2022 ESG & Sustainability Outlook

Key insights

Through our ongoing research with Woodwell, we have gained several key insights:   

• First, physical climate risks like heat, drought, floods, wildfires, hurricanes, water scarcity, and sea-level rise are driving this historic economic shift toward a low-carbon future.
• Second, climate risks are not priced into capital markets. This is creating market inefficiency and broader potential risk.
• Third, society’s awareness of and, therefore, resilience to physical climate risks is low.
• And fourth, solutions that help society adapt to and mitigate the effects of climate change are essential to ensure a sustainable economy.

These lessons continue to influence our approach to climate change. In 2020, we published our Physical Risks of Climate Change (P-ROCC) framework designed to help companies identify, analyze, and disclose their exposure to physical climate risks. In 2021, we expanded this to P-ROCC 2.0, calling for companies to disclose physical location data, which helps investors better assess their risks and discuss building operational resilience.

We have also communicated with the US Securities and Exchange Commission (SEC) following its request for input on climate disclosures for US-listed issuers. In a public letter and subsequent meetings, we emphasized market inefficiencies resulting from a lack of corporate climate transparency and expressed the need for consistent, standardized disclosure of Scope 1, 2, and 3 greenhouse gas (GHG) emissions and physical location data. We expect the SEC to release a proposed rule early in 2022. 

Through our efforts, we hope to help broaden awareness of physical climate risks and the need for markets to price those risks appropriately.

What you can do in 2022

To help your organization build climate preparedness, you may want to consider applying some of our lessons learned to your investment strategy:

• Learn about climate change investing
  

  — Ask external portfolio managers how they are considering physical risks of climate change. What data do they use, and how do they engage with companies?
  

  — If you have internal portfolio management, consider using P-ROCC or your own climate framework during engagements

• Communicate with policymakers
  

  — Ask regulators to request that companies disclose emissions and      location data
  

  — Encourage regulators to align frameworks with others being developed around the world

• Establish climate-aware investment portfolios
  

  — Options increasingly include a range of asset classes, including equities, fixed income, real estate, and alternatives

• Consider allocating assets to portfolios that fund climate solutions
• Set a net-zero goal and work with your investment managers to implement it

We look forward to building momentum in 2022 around climate investing and climate engagement. We continue to broaden our research with Woodwell and to engage with companies, clients, regulators, and industry groups on the many ways that we, as active investment managers, can reduce the real-world risks of climate change while strengthening capital markets. As an African proverb says, “If you want to go fast, go alone, if you want to go far, go together.” We hope by sharing our insights you will also feel inspired to take action on climate change to ensure a sustainable, low-carbon future.

 Toward carbon neutrality in 2022

Wellington has committed to being carbon neutral in our operations by the end of 2022. To achieve that goal, we are taking a multifaceted approach that includes prioritizing direct reduction of our activities that generate GHG emissions, sourcing renewables for our purchased electricity needs, and purchasing high-quality carbon offsets for our remaining emissions. I invite you to learn more about our carbon neutrality goal and approach to carbon offsets here.

Sustainable development

Beyond climate-related themes, we see attractive opportunities aligned with sustainable economic development. Two of our long-term, high-conviction themes are education and enterprise intelligence. Throughout 2021, the market continued to concentrate on lingering COVID-19 headwinds, geopolitical tensions, and a shifting regulatory environment. Moving through 2022, as the world gains greater clarity and confidence that the pandemic is behind us, we believe the market will begin to appreciate opportunities in education and jobs training, technology and services, and specialty (education-related) real estate investment trusts (REITs).

Within the enterprise intelligence theme, we are looking at companies whose tools and technologies improve data storage and security, automate manual processes, and enhance operational and labor efficiencies. The pandemic accelerated and expanded reliance on digital technologies, and we believe enterprise solutions should benefit from this structural tailwind. Within this theme, we are targeting enterprise software, cybersecurity, and digital platform companies.

Near-term risks on our radar

While our conviction in the long-term thematic opportunity is high, we are cognizant of the need for caution in the near term. The market’s recent increased support for sustainability-oriented themes has helped boost performance in these areas over the past 18 months. Apart from education, which is a decidedly contrarian idea, a sustainability “beta” has raised valuations for a relatively broad set of sustainable companies. We intend to proceed with caution and reassess the fundamental case for any investment in this space. In our process, we aim to examine the purity of a thematic exposure — what portion of a company’s revenue is aligned with a given theme, for example — and use exhaustive bottom-up research to identify companies with the potential to sustain growth and generate attractive returns on investment, even in the event of a temporary pullback in sustainability-related themes in 2022.

