What drives sustainable investment at a trillion-dollar US asset manager?

Hi and welcome to the Responsible Investor Podcast. I'm Elsa Holmes that Pell, Deputy Editor of Responsible Investor and I'll be your host for this episode. If you enjoyed this podcast, please make sure to subscribe and leave us a review or rating. And before we kick off, just a quick reminder that you'll find lots of articles on the topics discussed today on our website, responsible-investor.com. If you're not already subscribing, you can start a free trial today to get access to our daily news and analysis on Sustainable Finance globally. Today I'm delighted to be joined by Wendy Cromwell, who is the head of Sustainable Investment at Wellington Management. Wendy sets the research agenda and strategy for the Sustainable Investment Practice of the US Headquartered Farm, which is more than one trillion of assets under management and she's also a board member of the Principles for Responsible Investment. Welcome to the podcast, Wendy. Thanks for having me, Elsa. So to set the scene, what's it like being head of Sustainable Investing at a large US manager right now? Well, you know, we are a global asset manager and actually that's probably my favorite part of my role is meeting with clients, asset owners, regulators, policymakers and then companies around the globe. And one of the things that I see, in fact, I'm going to do a three-week trip in Asia and it's great to be meeting in those various geographies and come back with investment themes. And one of the things that I see right around the globe that's pretty consistent is this very nuanced landscape, persistent investment that is intersecting with three major investment themes that are somewhat common. The first one that I would say is national security and economic competitiveness and really national security and economic competitiveness sort of overriding concerns or thoughts around economic efficiency. So almost this idea that countries are more competing with each other in this day and age given the geopolitical backdrop than collaborating with each other and that has important considerations for SI and for the transition. AI, certainly, it comes up in every conversation and the race for dominance in AI and then affordability. And that's true in the US, that's true in Latin America, that's true in Asia and that's true in Europe. And all of those really have a form of an important backdrop for sustainable investment. And what kind of pensions are you spending the most time navigating them between the sustainable investment angle and other angles that will be crucial for the asset owners who talked about also for the respective governments in the countries where they're located? That's a really great question and it's really, it's something that we're very focused on. One of the things that I would highlight is the shape of the transition is really in what's happening in different countries or different regions is really underpinned by the economic underpinnings of each region or country. So let me give you the US context and this is probably one of the most eye opening slides that I use with asset owners and sometimes with policymakers to be honest and sometimes with companies. It really brings things to life. The slide it has two graphs on it and the first graph shows the US in terms of exports and the percentage of total exports that are oil and gas from the US over time. And that line is very low and then it hockey sticks up it it pivots upwards. So the US was energy dependent and became energy independent and in fact an exporter net exporter of energy over the last 15 years. And the second graph on that same slide is the flip side of that which is an import graph and it shows how much of total imports are related to green energy imports from other places so things like batteries and solar panels and the graphs look very similar. So they're very low for a long period of time and they hockey stick upwards. And so that's the economic context in which the US is operating. The US is fundamentally selling oil and gas and importing or buying green energy inputs. And that forms the economic context for policy decisions and tensions if you will as you were highlighting it because it's the country is fundamentally disincentivized from transition and quickly. And in different administrations have different have had different attempts to address that. The prior administration was focused on making things here so making those green energy inputs here and providing incentives to do that through the inflation reduction act primarily. The current administration is more focused on you know the tagline drill baby drill keeping the export line high but a lot of the decisions around geopolitics and self reliance also work towards bringing the import line down more build things domestically or friend shoring or reshoring and things like that. So you have to focus on where the intersection is between sustainable investment and climate interest if you will and those that are of interest to the administration or the country's economic backdrop and there is intersection there and it's not zero. I think people tend to focus on the areas where there isn't intersection. We like to focus on the areas where there are so one more example about how that works. I highlighted the theme of AI dominance and that many countries are pursuing AI dominance and certainly the US has administration has interest there too. What that is done is it's pulled forward the need for more power and for quicker time to power. So it's actually pulled forward investment in solar it's pulled forward investment in nuclear it's pulled forward investment or interest in advance geothermal and those are all technologies that could help manage the energy transition and bring down emissions as well. So it's looking for those areas of common interest even if they're for different reasons. How SI intersects with the other three major themes that I was just talking about and not thinking about SI and avoid or vacuum. Definitely and I think some really good example set of trade-offs but also as effectively how to manage them and finding these intersections as you put it. That brings me