Chapter 02

Sustainable
Growth, ESG
& State-Owned
Enterprises by Archie Hart,
Malcolm Gray &
Therese Niklasson

Growth is often seen as the cornerstone of generating returns over the long term. Investec Asset Management’s Archie Hart, Therese Niklasson and Malcolm Gray believe that there is a link between returns, quality and resilience and examine how these factors can be used within state owned enterprises.

Much of our work at Investec Asset Management is premised on two basic concepts: preservation and growth – the preservation of our clients’ capital and the growth of that wealth, in an effort to retain its real purchasing power and possibly improve it. We undertake this responsibility knowing that the future we are working toward is inherently uncertain. As such, we base our value proposition as a business, on the commitment that we will act as responsible “stewards” of our clients’ capital and use our skill to grow it. In order to preserve and grow the capital through our allocation decisions, we need to demonstrate two key characteristics: a strong sense of ethics, in terms of fulfilling this duty, and an exercise of suitable skill.

It is at the crossroads of the “ethics” of our actions and the “skills” that we deploy in guiding our clients’ capital into the future, that we encounter ESG. Here we are required to think through the environmental and social (the “E” and the “S”) implications of our investment actions and, in so doing, reflect on the governance (the “G”) principles and structures that are in place around our investments, in order to ensure that we meet our primary obligation. It is within this exercise of our core functions that “E”, “S” and “G” have become important components of our business over the past number of years.

In taking an ESG lens to an investment situation, a number of questions and challenges can be raised. It is also important to consider insights based on whether it is at the macro level (country) or a micro level (company). Importantly, we recognise that these can often be related. The ESG lens helps us identify risks and opportunities which may not be apparent through a traditional macroeconomic or company financial analysis lens.

We have experienced the benefits of this approach from both the reputational and capital risk perspective.

“It is at the crossroads of the ‘ethics’ of our actions and the ‘skills’ that we deploy in guiding our clients’ capital into the future, that we encounter ESG.”

Skills Ethics
And

ESG and growth

Before discussing why an ESG framework is needed for emerging market investors, it is important to address one topic at the heart of the matter: growth.

The concept of growth – in GDP, employment, disposable income, revenue, earnings and so on – is a key factor in assisting us to determine whether something has value or worth. However, the concept of growth presupposes that growth is an inevitable outcome and for that matter a desired one. This paradigm may have some inherent flaws, growth in a finite system cannot be infinite. These “limits to growth” have been well explored and articulated by various philosophers, academics and policymakers over the past 30 to 40 years1; however, they have recently been brought into sharper focus, with the impact of the global financial crisis (GFC) in 2008 and the pressure from issues such as climate and greenhouse gas emissions. Growth, with the incorrect motivation, may similarly prove to be unsustainable and sow the seeds of its own demise. Hence, the ESG lens we use is increasingly important in bringing sharper focus to the sustainability of growth, or rather the concept of “sustainable growth”.

“Much of the focus on efficiency, and short-term profitability, has resulted in a narrow focus, losing sight of key aspects that are core to long-term relevance, purpose and sustainability.”

The ESG framework is particularly important in emerging markets as we analyse state owned enterprises (SOEs), their role within the broader economies and their functioning as corporate entities.

There are numerous important examples to explore regarding the quality and sustainability of growth in emerging markets. There is a limited number of companies that embody perpetual growth (survive)2. Increasingly, and particularly since the 2008 GFC, focus on corporate “growth”, the sustainability of the corporation and the legitimacy of the system that promotes it – capitalism, has moved into sharp focus.

Michael Porter and Mark Kramer in their book Creating Shared Valued3 have provided the beginnings of a framework for reimagining the commercial corporate. They articulate well the crisis of legitimacy that corporates are increasingly facing. Importantly, they capture the real issue – namely the narrow, short-term focus on profit at the expense of deeper social impacts and longer-term more resilient, socially relevant businesses, sustainable ones.

Core to their argument is a provocative challenge to Milton Friedman’s view of corporate social responsibility.4 They argue that today’s corporate social responsibility activities are simply a focus on legitimising a business or managing reputation, seldom connected to the core focus of a business. More specifically, business should be focused on corporate shared value, which, at its heart, recognises that societal needs, not economic needs, define markets, and that social harms and weakness may well create long-term internal costs or inefficiencies for the business.

In many ways this “shared value” paradigm similarly aligns well with the ESG lens that we continue to develop within our business. As such, creation of economic value, by creating societal value, is well framed in focusing on three key areas, namely: reconceiving products and markets, redefining productivity in the value chain and building supportive industry clusters at the company’s location. In this way, the opportunity is to grow the total pot, not reallocate the existing one. Linking this back to the sustainable growth argument, such an approach again provides an additional valuable lens for trying to understand how and who can grow in the world we are moving towards.

