• Signatory type: Investment manager
  • Asset class focus of case study: Fixed income, listed equity
  • HQ Country: United States of America

A major challenge to ESG incorporation is applying big picture themes at the investment level. Themes such as climate change, modern slavery, plastic waste and deforestation are clearly important. The goal for investors is to transform these themes into investment theses that feed into capital allocation decisions and also help investors engage with companies to create meaningful, long-term change.

This case study focuses on dealing with the plastic waste problem. It highlights the process at MFS Investment Management which helps turn themes into actions. The process:

  • Begins with a broad view of the theme to understand as much as possible the impact, drivers, challenges and opportunities involved;
  • Creates a framework to turn qualitative insights into quantitative analysis;
  • Builds a quantitative model based on this framework that provides robust metrics;
  • Applies this model at narrower levels across impacted sectors;
  • Assesses impact at the issuer level and feeds into investment decision-making and engagement activities; and
  • Is repeated across sectors whilst also building in cross-sector impacts.

Why this approach?

As an active investment manager, assessing financial materiality and responsible asset stewardship are the key parts of MFS’s ESG integration philosophy.

Its main innovation was to look at the entire plastics and packaging supply chain. It then created a framework to influence investment decisions by breaking this chain down into four key sections — chemicals companies, packaging companies, brands and waste management — followed by a deep dive into the risks, opportunities and alternatives in each part of the value chain.

This innovation was needed because, although analysts know their industry well, they often do not have the same understanding of issues and challenges up and down the value chain. MFS’s ESG-dedicated analysts incorporated ESG factors and added considerable value by sharing views they developed working with sector analysts covering different industries to integrate ESG factors.

From a top-down perspective, the research covered the types of plastics available, existing and potential alternatives, and the opportunities and challenges presented by recycling. A bottom-up perspective focused on applying the framework to understand the economics of plastics, recycling and alternatives at the company level. This combination of macro and micro research allows MFS to better understand the potential winners and losers from dealing with the plastic waste problem.

The framework also allows more effective engagement with companies. For example, MFS’s analysts now ask more specific questions to company management around:

  • What they are doing to apply circular economy principles to plastics;
  • What needs to happen to get to 100% circularity;
  • The level and sources of capex required; and
  • How profits and margins are impacted by increased recycling.

The framework fits under MFS’s broader, multi-faceted ESG approach that combines thematic research, fundamental research, ESG data, risk management, stewardship and governance/strategy.

By looking for stranded asset risks from regulatory changes and higher consumer demand for more sustainable packaging, the framework allows MFS’s analysts to re-evaluate commodity costs, pricing power and capital investment arising from a shift from virgin to recycled plastics or other substrates. Every sector team uses this framework to evaluate impact across their companies and the knock-on effects across sectors.

It was applied first to the consumer staples universe, because plastic is a material risk in this sector. Application to the consumer staples sector is a good example of how MFS incorporated the framework into its investment decision-making. It allowed MFS to calculate the valuation discount or premium at the issuer level to assess risks and opportunities. Its analysts spoke with companies that MFS owns to determine the extent to which plastic is a driver of cost of goods sold (COGS). Assuming a 30% premium for virgin plastic, MFS estimated the required pricing necessary to cover the cost headwind to achieve company-issued targets and the gross margin/earnings headwind if companies cannot cover the cost headwind with pricing.

MFS found that the cost impact of investee companies achieving their targets appears manageable over the five-year to ten-year period most companies target, and can be covered with pricing increases below 1%. MFS also discovered that the headwind for achieving company-issued targets is the largest for non-alcoholic beverage companies, since they face the highest contribution of plastics to COGS.

Among MFS’s fixed income team, this is now a key topic discussed in terms of ESG materiality for several industries and their supply chains. For example, the beverage industry’s supply chain consists of bottle suppliers across a variety of substrates, including plastic, glass and cans. The ability to promote circularity in this supply chain means greater focus on understanding how beverage companies plan to promote recycling, substitute virgin PET (polyethylene terephthalate) containers and launch new beverage products in infinitely recyclable metal cans.

What were the outcomes, benefits, challenges and next steps?

The framework helps to identify both risks and opportunities at the issuer level. For example:

  • A packaging company held a buy rating until this new analysis altered MFS’s view on upside price potential and downside risks. The analyst highlighted the company’s active work with its customers to develop more sustainable packaging solutions but slow progress and greater public scrutiny led to a downgrade in rating and a reduction in MFS’s holdings;
  • MFS reduced holdings in a consumer staples company as changing consumer preferences and cost pressures are negatively impacting its bottled water business;
  • The investment manager invested in the debt and equity of can manufacturing companies as it believes they will likely be winners from the plastic battle, while MFS sees increased risks for incumbent plastic suppliers;
  • Its analysts identified different impacts across sectors over time, helping to understand how the plastic issue would likely play out across chemicals, packaging and oil and gas sectors and which companies within those are best placed to succeed through, for example, their ability to fund capex or deal with margin pressures.

MFS believes the plastics issue will continue to grow in concern for consumers, thus presenting a left-tail risk to returns. The benefit of the framework is that, by looking at the entire plastic value chain and then drilling down to the security level, MFS has a more holistic view of the issue and the complex connections across sectors and companies. This significantly helps its investment team have greater conviction in the companies in which it invests.

In terms of challenges, it can be difficult to get companies to talk about how they plan to play their part. In other cases, firms commit to too many initiatives, which raises concerns about their ability to meet the goals they have set. In these cases, MFS has engaged with the company to focus on the most material issues.

There are also forces at play that may change MFS’s investment theses, such as changes in regulations, technology and customer preferences. Addressing this requires real-time rather than point-in-time research. For example, a breakthrough in chemical recycling has the potential to make a meaningful change relatively quickly by making waste plastic valuable.

In addition, the issues are not necessarily clear-cut. For example, MFS’s research suggests that it is not clear that biopolymers are better than plastics from an emissions perspective due to the carbon footprint associated with the fertilizers used to grow crops and the chemical processing required to turn crops into plastics. It also suggests that plastic production using renewable energy has a greater impact on reducing carbon footprints than moving to biopolymers using corn.

Building and applying this framework has shown that incorporating thematic research into investment decisions is nuanced and complex. MFS recognises the value in collaborating with other organisations, including asset owners, NGOs, data providers and independent global institutions to get a complete picture of the issues involved and an understanding of how investors can collectively effect positive change.