to another topic. You say you spend a lot of time talking to asset owners globally. So I wanted to pick up on what you're hearing from them on stewardship where it feels like there's certainly some tension as well between asset owners and managers and it's being perhaps played out a bit more publicly than never before and yeah managers really are being pulled in different directions on climate and sustainability and we've seen this outside of the US as well. Here in the UK for example, a recent investment association report talked about what it called unrealistic expectations on managers around stewardship with individual companies. So how are you guys managing that in practice and suppose other areas where you've had to be very clear with your clients or prospective clients and say this is as far as we can go on this. I think about all of this. Sometimes I don't think about them as tensions as much as I think about them as an evolution, almost a natural evolution of the industry. New industries go through different phases and certainly we went through a rapid growth phase in sustainable investment where people just wanted to do things quickly and as things mature, I think asset owners and asset managers are really investing in understanding the nuance behind sustainable investment and the interactions between different themes. So the tensions that you're referring to in shareholder interests and stewardship really are part of that natural evolution. So asset owners have an interest in understanding the sustainable investment practices of their managers. They have lots of managers. So there's an interest in trying to have things that are comparable and common that they can evaluate. And so there's an interest in looking at things that are somewhat numerical and maybe less nuanced. So how many proposals did you vote for or against a management on and things like that? And then looking at managers on that basis or how many people do you have in your stewardship practice or how many engagements did you do? So it's real quantification versus digging into the underlying kind of nuance of what all that means and how it works. But what I've seen and I think it's a great development is asset owners and some of the most sophisticated asset owners trying to get behind those numbers and those metrics and really understand the outcomes that are associated with the work. And I highlighted this I believe to you before, Elsa. One of the newer practices from some sophisticated asset owners is they will send you several key votes, a 10, 12 that are aligned with their interest and that they're interested in diving into and they'll ask you to, you know, share back with them, all of their managers share back with them, how they voted on these things. And then they'll sometimes they'll ask for a little bit of a description about why or sometimes they'll arrange a call to discuss with the managers, you know, if there's a difference in expectation of how they thought you would have voted and how you voted why that is in a real curiosity around that. And that's where we've had the best dialogues with our asset owners, even in cases where we may be voted differently than they would have thought we can then explain to them, well, in this instance, you know, we had voted this way last year and we're voting this way this year. And this is why we changed our vote. And here's the dialogue that we've had with the company or we'll say actually we think it's very important to prioritize issues with companies. And so we prioritize another issue over this one in this instance because we need them to continue to make progress on it. And it really allows them the asset owner to understand the asset manager or stewardship practice and how it intersects with their investment practice, but it also allows the asset manager to understand and what the concerns of the asset owner are. And I think that's the healthiest way it takes more time. It's certainly more nuanced, but it also is less tick boxy. And I think asset owners don't want their practice to be tick boxy and they don't want their asset managers practice to be tick boxy. So sometimes taking that extra step and doing that extra investment is very productive in terms of achieving the outcomes that you're interested in. - Yeah, and like you say, obviously, that that sound like time consuming, but I guess then at least this is aligned with the fact that both on manager and asset owner sides, I'm hearing more and more the need for focused engagements, picking specific themes, topics, industries, rather than spreading yourself too thin. So I guess maybe the time that would have been spent on what you call potentially more boxy activity can be spent on these real in-depth dialogues to help both parties then, as opposed moving forward. - I think the other area where this comes up is the idea of systemic engagement or management of systemic risks. And we're very clear with asset owners how we think about that, that there are limits to what you can achieve with individual companies on systemic risks. Certainly, you can engage with companies on systemic risk when it's material to that company. And that, so there can be, I use the word intersectional at there can be an intersection of company focused engagements and also systemic risk management. But beyond that, we bring into the discussion our engagement with sovereigns and the work that we do there because they're you're going directly to a country and the leadership of the country or the Ministry of Finance or things like that. And having direct dialogue on how they could manage these risks better, which provides more of a enabling environment in total. And then the third way that we think about systemic risks management is engagement with different types of either policy makers or other types of stakeholders that again help to improve the enabling environment. So for example, the ISSB has been having consultations in various countries about adoption of S1 and S2. We tend to participate in those consultations. We tend to advocate for different geographies to adopt ISSB so that investors and companies have a common global baseline from which they're operating. It's so interesting on systemic