¹sciencebasedtargets.org, as of 1 November 2021.

Financial inclusion

Many households and small businesses are struggling to recover economically or avoid slipping further behind. Access to affordable financial products and services, including technology, is vital for greater financial inclusion. For 2022, we have identified impact opportunities in companies and issuers that support small businesses and entrepreneurs, especially those in emerging markets who may find it difficult to access financial resources from standard lenders or other providers.

One company in Puerto Rico expands financial inclusion by providing financial services to local individuals and small business owners. The island has been devastated by natural disasters and persistent economic recession. We believe its recovery and rebuilding process requires steady, broad-based access to financial services. We have also identified companies that support underserved and underbanked populations in emerging and frontier economies, including a financial services group whose products help low-income communities in Africa, where the cost of insurance to cover basic needs like funeral expenses can wipe out family savings. In fixed income, we have identified an issuer whose financial technology solutions enable and lower the costs of e-commerce for small businesses in Brazil. The company’s platform facilitates its customers’ ability to scale by reaching new markets and pursuing growth opportunities.

Digital divide

Reliable digital connectivity has become critical for social and economic stability, yet digital inequality across developed and emerging markets continues to widen. We anticipate significant long-term demand for technologies that support communication and connectivity, particularly for education and job training, financial services, and health care. This theme also allows us to gain exposure to another critical sustainability issue: evolving electric grids to be more energy efficient. We are invested in a bond issued by a Costa Rican telecommunications and energy company, for example, whose coupon rate is linked to the installation of smart electricity meters. We believe this company plays an important role in expanding information and helping rural communities participate in the digital economy, while reducing the energy required to do so.

Health

The pandemic revealed a widespread lack of access to affordable care, pervasive inefficiencies in health service and delivery, and chronic underinvestment in health care infrastructure. As societies appreciate the importance of narrowing these gaps, impact companies are stepping up to fill them. Across emerging markets, we see opportunities for the vertical integration of health care services, which tends to improve the quality of care. In Brazil, we have an opportunity to invest in a vertically integrated health services company that aims to improve access to quality care for lower-income populations. The company’s networks of clinics and hospitals provide basic services, including maternity and dental care in and around São Paulo. In India, we are exploring an impact opportunity in a brick-and-mortar health services company that is expanding its telemedicine business to better serve rural communities.

Vertical integration has contributed to rising health care inflation in some emerging markets. We will continue to engage with companies to understand how they manage and mitigate the effects of rising health care prices on consumers. In 2022, many countries will continue to grapple with the costs associated with containing the spread of COVID-19, along with the inflationary pressures of a rebound in demand for elective care.

New models for health care provision fit well in our health theme and meet our standard for impact. In the US, we have identified solutions that empower local physicians to deliver primary care as a first line of defense for disease prevention, helping to improve outcomes and lower costs for patients. In China and other emerging markets where spending on health care infrastructure has historically been low, we believe technologies that allow elderly or rural patients to access a health care provider virtually can significantly expand access and lead to better health outcomes.

Climate change: Impact opportunities span multiple themes

Research conducted by Wellington’s Climate Research Team and our climate science partners at Woodwell Climate Research Center confirms the need for governments and businesses to improve climate resiliency. The necessity for climate solutions that help society adapt and protect lives and property from climate events crosses several of our impact themes. Within safety and security, we have identified innovative companies that manufacture impact-resistant windows and doors developed to withstand severe weather conditions. We have also identified green bonds from issuers whose projects primarily contribute to affordable housing, clean water and sanitation, and financial inclusion projects. Investing in these issuances enables us to support issuers’ ambitions to improve energy and water efficiency, employ sustainable building materials, and otherwise facilitate the transition to a low-carbon economy.

