ESG Investing in an Uncertain Environment

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Crystal Maloney, CFA, CPA, CMA

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Crystal Maloney, head of equity research, CIBC Asset Management.

Russia’s invasion of Ukraine has had significant human and social consequences and implications on ESG investments. For investors, the geopolitical risk is higher, and it has had economic and market consequences with supply chain impacts and contributions to the inflationary environment that we continue to experience. For example, we saw impacts on energy and agriculture commodities which caused significant global economic disruption, and we believe some of the effects will be ongoing. The war raised ESG questions in regards to the future of renewable energy dependency, the human rights considerations of the invasion, and governance downgrades of Russia and Belarus.

Over the last year there have been a number of factors that we think need to be taken into consideration in this context, thinking about the implications of high inflation, higher rates, energy sector, and the war in Ukraine.

Firstly, energy transition. We believe that investors may need to take a closer look at their energy transition assumptions. Given the world’s dependency on Russia and the Middle East as energy sources, this energy transition could take longer than some had originally expected. Also given access to raw materials, such as copper, that are necessary to rebuild the grid. There are also potential impacts on nuclear power as many investors are revisiting its role in energy transition.

There’s been some evidence in global and U.S. focused sustainable funds that investors are adding exposure to nuclear involved companies for the first time in a long time. We saw that in 2022.

In terms of the impact on renewables, the energy crisis has expedited the timeline to transition to renewables. In terms of inflation, our view has been impacted within the industrial sector, for example, where we continue to look for companies such as the rails that have strong pricing power to offset the higher inflationary environment that we were seeing. Also, with respect to higher interest rates that impacted our sector outlook, we saw significant impact on the higher growth and more expensively valued technology sector over the last year. And then recovery once there was greater certainty that we were at or approaching the end of the tightening cycle.

We continue to focus on stocks that are at least priced relative to their long-term fundamental value and our ESG analysis helps us form a comprehensive view of a company’s outlook with those ESG factors informing our traditional fundamental views. We are seeing many opportunities in the Canadian market, and with volatile market conditions, this has created opportunities for stock picking. CP Rail is one company that we quite like at this time. It is defensive play, and it is a best-in-class rail holding. We have increased our conviction recently, stemming from their acquisition of KSU, where we see good opportunities for revenue cost energies that seem more than attainable.

We like CP given its defensive characteristics of the business, and we believe that the Kansas City Southern transaction provides a solid growth lever in order to capture market share and increase profitability. We view the end-to-end solution that it offers into Mexico and the development of east coast port positively, allowing the company to take market share and capitalize on demand trends. CP is a high-ranking Class One rail in regards to ESG. It has a high degree of transparency, strong safety track record. It’s ahead of its peers in energy efficiency and diversity programs in place. In comparison, KSU is lagging, and we see an opportunity for its metrics to improve on this front following its acquisition by CP.

The second opportunity that we liked is WSP Global. This is another company in the industrial space, and not only is it an ESG leader, but it also serves clients in the environmental sector. This is a high quality, global pure play engineering design firm with a strong M&A track record and increasingly defensive characteristics. Diversification within its business mix mitigates the downside risk in our view, and we expect superior performance versus its peers.

Despite the challenging macro backdrop, the company continues to outperform peers and deliver superior organic growth and experience margin expansion. I mentioned the WSP is an ESG leader. It’s leading the way for engineering and construction companies. It was the first global firm to link its credit facility to ESG related targets, such as carbon targets and the percentage of women. It has above average disclosure and assessment, health and safety ethics, and employee relations and training. It’s acquisition of Golder in 2021 positions it also as the number one environmental consulting firm globally, and it is fast tracking its green strategy.

Thirdly, Kinaxis is the leading provider of cloud-based supply chain software that is one of the opportunities that we see at this time. This company is at the cusp of accelerating growth given its product that addresses a pain point experienced by enterprises in terms of supply chain software. Enterprises continue to rely on rudimentary solutions, such as Excel, to manage their supply chains. We believe that Kinaxis has a product that addresses the needs of large enterprises who are more willing to change now than in the past. Supply chains concerns have moved from secondary to a board level issue over the last couple of year, and we believe that Kinaxis should a beneficiary of this trend.

From an ESG perspective, Kinaxis is also a leader. In 2020, it achieved carbon neutrality through carbon credits, and they use renewable energy at all of their data centres. They also report scope one, two, and three emissions, which is a rarity across industries. On diversity and inclusion, Kinaxis has exceeded its goals with female representation at the board level, management level, and in terms of all employees. Also unique within its sector, Kinaxis has targets for hiring candidates on the autism scale and persons with disabilities.

There are a number of items that we are keeping an eye on in terms of the upcoming year. We’re expecting to see greater developments in terms of greenwashing regulations, updates from the SEC on climate risk disclosure rules, whether that will include scope one, two, and three emissions or not. As well as final standards from the ISSB, the International Sustainability Standards Board, which is combining the frameworks of many different organizations including SASB and other frameworks that will look to standardize disclosure frameworks.

This will make it easier for investors to compare across companies as well as for those companies to provide standardized disclosures for investors to interpret.