By Hamlin Lovell, NordicInvestor

This interview is part of our upcoming report on ESG in the Nordics

LocalTapiola Asset Management Ltd is owned by a collection of 21 mutual insurance companies in Finland: 20 non-life companies and one life company. Its asset management units include liquid equities and fixed income and in 2020 it acquired fund management company, Seligson & Co. (Real estate is run by a separate company, LocalTapiola Real Estate Asset Management Ltd).

NordicInvestor interviewed Outi Kalpio, Director of Portfolio Management and ESG, who works for the asset manager on behalf of internal clients investing directly into equities and fixed income. The firm manages around EUR 10 billion in listed equities and fixed income, and has about 30 mutual funds as well as unit-linked products managed for the life company.

LocalTapiola AM’s investment philosophy is to a large extent based on active stock-picking and credit picking, running concentrated, high conviction books with no index investing. “Fundamental analysis has included qualitative factors such as ESG for over 20 years, and the ESG policy has become more standardised and systematized over the past 15 years. But there has never been a separate ESG department as such. Portfolio managers are expected to integrate the analysis into their daily work,” says Kalpio.

ESG Priorities and Coverage: a high active share although ESG benchmarks have not yet been adopted

ESG priorities are climate change and climate change mitigation for the E; working conditions and human rights for the S, and board structure, directors’ independence and diversity for the G.

ESG principles apply to all asset classes and strategies, though their exact application can be tailored to equities and sovereign bonds and may also differ for external managers.

LocalTapiola AM has a high active share due to both its investment style and its ESG philosophy, and these two cannot be split. “For instance, the quality factor often has a high overlap with ESG. The firm’s investment style also emphasises growth, competitive advantage and well managed companies and sectors. We have more exposure to healthcare, industrials and consumer services, and less to commodity driven sectors”.

For example, for LocalTapiola ESG Europe Mid-cap active share is 87,5% and tracking error 4,36, vs Morningstar Developed Europe Mid Cap Target Market Exposure NR EUR. For LocalTapiola ESG USA Midcap active share is 96,2% and tracking error is 7,1 vs Morningstar US Mid Cap Target Market Exposure NR USD.

However, one obstacle to a much deeper ESG approach in the future may be some clients’ preferences for standard traditional market benchmarks., which then may impose constraints in terms of active share and tracking error. “For some clients moving to more ESG aligned benchmarks can be a long process,” says Kalpio. “We are currently not using ESG or PAB benchmarks but are investigating the possibilities to use them for certain mutual funds and/or client portfolios. When it comes to client portfolios, it is of course in the end the client who chooses the benchmarks but we are prepared to support our clients in transition,” she adds.

Data and reporting: in house analysis essential

Another challenge in ESG is data gaps, especially for emerging market companies. “The firm reviews some external data, but does not rely on third party ratings. We always want to do our own analysis, scrutinise the value of the data and compile it with our own company knowledge. Our own analysis over-rides the third party ratings,” says Kalpio.

Raw data is external, mainly from companies but also from some data providers. “We look closely at the data, scrutinise the methodologies and make our own calculations, so that the data can be used by our portfolio managers and it adds value to our investment process and ESG reporting. Data is easier to analyse at company than portfolio level. Because company reporting is not standardized you may end up “adding apples to bananas”. Carbon emissions can be aggregated across the portfolio, but for example water indicators cannot be compiled for the whole portfolio. We want to be specific in disclosing what is relevant to clients, and sometimes the data you get is not relevant or the relevant data is not available”.

There is room for data providers to improve: “we expect further consolidation amongst traditional financial data providers, but some of them are stuck with old ways of thinking about and finding data. We also see room for more flexible and innovative start-ups using artificial intelligence, which may also have lower costs”.

Regulation will be one driver of change in data provision: “data providers may also need to adapt to the EU SDFR and Taxonomy, which for example apply different types of business classifications. The understanding of responsible and sustainable investing is evolving very fast and will be different in five years’ time”.

Exclusions, best in class and transition: prioritizing transition

LocalTapiola AM publishes an exclusion list of around 80 companies that breach norms or are active in areas such as controversial weapons. There is potential for companies to become investible again in some cases: “Novartis AG was released from the exclusion list after some cases relating to alleged bribery and corruption were concluded. It still is on our watch list and therefore under scrutiny,” says Kalpio.

On top of this, there are a range of industries that are in practice excluded in active equity and credit portfolios. The industries include weapons, tobacco, gambling, adult entertainment, and fossil fuels, peat and coal above certain thresholds such as 25%. “Overall, the carbon intensity of most portfolios is quite low,” says Kalpio 

Although no list of companies in these industries is published, the names could be shared with clients. One reason for not publishing the full list of excluded companies is that LocalTapiola AM are running relatively concentrated portfolios of 35 companies, so the exclusion list is already longer than the portfolio. “It is more relevant for clients to look at the names of companies that are actually invested in,” says Kalpio.

