A green bond is one whose proceeds are directed exclusively to financing projects that have a positive environmental impact. However there is still no one widely accepted definition of what constitutes green.
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ESG at Mondrian
Mondrian believes that the inclusion of ESG factors is essential in understanding risk-adjusted returns for both dedicated ESG and standard strategies. Mondrian’s long-term, fundamental research process has always demanded that analysts strive to consider all material risks that could influence a security or market’s valuation, including those factors rooted in environmental, social and governance concerns.
“Implemented in a systematic and consistent manner, ESG incorporation can be effectively integrated into a value investment philosophy.”
The willingness of value investors to take a position in a broad range of companies and industries – including those that typically score very poorly with regards to certain ESG characteristics – has been taken by some to mean that a value investment philosophy is incompatible with the incorporation of ESG factors. This needn’t be the case as demonstrated by Mondrian’s integrated approach to incorporation in our equity and fixed income strategies. In particular, Mondrian recognizes that climate change must be considered as a risk to the long-term future of economies and individual business, and addresses these concerns through its bottom-up analysis.
Analysts adopting a holistic approach, rather than ESG specialists operating in silos, create greater efficiency and context, focusing on the most material issues for a company.
Mondrian has always believed it is the responsibility of all investment professionals to understand and incorporate the impact of environmental, social and governance factors on our present and potential investments, and their sustainable profitability.
Mondrian’s ESG Steering Committee, which is comprised of senior representatives from each of the investment and client service teams, sets and reviews firm-wide objectives and initiatives to ensure that our resources and investment staff are capable of meeting ongoing developments associated with ESG-related issues.
Strategy Integration
In advocating for an integrated approach, we argue that all material factors that could influence a company’s valuation – as determined by its future cash generation and shareholder returns – should be rigorously analyzed and incorporated as part of an in-depth research process. Considerations stemming from environmental, social, and governance concerns must, where material, be included in this process. Taken not in aggregate but as individual concerns, they can be understood in the context of the company’s specific financial and operational situation.
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The result of this risk-based approach is that, much like any other strategic, financial or regulatory risk incorporated into an equity valuation, the presence of material ESG-based risks need not preclude investment, provided that they are adequately discounted in the market price.
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Across all of Mondrian’s equity investment products, the research process is driven by extensive, bottom-up fundamental company analysis which includes a comprehensive program of meeting with representatives from current and prospective holdings. We believe that the value of any equity security is equal to the present value of its future cash flows to the investor, which are primarily dividends. The principal focus of our investment professionals is constructing long-term forecasts for these cash flows utilizing our dividend discount methodology.
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Clear ESG Integration Process
To make the integration of these factors in the equity valuation process more transparent, Mondrian utilizes a proprietary ESG Summary Report to document the research and analysis carried out on ESG factors, including the quantitative impacts in our valuation models.
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The ESG Summary Report explicitly documents the influence of ESG risks and opportunities on our valuation assessments and is completed for all current and prospective equity holdings. By systematically considering both a set of core values as well as company-specific concerns, we aim to capture and quantify material factors that could impact the base, best and worst -case scenario risk analysis over the short, medium and long term. Documenting these factors helps Mondrian quantify the impact of ESG risks on a company’s valuation and sustainability.
Climate Change
Mondrian uses long-term investment models to evaluate the operating environment of each investment over an extended time horizon. To the extent that issues such as climate change, carbon emissions, water usage and energy usage have been identified as potential risk factors to consider in evaluating the investment case of a particular company, our analysts will conduct further investigation into the extent of these risks as well as risk mitigation. The findings from this questioning and disclosure will be incorporated into our overall investment evaluation of the company and highlighted in the ESG Summary Report.
Stewardship
Stewardship considerations are part of the initial purchase decision, subsequent monitoring of an investment and any ongoing dialogue with an investee company, including active participation through our proxy voting process. A key element of our process is actively meeting with and engaging with management and the board of current and prospective investments to discuss the:
- Current and long-term outlook for the business
- Risks to that outlook and the company’s business
- Company’s future business strategy
- Governance policies and structures that support or hinder our confidence in the future outlook
Governance discussions will include governance policies, corporate structure, management and board experience and composition, remuneration policies, board oversight policies and procedures, climate change impacts, human capital concerns, and policies on shareholder returns.
