ESG in emerging markets

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For professional investors only www.hermes-investment.com

Hermes Emerging Markets

White paper, December 2015

Key pointsOur experience as long-term investors, and as people, leads us to believe that the investment maxim of increasing shareholder value above all other concerns should be re-examined

We should ask: what are the broad effects of investing in a company – on society, the environment and on all shareholders – and can they be divorced from the movement of its stock price?

Environmental, social and governance risks can incur harsh financial consequences, particularly within the extensive time horizons of long-term investors, such as ourselves

It is part of our duty to integrate these risks into our investment decisions, and engage companies about them – for the benefit of our clients, their investors and for the innocent bystander, too

ESG in emerging markets

Challenging the dominant investment paradigm

By Gary Greenberg, CFALead Portfolio Manager and Head of Hermes Emerging Markets

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Newsletter, December 2015

Professional investing is a relatively young industry, and although stock markets have a much longer history, our understanding of how they work and how money should be managed continues to evolve. To form order out of the chaos, investors adopt paradigms that help them understand what is happening in the markets, and how they can respond.

Paradigms don’t last forever – in science, philosophy or investing. One investment paradigm is the legal responsibility of an agent to allocate funds as a “prudent man would invest his own capital”. Another, Modern Portfolio Theory, assumes that markets are rational and efficient, equates risk with volatility and implies that there is a positive correlation between risk and return. Meanwhile, the Efficient Market Hypothesis, in its various forms, makes simple but unobservable (and, in its purest form, unrealistic) assumptions about the financial world. Finally, many professional investors are guided by the paradigm that maximising shareholder value is the ultimate goal of all commercial activity. By extension, in perceiving modern humans as “homo economicus”, the shareholder value paradigm posits that the accumulation of wealth is the chief purpose of our lives – apart from biological imperatives such as the perpetuation of our genes.

Our years of experience as long-term investors, and as people, have led us to suspect that most of these paradigms should be re-examined. In this issue of Gemologist, we focus on the investment industry’s conceit of maximising shareholder return above all other considerations.

To rent or to own?In the mid-1990s, when I was running an Indian smaller companies fund, I went to southern India to visit SIV Industries, a business that made Rayon, a fabric used in clothing. Rayon is made from purified cellulose mixed with sulphuric acid. The company, in which we were invested, had a good reputation as a reliable supplier. But visiting the plant was an alarming experience: the acid from the slurry line would splash onto the bare feet of the workers manning it. Management maintained they were powerless to “force” the workers to wear industrial shoes (it is hot in southern India, and ventilation throughout the factory was “natural” – i.e., no air conditioning, just open windows), so worker safety was not their responsibility as they had done as much as they could. This bothered us enough to sell the stock. It transpired that worker safety was not the only the only responsibility that SIV neglected: two years later, the company was discovered dumping effluent into a nearby river and was forced to shut down.

Similarly, a US pension fund might invest beneficiaries’ savings in an Appalachian coal mining company found guilty of environmental pollution – management might consider the potential fines to be a cost of doing business – but which is trading at a cheap price relative to its history. If the underlying fund manager is investing for retirees that live in the area being mined, does their ownership of the stock make the pension fund and the manager complicit with activities that damage the environment and may cause these same beneficiaries grave illness later on?

Such scenarios raise difficult questions. In our extensively interconnected world, clouds of industrial pollution waft from China across Japan to the US West Coast, undiminished by regulation, the result of the red-blooded pursuit of profit by Chinese “entrepreneurs”. A drive to save cash and boost return on equity in an effort to maximise shareholder value resulted in BP’s Deepwater Horizon disaster. And we are yet yet to learn whether the pressure to fuel higher shareholder returns drove Volkswagen to systemically cheat US emissions tests.

We would argue that the current hierarchy of investment incentives for managers, based on maximising returns over a three-month to a three-year time horizon, makes investing incompatible with solutions to the very real problems we face as a civilisation, from extreme inequality, to pollution, water scarcity, climate change and forced migration, and the protection of employees’ lives and preservation of health in local communities. Of course, technology may ultimately save the day, but putting all of our faith in some range of new monitoring techniques seems inadequate.