There is some latitude to invest in “best in class” companies that might sometimes be in relatively coal or fossil fuel intensive industries. “There is no formal or official “best in class” approach, but the general tilt towards quality means that most companies owned have good ESG disclosure and high ESG ratings, and we do not invest in companies with the lowest ESG ratings. The analytical work and calculations are done in house as part of the investment process, and not a separate filter. In carbon-intensive sectors we only invest in best-in-class companies, based on CO2 emissions,” she explains.

But future transition matters more than historical absolute or relative ESG performance: “we are very much focused on future transition, and we do not make investment decisions based on backward-looking information that may be one or two years old. It is very important to invest also in transition. Dark green companies may already be crowded trades and investing in only these companies does not change anything in the real world. We would rather invest in companies changing from light green to dark green or even from brown to green”.

Transition investing requires ongoing monitoring: “we also need to make sure that companies are keeping to their plans and promises on transition. We cannot invest on hope forever,” says Kalpio.

Impact investing and SDGs: environment beyond climate, and social SDGs

LocalTapiola AM do not find it easy to split strategies into different ESG categories, such as integration or impact investing, because there is so much overlap. Nonetheless, some strategies could easily be perceived as “impact investing” and are classified as article 9 under SFDR. “For instance, thematic equity funds include LocalTapiola Sustainable Environment, which covers all sorts of environmental issues including climate change. LocalTapiola Sustainable Positive Impact bond fund invests in green and social bonds and also in companies that advance a range of Sustainable Development Goals (SDGs) through their business”.

SDGs prioritised include: 3 (healthcare); 7 (sustainable energy); 8 (growth and worker rights); 9 (infrastructure); 12 (sustainable consumption and production), and 13 (climate).

Engagement: direct and collaborative

Engagement is increasing and is a more powerful way to reduce emissions than just exclusions. ”Direct engagement with companies includes asking them to report carbon emissions and set science-based targets for emissions. Collaborative engagement via the PRI has touched on topics such as taxation, and food supply chains,” says Kalpio. We also attend to AGMs globally through proxy voting services and vote on shareholder resolutions.

Climate targets and reporting: part of broader ESG reporting 

LocalTapiola AM has also committed to the net zero asset manager initiative. ”We have publicly  and officially committed to net zero by 2050, but realize that the actions taken must by front-loaded. The roadmap for an asset manager to reduce the client portfolios’ net emissions to zero is not completely clear yet. Will there be new asset classes or instruments, compensation, and how will external asset managers respond?”.

Equity carbon emissions for active equity and credit portfolios are already coming down, thanks to exclusions and best in class. Reporting is mainly based on TCFD recommendations. ”In July 2022, targets for all asset classes will be set, including sovereign bonds, funds of funds, external funds  and so  on,” she adds.

LocalTapiola’s mutual fund ESG reports cover not only carbon emissions and carbon intensity but also a range of other ESG metrics, including governance, diversity, board independence, and sometimes external fund ESG ratings. Asset management clients get the same sorts of reports, twice a year.

EU Sustainable finance framework: concerns over clarification, finalization, slow progress, transition, Eurocentricity, subjectivity

The SFDR is still in draft form but the early indications are mixed. “It is well intentioned, should have a positive impact on markets and people, and good to avoid greenwashing. But the early years may prove to be confusing, and open to different interpretations. It will increase transparency, but is focused more on risks than opportunities, so the disclosure is not balanced. There is a lot of information for retail clients to digest, including the PAI measures and taxonomy”..

The taxonomy is only one framework. “We expect that green companies will be long term winners regardless of whether they are aligned with the taxonomy, which may be political and may not be technology-neutral. We also realize that company performance is also affected by other issues, such as the economic cycle, management quality and strategy”. It is not clear now if or how many transition activities fit into the taxonomy.

The taxonomy is going to broaden out but it may not expand fast enough to keep pace with new technology: “The taxonomy has gotten very political and it takes years to get out the technical criteria even for the first two objectives. There will be reviews later but if these also take years to agree on, my fear is that some new green innovations and solutions may be missed and left out of the taxonomy. It could therefore get “out-dated”. It could hinder the development if these new solutions don’t get enough finance because they are not recognized by the taxonomy,” says Kalpio.

“SFDR should increase disclosure but data gaps remain and there is some risk of greenwashing. The data gaps are not a problem for ESG integration, where we do our own analysis, but are an issue for standardized disclosure at portfolio or entity level,” says Kalpio.

More collaboration may lead to common data. But one obstacle to harmonised reporting is companies outside Europe. It is an EU, not a global framework. ”Why would non-EU companies align their reporting to the EU regulation? They already have other disclosure requirements and it would be an extra burden”.

Article 8 and article 9 both have a wide range of different strategies and impacts. “The classification helps us to identify the universe, and we will probably allocate more to article 8 and 9 funds, but we still need to look at which strategies match our preferences. Our external managers already have a high level of ESG integration and extensive ESG/Sustainable product offering. There are and will be different definitions of impact investing, so it is not clear that the regulation will move impact into the mainstream. Anyway the data disclosure is not yet good enough”.