Towers Watson rolling out new framework linking sustainability analysis and asset class returns

Major climate change initiative from influential investment consultant

Towers Watson, the investment consultant that is now part of the wider Willis Towers Watson risk management group, is rolling out a new sustainability framework that seeks to link sustainability analysis with investment returns.

One of the pillars of its sustainability analysis, the firm says, is its industry-level research to determine how business profit pools are likely to change and how private and public capital will be allocated. 

When it’s complete, the framework will allow investors to “seamlessly integrate the same financial, sustainability and ESG metrics into all aspects of portfolio management” i.e., from risk management, through portfolio construction, all the way down to security analysis. 

And the framework can be used to understand and quantify climate-related risks, opportunities and financial returns, according to its latest Global Markets Overview – saying it is topical in light of the recent recommendations from the Task Force on Climate- related Financial Disclosures (TCFD). 
The overview is put together by the firm’s Asset Research team under David Hoile.

Towers Watson was not directly involved in the TCFD though its rival Mercer was an advisor; the creation of the framework is important given Towers Watson’s bellwether role for institutional investment.

Although consultants weren’t central to the TCFD recommendations, released on December 14 last year, the panel did recognise that they and many other organisations (credit rating agencies, equity analysts, stock exchanges etc.) also use climate-related financial disclosures – “allowing them to push information through the credit and investment chain and contribute to the better pricing of risks by investors, lenders, and insurance underwriters”.

Towers Watson thinks grouping the drivers of sustainable long-term outcomes into mega-trends and micro-trends and thinking through how these impact the shape of expected returns is an “important addition to an investor’s typical toolbox” – although it admits it’s “not a straightforward undertaking”.

It says: “It is tempting to draw sweeping conclusions when it comes to determining the impact of sustainability or ESG factors (such as climate change, wealth and income inequality, pervasive technology, dysfunctional governance, etc.) on expected returns.“Such conclusions lack credibility and objectivity and, therefore, struggle to support meaningful action. There is no choice but to think in detail about the socio-political, environmental, economy and industry implications of a particular trend, but with an eye to extracting the most likely and important implications for asset prices. Investors then need a robust mechanism to turn those implications into quantifiable and testable asset-class level expected returns.

“And it is crucial that this mechanism accounts for current asset pricing because it may, or may not, discount sustainable conditions.”

“We seek to be approximately right rather than precisely wrong”

As for linking sustainability analysis to asset class returns, the firm says the first step is to determine the most likely and important changes a given trend will have for the “key determinants of asset pricing”. The second step is to determine what those shifts might mean for the “central path and distribution of asset returns, conditional on starting market pricing”.

A feature of the new approach is industry-level analysis to provide “insight into shifting profit pools”.

Armed with an understanding of how profit pools are shifting in size/composition in response to sustainability factors, Towers Watson says it can then “contrast our own view of the evolution of ROIC [Return on Invested Capital] with that implied in market pricing and, in a systematic way, extract the implied impact on expected returns”.

It is seeking to “broadly identify” the size of the impact of sustainability factors on asset returns, saying: “We seek to be approximately right rather than precisely wrong.” The goal is to understand the opportunities and risks for portfolios from sustainability analysis, given starting market prices.

The consultant advises clients to “develop a strong set of beliefs for the likely impact of climate change and invest accordingly”. It admits this can be challenging, so argues that long-term scenario analysis linking physical risks to economic outcomes, industry implications and asset class returns is the way to approach this.