Investors may indeed ask: are we responsible for this anyway? Very few of us are directly accountable, as we don’t manage the world’s influential companies and, at most, are insubstantial shareholders in them through our pension savings. Even fund managers rarely control more than a fraction of a large company. Furthermore, they may find themselves conflicted as confronting management on sustainability matters may compromise their privileged access to detailed explanations of the business, not to mention their guidance on operations and financial progress, which are “useful” in investment decisions.

So, as investors we face difficult questions. What are the full implications of investing in a company, and can they be divorced from the movement of its stock price? Within the paradigm of maximising shareholder value, does investing in a Singapore-based deepwater oil rig builder with a subsidiary that makes land mines, or a Thai tuna canner overlooking the use of child or slave labour in its supply chain, convey no responsibility whatsoever to the fund manager or her beneficiary? Does an investor consider himself to be an owner of shares, who therefore bears some responsibility for what the company does, or is he a renter of shares, interested only in the potential financial gain?

As investors we face difficult questions. What are the full implications of investing in a company, and can they be divorced from the movement of its stock price?

We consider ourselves to be long-term owners of shares on behalf of the underlying beneficiaries. Even though investors benefit from the legal shelter of liability for the company’s debts or actions, we are ultimately responsible for the selection of its board, and therefore its oversight of management and the actions of the company in its societal context. If we are to profit from gains that the company makes, we are also responsible for the problems it may cause. We are responsible for ensuring, and must ensure, that both its gains and ours are not ill-gotten.

That means extra work in analysing companies: understanding externalities, governance practices, environmental impacts, treatment of workers and their influence on local communities. The first step is to understand the company in light of its environmental, social and governance (ESG) practices.

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Integrating ESG risks alongside financial metrics in the valuation of stocks is a relatively new concept, with the exception of some specialist fund managers. But it is beginning to generate substantial interest. For example, in June the California Public Employees’ Retirement System launched a pilot program that will, in time, ensure that all appointed fund managers articulate how ESG principles are integrated into their investment processes. With over $300bn in assets, the fund’s initiative will be influential. Other major asset owners also consider ESG risks seriously: in 2008, the $184bn California State Teachers’ Retirement System updated its policy for mitigating ESG risk from the original process, which was created in 1978, and the $268bn Canada Pension Plan Investment Board has an in-house sustainable investing group that monitors how ESG factors are affecting the long-term performance of companies. Change is happening in legislative circles, too. In October, the US Department of Labor overturned its 2008 ruling that pension trustees should focus only on the economic interests of the funds they oversee, allowing them to factor human rights, environmental sustainability and good governance into investment decisions. We expect that more asset owners will become increasingly aligned with such initiatives, and that ESG analysis will gain greater acceptance in the asset management industry. Consequently, it will expand the scope of mandates from a focus on shareholder value to include the impact of companies on a planet with finite space, resources, biome and an atmosphere shared by all.

As things stand today, a fund manager’s primary responsibility is to provide a return for her client, whether the client is an intermediary or an end investor or beneficiary. If this end investor has no regard for ESG considerations, they are free to appoint intermediaries who pick managers that invest in companies which believe the financial penalties for not complying with environmental or social laws and regulations – not to mention the risk to reputation – are outweighed by financial benefits. Or to invest in companies like those of the US tobacco industry in the 1950s, which funded the Tobacco Institute, a pseudo-scientific research organisation which succeeded in delaying for decades the inevitable social reaction, and its implications for corporate profits, to the deaths and damage caused by smoking. Recently, Exxon has been accused of funding climate-change denial research, though the company has said it was not involved.1

Leaving aside the implications of such “tainted” research, we focus on the legal and then ethical responsibilities of the fund manager. Alarmingly, such detachment from the societal implications of investing is not merely the norm: it is mandated, meaning that examining the broader, long-term consequences of investment decisions requires special justification.

Today, the leading ESG investors and advocates are pension funds, whose distant time horizons mean that the wider societal side effects of neglecting ESG factors will likely surface within a time frame relevant to them, bringing financial consequences. Providing a great compound return for beneficiaries at the cost of, say, the eventual pollution of the local water supply, is clearly not an optimal outcome.

