Monday, 20 February 2017
Last updated 2 days ago
Aug 12 2014 | 9:18am ET
Bruce Kahn spent over 15 years as a research scientist/consultant on environmental issues before leaving the Ivory Tower for Wall Street:
“I found that in order to make effective changes on the environmental front, we needed to shift the way capital markets price the risk of environmental issues,” Kahn told FINalternatives' Mary Campbell in a recent interview. “And so that's why I left academia and consulting to come to the capital markets: to use the capital markets as both stick and carrot for repricing environmental risk...”
Kahn has spent the last decade in “the capital markets,” managing a sustainable investment portfolio at Citi Smith Barney and serving as a director and investment strategist at Deutsche Asset Management.
“At Deutsche Bank I worked with Kevin Parker in the Deutsche Bank climate change advisor group and he was the head of Deutsche Asset Management. He retired from Deutsche Bank and then we decided to start a new firm focused explicitly and solely on sustainable investment...”
Thus, in 2013, was born Sustainable Insight Capital Management, a New York-based long-only fund that “first and foremost,” said Kahn, has “a focus on generating alpha, but that alpha is predicated on integrating environmental and social governance metrics into our investment process.”
“At the core of it is, how can companies be more efficient with their resources that they have and, as a society, how do we get those corporations to internalize some of the economic externalities that they cause from their activities?” said Kahn. “We don't want companies to not be profitable in order to protect the environment, we want companies to be profitable by protecting the environment.”
Two other DB veterans round out SICM's team: John Willis, a former DB managing director and global head of trading, is a portfolio manager and Paul Spence, the former global head of risk and portfolio analytics at Deutsche Asset Management, is SICM's head of portfolio risk and construction.
ESG And The Bottom Line
SICM targets “good companies” although, laughed Kahn, “I'm not sure why anybody would say anything other than that.”
“There's two things to evaluating a good company. One is, you evaluate the company and you have to do a 360-degree review of this company, so we use the addition of environmental, social and governance (ESG) factors as an additional guide to what makes a good, strong company.
“But the second part of identifying a good investment is, how does the market view a good company?...We believe that security selection really demands harnessing the collective brain power of all the world's analysts in order to determine potential sources of alpha, and by doing that we can capture not only how well the company is doing but how everybody else is seeing that company.”
SICM's evaluation of ESG incorporates climate change:
“What is the risk that these companies are facing from these variables and has it been priced? It's one thing to say, 'Well, real estate in Florida is under tremendous climate change risk'...but if real estate prices aren't reflecting that, then it's not a high risk from a financial perspective.
“So...we stress test it. If there is a carbon price—tax or cap and trade—levied, how will this company respond? What will happen to its valuation? And so we take that risk factor into consideration when assigning our expected return from any given company.”
Key to SICM's approach is the idea that actions that are good for the environment or society can also be good for a firm's bottom line. Kahn, who hasn't entirely left academia behind, teaches a course on this subject at Columbia University.
“Most people come in and think that, if you have to spend money on becoming more green then you should lose market share and...it should provide a ding to your earnings per share. And the evidence is just not that. The evidence is the opposite, which is that most emission reduction projects end up having a high return on invested capital—north of 10%...Any innovation, any project at a company level is going to cost money but there's a return on investment that can be significant.”
Kahn cited academic research demonstrating that companies with strong environmental records get a lower cost of debt capital:
“It makes intuitive sense: Am I going to lend you money if I think you're going to get fined for polluting? No, I'm going to say, 'Well, I'll lend it to you but I want a little bit more interest rate on you because you just seem to have a lot of problems.'”
Research, he said, has also shown that companies with better ESG performance tend to produce a higher return on equity although he treads cautiously here, pointing out that many factors contribute to an equity premium. Nevertheless, he said, “those who perform high on ES & G perform better in the market, both in an accounting way as well as a market pricing way.”
Stages Of Grief
Asked if investors are responsive to SICM's pitch Kahn said, “Absolutely,” comparing their response to the seven stages of grief:
“They're kind of creeping down that process of bereavement toward a cold, sobering fact which is, their assets are subject to climate change risk. At first it was denial, 'Oh, we don't believe in climate change.' Now it's 'We believe in climate change. What are we going to do about it?'”
They're asking good questions, said Kahn, and beginning to judge asset managers on their recognition of and response to climate change risk.
“They're absolutely terrified that their assets are going to lose a significant amount of value. They don't know how, they don't know where, they don't really know what to do about it. But they are expressing a lot of interest...”
Asked if he, personally, is optimistic about our chances of avoiding an environmental disaster, Kahn replied:
“I'm pretty optimistic that humans aren't going to go extinct, if that's what you're asking...People have been talking about the destruction of planet earth—the rock will still be here in space. Let's start there.
“Now, what is standard of living and our quality of livelihood and quality of life? That will change and that's going to change dramatically and it will change asymmetrically...Places in the world that are already feeling stresses from dramatic shifts in climate, those places are very susceptible to social unrest...
“On the other hand, I have great optimism that we have the technology and the capital to rebuild and transform our energy system to reduce our emissions...As an investor I'm very optimistic...investing is about the future and it's not only about what the future should look like, it's about what the future will look like and we know it's inevitable that we will invest in new infrastructure, invest in new agricultural...technology, and new power and new energy, so I'm very optimistic.
“Wealth will be created—asymmetrically, but it will be created.”