In 2022, we will continue to set a high bar for verifying the materiality and credibility of sustainability-oriented structured-finance solutions — and their sustainability performance targets. We aim to invest in issuances that incentivize issuers to improve their sustainability profiles. We have observed greater focus from companies and issuers on setting targets with sustainability metrics. This disclosure provides us with opportunities to engage in best practices with respect to reporting and tracking key issues like decarbonization efforts and supply-chain transparency. We will also continue to engage with boards and management teams to establish metrics that demonstrate positive social and environmental impact.

Talent management

In our view, a positive environment for talent can influence productivity, innovation, reputation, and loyalty. Today, rising inflation and labor shortages are driving wages up, making talent management more important than ever. Over the coming year, we expect to allocate more of our research and engagement time to talent and culture, as these pressures are unlikely to abate. Which companies can attract and retain top talent? Which are building diverse, adaptable workforces? Does a company have a culture of innovation? Talent management is especially important in sectors like health care, where continuous scientific innovation and knowledge of prior developments are keys to developing long-cycle advantages. Similarly, technology companies must access and retain workers with cutting-edge software and programming skills in order to stay competitive.

While highly skilled workers have typically been treated well via equity-based compensation, less skilled workers have not benefited from the growing economic pie in the same way. However, today’s tight labor markets help give lower-wage stakeholders a voice to push for more equitable treatment. Even companies with what we consider to be great cultures and fair compensation plans are seeing more active union activity and pressure for pay rises. We will continue to ask companies how they are managing talent-related pressures, and we generally favor purpose-driven businesses with talent-focused cultures. We will balance our engagements with fundamental research, including on employee reviews and CEO approval ratings.

Supply-chain accountability

The market’s current concerns about supply-chain disruption are very short term, focused on temporary low capacity, labor shortages, and lingering COVID-related restrictions. Within the next year, we expect ships will start moving out of China again, backlogs at ports will clear, plane-belly capacity will recover as travel restrictions ease, and labor conditions will rebalance. In our view, the real challenge is how well companies understand and manage their entire supply chain — through to source materials — over the long term. This is another area of focus for us in 2022.

Because supply chains are often complex and opaque, building resilience to avoid interruptions requires constant oversight and investment and a long-term mindset. We want companies to focus not only on dependable logistics and inventory levels, but also on labor-related risks such as exploitation and on climate transition- and physical-risk exposures. For example, we work with companies to understand how they partner with suppliers to help them source renewable energy to reduce their carbon footprint. We also engage on social risks, holding companies to account for their entire value chain.

While companies are often far removed from raw materials sourcing and other early supply-chain links, labor abuses at this end of the value chain can be rampant. Traceability is at the core of strong supply-chain stewardship: If you track it, you can manage it. When it comes to the risk of human exploitation, we want companies to demonstrate decisive remediation, addressing thorny issues like modern slavery when and where they arise. Mitigating these risks can have a positive financial impact for a company by reducing disruptions, fines, and other unexpected costs.

Biodiversity engagement

Environmental impact and climate concerns are also a focus for 2022. In particular, we expect to do more work on the issue of biodiversity. It is increasingly clear that companies will be held to account for their impact on local ecosystems. Raw materials extraction and cultivation and midstream industrial processes exacerbate the adverse effects of climate change. Habitat loss, including deforestation for the sourcing of lumber and other materials, is a major contributor to biodiversity degradation. Society must address the rapid decline of biodiversity to preserve longer-term access to food, clean air and water, and availability of raw materials.

We ask the boards and management teams of our portfolio companies — regardless of their direct environmental footprints — to embrace more environmentally sustainable practices as a means of protecting shareholder value. We want evidence that environmental externalities are factored into capital allocation decisions. For example, we look for leadership on supplier practices and sustainable-product innovation. This might mean reduced use of toxic substances in production processes, a commitment to environmental-impact assessments for future projects, or greater accountability for waterway pollution, to name a few.

Finally, we believe companies that have embraced science-based targets to reduce emissions in line with the Paris Agreement should also consider how they can commit to science-based targets that align with the Biological Diversity’s Post-2020 Framework. In the coming year, we will look to engage in two-way dialogue on how companies might shape these commitments.

Final thoughts for 2022

Our conversations with portfolio companies continue to help us to better understand the challenges they face in managing talent, supply-chain, and environmental challenges. While these efforts can be costly and require multiyear commitments, when companies operate from a position of strength and can reinvest high returns on capital in all stakeholders, we believe they can improve resilience far into the future.