The stewardship premiumHermes EOS, a global leader in corporate engagement and stewardship services, acts on behalf of ourselves, other investment teams and 41 pension funds worldwide, advising on £146.6bn in assets. The team

provides valuable information about the ESG performance of portfolio companies to us, and through joint engagements with businesses we gain insight into whether this performance is likely to improve or worsen. Importantly for us as investors in emerging markets, this engagement provides intelligence into how the board and management teams of companies approach governance, which we believe is critical to the long-term prospects of a stock. Together we assess companies’ relationships with employees and local communities, which is not always a vision of shoulder-to-shoulder solidarity, and their treatment of the environment.

And it works. We see plenty of first-hand examples of how successful engagement on ESG risks can improve the financial performance of companies, benefiting society as well as investors. This anecdotal evidence is corroborated by an academic study of the impact of Hermes EOS’ engagements with companies in the extractives sector – miners and producers of natural resources, and the businesses providing ancillary services. The study, by Hoepner, Oikonomou and Zhou from the Henley Business School at the University of Reading, assessed 131 companies, of which 56 had completed engagements. It found that businesses undergoing engagement generated an average annualised return about 4.8% higher and exhibited lower volatility and downside risk than unengaged peers2.

Of course, good ESG practice is beneficial whether engagement takes place or not. A study by MSCI found that the inclusion of ESG factors through both an “ESG Tilt” strategy, which overweighted stocks with higher ESG ratings, and an “ESG Momentum” strategy, which overweighted stocks that have recently improved their ESG ratings, resulted in outperformance of the global benchmark over the last eight years3. Research by our global equities team has demonstrated that, in developed markets, avoiding companies with bottom-decile corporate governance rankings can add as much as 30bps per month to returns4. Although the data is not yet available to measure the impact of corporate governance in emerging markets, logic would indicate that the effect would be, if anything, more pronounced. Further evidence of the efficacy of ESG integration in our universe is the outperformance of the MSCI Emerging Markets ESG Index over the MSCI Emerging Markets Index (see figure 1).

Figure 1. ESG adds alpha in emerging markets, according to MSCI

Annual performance (%)

Source: MSCI as at September 2015. Performance denominated in USD.

1 ““What Exxon knew about the Earth’s melting Arctic”, by Sara Jerving, Katie Jennings, Masako Melissa and Susanne Rush, published in the Los Angeles Times on 9 October 2015.2 “ESG engagement in extractive industries: risk and return,” by Hoepner et al, 2014.3 “Can ESG add Alpha?”, June 15, 2015.4 “ESG investing: does it just make you feel good, or is it actually good for your portfolio?”, Hermes Global Equities, January 2014.


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2008 2009 2010 2011 2012 2013 2014

MSCI Emerging Markets ESG Index MSCI Emerging Markets Index

5.20

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76.07

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79.02

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1.63

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21.64

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18.63

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Therefore, contrary to the received wisdom that ESG and engagement lie outside the paradigm of shareholder value, and indeed represent an additional cost to portfolios, there is strong evidence arguing that integrating these decisions into stock analysis enhances risk-adjusted returns.

Upon reflection, how could this not be the case? In the age of the internet, when information spreads rapidly, the costs of pollution, mistreatment of staff, and poor governance are increasingly obvious to everyone. We no longer live in the 1950s, where land grabs, reckless pollution, discrimination on the basis of gender, race and religion – among other injustices – were part of business.

Recognising this, if we, as professional investors in emerging markets, also want to act as responsible agents, what are our options?

We evaluate the behaviour of companies in relation to ESG factors. We use a quantitative screen to highlight existing concerns, then dig deeper to understand the company’s awareness and attitude to these matters, and their approach, if any, to resolving them. Our investment team shares information with Hermes EOS, which in many cases has a history of engaging with the companies in question, then go further by asking our own questions in an investment-based discussion.

We subadvise a “positive impact fund” that invests in emerging markets for Calvert Investments, a US mutual fund company. Here we complement our core approach by subjecting companies to a requirement to tackle ESG challenges substantively and creatively, in addition to passing screens that test whether they are involved in certain industries, such as weapons or tobacco, or violate human rights.