Mondrian invests in bond markets that best compensate for inflation and sovereign credit risks, measured by a market’s Prospective Real Yield (PRY). We define PRY as the 10-year government bond yield less Mondrian’s inflation forecast and sovereign credit adjustment. Our approach to integration of ESG considerations in the fixed income investment process is consistent for both sovereigns and corporate credits in the explicit incorporation of ESG factors into an issuer’s proprietary credit rating. Mondrian is a signatory to the Principles for Responsible Investment (PRI) Statement on ESG in Credit Ratings.
Sovereign Credit Analysis
Sovereign credit analysis is an integral part of our top-down investment process. This analysis includes environmental, social and governance factors, which ultimately inform our sovereign credit adjustment. The weaker the overall credit assessment, the higher the sovereign credit adjustment, resulting in a greater PRY premium required to drive an allocation.
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ESG considerations are an important part of our assessment of sovereign creditworthiness, which feeds into our valuation process. Good governance, the rule of law, unambiguous property rights and the control of corruption are fundamental pre-requisites for sustainable growth and development, which support a government’s ability to service its financial obligations.
Climate Change
Protection and maintenance of the environment for the wellbeing of future generations is essential for the long run viability of the economic activity that supports the sovereign. In the shorter term, undiversified economies based on commodities, agriculture or tourism are prone to environment-related shocks, such as flooding and storm damage that can place additional burdens on the sovereign balance sheet. In order to assess environmental strengths we compare countries using the Environmental Protection Index compiled by the Yale Center for Environmental Law & Policy. This ranks countries on twenty-four different environmental performance indicators along two dimensions of sustainability – environment health and ecosystem vitality.
Corporate Credit Analysis
Corporate credit analysis explicitly incorporates a proprietary environmental, social and governance rating. This contributes to our corporate credit rating for each issuer, which in turn directly impacts how much of that issuer’s debt can be held across our portfolios according to our issuer diversification limits. All corporate bonds in which we might invest are given an ESG rating. We consider the environmental policies, the social impact of the company’s activities, the governance of the company, and the strength of the active ESG policies the company is pursuing, and adjust our internal rating accordingly. Engagement with issuers forms an integral part of our assessment, raising factors identified in our ESG analysis directly with the company.
Climate Change
The impact on credit quality from environmental risk factors varies greatly by industry. Environmental factors can present both fundamental business risks, for example that posed by the shift to renewable energy on the oil & gas industry, as well as reputational risks. In order to assess environmental risks to credit quality, we reference MSCI ESG research in addition to information collated through credit analysis from sources such as annual reports, rating agencies, discussions with management and industry research reports. Our environmental assessment contributes to our corporate credit rating for each issuer, which directly impacts portfolio allocation.
Stewardship
Engagement is integral to the investment process on both the corporate and sovereign side, as we meet with debt issuers as a matter of course to further our understanding and highlight issues of importance. We raise the ESG issues we deem material to a company at the time of each credit review and follow up on at least an annual basis as part of a structured program of ESG engagement.
Dedicated ESG Strategies
Mondrian’s firm-wide approach to integrating ESG factors is first and foremost a risk-based approach, but we also provide solutions for clients that would like to pursue principles-based capital allocation through our dedicated ESG products. Mondrian’s long-term, scenario-based approach to value investing is particularly well-suited to the integration of ESG factors, which are essential in understanding risk-adjusted returns. Our International Equity and Global Equity ESG products build on this value approach by combining risk-adjusted returns with principles-based capital allocation decisions:
- Holdings should normally meet or exceed a minimum threshold as assessed using Mondrian’s proprietary ESG Summary Reports
- Exposure to business involvements deemed unacceptable for the ESG mandate- presently fossil fuel extraction, weapons and tobacco- should be minimized
- Positive consideration would typically be given to stocks with more favorable ESG characteristics where two or more companies exhibit comparable valuations
Our dedicated ESG products demonstrate Mondrian’s defensive, value-oriented characteristics while placing greater emphasis on ESG concerns in portfolio construction. For more information about our dedicated ESG strategies – see here:
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Insights
CEO and Group CIO, Clive Gillmore, shares what he sees as the difficult moral choices embodied in ESG investing and how Mondrian embraces ESG issues into our methodology.
Mondrian’s David Cudmore discusses with ESG Clarity the increasing importance transition bonds have in the growth of the green bond market.
In this exclusive interview manager Mondrian’s David Cudmore talks about the importance of sovereign issuance and what’s next for the green bond market, and the launch of Mondrian’s Global Green Bond Fund.
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© 2021 Mondrian Investment Partners Limited is authorised and regulated by the Financial Conduct Authority – Firm Reference Number 149507.
All information is as of December 31, 2020 unless otherwise noted.