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.

While the EU and other jurisdictions have been pressing ahead with ESG policy and regulations aimed at creating market clarity, the SEC has been way behind. However, recent developments demonstrate that a U.S. catch up is underway. On March 4th, the SEC issued a press release announcing its “Climate and ESG Task Force,” which will “identify any material gaps or misstatements in issuers’ disclosure of climate risks under existing rules…[and] analyze disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies.”[1] Additionally, in its 2021 priorities for examinations, the SEC stated it will include physical climate risks in its assessment of business continuity plans. “As climate-related events become more frequent and more intense, we will review whether systemically important registrants are considering effective practices to help improve responses to large-scale events.”[2] As US SIF CEO Lisa Woll notes in Barron’s, “It is extraordinary that it took until 2021 to have a position focused on these matters, but it is a clear signal that the SEC understands the critical role that the climate crisis and a range of ESG issues play in the investment process.”[3] Last week we kicked off our ESG Practice Playbook, in partnership with RIA Channel, and held our second session yesterday. Don’t worry if you missed them – you can still register and access the playbacks. Several of the questions we received from the event related to definitions, how to know if an investment product is truly ESG, and how to compare different ESG strategies. These are foundational challenges for anyone embarking upon their ESG journey, which is increasingly challenging given the product expansion in recent years! There are a multitude of ways a fund can include ESG in the investment process. It’s therefore critical to go beyond the fund name and marketing headlines and dig into the detail to understand the philosophy, use of data, alignment with shareholder engagement, and proxy voting policies, among other factors. We’re encouraged to see the SEC taking a stronger educational role alongside integrating ESG into its enforcement procedures. Check out this SEC Investor Bulletin that defines an ESG fund and provides several considerations for performing ESG due diligence.

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.

We are featured in Refinitiv’s latest publication of ESG trends. In it, Jeff reiterates his view that we are facing a significant repricing driven by climate change that will impact multiple asset classes. As always, we encourage advisors and investors to assess their portfolios for climate impact. Featured insights and takeaways from other contributors include: Circular economy practices are expected to gain more traction in 2021, which “represents a systemic shift in our current conceptualization of wealth generation and well-being.” Corporate incentives will increasingly be linked to ESG metrics, or at least shareholder resolutions will increasingly make that ask. Addressing racial inequality requires multiple solutions e.g., removing lending biases, improving board diversity, investing in managers of color, and venture capital funding. Social indicators, in general, will gain more focus as “the pandemic continues to reveal the weak points of our societies.” The full report is available here, but a shorter overview can be found here. Finally, as Jeff states in the piece, “[we] have a tough road ahead, but we believe there are amazing feats along the way. Human potential is always in abundance.”