In this piece, we take a deeper dive into each of the dimensions of ESG within emerging markets, along with examples of positive and negative characteristics in companies we have held or continue to hold, and, where relevant, a brief history of Hermes’ engagement with them.

Governance risk in emerging markets Corporate governance is about maximising value for all shareholders, so here we put aside the discussion on benefits for the wider society and focus on the protection of minority shareholder rights. Subordinate to the will of dynastic family and state ownership, minority investors in emerging markets have consistently applied a governance discount to stocks with conflicted management. We have learned to be initially sceptical when researching companies, especially if the state owns a large proportion of the shares. As seen recently in Brazil, government shareholders directed energy, utility, and banking businesses towards national or party projects that were against the interests of minorities. In Russia, oil and gas companies have invested to further state agendas. Government-appointed executives tend to run many of the larger index stocks in China, often neglecting returns and doing the government’s bidding.

However, the track record of emerging markets in governance, while providing little scope for enthusiasm, does provide much room for improvement.

Figure 2. Overall, governance in emerging markets is on a downward trend

Emerging Markets Governance Indicator*1210080604020098

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*Includes China, Brazil, Russia, India, Mexico, Indonesia, Turkey, Malaysia, The Philippines, Thailand and South Africa. Indicator is an equally-weighted average of the following measures: Government effectiveness, voice and accountability, political stability and violence, rule of law and control of corruption. Source: World Bank and BCA Research at August 2015.

The major governance problem with these companies is usually capital discipline, resulting in less excess capital returned to shareholders through dividends or share buybacks. This is due to two prevailing definitions of excess capital: in the company’s view, there is never any excess capital to return to shareholders; in minority shareholders’ view, there is always plenty. This difference relates, in part, to divergent understandings of the cost of equity capital.

To business people with no formal training, the cost of equity is simply the value of the stock dividend – that’s how much they have to pay to shareholders as compensation. To business people trained in business schools, the cost of equity is the risk-free rate plus a risk premium. Inevitably, developed-world investors assign a higher cost of equity to companies than the dividend yield, resulting in a broadly held view – shared by us – that capital discipline at emerging-market companies is lax. Capital investment projects that make sense at a cost of capital of 2.5% (a typical dividend yield for an emerging-market stock), may be unattractive at a typically modern emerging-market firm’s cost of capital of 10%. In addition, the motivation for undertaking projects may range from providing jobs for family members to jobs for the electorate, neither of which are priorities for minority investors or add value to the company in itself. In exploratory meetings with an overcapitalised state-owned enterprise (SOE) or family-controlled business, a telltale sign that our interests will remain ours alone often arises when we suggest increasing the payout ratio. At this point, the Chief Financial Officer might start laughing. We enjoy the moment, then move on to another investment idea.

Sometimes businesses in emerging markets are discounted too harshly and offer short-term trading opportunities. For example, many investors are currently exposed to a certain Asian conglomerate, having judged that in spite of the very modest growth outlook for its high-end consumer electronics, some of its enormous cash pile could be returned to investors – and the company’s recently announced share buyback should reward their patience. This follows the government’s prodding of family-controlled businesses to respect minority shareholder rights. Similar government pressure has been applied to oligarchs in Russia, too, with little effect so far.



5 Principle three of this charter states: “Businesses should uphold the freedom of association and the effective recognition of the right to collective bargaining”.

Improving governance: Asian tech Our client portfolios are invested in an Asian manufacturer of consumer electronics with whom Hermes EOS has engaged since 2009. The investment team joined the dialogue, which has focused on working conditions that are alleged to have played a role in the deaths of some employees in recent years. We were also concerned about the company’s limited transparency and communications about its strategy, and the board’s ability to effectively challenge the powerful founder of the company, who is also its CEO and chair, as he seemed to run the business without sufficient checks and balances. The board itself did not appear to consist of people with a suitable diversity of backgrounds, experience and skills. The company’s succession plans were opaque, too, posing a governance risk intensified by the power of the founder, as if it was unwilling to contemplate life after his retirement.

