Approach to responsible investment

Our equity income investment philosophy is based on the fundamental belief that a long-term perspective is required to deliver a higher income stream from equity investments. This approach contrasts with the status quo equity income approach that places greater emphasis on near-term dividend yields and the ‘next upcoming dividend’. We seek to provide our conservative equity investors with attractive long-term total returns, which is comprised of income plus capital return, through exposure to a portfolio of our best investment ideas, regardless of dividend yield, and the selective use of options to deliver the additional income and lower volatility objectives.  This long term perspective means we believe it is imperative to consider climate-related risks within our portfolio, as the implications from climate change have the potential to place financial, social and regulatory pressures upon companies now and into the future.

As the global economy reduces its reliance on carbon, this presents transition risks as changes in technology, policies, investments and consumer preferences occur. In addition, companies that are unable or unwilling to transition may face reputational damage and can risk losing their social license to operate.  One particular area of focus for the team is the consideration of the timeline for usefulness of a company’s assets, as we seek to assess the risk of stranded assets. In some cases, it may be appropriate for companies to incur higher near-term capital investments in order to ‘future proof’ their assets to provide optionality to integrate new forms of low carbon technology as it becomes available and economical. High emission generating firms in the Materials sector have already been making sizable investments in these areas.

Regulatory and policy developments continue to evolve in an effort to tackle climate change and could present a number of risks and opportunities for our portfolio. For example, policy changes increasing the pricing for carbon emissions have the potential to adversely impact upon carbon intensive companies. On the other hand, incentives and government grants could lead to investment opportunities for companies with initiatives that accelerate the transition to a low carbon economy.

The transition from fossil-fuel based energy production and consumption to renewable sources of energy particularly has implications for oil, gas and coal companies. We have already seen some of these risks materialise within the Utilities sector, as shifting consumer preferences and increased pressure from society has contributed to a number of coal-fired power stations bringing forward their retirement dates. At the same time, the transition also presents significant investment opportunities in energy storage (batteries), renewable energy (wind turbines), emissions capture (carbon capture and sequestration) and alternative forms of energy, such as hydrogen.

Another climate-related risk the team considers is the physical risks arising from the increased severity or frequency of climate events and longer term shifts in climate patterns. These can have financial implications for companies, such as damage to key assets or indirect disruption to operations or supply chains. Consumer Staples companies and industrial manufacturers are particularly vulnerable to these risks. The insurance industry will also have to navigate the impact of rising claims from the increased severity and prevalence of natural hazard events. This has already seen insurers expand their catastrophe budgets and increase premiums in some insurance lines.

The Equity Income team’s long term perspective aligns with the need for companies to appropriately manage climate risks and work to implement measures to reduce their carbon footprint to ensure their viability into the future. We utilise a number of tools and risk assessment processes, which have been established to help the team analyse and identify the sources of ESG and climate change risks in the portfolios. These include a proprietary Environmental, Social and Governance (ESG) scoring system used by our Equity Analysts and the firm-wide Carbon Footprint report which is explained below.

Analysts are responsible for monitoring which companies have committed to net zero targets and whether their emissions are reducing over time. The starting point in the climate-related risk assessment is the proprietary ESG scoring system. The scoring system is an internally developed tool that draws on both our analysts’ experience and expertise as well as best-in-class quantitative data. Each of E, S and G are scored (with analyst input and external data weighted 50 / 50) for all of the companies under our coverage, with the final score allowing us to compare stocks across industries and sectors. The scoring system utilises climate-related data from Sustainalytics, MSCI and ISS to identify climate change risks, such as carbon footprint, emissions intensity and exposure to fossil fuels. These inputs and resulting scores help the analysts and portfolio managers to identify the risk exposures for each company and are factored into model forecasts, Discounted Cash Flow (DCF) valuations and stock recommendations. Analysis is stress tested and screened under a peer review process. This process seeks to highlight the depth of the analyst’s and team’s conviction in any given target price and recommendation.

The firm wide Carbon Footprint Report provides an overview of the team’s carbon footprint, emissions and intensity profile against its benchmark - highlighting at the portfolio-level, the sectors and companies that are contributing positively/negatively to the portfolio's carbon emissions. The capture of factual data better equips our analysts and portfolio managers to discuss how prepared a company is to transition to a low carbon economy, and the likely impacts of such a transition on the company. The analysts also use ISS DataDesk to run carbon and transition risk scenarios and run quantitative screens on scope 1 and 2 emissions¹ for potential carbon tax adjustments.

