments, and conducts research into environmental and social issues. Before joining us, he worked as an environmental chemist for Severn Trent Water. Ryan has an MSc in Environmental Chemistry from Nottingham Trent University and is a CFA charterholder. *As at 30 November 2018.

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Supply chains: Materiality materializing

‘Supply chain’. You might think you’re safe to assume that this phrase implies a direct link between a company and its suppliers. However, in reality, supply chains are more like a network of waterways, with thousands of tiny tributaries converging into large rivers of production and sale. This complexity and scale is one of their strengths; when you have a problem in one part of chain, you simply reroute elsewhere. And the best supply chains are also the best kept secrets– you only have to see the success (and secrecy) of Amazon for this.

Scale brings speed. You’ve forgotten a friend’s birthday, and you need that present tomorrow, no problem. But scale also makes addressing sustainability concerns challenging.

But how do you manage the risks associated with labour conditions or the environmental impact of a distant company manufacturing on your behalf? You also need to bear in mind that the environmental impact of a corporation’s supply chain often far exceeds that of the organisation; CDP estimate that supply chain emissions are typically 5.5x more than a company’s direct emissions.


Source:CDP, Supply Chain Report 2019

But it’s not all bad news. The complexity of supply chains can make sustainability difficult to address, but that doesn’t mean it’s impossible. Companies are increasingly targeting their largest suppliers on sustainability. In many industries, corporations share the same suppliers with their peers which offers the opportunity to collectively leverage better supply-chain sustainability. Especially in the technology sector, where the likes of Apple, Microsoft, and Salesforce all buy products from the same semiconductor and hardware manufacturers who are mostly based in Asia-Pacific.

So this is why, when we think about supply chain issues for a given industry, we always consider the nature of the customer-supplier relationship and what are the incentives for both parties to address sustainability concerns. Suppliers that are financially dependent on customers with strong sustainability practices are also likely to be under the most pressure to adopt similar practices themselves. This dynamic is strong in tech, whereas, in sectors like apparel, relationships tend to be shorter and incentives therefore typically less (although there are always exceptions).

At the cutting edge of all this, the most advanced corporations are working on enabling innovative financing mechanisms to support their closest suppliers efforts to adopt more sustainable practices. (In return they are required to report on various sustainability metrics.)

Suppliers therefore ignore sustainability at their peril.

  • This year, 43% of CDP supply chain program members confirmed that they currently deselect existing suppliers based on their environmental performance. 
  • A further 30% indicated that they were considering this in the near future.

Let’s hope these broad efforts slowly ripple upstream through the many tributaries of supply chains.

Source:Bloomberg, Greening the supply chain: New moves companies are making, March 2019

About the author

Ryan Smith is Head of ESG Research. He joined Kames Capital in October 2000 as an SRI analyst and was appointed to his current position in September 2002. He has 18 years’ industry experience*. His role involves managing the team that conducts the ESG screening process for our Responsible Investing funds. Ryan’s team also provides corporate governance screening and research for all equity investments, and conducts research into environmental and social issues. Before joining us, he worked as an environmental chemist for Severn Trent Water. Ryan has an MSc in Environmental Chemistry from Nottingham Trent University and is a CFA charterholder.  *As at 30 November 2018.

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The Forward Thinkers

As Kames approaches 30 years of ethical investing, one of the questions we’re being asked the most is essentially what’s changed in that time and why?’

The answer to this is multi-faceted. For many industries, sustainability has become a commercial imperative (see mining example below). But multiple drivers now mean that the sustainable investment opportunity set has increased. Or to put it plainly, there’s more sustainable stuff to invest in. In part this has been technology enabled and we have written about sustainable disrupters frequently (e.g. here, here and here).

But technology can be enabling too. Specifically, enabling traditional industries to seek out operational (and therefore sustainable) efficiencies, which in aggregate can be significant.

Sensors are now pretty cheap, so they can be used to create ‘smart’ industrial equipment- able to monitor their own performance or that of their physical environment, e.g.  temperature, pressure, humidity, vibration.