We think that using an ESG lens could help in identifying these issues and determine the sustainability of growth. It could be argued that social insight of a demographic dividend is still a tailwind, with the impact of price equalisation equally supportive of sustainable growth. However, debt and environmental challenges, combined with rising inequality, appear increasingly relevant headwinds to many of the emerging markets we assess. rising inequality, appear increasingly relevant headwinds to many of the emerging markets we assess.

“Business should be focused on corporate shared value, which, at its heart, recognises that societal needs, not economic needs, define markets.”

There is no better place to start than with emerging market investments which reflect a large component of state control, social impact, environmental proximity and potential value – the state owned largest emerging market oil and gas giants such as Gazprom, PetroChina, Petroleo Brasileiro (Petrobras) and China Petroleum and Chemical Corporation (Sinopec). State-owned companies have evolved over the last several decades, with some of the largest examples fulfilling the roles that private corporations would fill in developed markets.

In each of the examples listed above, the growth has been staggeringly large – these companies have invested around US$590 billion in just four years between 2009 and 2012.

As such, it might be thought that this must have generated significant economic growth in these economies. Unfortunately, it appears this growth is unsustainable in several different ways.

Financial
sustainability – headwind?

“The market has effectively discounted every US dollar invested by Gazprom by 70% and Petrobras by 40%.”

Financially, unsustainability is a key vulnerability. In aggregate, these companies were forced into the capital markets to finance their growth – given that their investments outweighed the operating cashflows from their businesses. Rising debt levels are clearly bearable, in the short term, for most of these companies, but in the longer term they will likely prove to be an unsustainable headwind.

This shortfall in operating cashflows also partly relates to government decisions to sell gas or oil products at discounts to the international market prices, therefore reducing the operating cashflows required to fund these capital expenditures. This is done due to a politically motivated desire to help the populations of their countries (alternatively known as voters) to make ends meet.

It could be argued that this is a fair alignment with a shared value concept. However, the biggest beneficiaries of this politically inspired largesse have often proved to be those with the biggest cars and biggest houses, certainly not the poor. Hence, these are more akin to payments, than ubiquitous shared value. In fact if the real desire was to assist the poor, then targeted income support from the government, redistribution of taxes and profit sharing from financially sustainable businesses would have been the most efficient and effective way of achieving this.

As a result of misguided actions, these companies are generating financial returns below any conceivable estimate of their cost-of-capital (historical return on assets respectively of 9.9%, 5.5%, 3.3% and 5%). Hence, it is unsurprising that the market has effectively discounted every US dollar invested by Gazprom by 70% and Petrobras by 40% (as measured by the discounts of their share prices-to-book values), sending these companies a clear message on their financial sustainability, or lack thereof.

Dollar Bill

Shared or snared value?

Many of the companies in question are perceived to be associated with a challenging and often questionable governance framework, a view shared by organisations such as Transparency International. The issues are mainly related to a lack of transparency, especially around financial reporting (accounting), controls and safeguards. Our experience is that strategies and forecasts are often based on information which is classified, leaving analysts guessing and judging trustworthiness. It is the view of most shareholders that rents are being extracted which is effectively theft. Why? To paraphrase the prolific American bank robber William ‘Willie’ Sutton: “Because that’s where the money is!”

The plunder of state-owned companies is a sad legacy and dark side of market system evolution and, in many ways, a drag on

sustainable growth. Poor governance systems are often to blame for this perpetuated abuse, as it ripples through an organisation and affects many areas. A good example is that of resulting poor safety practices. In the ex-Communist countries, where there is a tradition of secrecy, media control and weak forums for free speech, this has been a particular challenge. Between 2010 and 2011, no less than 40 Gazprom employees and contractors died5. Additionally, a Sinopec pipeline exploded in November 2013 in Qingdao, killing 62 people. Clearly, weak governance and misplaced priorities can result in the worst possible outcome – human fatalities.

Effective corporate governance is undisputedly an important factor behind well-managed countries and companies, often result in lower risk and lower cost of capital.6 The graph illustrates the negative newsflow on a range of governance indicators (corruption, bribery, money laundering and extortion,compensation, misleading communication, fraud, tax evasion and anti-competitive practices) for two key market cohorts going back to 2010.