During the course of the engagement – which consisted of meetings with senior management, telephone calls, written communications, site visits and collaboration with other investors – the company’s relations with employees have improved. By the end of 2013, it had satisfied many of the recommendations set by the US Fair Labor Association, with appropriate working hours remaining an exception. The changes include: higher pay, moving production sites closer to the homes of migrant workers, increasing off-site housing, providing more counselling, and automation and job rotation for the most monotonous work. Within the same period, the company started to disclose more strategic information to investors at the 2014 and 2015 annual general meetings and on its website, and revamped its annual sustainability report for 2015.

In a sign of good faith, an adviser to the founder participated in a recent meeting with Hermes and fellow investors to discuss the company’s willingness to be more transparent about strategy, governance and workplace matters. Coupled with progress in its core business and rising profitability, these improvements in governance and employee relations can lead to a higher valuation multiple, and for this reason we are happy to continue to hold the stock.

Poor governance: Asian autoWe have engaged with an Asia-based, global automobile manufacturer, on a range of concerns. Hermes EOS first approached the company following the 2006 indictment of its chair and CEO for embezzlement and bribery charges. We were primarily concerned about the insufficient oversight of the board and the company’s apparent dependence on him.

In time, the company implemented a number of measures, including the establishment of an ethics committee, led by an independent director, and more recently made plans to set up a board-level committee tasked with protecting the interests of minority shareholders and facilitating communications between them and the board. The relationship with its labour union has been difficult for some time, leading to recurring strikes interrupting production and compromising its ability to abide by the UN Global Compact.5 After we discussed the situation, management began a constructive dialogue that culminated in the first agreement between both sides and permanent positions being offered to a substantial number of contractors.

So far, so good. However, we believed that more work was needed to meaningfully improve the treatment of minority shareholders and acknowledge labour rights. Also, the company had just spent billions of dollars on land for a new headquarters in a famously affluent area of a major Asian city. This expense made no sense to us or to the market,

and the company’s stock price fell sharply after the deal was announced. We suspected therefore that the improvements in the company’s governance, and plans to remedy the situation, were largely cosmetic. Later, when we met with representatives of the board, these misgivings were confirmed, as it became clear that addressing the fundamental problems and challenges requires a different calibre of directors. We subsequently sold the stock.

We have since spoken with the company’s new head of investor relations, highlighting the company’s lack of capital discipline, lagging adoption of green technologies and labour relations as key ESG concerns, alongside the strategic matter of disappointing sales in key markets. And although the company seemingly made significant progress with its union, strikes continue. Unfortunately, nothing in our meetings so far has suggested to us we should change our minds about owning the stock, though Hermes EOS’ engagement on behalf of other investors continues.

Social risk in emerging markets These risks relate to a company’s social license to operate. As a member of the community and a beneficiary of common goods like roads, potable water, breathable air, a functioning legal system, and security (the commons), a company with the privilege of doing business has a number of social obligations to fulfill in the places in which it operates. Besides the obvious but often assiduously avoided duty to pay taxes, these include: the effective tackling of bribery and corruption, respect for human and labour rights, managing supply chains with integrity, upholding indigenous peoples’ rights, operating safe workplaces and making efforts to ensure that employees are healthy.

In emerging markets, engagements on social risks typically focus on accident rates among workforces in the extractive industries, tracking the sources of raw materials in the technology industry, the transparency of clinical trial data in the pharmaceutical sector, zero tolerance of child labour, clear oversight of supply chains for consumer goods companies, and for utilities companies, the safety of local populations near high-risk nuclear operations.

Positive social risk management: African health careWe consider a South African hospital group that we invest in to be an excellently run business, with world-class occupancy levels and margins, and which offers exposure to a secular trend with long-term visibility. It is one of the top-three health care providers in South Africa, a country where health standards are generally poor and the incidence of HIV, tuberculosis, silicosis and infant mortality are high, and it is growing while doing good. The company provides access to affordable healthcare through its general hospital operations, primarily in South Africa, and is undertaking a public-private partnership to expand access to care and philanthropic efforts. It has won tenders from leading insurance companies offering products that are cheaper than many of those on the market, such as the Government Employees’ Medical Scheme in South Africa, and the Keycare health insurance product offered by financial services company Discovery. It is also expanding in India and Poland, where it plans to grow by consolidating other businesses.

