Case study by RARE Infrastructure Limited

RARE’s investment team is focused on listed infrastructure, with eight research analysts and seven team members contributing to portfolio management. Our universe is comprised of over 300 stocks, in both developed and emerging markets. Four different investment strategies are drawn from this research database: value (global infrastructure); emerging markets; real assets (inflation protection); yield (high, sustainable dividends).

Key findings

  • ESG factors should be identified in the research due diligence process, and then incorporated at the most relevant stages of valuation analysis and portfolio construction.
  • Portfolio managers need to understand what the material ESG factors are, how they are captured and probable variations from the baseline forecasts.
  • Stock risk encompasses more than the cost of capital or share price volatility, it also includes upside and downside scenarios as well as asymmetry and probabilities.
  • Portfolio construction starts with the outputs from internal and external research, along with many other inputs, and synthesises all of that information into stock weights.
  • Building a common database and research platform allows different investor preferences to be applied across investment strategies.
  • Interrogating this data shows the exposure to portfolio risks, as well as how these risk exposures have changed over time.

ESG factors are captured in the investment process:

  • Cash flows capture ESG where it is possible to quantify impacts, for example carbon costs in the EU Emissions Trading Scheme, or social expenditure that is supported by a regulator. Asset level and corporate forecasts are compiled for each demonstrate social responsibility
  • Discount rates are adjusted for ESG risks, for example a history of detailed disclosure, or conflicts of interest between a controlling shareholder and minorities. Higher risks result in a higher cost of capital.
  • Portfolio construction takes the valuation outputs from the research process (primarily a five year IRR). Based on the risk/return properties of each stock, weightings are allocated to provide desirable portfolio characteristics.

ESG inputs to portfolio construction

ESG is best integrated in investments by quantifying issues into cash flows and valuations. This leads to an assessment of sustainability at the same time as financial factors are considered. We adjust the discount rate for each company based on qualitative risks, including ESG factors as well as regulation, predictability and inflation protection.

In addition to internal research, RARE has engaged Sustainalytics to provide independent analysis. ESG ratings for each company are considered when adjusting discount rates and portfolios are compared to the global listed infrastructure universe.

“Embedding sustainability into our investment process and portfolios provides another source of alpha for our clients.”

Richard Elmslie (Investment Director & Senior Portfolio Manager) RARE Infrastructure Limited

Portfolio ESG ratings compared to Universe (out of 100)

Synthesisng ESG in portfolio construction

The research process provides portfolio managers with a forecast return for each stock, a discount rate (proxy for risk) as well as an understanding of the variability of returns. By considering downside and upside scenarios, each stock weight can be adjusted to match the level of conviction held by the team. A stock with high forecast returns and little risk, for example a regulated power line carrying renewable energy, deserves a large portfolio weight, while a stock with moderate returns and high risks, for instance a port operator with poor labour standards, is unlikely to be included.

Once a material factor has been identified in due diligence, it should be incorporated in the most relevant way possible. There should not be double counting of the same factor, for example both penalising cash flows and discount rates for the existence of an emissions trading scheme. A shared understanding of ESG risks and opportunities can only be achieved when analysts and portfolio managers communicate their assumptions and conclusions clearly to each other.

ESG factors not captured in risk and return forecasts can be caught by the portfolio construction overlay. This may be done by adjusting stock weights to reflect the interaction of risks between stocks, or by considering asymmetric risks for a particular stock, for example where internal research sees greater upside than downside. Intelligent screening can also be incorporated to avoid some larger risks, for example avoiding coal-fired generators in countries that are adopting a carbon price.

Outliers identified by Sustainalytics and the internal due diligence require particularly close attention from portfolio managers, since they signal exaggerated risks or opportunities.

Portfolio characteristics

By estimating common risk factors across the investment universe, we have been able to work out where portfolios are exposed to these risks overall. These factors include macroeconomic sensitivity, financial risk and commodity prices.

Portfolio managers can then see how stock weights combine into portfolio exposures. The chart below shows the value portfolio being exposed to higher GDP, lower real interest rates and broadly neutral to carbon prices (and it further breaks out those exposures by region):

Weighted beta to a move in macro risk factors

Based on the regulatory and operating environment it may be preferable to get exposure to some sectors in a particular country. For instance, Brazil has abundant rainfall and supportive inflation protection for utilities, so hydropower is attractive in that country. We limit portfolio risks by placing guidelines on exposures. For example, an asset maturity target reduces downside from having too much exposure to greenfield projects, while a transport sector limit restricts the total weight in toll roads from being too low or too high.

As stock weights change in a portfolio the risk exposures will also change. The chart below demonstrates this and also compares portfolio exposures to the universe.

Weighted beta to a move in macro risk factors

When the risk, return and exposure characteristics of each stock are stored in a research database, then portfolios can be tailored to client preferences. Our climate change strategy, for example, is optimised for low GDP sensitivity and positive exposure to carbon prices – putting into practice the Mercer report on climate change scenarios from February 2011.