Here we have compared developed market and developing market (MSCI Developed Markets and the other IAM Horizon Markets universe7) governance new frequency per 100 companies.8 Such data will become increasingly important in helping managers better identify key headwinds or ESG risks to governance and company growth. Interestingly, the chart indicates a higher number of negative governance newsflow for developed markets, as well as a slight increase in newsflow in developing markets. We believe that this is a symptom of increased focus on transparency around these issues as they are increasingly treated as material for businesses and growth.9

Events

Environmental headwinds
– risk and opportunity

In emerging markets, the macro-environmental headwinds are increasingly presenting a “growth constraint”, while the impacts are eroding the opportunity of shared value. Even though these companies are often drilling in sensitive environments, low pricing of energy encourages and incentivises greater use of carbon-based energy, to the detriment of both local communities and the world at large. Even if just 10% to 20% of the monies invested by these oil and gas companies was directed into renewable energy it could have a meaningful local impact in driving an energy mix change and also have a global impact. It is encouraging that China (in particular) has recently realised that its current policies on economic growth and energy use are unsustainable, and has taken a meaningful leadership role in driving the adoption of renewable energy.

One of the key issues around improving the sustainability and quality of the growth of emerging market economies is how to reform

state-owned enterprises (a significant part of the investable universe in countries such as China, India and Russia, in sectors such as oil and gas, mining and banking). Many of the issues that plague emerging markets (huge misappropriated resource rents, dysfunctional banking and financial systems) can be laid at the door of these state-owned companies. Significant, thorough and rigorous reforms of these companies would do much to improve the quality of economic growth in many emerging market countries.

Although progress, in some sense, has been slow, there are encouraging signs. The Third Plenum in China elevated the market to play a decisive (previously a basic) role in allocating resources. More recently, the Reserve Bank of India’s new governor, Raghuram Rajan, has pledged to reform India’s dysfunctional financial system. The green shoots of reform are there, but they need to be carefully nurtured.

“Even if just 10% to 20% of the monies invested by these oil and gas companies was directed into renewable energy it could have a meaningful local impact in driving an energy mix change and also have a global impact.”

Gas Flame
Values

Value at the intersection of ethics
and skills – ESG identifies sustainable growth

“Most importantly, thorough reform and evolved systems of value creation could continue to lift millions out of poverty and give their children and their children’s children an immeasurably better quality of life.”

Meeting the wealth preservation and growth objectives of our clients is, by its nature, a challenging endeavour. Our evolving ESG lens can play an important role in realising value for our client – and recognising headwinds, from a macroeconomic perspective, is as important as understanding how value can be developed, shared and sustained. Getting it right can have material benefits. For example, if Gazprom was managed half as well as Exxon its share price could increase tenfold10, not even taking into account the social and shared valued that would be accrued.

The pay-offs to action are huge for investors and communities alike. Most importantly, thorough reform and evolved systems of

value creation could continue to lift millions out of poverty and give their children and their children’s children an immeasurably better quality of life. We believe getting this right will provide sustainable wealth creation for our clients.

It is clear that the investment landscape is changing and that the concept of “growth” needs to be considered within a sustainable framework. Hence the ESG lens we use helps us identify risks and opportunities, which may not be apparent by simply looking through a traditional macroeconomic or financial analysis lens – thereby placing an increasingly important role in bringing sharper focus to the sustainability of growth.

Archie Hart, Malcolm Gray and Therese Niklasson are part of the investment team at Investec Asset Management. Therese is Head of ESG Research, Malcolm is a portfolio manager for South African equities and Archie is a portfolio manager for Emerging Market equities, within Investec’s 4Factor team.

1 Reference to Rachel Carstens, Brundtland report, RIO, Millennium Ecosystem Assessment (MEA) COP process etc.

2 Well documented in the Good to Great and Built to Last book authored by Jim Collins et al.

3 IMichael E. Porter and Mark R. Kramer – Creating Shared Value – How to reinvent Capitalism and unleash a wave of innovationand growth, Harvard Business Review, Jan/Feb 2011.

4 Milton Friedman famously argued that Corporate Social Responsibility was a “fundamentally subversive doctrine” in a free society and that “there is only one social responsibility of a business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the games..”. See further, The New York Times Magazine, 13 September 1970.

5 Source MSCI.

6 (Byun et al, 2008). Byun, Kwak and Hwang (2008) “The implied cost of capital of equity capital and corporate governance practices”. Asia-Pacific Journal of Financial Studies v37 pp139-184.

7 The Investec Asset Management Horizon Markets Universe is made up of All MSCI EM less the BRIC countries, Taiwan, Korea and South Africa. Add MSCI Frontier Markets and non-indexed countries.

8 The Investec Asset Management Horizon Markets Universe is made up of All MSCI EM less the BRIC countries, Taiwan, Korea and South Africa. Add MSCI Frontier Markets and non-indexed countries.

9 Source RepRisk ESG Business Intelligence, Investec Asset Management.

10 Currently a barrel of oil and gas owned by Exxon is currently valued at approximately US$18/barrel, a barrel owned by Gazprom is valued at barely US$1/barrel.

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2.2
Institutions & Peace by Louise Arbour, Former CEO, International Crisis Group