Recognising the key role performed by doctors and nurses in any society, and the scarce resources in South Africa, the company offers medical training and pays close attention to staff satisfaction levels. It also aims to reduce its environmental impact. Since 2013, it has been

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committed to reducing its carbon intensity, measured as tonnes of carbon dioxide emitted per patient per day, by 10% before 2018. This involves making energy efficiency a focus of upgrades to existing facilities and for new properties, with heating, ventilation and air conditioning systems – which account for 60% of energy consumption at some sites – a key focus. A group-wide objective is for energy and water consumption to be monitored in real time.

The company has definitely earned a social license to operate (literally). Combined with its profitability and valuation, this makes it a good long-term investment, in our view.

Poor social risk management: Anglo-African minerWe were in a meeting with a senior officer of a Jersey-based diamond miner with operations in South Africa and Tanzania, and he was talking about labour costs. So we thought we’d ask about labour conditions. We asked about housing conditions for the employee miners, and he replied: “Well, the housed miners live in company-provided housing near the mines.”

This begged the question: “There are ‘unhoused’ miners?”

“Yes,” he replied. “They come in from the bush and tend to sleep in tents or lean-to huts.”

We suggested that perhaps the company should consider providing housing for them, too. Not only as a deserved benefit for labour, but also to benefit operations. Surely healthy, well-rested workers reduce the risk of injuries, even fatalities, in an industry that can extract a high human toll if situations are not managed carefully? Although the conditions in diamond mines tend to be better than conditions in platinum mines in South Africa, the “relaxed” attitude of the company to the fundamental human needs of its workers was a factor in our decision to sell the stock.

The mistreatment of employees not only strips a company of its social licence to operate: it often levies financial penalties. Such actions typically manifest as public knowledge at some point, increasing the reputation risks for the company at fault.

We know a gold miner in South Africa that has attracted scorn for the basic shelter it has provided for workers. In an area where temperatures drop to 2ºC at night, sleeping in unheated concrete rooms on a bed with no sheets, no pillows and two small blankets is no way to recover from a shift at the coalface where incidence of HIV, tuberculosis, and silicosis is high.6 It’s not great for the company’s share price, either. Every time we are tempted to invest in the company, we remember its social risks and move on.

Environmental risks in emerging marketsCompanies benefit from and should be accountable for their use of the commons, given the potential environmental costs for society: localised pollution, stress on water supplies and climate change. Natural gas producers should prevent methane leaks, contamination or exhaustion of water sources, workplace accidents and strikes resulting from fraught labour relations. Effluent from pharmaceutical manufacturing, if untreated, can result in fines as well as lawsuits, putting a company’s relationship with the surrounding community at risk. Of course, utilities face obvious environmental risks, from caps on

carbon emissions, potential breaches of air and water pollution thresholds, the safe disposal of nuclear waste, to the less obvious risks such as those arising from the displacement of local populations and ecosystems from hydroelectric power projects. These risks are real and present, but in time technological disruption may drive down the cost of solar electricity and make power storage a viable option. Such considerations are important for long-term investors in fossil-fuel companies, as deposits may be left in the ground or partially used as governments and consumers seek cleaner energy. The availability of water, vital to all forms of life and to most forms of business, is a risk for numerous sectors in emerging markets and may incite geopolitical conflict where none existed before.

In exploratory meetings with an overcapitalised state-owned enterprise or family-controlled business, a telltale sign that our interests will remain ours alone often arises when we suggest increasing the payout ratio. At this point, the Chief Financial Officer might start laughing. We enjoy the moment, then move on to another investment idea.

Hermes EOS is currently working with a number of emerging market companies in the extractives industry, none of which are currently in our portfolios. We have held some of these stocks in the past and engaged with companies’ management teams and directors to improve their corporate governance, and succeeded in some cases. For example, due to pressure from us and from other investors, Petrobras added two directors representing the interests of minority shareholders to its board, one of which heads the company’s audit committee. Admittedly, much more needs to be done, but this is a promising sign. Recently, the Brazilian government was legally prevented from voting on its shares in an electrical utility after attempting to support tariff cuts for the utility, which would clearly not have been in shareholders’ interests.