Then you have cheap computing power (combined with communication networks) which is enabling the capture, management, analysis (machine learning) and storage of increasingly large amounts of data (from those handy sensors I told you about). Machinery and industrial assets are becoming digitalised. Welcome to Industry 4.0 and companies like Kames hold* UK-listed Aveva Group Plc and Paris-listed Schneider Electric SE.

Imagine you could predict the future? That’s literally one of the services that Aveva and Schneider Electric are trying to do for their clients using predictive maintenance. Rather than follow a simple calendar-based schedule, using the data generated from the sensors on your physical asset, predictive maintenance uses machine learning to spot problems before they occur. Companies are better able to identify underperforming assets, plan and prioritise maintenance, reduce downtime, avoid costly (and possibly catastrophic) events and improve safety and regulatory compliance. Sensors and computer chips now measure and collect information from jet engines to wind turbine gearboxes.

A ‘digital twin’ – the digital representation of something physical- no longer the stuff of science fiction. Digital twins are now employed in a variety of industries at a multitude of scales. Mining is becoming increasingly energy intensive as ore grades decline, forcing companies to become increasingly efficient. Like a number of others, UK-listed miner Anglo-American** is digitising its mining fleet and using machine learning to improve precision and efficiency.

Less energy and water in + less waste out = less costs + more productivity.

At a completely different scale, Singapore (yes, as in the whole city!) is working on a digital twin. Singapore is known for its efficiency, but its density provides little room for physical infrastructure experiments. A digital model would allow designers, planners and policymakers to explore future city-scapes. Static locational data of every building to bus-stop, alongside dynamic data of where the buses are and even things like dengue fever clusters. The UK wants to do something similar for the whole of the country’s infrastructure network. Incredible.

*As at time of writing 08/03/19 Kames Capital holds
**As at time of writing 08/03/19 Kames Capital does not hold

 

About the author

Ryan Smith is Head of ESG Research. He joined Kames Capital in October 2000 as an SRI analyst and was appointed to his current position in September 2002. He has 18 years’ industry experience*. His role involves managing the team that conducts the ESG screening process for our Responsible Investing funds. Ryan’s team also provides corporate governance screening and research for all equity investments, and conducts research into environmental and social issues. Before joining us, he worked as an environmental chemist for Severn Trent Water. Ryan has an MSc in Environmental Chemistry from Nottingham Trent University and is a CFA charterholder. *As at 30 November 2018.

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Open and Honest

Ever worked in a company that required you report ‘near miss’ events? That is, events that could have or nearly did result in an accident. The rationale is straightforward; an open reporting culture and investigating the near misses should help avoid the real thing, which at the extreme can be both fatal and catastrophic. In heavy industries where safety is critical, ‘sweating the small stuff’ is important.

Slightly different, but there are safety parallels in a recent study* which looked at whistle-blowing data from US listed companies. A requirement of many markets (for example, Sarbanes-Oxley in the US), whistle-blower systems are intended to provide a secure and anonymous means to report issues and provide an alternative to the traditional reporting and monitoring mechanisms that companies employ. And they are important, because employees, as insiders, are best placed to identify inappropriate behaviour within a company*.

What did the study find? In a nutshell, evidence of more whistle-blowers is a good thing at a company. Counterintuitively, more internal whistle-blowers doesn’t mean more (frequent or serious) problems. Rather, it showed (in US companies at least) that the more employees use internal whistleblowing hotlines, the less lawsuits companies face, and the less money they pay out in settlements. Use of whistle-blowing is actually a sign of open and effective communication channels; employees believe that problems will get sorted. Conversely, it’s not hard to imagine that when management abuse these processes (insert name of UK-listed bank here), this belief is eroded. Avoid the ‘accident’ (and the associated public relations disaster), address internally and learn from your mistakes.

And from a governance perspective, did the study identify any particular company traits? Yes. Autocratic executive management teams with governance protocols that limit minority shareholders are less likely to pay heed to these systems. As are fast growing companies (where other studies have shown that accounting misstatements are more prevalent) which is important for us to bear in mind given our focus!

