Responsible investment has been core to Newton’s investment approach since our inception in 1978, when we began actively voting on our clients’ shares. Since then, our responsible investment approach has grown to include environmental, social and governance (ESG) integration and active engagement. This is done to identify risks and opportunities which have the potential to affect companies’ performance over the long term. As part of this process, all equity securities which our research analysts wish to recommend must have an in-depth ESG quality review completed by our responsible investment team, and in early 2016 we conducted a review of a budget airline carrier.

What Were the Red Flags?

At the time of investment consideration, a number of governance concerns were identified in this airline. The board had very few independent members, at a level which did not meet UK Corporate Governance Code standards. Its membership was almost exclusively men, and two-thirds of the board was comprised of one nationality, despite this being global company; to us, this demonstrated a lack of diversity. In recent years, a light has been shone onto this issue as an increasing amount of research suggests that a lack of diversity can negatively affect a company’s financial performance.

We were also concerned that a board lacking independence and diversity would not offer sufficient challenge to the company’s CEO.

Remuneration is an issue that has attracted considerable investor attention in recent years. As an investor, we are encouraged by transparent disclosures by companies and evidence that remuneration is used to incentivize long-term, strategic thinking. However, the airline disclosed little information in relation to executives’ bonuses or the long-term components of their pay, raising questions on how they were being incentivized to run the company over the short and long term.

Employee relations were also identified as a potentially material issue following extensive labor disruptions.

The airline has a seasonal schedule whereby the number of flights is increased or decreased owing to varying demand throughout the year. As a result of this seasonality, the company does not ensure that employee compensation agreements remain constant across this time. On the upside, this has led to lower labor costs and lower fares, benefiting both the company and investors; however, on the downside, this leads to an unhappy workforce which feels increasingly unable to engage with management.

Tensions have been further inflamed by failed union negotiations across multiple European countries, where unionization levels are high and company engagement is commonplace. As a result, we were aware of a potential risk to the company’s bottom line. Customer demand for low-budget, short-haul flights is known for its flexibility – customers are likely to pick the cheapest and most convenient options for their journey. This can lead to considerable surges and falls in demand. This means that well-timed industrial action can cause major disruptions.

This risk materialized between 2014 and 2016, when, following increased media coverage, the airline saw strikes in a number of countries, and received a large fine over labor law violations. The company was also forced to cancel a significant number of flights, affecting hundreds of thousands of passengers.

How Do We Integrate ESG Research Into Investment Decisions?

After discussing these concerns with our sector analyst, our ESG research was circulated to the whole investment team. This flagged our concerns to the portfolio managers and made sure that this analysis formed part of the overall investment decision.

This example demonstrates how a company’s handling of ESG risks can negatively affect its financial performance. It also highlights why we undertake ESG analysis before recommending all companies for investment.

How Have We Engaged with the Airline?

Since investing in the company, we have sought to engage constructively, taking a twofold approach. First, we have engaged with the company to better understand how it is managing risks associated with labor and union relations. This has included our work as part of the Workforce Disclosure Initiative (WDI), a collaborative investor group aiming at improving public information and data around company workforces and supply chains. We have also engaged with the company to obtain information regarding remuneration practices, and on succession planning at the board level, to inform our views on corporate governance, and the effectiveness of the board more specifically.

Secondly, investors can engage for change, and we have used our engagements with the airline to make constructive suggestions, and openly share our feedback and concerns. On remuneration, we have expressed our dissatisfaction at the granting of shares to independent directors, which can compromise their independence. We have been pleased that the airline has subsequently agreed not to repeat this practice in the future, following investor feedback. In addition, we have pushed the company to address the root causes of the labor unrest, which resulted in operational, financial and reputational disruption. We have seen some improvements, such as the migration to local contracts, which presents benefits to employees, and the use of employee engagement surveys and feedback opportunities. The company has also hosted its first annual ESG event, designed to improve transparency and communication with investors.

While these are all steps in the right direction, we will continue to engage with the company on both corporate governance and labor practices, as there is room for further improvement. This will include continuing to engage both directly and alongside other members of the WDI, to encourage the company to disclose this material information.

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Newton research performs ESG quality reviews on equity securities prior to their addition to Newton’s research recommended list (RRL), which are typically refreshed within a three-year period. ESG quality reviews are not performed for all fixed-income securities. The portfolio managers may purchase equity securities that are not included on the RRL and which do not have ESG quality reviews.