The Need For Science-Based, System-Level Engagement And Stewardship

What do climate change, deforestation, biodiversity loss, ecosystem degradation, population growth, eating habits, and communicable diseases have in common? They are all related to each other and our interconnected global world is accelerating and magnifying the negative feedback loops between them. There is strong scientific evidence behind this claim but I didn’t learn this from reading a scientific journal. I learned about it in a recent report, “Pandemic: The inextricable link between human, animal and ecosystem health and the emergence of communicable disease” by Anita D. McBain, Head of Responsible Investment and ESG at M&G Investments, a London-based active asset manager with $364 billion in assets under management as of December 31, 2019.

This is an unusual report to be written by an asset manager. When asked what motivated her to do this research, McBain explained: “Long term active asset managers like M&G need to be aware of all risks that may affect our customers’ investments – both financial and non-financial. The current pandemic has brought into sharp focus the unintended consequences of unsustainable behaviours and serves as a stark reminder that everything comes from somewhere.”

I believe this report has two important implications. The first is for how asset managers engage with portfolio companies. The second is for how asset owners exercise their stewardship responsibilities with external asset managers. I will elaborate on these points after summarizing this report. But first a bit of grim history.

The first of the 10 greatest epidemics in history (a pandemic is an epidemic gone global) was the Plague of Justinian in 541-542. It killed an estimated 100 million people, about one-third of the world’s population. It was followed 800 years later by the Black Death of 1346-1350 which killed 50 million people, about 10 percent of the world’s population. Five hundred years later came the Modern Plague of 1894-1903 which killed 10 million people (six percent). Since then, there have been seven more, all of which killed 10 million people or less except for HIV/AIDs at 39 million over the period 1960 to the present. As of May 15 , COVID-19 has killed some 300,000 people globally.

The good news is that pandemics are killing less people in absolute terms and especially in relative terms. The bad news is that they have become more frequent. And this is likely to increase if the proper measures aren’t taken such as eliminating wild animal trade, studying as many viruses as possible, developing vaccines, putting in place government programs for fast funding when a new pandemic occurs, and having the business community better prepared to deal with a pandemic.

McBain’s report provides an incisive analysis of the complex set of factors, shown in the figure below, that contribute to the increasing number and spread of communicable diseases, some of which will become pandemics if not properly managed. One type of communicable disease is zoonotic diseases or zoonoses. These are the result of viruses that reside in animals without harming them that get passed along to humans, sometimes through an “amplifier” animal, where the results can be deadly.  

Animals displaced due to deforestation shed viruses in the stress of moving, often to locations near humans. One of the causes of deforestation is population growth and the need to meet a 56 percent “calorie gap” between now and 2050 as the world’s population grows from 7.8 billion to 9.8 billion. More of these calories are now being supplied by meat; over the past 50 years the population has doubled while meat consumption has trebled. This is unsustainable from an environmental point of view. As shown in the diagram below animal-based proteins are enormously resource intensive compared to plant-based ones, especially in terms of rainwater and GHG emissions from land use change and agriculture production, with beef being the biggest offender by far. In 2017, agriculture represented 20 percent of CO2e, 11 percent coming from crops and livestock and nine percent from related land use.

Climate change is a major contributor to biodiversity loss and the degradation of our ecosystems which, in turn, exacerbate the spread of communicable diseases. To illustrate these interaction effects, McBain gives the example of the 1998-99 Nipah virus in Malaysia which resulted in acute encephalitis:

“Deforestation in Malaysia, for oil palm conversion, had resulted in habitat loss and fragmented ecosystems. Native fruit bats, forced out of their natural habitat and facing ecosystem degradation, foraged further afield for food. The fruit bats, the reservoir hosts, identified fruit trees in close proximity to pig farms and through natural processes (defecation, urine and saliva) contaminated the underlying land where pigs rummaged for food.

The pigs, who developed a distinctive bark-like cough, became amplifier hosts. They eventually passed the virus on to farmers and abattoir workers, abundant human hosts, resulting in further transmission and eventual outbreak.”

Interesting science but what does it mean for an investor? McBain is clear on this point. Her argument is that companies who do not understand these interconnections will be poorly prepared to handle the next pandemic. We already have plenty of evidence that most companies were ill-prepared to deal with COVID-19. It’s also pretty clear that many of them are putting shareholders first to the detriment of their employees, suppliers, customers, and the communities in which they operate. McBain believes that companies which understand these interconnected, system-level effects will be better able to “to demonstrate innovation, resilience, technological advancement, adaptation and mitigation” and to conduct “scenario analysis and modelling of catastrophic risks, such as pandemics, supply chain failure or cyber-attacks.” She also calls on boards to show strong leadership, oversight, and ownership of risks and opportunities. When asked how many companies meet these criteria of hers, McBain replied, “We are starting to see encouraging disclosure from a number of companies that address issues like supply chain management and labour practices which are material to every company when universally calamitous events like COVID-19 occur. Companies that have invested in employee health and well-being and can evidence supply chain transparency and traceability demonstrate more resilience and better positioning to innovate and adapt to future risks.”

I can already hear the typical company response to McBain’s recommendations: “Yes, easy for you to say but when are you going to quit harassing us about next quarter’s earnings?” Fair enough. Investors need to be able to make a credible case to companies that they have a long-term view in their investments. The ultimate test of this is how long the investor holds the stock. Being comfortable doing so, however, means that the investor needs to be confident that the company meets McBain’s above criteria.

Which brings me to the point of how asset managers engage with companies. While there is a clear trend towards greater engagement based on a more sophisticated understanding of sustainability issues, for the most part these are conversations based on a single topic. In order for investors—both the engagement teams and portfolio managers—to assess how well-positioned companies are to manage interconnected issues, with the ones in McBain’s study just being one example, they need to build their own capabilities here as well. This will require going beyond the economic analyses they are comfortable with and understanding science-based issues that underly the challenges and opportunities facing their portfolio companies.

Which, in turn, raises my second point. In order for asset managers to take a long-term approach and build these capabilities for more effective engagement, they need at least the permission and, even better, the support of their asset owner clients. One of the reasons companies face short-term pressures from asset managers is that the latter are under short-term pressures themselves from their asset-owner clients. A welcome development here is an initiative by asset owners to call on and enable asset managers to take a long-term view which I described in a previous post: “Asset Managers Get Their Own Letter: One From Chris Ailman, Hiro Mizuno, And Simon Pilcher.”

It then follows that asset owners need to evaluate their asset managers in terms of how their portfolios are contributing to system-level goals.  Welcomed here is a recent report by The Investment Integration Project (TIIP), “Asset Owners Can And Should Evaluate Their Manager’s Performance Towards Systemic Goals’” which contains six recommendations for how to do so. Here too capability-building is required, this time on the part of asset owners.

The logic is straightforward. Asset owners need to understand the system-level implications of science-based interconnectedness so they can evaluate their asset managers on this basis who, in turn, can evaluate their portfolio companies and help them improve their own capabilities on this score. The question for me, and one for which I have no answer, is how to do this? What is the theory of change for how the necessary shift in mindset and capability building in asset owners, asset managers, and companies can happen at the speed and scale necessary to make a difference for sustainable development? Perhaps a worthy subject of a future report by McBain.

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