Investors and fund managers can no longer ignore the link between ESG, risk and investment outcomes

Environmental, Social and Governance (ESG) criteria are fast becoming key drivers to investment allocation and outcomes. This is a welcome development from Forza Capital’s perspective, and one we feel is here to stay.

ESG can be a divisive topic that elicits emotive responses both for and against the concept. Even disregarding the moral and social responsibilities and focusing entirely on financial outcomes, our view is that the pursuit of strong ESG outcomes is critical.

What is ESG?

ESG refers to the three criteria that are increasingly used to assess the return and risk of investments beyond financial outcomes.

Investing does not occur in a vacuum – in fact, investing is the aggregate exposure to risk management, corporate behaviour, investment markets and environmental responses (both in the biological and human behavioural context).

ESG is inextricably linked to investment returns in the same way that investor behaviour impacts market performance. There is a well-established positive correlation between managers and investments that have strong ESG credentials and long-term outperformance. ESG is really just another form of risk analysis and management that looks at ‘non-balance sheet’ issues to analyse where investment performance may be positively or negatively impacted by corporate behaviour.

Very quickly, the narrative on ESG is moving away from a ‘nice to have’ to a mandatory and minimum requirement. Some of the greatest risks in investment markets over the last year have come from non-financial sources. Consider the Banking Royal Commission where the cost of appalling and ingrained governance failures was ultimately borne by consumers. Or the environmental disaster that was the worst bushfire season on record in 2019/20, which occurred as climate action was elevated as the global social movement of this time.

Given the above, you can probably appreciate why the team at Forza believes in the importance of ESG within our business and investment decision making framework. ESG is, and has always been, at the core of what we do and has driven our thinking long before it was commonplace in investment markets.

Why you may ask? The answer is amazingly simple – done properly, applying an ESG focus costs you nothing but can materially reduce risk and improve performance.

Why should ESG be prioritised when the world is in crisis?

Endurance elite athletes all agree focus is most important when you’re exhausted. We are facing probably the greatest existential threat to markets in living memory with COVID-19, and responsible corporate behaviour is as important now as ever. Scott Morrison was right in warning that companies will be judged by how they respond during this time.

The fallout from COVID-19 has highlighted the causal link between social outcomes and financial ones; after all our economy depends on the actions and decisions of individuals. Right now, these decisions and actions are creating extraordinary change, stripping some industries and business bare, whilst driving unprecedented growth in others.

Furthermore, the economic failures that are unfolding continue to highlight the social divide of those with savings and those without. Governments everywhere are concerned about the social aspects as this paradigm gives rise to social uprising, conflict, and even the potential for the fall of governments.

The importance of sound Governance is particularly evident in downturns, not bull markets. In fact, buoyant markets help lousy operators cover up mistakes and poor decision making. At times like these, there is nowhere to hide. It is just unfortunate that COVID-19 will claim many quality businesses as well as those lacking governance.

What has ESG got to do with risk, and how does it apply to property?

To date, many investment professionals have not really considered, or priced, the cost associated with acting unsustainably. Poor governance can lead to major financial loss for many and inadequate environmental controls are resulting in catastrophic global changes, increasing electricity costs, higher insurance premiums (or lack of insurance availability) and accelerating obsolescence.

The social impacts of poorly designed, poorly built dwellings are being felt by whole communities, particularly as people are confined to their residences day and night. All of these costs are starting to manifest themselves in markets and are forcing behavioural change.

Property has been at the forefront of ESG development for two reasons. Firstly, property is a major producer of greenhouse gases through embodied energy in construction materials and through ongoing energy usage. Secondly, building design is key in facilitating behavioural change of residents and occupants.

One key application of ESG to property relates to the recycling of old buildings. There should be a broader acknowledgement that the embodied energy in new buildings makes truly sustainable development nearly impossible. By recycling old buildings, we can reduce planning risk and rejuvenate existing assets, creating positive environmental, social and financial outcomes concurrently.

Where the construction of new buildings is necessary, design should go beyond code compliance to achieve leading environmental credentials at the time of construction. Many of the most impactful environmental building design elements, such as façade shading elements and integration of green walls and deep planting, are thousands of years old and cost almost nothing.

Technology also has a strong ESG role to play, especially when it comes to property. Building Management Systems can be used to fine tune an asset’s operation to minimise energy wastage, improve efficiency and reduce costs whilst also improving the occupants’ quality of life.

The considered use of buildings and supportive planning frameworks are also important. The co-location and integration of amenities such as childcare alongside offices can allow primary carers to advance in their careers whilst balancing family demands. This in turn can increase employee retention, and tenant retention for landlords.

PV solar arrays can also be deployed to reduce energy use, roof heat load and to create financial gains. In Queensland, where most leases are on a ‘gross’ basis, PV cells can be used to reduce common area power and increase net income. If a property sells on a 6% cap rate, there is a nearly a 17X multiple on the additional net income whereas the solar PV arrays typically cost 4-5X the annual savings generated. That is a significant arbitrage and a compelling investment outcome, both in terms of financial and ESG outcomes.

Other ESG considerations for new buildings include integration of End of Trip facilities that encourage people to ride or run to work, the creation of communities for the sharing of resources and experiences, improvement of air conditioning systems to both reduce load and increase fresh air and better design layout to improve the health and wellbeing of occupants.

Our view is that by designing for the future, we can increase building lifecycles and resilience, reduce redundancy and running costs, and improve tenant attraction and retention. In time we believe a demonstrated ESG commitment will mean we can access more diverse debt funding sources with optimised pricing outcomes to reflect our enhanced risk profile.

Similarly, across our portfolio we are focusing on the future requirements of our buildings to better position our assets, and we are using our learnings to refine our search filters for new opportunities.

Since 2010, ESG has been a strong focus at Forza. For much of this time, ESG was not associated with strong financial performance. We are relieved this is no longer the case.

Final Words

ESG is no longer optional or nice to have, and ESG considerations will continue to flow into investment markets. Both those who actively choose to be at the forefront of this movement, and those who are dragged into it through customer, client or regulatory demands will find it an unavoidable element of business and investment.

Outside the environmental considerations for us and future generations, real assets play a key role in the operational lives of our society. Property fund managers wholly benefit from using ESG to proactively identify risks and create opportunities to secure tenants, source funding and optimise pricing outcomes.

Forza is committed to achieving our ESG objectives and have set our sights on achieving net zero carbon emissions for our office. Investors will also benefit from our transparency and disclosure on ESG items in our quarterly fund updates as well as IM’s and communication moving forward.

While the criteria are currently difficult to quantify, better tools and systems will evolve to measure the positive impacts. We hope these will become commonplace for all fund managers in times to come. In the meantime, by understanding the importance of integrating ESG and being at its forefront, we intend to remain ahead of the competition and offer investments which not only enhance value but reduce risk and obsolescence for our investors.