Positive environmental risk management: Russian miningA large Russian resources company operating in the Arctic Circle has developed a reputation as one of the worst polluters in its industry, with massive sulphur dioxide emissions from its polar operations being environmentally destructive. Severe air and water pollution from heavy metals is taking place, and vast areas of forests around the plants have died. The high concentration of sulphur dioxide and heavy metals have led to a high incidence of respiratory disease, weakened immune systems and increased rates of disease among local children. In areas near the company’s plant in the Kola peninsula, life expectancy is on average 10 years below that of most other Russians, particularly for the workers.

I have held discussions with the company’s management since the mid-1990s about such degradation. They have always recognised and accepted this as a problem, and in recent years have instituted an

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environmental management system to gradually reduce emissions from its metallurgical production facilities in Norilsk. Hermes EOS started its dialogue with the company in 2012 on behalf of other clients, and we have met its senior management over the last several years to speak about the company’s performance and plans. The company aims to reduce the amount of sulphur produced in downstream processing plants and plans to close the dirtiest smelter in its polar division by 2016. Its newest smelters, which have filters to collect sulphur, will then be used for all production. Given that the average age of smelters across the industry is 45 years and that of the company’s 73 years, shutting down its oldest facilities will substantially reduce sulphur dioxide emissions, by as much as 15% in the medium term and by 75% in the long term. Updating its smelting and refining capacity will substantially boost earnings, but is also a practical necessity as these improvements are required for the company to maintain its licence to operate. We believe that these improvements in environmental stewardship are important components of the long-term investment case for the company, along with operating efficiency and, of course, the nickel price itself.

Poor environmental risk management: Asian conglomerateEnvironmental neglect does not usually occur in a vacuum: it can signal that a company is poorly governed and disregards employee safety and welfare.

Early this year, following a year in which there were well over 100 reported illnesses as well as more than 50 deaths among employees in its manufacturing operations, an Asian conglomerate agreed to compensate workers who had been diagnosed with serious disease. Afterwards, the national court of the business’ home market linked the death of a young worker, who died from a severe illness in 2009, to the five years of exposure to chemicals she incurred at the manufacturing line of one of the company’s subsidiaries. The court reported that it was unable to investigate the worker’s exposure to carcinogens due to lack of cooperation from the company. A series of other workplace incidents occurred in 2013: an employee death and four injuries from poisonous gas inhalation at a company-owned plant; a leak within a factory run by the company that hospitalised six workers; a fire at another of its plants, allegedly due to a failure to maintain safety regulations; and the bursting of a large water tank at a separate plant, leading to the deaths of three workers and injuries to more than 10 others. The tank burst during a stress test, despite the company learning of fractures in the structure beforehand7.

Accusations of labour violations also exist within its supply chain. In April, the company admitted to sourcing tin from an island in Indonesia where mines allegedly depend on child labor, as well as causing vast environmental damage that is a factor in the deaths of more than 100 workers per year. In China, the company has been accused of inhumane and illegal work practices at its factories, including forced overtime, unpaid work, use of underage workers, gender discrimination, unsafe work practices, and verbal and physical abuse. In Brazil, the Ministry of Labor and Employment filed a lawsuit against one of its divisions for alleged labour rights violations8.

The history of of self-interested and detached family-run companies in certain Asian markets is replete with episodes in which the rights of workers, minority shareholders and wider society are disregarded. Of course, they are far from being unique in emerging markets – or developed ones, for that matter. We do not own these types of companies, partially because of the commercial prospects for their businesses, and partially because of their ESG track records.

One market that we are particularly wary of is “Korea Inc.”, which trades at a well-deserved discount, in our view. This will eventually close as family-controlled corporations become accountable to the minority investors who, in aggregate, own the majority of their shares. While it is possible to make money by trading with a focus on mean reversion in Korea, we find that governance problems make it difficult to find quality companies that can provide compounding returns that add value to a buy-and-hold strategy over many years. Therefore we hold few names in this market, judging the balance between risk and reward to be better elsewhere. That said, the recent decision by a large business to buy back and cancel billions of dollars in its shares, is a welcome reward for its foreign shareholders. This is a positive development that other large companies in this market would do well to emulate.