We recognise that there is no single perfect solution to measuring climate-related risks due to limitations in the accuracy, completeness and reliability of data. However, we believe that through the combination of the metrics, tools and risk frameworks that we use, provides us valuable insights which aids in the recognition of climate-related risks, feeds into the analyst research and ultimately impacts portfolio construction decisions.

¹Scope 1 refers to greenhouse gas emissions that are directly caused by a company’s operations. On the other hand, Scope 2 emissions are indirectly caused by the company through their consumption of purchased energy.

A firm-wide exclusion policy applies to companies involved in tobacco manufacturing and the production of controversial weapons. Outside of this, the team firmly believes that ownership and engagement for change is more effective and more value-adding for clients than negative screens.

The Equity Income team uses a downside due diligence process when assessing a potential investment decision, which takes into account analyst ESG scores and their commentary in regards to climate-related risks. Our ESG analysis and rating system can and does impact potential portfolio positions, particularly if risks become more material. Decisions, which are made on a case-by-case basis, can result in higher or lower portfolio weight than would otherwise be the case or, in material instances, a complete exit/entry of a stock.

Key performance indicators used to track the portfolio’s progress include level of carbon intensity and the 3 year change in the stock's carbon intensity that feeds into the ESG rating. Carbon intensity is tracked at both the portfolio and company level through the use of the Carbon Footprint Report, ISS DataDesk and the team’s ESG scoring system. Companies that are not demonstrating improvement are subsequently penalised in the scoring system and will result in further ongoing engagement and monitoring by the team.

We believe that active direct dialogue with senior company management and chairpersons is a valuable tool in addressing any climate-related risks identified. Through this process, teams seek to gain comfort that a company’s senior management and board are aware of, and accountable for, the management of climate-related risks. Where we feel material risks are not being appropriately addressed we will work with our internal Responsible Investment team to develop an engagement strategy for the issue. This can then flow into our proxy voting and investment decisions.

Our active approach to voting allows us to individually assess the merits of, and submit votes for, all proposals. In light of any climate-related issues, our assessment of proposals is based on our analyst’s expert knowledge of the company and additional insight offered through both CGI Glass Lewis and Ownership Matters. We utilise the research capabilities of two separate proxy advisers to ensure diversity of thought. When voting against the management or proxy adviser recommendation, the analysts are required to submit supporting comments that rationalise and explain their voting decision, which allows the team to keep track of the issue.

A series of portfolio targets have been established by the Equity Income team.

Our assessment framework is based on the net zero alignment maturity scale contained in the Institutional Investors Group on Climate Change’s (IIGCC) Paris Aligned Investment Initiative framework but is tailored to the Equity Income team to reflect our expectations of companies as they transition.

By the end of 2025, the Equity Income team aims to progress towards the following short term targets using this framework:

• At least 40% of FUM is invested in companies that are ‘Aligning to net zero’
• All companies owned by the Equity Income team that are in a high impact sector as defined by the IIGCC framework have an ambition to decarbonise their business.

Between 2025 and 2030, the Equity Income team aims to progressing towards the following medium term targets using this framework:

• At least 50% of FUM is invested in companies that are ‘Aligning to net zero’.

Long term targets include:

• All companies owned by the Equity Income team are ‘Aligning to net zero’ by the end of 2040
• All companies owned by the Equity Income team produce net zero emissions by the end of 2050.

For more details on how the terms 'Net Zero', 'Aligned', 'Aligning' and 'Committed to Aligning' are defined, please read Our climate metrics and target. These definitions follow the guidance from the IIGCC’s Net Zero Investor Framework.

These targets have been formulated based on: (i) available information and representations made to First Sentier Investors by third parties, including, but not limited to, portfolio companies; and (ii) assumptions made in relation to future matters such as the implementation of government policy in climate-related areas, enhanced future technology and the actions of portfolio companies. Such information and representations may ultimately prove to be inaccurate and such future matters may not ultimately be realised. As such, First Sentier Investors cannot guarantee the achievement of these targets. These targets are subject to ongoing review and may change without notice.