Explore the Thinking behind our investment approach

“When you need water, water is the only thing that will do.” ~Matt Diserio, President, Water Asset Management Climate change is increasingly disrupting the hydrological cycle, manifesting in increased flooding and droughts. Alongside this, multiple other human activities are leading to water shortages, the spreading of disease, and pollution. While we all know that water is critical to life, we don’t always act in a way that aligns with its value. The poor and those living in rural areas are generally most affected, but urban residents are also at risk. A UN progress report recently noted that “even before COVID-19 struck, the world was off track to meet Sustainable Development Goal 6 (SDG 6) – the goal of ensuring water and sanitation for all by 2030.”1 Water is a key investment theme for Gitterman Asset Management: our SMART Climate UMA includes an allocation to Water Asset Management’s Global Water Equities strategy and our mutual fund models include the Virtus AllianzGI Water Fund. As global financial markets embrace ESG and climate change risks and opportunities, water’s role in company value chains is becoming more transparent. This is leading to a greater focus on water conservation and treatment, and an awareness of the need for infrastructure improvements. Innovations in the water space include “smart meters” to manage water use, advanced treatment technologies, and redesigning consumer packaging to reduce water requirements in manufacturing processes. From an investor perspective, water is an opportunity for positive impact, both directly with regard to water systems, and also in relation to improvements in energy efficiency related to water services. Water has also “historically acted as an effective hedge against inflation” and demonstrates “relatively low levels of risk and volatility.”2 For more information, check out this interview with Matt Diserio on TheIMPACT TV and then connect with us for a deeper dive on how our SMART Climate UMA incorporates the water theme.

Sustainable investing industry jargon can be challenging. Certain terms may seem straightforward but are more complex if you look deeper. Over the past three weeks, our ESG Practice Playbook has been covering some fundamentals, which we would like to briefly revisit here. The concept of financial materiality in the U.S. is connected to a 1976 Supreme Court case. Publicly listed companies must disclose material information when there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”1 In the ESG world, financial materiality topics differ from industry to industry. For example, what’s most relevant to a company like Amazon is not necessarily what’s most relevant to Tesla, Nike, or Exxon. Enter the Sustainability Accounting Standards Board. SASB provides guidance on ESG disclosures not covered in traditional accounting, and also a framework for determining which data points are material across industries. The U.S. Supreme Court definition remains the foundation for SASB standards, but as SASB expanded internationally, their definition of materiality was updated: “Information is financially material if omitting, misstating, or obscuring it could reasonably be expected to influence investment or lending decisions that users make on the basis of their assessments of short, medium, and long term financial performance and enterprise value.”2 Asset Managers may leverage SASB standards as a base, and add their own research to arrive at a proprietary financial materiality matrix. Other notions of materiality can also go beyond the investor perspective. The Global Reporting Initiative (GRI), for example, takes a broader stakeholder approach in its standards. In addition, there is a growing understanding that topics that are of material importance to stakeholders may become financially material to companies over time. This concept has become known as “dynamic materiality.” ESG ratings agencies which use materiality to define and weight the importance of ESG topics in arriving at scores and ratings are continually evolving. As MSCI states in its ESG Industry Materiality Map, “We recalibrate the model, including identifying industry Key Issues and setting weights, every year based on the latest data and research as well as input from our regular client consultations. As a result, you should expect to see changes in this ESG Industry Materiality Map over time.”3 Research has shown that “firms with good performance on material issues and concurrently poor performance on immaterial issues perform the best.”4 For a deeper dive on material sustainability topics and corporate performance, check out this milestone paper, Corporate Sustainability: First Evidence on Materiality, by Khan, Serafeim, and Yoon.

More and more countries and individual businesses are making Net Zero commitments, moving beyond carbon neutrality to removing human-induced CO² emissions from the atmosphere. Carbon neutrality and net zero emissions are often used interchangeably, but there is one key difference. Carbon neutrality can be achieved by balancing greenhouse gas (GHG) emissions with offsets via buying carbon credits. This means carbon neutrality can be achieved without reducing emissions. Essentially, net zero carbon challenges “business as usual,” while carbon neutrality allows emissions to remain the same. These commitments necessitate understanding terminology, emissions baselines, setting targets, and managing progress. The classification system for greenhouse gas (GHG) accounting, created by the Greenhouse Gas Protocol, measure carbon footprint using three categories of emissions: SCOPE 1 – Direct GHG emissions attributable to operations owned and/or controlled by a company, including vehicle fleets and facilities. SCOPE 2 – Indirect GHG emissions from purchased or acquired electricity, heating, and cooling. SCOPE 3 – Indirect GHG emissions not covered above, such as supply chain emissions, business travel via non-owned vehicles, and emissions associated with the “use phase” of products. Reporting and disclosure related to Scopes 1 and 2 is more mature. However, the deepening scrutiny associated with net zero targets means that “Scope 3 investment risks are mounting. These risks may come from new regulation of a company’s high-emission products and shift in end-product market demand driven by climate concerns.”¹ Investors have traditionally focused on Scope 1 and 2 emissions, but as the state of Scope 3 reporting improves, investors like Gitterman are looking to manage Scope 3 risks. Scope 3 is the biggest area for innovation in carbon reduction, especially because for some companies and industries, Scope 3 emissions dominate their overall carbon footprint. Seeking Low-Carbon Solutions? Our SMART Fossil Fuel Free Models were launched in 2016. They are a family of global climate aware investment allocation strategies that screen for fossil fuel and utilize carbon foot-printing tools to guide investment decisions. On the equity side of the portfolio, we use Morningstar’s Global Equity Classification Structure to identify key industries partaking in direct fossil fuel investment. The SMART Fossil Fuel Free models divest from these industries, with the exception of specific diversified water utilities. This is due to our belief that water investments have a strong sustainability thesis, specifically as it relates to UN Sustainable Development Goal #6: Clean Water and Sanitation. On the fixed income side, we carry out divestment from fossil fuel on a best effort basis, depending primarily on direct dialogues with fund managers and a quarterly analysis of bonds with fossil fuel involvement. We go beyond simple divestment of energy sector companies to understand the carbon footprint of the portfolio using Scopes 1, 2, and 3.