risk. I feel like this is a very kind of live debate and a hot topic at the moment. Are there any particular systemic risk topics where you think engaging with individual companies rarely makes any sense and it's all about going to the policy makers or other kind of decision makers to drive the topic forward? - No, I think what I would say instead is that not all systemic risk issues manage all companies. In fact, our ESG research analysts are embedded in our sector teams. So we have within our sector teams a global industry analyst who follows equity fundamentals, a fixed income, credit analyst who follows fixed income fundamentals, and an ESG research analyst who follows ESG fundamentals all within the same sector. And they come up with that materiality framework together and they also meet with companies together and they also do initiations together. And each of them have ratings on companies independently because we like to think that we would like to understand how the ESG factors affect the equity in the fixed income and sometimes that's different from one another. You might have different impacts. So instead of saying that a systemic risk issue is uniformly not applicable to all companies, I would say systemic risk issues are not applicable and evenly to all companies and they may be applicable to some and not to others. - So staying with AcidoneStem, you mentioned some of these big macro themes in your intro. Can you talk to me a little bit about how clients across the world are talking about this water interested in and perhaps how that links to your sustainable investment research and your actual investment approach? - Sure. So just a reminder of the themes really quickly, it's this idea of national security and economic competitiveness is one. And if there's somewhat together AI and the race for dominance there and then the third being affordability. When I think about national security and economic competitiveness, when you say security, it certainly does mean security in the traditional sense where you see programs like ReArm, EU and things like that. So the defense stocks and there's been a big conversation in sustainable investment about defense names and that it's underpinned investment themes in that area. But also in the sense of self-reliance and what you're going to build within your own country and what strategic sectors you're going to name and invest in. And certainly that's formed the backdrop of some of our investment research. I highlighted earlier this idea of AI dominance and nuclear and AI dominance and advanced geothermal and really in some ways we see that theme pulling investments in renewable energy forward. And we see there's all of these graphs that we have where you see a pick up in investment or pick up in production in 2023, which is really when this AI theme and focus on AI really started to take off. And so all of that gives us some conviction that we're getting more investment more quickly than we otherwise would have in renewable technologies and it's accelerated. So there is a positive to that. There's a negative to it too in that we need more power in general and there's not a lot of, because people are moving so quickly, there's not a lot of guardrails. On this investment yet, but there is a real positive that those technologies are probably going to come to fruition and be more competitive earlier than they would have otherwise. And some people ask about the US administrations focus on fossil fuels. And certainly they are interested in fossil fuels, but it would be wrong to, in my view, to mistake this and interpret it as a foreshadowing of a broad or permanent societal shift away from our back towards hydrocarbons. So the underlying trend is less about this pro fossil fuel concern, but it's more about being pro affordability and pro reliability and pro power and more and quicker time to power. So thinking about what's really driving that versus the maybe most obvious and outward theme is helpful. And we Steve voters and policymakers alike increasingly focused on energy systems that deliver stable low cost power, particularly in times of this economic and geopolitical volatility. So again, the themes, I think importantly considering these major themes alongside SI and SI alongside these major themes drives you to areas of interesting investment research. Obviously, transition investing is a huge part of this, but it still seems like transition, fine as transition investing. It's quite challenging for many investors and even starting with how to actually define it. So when you are assessing transition related investments and opportunities, what are the key questions you're asking to determine whether it's credible and investable? - Well, it's a good question. I sit in Boston, that's my home office, even though I do travel a fair amount. And on my floor, the sustainable investment team sits alongside the energy and utilities team and the commodities team. So we have great dialogues on all of these topics. And last week I was talking to our renewables analyst and having a similar discussion about the framework for investing in transition assets and what we should be considering. And I think that the framework is more about looking for technologies that address multiple facets of the energy transition. So not only technologies that address or reduce emissions, but also those that solve a problem. And I've referred to some of these already, so solar and batteries and geothermal, they solve an urgent need, we need to generate electricity while also reducing emissions. And then other technologies and carbon capture, I believe maybe one of them, it primarily lowers emissions, but it's not solving a problem in addition to that. And so it doesn't in this volatile political world that we're in, those technologies that can't stand on their own, they're gonna struggle to hit commercialization objectives. And so thinking through that and asking ourselves, what is the core value proposition and does this technology, you know, quote, make sense ex-government support? What is the relative valuation of the energy transition technology versus the incumbent technology? So while we may think that transition technologies should