Finally, remember, this is for companies in the US, a nation which psychologists and sociologists would classify as having ‘low power distance’*. Psycho-babble what? Power distance is the ‘extent to which the lower ranking individuals of a society accept and expect that power is distributed unequally’*. This been measured on a country by country basis and it has been found that many developing countries have ‘high power distance’. To stretch the safety parallels to their limits, safety stats in developing markets often look great. At face value, the data says, ‘nothing to see here’. But accidents often go unreported because employees are (more) respectful and submissive to their employer. Taiwan, India, Japan et. al all require whistle-blowing systems and processes like the US does, but I imagine the hotlines in these countries probably don’t get a lot of calls.

In case you were in any doubt, open and honest corporate cultures work best. If management teams are targeting ‘zero’ whistle-blower reports they are missing the point.

*Stubben, S. and Welch, K.T, (2018); Evidence on the Use and Efficiency of Internal Whistleblowing Systems
*Dyck, A., Morse, A., and Zingales, L. (2010); Who blows the whistle on corporate fraud?; The Journal of Finance; 65(6), 2213-2253.
*Outliers: The Story of Success; Malcolm Gladwell (2008)
*https://en.wikipedia.org/wiki/Power_distance

About the author

Ryan Smith is Head of ESG Research. He joined Kames Capital in October 2000 as an SRI analyst and was appointed to his current position in September 2002. He has 18 years’ industry experience*. His role involves managing the team that conducts the ESG screening process for our Responsible Investing funds. Ryan’s team also provides corporate governance screening and research for all equity investments, and conducts research into environmental and social issues. Before joining us, he worked as an environmental chemist for Severn Trent Water. Ryan has an MSc in Environmental Chemistry from Nottingham Trent University and is a CFA charterholder.

*As at 30 November 2018.

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Transition transmissions

Christmas; a time of festive good cheer and occasional natural gassy excesses. Fortunately, this brussel sprout-fuelled bonanza tends to pass by mid-way through whichever repeat you happen to be watching on Christmas day.

Contrast that with the US – which is increasingly gassy all year round!

I know what you’re thinking- what am I talking about? Am I just being rude? No, I’m referring, of course, to the US’s natural gas production. Which is at record levels, as is gas power electricity generation. In fact, the US became a net exporter for the first time in 2017 (liquid natural gas (LNG) exports rose 58% in the first half of 2018, compared with the same period in 2017).

Which is good, because globally gas (as a cleaner burning fuel) is benefitting from coal’s demise. Hence its ‘transition fuel’ status.

Source: BP Statistical Review of World Energy.

The problem is, that assumption only holds true if you don’t let methane (the main component of natural gas) leak out everywhere during its production or transport! If this happens, the arguments around ‘transition fuel’ begin to break down since methane is a far more potent greenhouse gas than CO2, (think 80x more potent). If that happens US gas’ export potential also becomes potentially diminished.

That’s why both Kames and Aegon Asset Management recently supported a collaborative letter from investors to 29 oil and gas companies urging their support (publicly and privately) for sensible methane regulations by the US Environmental Protection Agency’s (EPA). Specifically, our concerns relate to the EPA’s proposed roll-back of standards regulating oil and gas methane emissions and the risk that further proposals will eliminate direct regulation of methane emissions from US oil & gas drilling sites completely.

Minimising methane leakage is important, not least because recent scientific studies* (based on analysis of 30% of sites in the US) suggest that methane leakage from the oil and gas industry are 60% greater than official estimates. We expect the highest ESG standards and we also want a level playing field for the companies that we invest in**; for the oil & gas majors (who argue that they hold themselves to the highest international standards) and the rest. Involuntary natural gas leakage of any sort is never a good thing……

*https://www.nature.com

**Kames Global Sustainable Equity Fund doesn’t invest in the oil and gas majors (or minors).

About the author

Ryan Smith is Head of ESG Research. He joined Kames Capital in October 2000 as an SRI analyst and was appointed to his current position in September 2002. He has 18 years’ industry experience*. His role involves managing the team that conducts the ESG screening process for our Responsible Investing funds. Ryan’s team also provides corporate governance screening and research for all equity investments, and conducts research into environmental and social issues. Before joining us, he worked as an environmental chemist for Severn Trent Water. Ryan has an MSc in Environmental Chemistry from Nottingham Trent University and is a CFA charterholder.

*As at 30 November 2018.

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