The investor and the innocent bystanderAs more investors identify themselves as long-term owners of companies, and as digital technology makes corporate activities increasingly visible to a larger audience, ESG analysis is becoming recognised as an important concept whose time has come in emerging markets. In several years, we believe that having the expertise to integrate these risks into stock valuations will not be exclusive to specialist fund managers, but will be integral to the decisions of mainstream investors. Hopefully, such risks will have been diminished by then, as technology improves our ability to live sustainably and ensure that our commons is protected. Presently, however, many emerging market companies are learning these concepts for the first time, and we encourage investors to engage to help convey their materiality. This will reward their beneficiaries, the end-investors, in at least two ways: improving their returns, and helping to ensure that the healthy planet in which they laboured still exists when they retire.

To us, such potential outcomes make ESG analysis too important to ignore within the paradigm of maximising shareholder returns. Indeed, as we have shown, it can be compatible with this objective over the long term. But we consider it to be powerful in its own right. For us, ESG integration directs the focus of investing from outperforming this quarter to generating sustainable returns for many years. In seeking this, investors can work collaboratively – with each other, and with companies – towards financial gain while respecting the wellbeing of others and the integrity of our shared environment. Such investors, and we count ourselves among them, seek long-term value not only for shareholders, but for the innocent bystander, too.

Gary Greenberg, CFA Lead Portfolio Manager and Head of Hermes Emerging Markets [email protected]

7, 8 “The Most Controversial Companies of 2013”, published by RepRisk in April 2014.

This document is for Professional Investors only.The views and opinions contained herein are those of the Hermes Emerging Markets team and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products. The information herein is believed to be reliable but Hermes does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. This document is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Figures, unless otherwise indicated, are sourced from Hermes. The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are required to make themselves aware of and to observe such restrictions. Issued and approved by Hermes Investment Management Limited (“HIML”) which is authorised and regulated by the Financial Conduct Authority. Registered address: Lloyds Chambers, 1 Portsoken Street, London E1 8HZ. Telephone calls may be recorded for training and monitoring purposes. Potential investors in the United Kingdom are advised that compensation will not be available under the United Kingdom Financial Services Compensation Scheme. HIML is a registered investment adviser with the United States Securities and Exchange Commission (“SEC”). CM154357 10/15 T3198

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Hermes Investment ManagementHermes Investment Management is focused on delivering superior, sustainable, risk-adjusted returns – responsibly.

Hermes aims to deliver long-term outperformance through active management. Our investment professionals manage equity, fixed income, real estate and alternative portfolios on behalf of a global clientele of institutions and wholesale investors. We are also one of the market leaders in responsible investment advisory services.

Our investment solutions include:

Private markets

International real estate, pooled funds, segregated mandates, UK commercial real estate, UK commercial real estate debt, UK private rental sector real estate, infrastructure and private equity

High active share equities

Asia, global emerging markets, Europe, global, and small and mid cap

Specialist fixed income

Absolute return credit, global high yield bonds, multi strategy credit, UK government bonds, and UK and global inflation-linked bonds

Multi asset

Multi asset inflation

Responsible Investment Services

Corporate engagement, intelligent voting and public policy engagement

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Why Hermes Emerging Markets?From top to bottom

Bottom-up analysis finds quality companies trading at attractive valuations. This is rooted in a top-down framework that identifies countries with conditions supportive of growth.

Quality and safety

Buying quality companies at a discount gives a margin of safety in a volatile asset class.

Truly active management

A concentrated portfolio with a high active share, invested with a longterm perspective.

Experience and rigour

Manager Gary Greenberg has three decades of investment experience, and is supported by a team of six.

Integrated ESG

Environmental, social and governance factors are integrated into our analysis for a comprehensive view of risk.

Multi-cap

The portfolio invests across the market cap spectrum, fully able to benefit from mid-cap exposure.

Contact informationBusiness Development

United Kingdom +44 (0)20 7680 2121 Africa +44 (0)20 7680 2205 Asia Pacific +65 6808 5858

Australia +44 (0)20 7680 2121 Canada +44 (0)20 7680 2136 Europe +44 (0)20 7680 2121

Middle East +44 (0)20 7680 2205 United States +44 (0)20 7680 2136

Enquiries [email protected]

Documents

ESG in emerging markets