The U.S. is now officially back in the Paris Agreement. Messages coming from the government on climate change are strongly worded, but it’s still early days in terms of tangible actions. As The New York Times noted, “There are two immediate signals to watch for. First, how ambitious will the Biden administration be in its emissions reductions targets?” and, “…how much money will the United States provide to help poor countries adapt to the calamities of global warming and shift their economies away from fossil fuels?”1 On April 22nd, Earth Day, President Biden will hold a “Climate Summit,” which should give some insights into these questions. In the meantime, domestic climate adviser, Gina McCarthy “has pledged “the most aggressive” carbon cut the U.S. can make.”2 The White House is also working to determine the “social cost of carbon,” or SCC, which “would be considered in every rule, regulation and policy enacted as part of President Joe Biden’s “whole-of-government” approach to tackling climate change.”3 Carbon costs in other countries are running between $20-$100 per ton. Following the same method as the Obama administration could result in a cost of $125 per ton, the same value New York State recently announced as its carbon value.

Despite an increasingly polarized political landscape, one area where there is bipartisan support for governmental intervention is climate change. A Pew Research survey in June of this year found that “a majority of U.S. adults want the government to play a larger role in addressing climate change”, with around two-thirds saying that “the federal government is doing too little to reduce the effects.” Unsurprisingly, given the proliferation of wildfires, hurricanes, drought, extreme heat, and other impacts, most Americans “continue to say they see the effects of climate change in their own communities.” For those actively focused on climate change, the last few years have been devastating when it comes to U.S. climate policy. Pulling out of the Paris Agreement and the rolling back of regulations have put the country further and further behind the progressive efforts of other regions. However, 2020 has also brought some glimmers of hope, one being a report published by the Market Risk Subcommittee of the Market Risk Advisory Committee (MRAC) of the Commodity Futures Trading Commission (CFTC) in September. The CFTC, which regulates the U.S. derivatives market, was not the most obvious messenger of the seminal work, Managing Climate Risk in the U.S. Financial System. Jeff Gitterman recently interviewed Bob Litterman, founding partner and Risk Committee Chairman of Kepos Capital, and chair of the CFTC’s subcommittee, to discuss the process. The subcommittee, a diverse group of participants ranging from agricultural and energy companies, NGOs, academics, and financial services firms, “voted unanimously 34-0 to adopt the report” and its 53 recommendations. This bipartisan consensus was achieved by focusing on where they could secure agreement among the participants. One of the primary conclusions is the simple statement that climate change “poses a major risk to the stability of the U.S. financial system and to its ability to sustain the American economy.” As a result, the most critical recommendation is that a price on carbon that is “fair, economy-wide, and effective in reducing emissions consistent with the Paris Agreement” is the “single most important step to manage climate risk and drive the appropriate allocation of capital.” Litterman notes that carbon pricing is “an inevitable policy response” to climate risk and that once appropriate incentives are established, the financial system will go into action. However, the report did not go as far as to suggest what that price should be, as this, and the mechanics of the policy, are the role of Congress. As a risk manager, Litterman advises that “time is a scarce resource” when you’re managing risk. The longer the U.S. waits to take decisive action, the more likely it is that we face a “disorderly transition” and sudden devaluation of assets. While many would prefer climate action to be driven solely by an intrinsic motivation to steward the Earth, progress to date suggests this will never happen. We agree with Litterman that changing behavior requires changing incentives – whether those be tax credits, regulations, subsidies, or other policy levers – and we are well beyond the time to act. We hope that the work of the CFTC’s subcommittee along with positive signals from the incoming Biden Administration will incentivize climate action underpinned by an exciting new era of U.S. innovation.

Over the last several years, ESG data has become increasingly rich and sophisticated. However, the “S” has presented more challenges in terms of data as “social principles have gotten far less representation in portfolios than environmental and governance issues.” This is because the “S” covers such a wide range of topics and because broader sustainability reporting, although progressing at speed, has not yet resulted in commonly adopted standards and best practices. However, “[t]his dynamic is changing, as asset managers, advisors, and investors demand information and flex their shareholder muscle, and as more mutual funds find effective ways to sharpen a social focus.” Read more in Barron’s to learn how Jeff Gitterman and Adam Bernstein see the change in the market when it comes to the “S” in ESG, and which mutual fund families and products are leading the way.