deserve a premium, and I think over time they do, at the end of the day, valuation doesn't really stand alone in a vacuum. People are going to make choices, between existing technologies and the transition assets. And you have to understand the pricing differentials and if they're gonna be economically competitive. But the nice thing in today's market is you can often buy transition assets at a discount to the traditional assets. So you have this long-term theme and you have valuation in your favor. - Okay, and moving then on from the need to transition to the need to address physical risk and adaptation, I know that physical risk is a big one for Wellington and I think it's fair to say one of the biggest themes for responsible investors over all this year. So can you talk to me a bit about how that's reflected in your investment thinking today and how you got there? - I'll go back in history just a little bit back in 2018. One of the things that we observed is that there was a lot of research going on, rightly so, on the transition side of things. And certainly there's a lot of international agencies that do for us. forecast about the transition and they do work on sectoral decarbonization, et cetera. But there wasn't a lot of discussion around physical climate risks. And in fact, at that time, there was almost a consideration that physical climate risk were too far away to matter and that they didn't happen in an investable timeframe. And we just said real curiosity about whether or not that was true. And we decided to explore it. And we work with a climate science research partner and we formed that partnership in late 2018. Their name is Woodwell Climate Research Center. And we asked them about heat, drought, wildfire, hurricanes, floods, access to water, sea level rise, and where it was going to happen and over what time frame. And then we layer onto their scientific assessment, capital markets information and try to understand which securities will be impacted by those insights. And that's been an incredibly productive relationship for us over time. And I think incredibly productive for them too, because they understand now more about capital markets and we understand more about climate research. So beneficial in both directions. And one of the things that we learned immediately was that physical climate risk, which I think now is more obvious, isn't too far away to matter and that it is impacting securities in an investable timeframe. But it doesn't impact all securities evenly and not all securities will be impacted. So really understanding if a company or its assets have a value in a location is key to understanding whether these climate risks will be impactful. And we invested in creating an in-house tool that we call climate exposure risk application. We refer to it as Sarah so that investors can on their desktop bring up an investment and look at it through this lens. So you see which climate risks are present in the location of the investment. And then you also see the capital markets information about that investment. One of the easiest use cases to visualize is for our municipal bond team. Municipal bonds are financing a project in a location. So there's inherently locational value in the security and they'll pull up two different issues at the same time and look at their capital markets information. So the yield, the credit quality, the maturity, etc. alongside the climate information and they will find securities that are priced the same that have very different climate impacts. And so of course they want to buy this security for the same price that has a lesser climate impact than the one for the same price that has more. And we've evolved since then even to focus on shorter term monitors. So last year our climate research team in coordination with our commodity team and with Woodwell created a drought monitor that really gives you more of a year over year prediction, even season over season about where we will experience drought. And to what extent are where conditions may be more wet or more dry. And then they find a direct relationship with commodity pricing which then can help inform your decisions on commodities, but also on companies where commodities are an input or an output, also on countries or sovereign issues where they're reliant on hydropower. You know, what will that look like and what kind of hurdles will the country face. So there's a lot of fruitful research to be done and continue to be done in physical climate risk. And that's been an area that we've pursued over that time frame. Do you take some of the research outcomes that you're getting to companies for engagement purposes as well and say you can look with identified that they were at risk of XYZ and how is engagement on physical risk going? I'm so glad you asked that because I kind of left that out of my my answer. So Sarah the tool itself, we also have physical climate risk ratings that come out of it. But those ratings only tell you what the data shows. I'm so they'll say this location is going to be impacted in this way. And this company seems to be exposed to it. It doesn't tell you whether the company has built any resilience measures in to address that concern. So that is something that we do. We bring the tool actually creates maps and sometimes we bring those maps to companies and we'll ask them questions about this physical location or that physical location. And then the best management teams will have considered it already and they'll say, oh, yes, we're aware and here's how we're addressing it or here's how we're trying to mitigate this risk or diversify this risk. And then some management teams really haven't considered the risk that we've identified and that not only gives you information about that specific risk, but also about the quality of the management team. If they haven't considered the specific risk, what else are they missing? So it is part of our engagement process. And on the positive side of things, sometimes we'll identify companies that we think have an opportunity for expansion or places where they could sell their product based on increased need based on what we observe about changing climate risks and we'll introduce that to the company as well that not all companies that we see is climate solutions companies see themselves that way. And if some of them do some of them don't, but if we're able to identify areas where they may be able to expand their sales because of this other theme that they hadn't quite considered that can be potentially beneficial as well. I think it really sounds like you've been focused on this for much longer than a lot of investors actually. So we'd be interesting to hear about some of the specific outcomes on your portfolio. Have you have you divested because of physical risks, for example? Sure. So we actually, when we're thinking about divestment, we use the term cell discipline because we feel like it is more investment related. Sometimes divestment has a connotation of being very rules based where cell discipline is clearly part of your investment process. And to the extent that our various investment teams are integrating climate risks and using this tool to help them make assessments about securities. We want to really emphasize that if they're selling a security, it's because they don't think it has value because of their cell discipline. I have an example from an industrial company that we were analyzing and we discovered that they'd built a significant manufacturing plant in a flood zone. And we brought this to your question earlier about engagement. We brought this question to them about this new plant and being in a flood zone and asked them about any resilience measures or how they had thought about that and became increasingly clear to us that they hadn't thought about it. And layer onto that concerns about the management team. In general, if they had a genus and a gym before, if they haven't considered this, what else haven't they considered? We decided to sell that security based on that interaction. But it really was part of the investment process. And there are other areas where we've decided to increase our position because the company was interested in expanding their sales into a region that we'd identified. And one or two cases we've actually seen in their annual report references to the work that we've done through our climate exposure risk application. And it doesn't refer to Wellington by name, but it talks about an asset manager highlighting to them through their climate analysis, the opportunity for growth in this region and they've expanded into this region. So it can work in both ways. That's great. Yeah, it would be really interesting to catch up again after your A-trip because there I feel like both the transition and the physical risk is it's so prominent there and it would be really, yeah, I'm sure you'll get a lot of interesting insights and inputs there, both from investors and holdings. Yeah, I would say Australian asset owners, when we started talking about physical climate risk, they were early adopters of this in terms of thinking about it and trying to integrate it into their investments for obvious reasons. I think they've seen it. They've seen it up close. But one thing I would say on the asset owner side that we haven't fully seen is the last couple of cops, there's been more focus on adaptation and certainly asset owners are talking more about adaptation, but there's still a bit of a disconnect in terms of how adaptation investments can be implemented in investment policy. So asset owners have frameworks for thinking about how to invest in the transition and some of them have transition goals or transition policies, but they haven't quite figured out particularly on the public market side, how to have an intentional investment in adaptation. So that's an area probably where we could do more work. Almost a call to action there. So what do you think they could start and if they're starting from scratch and with limited resources? Well, we've seen one or two. I think where the tension is there is when you think about climate investing, most asset owners or most people think about investing in technologies that are going to bring emissions down and then they're tracking their emissions over time and they have goals for their emissions over time or they have goals for transition alignment over time, things like that. And adaptation investments don't always help that you may be investing in a solution that doesn't bring your emissions down. It may be more efficient than other solutions in the same space, but it's helping consumers or economies or society really thrive or survive in a changed climate, equally important. So you may need to carve that out of your if you have a net zero goal, for example, net zero by 2050 and you're on a decarbonization pathway. There's this tension if I invest in these adaptation securities, which I know are needed and could be productive both societally and from an investment standpoint, but it's going to bring me back to an earlier point online. by decarbonization pathway, do I want to do that or not? I think you probably have to carve that out and have an intentional allocation there in your investment policy and recognize that. And again, it's this idea of all of this nuance in SI where the early frameworks didn't accommodate for it as much people were just trying to get going and get things done. And now when you're seeing that we need to work on both transition and mitigation and physical risks and adaptation, you probably need to have allocations outside of your decarbonization pathway that accommodate for that. Yeah, that's like a heightened version almost of what people are saying about transition investments where you might have to see emissions go up in the short term to go down in the long term. And this isn't even more striking and potentially complex version of that. And that's really interesting. Thank you so much for your insights today, Wendy. It's been really interesting talking to you. And I think that that's a good note to end on and for for us to follow up on it at RRI as well. Thank you very much. Well, thank you, Elzad. It's always a pleasure to talk to you. Thank you also to our listeners. I hope you enjoyed this episode and don't forget that you can listen to our hold back catalog of episodes on your platform of choice. Thanks so much and we'll be back again soon.