With great power comes great responsibility. As ESG momentum intensifies, the scrutiny over the pharmaceutical sector's role in society is increasing. How ‘pharma' evolves to meet fresh ESG challenges will present challenges and opportunities for the sector's constituents, argue Chris Elliott and Sawan Kumar
Undoubtedly, the Glaxos, Astras and Sanofis of the world have a significant role to play in the health of society. However, improving access to healthcare, creating therapies and vaccines, and driving medicine affordability, while keeping stakeholders happy, is not an easy remit.
When considering ESG, it is important to stress an obvious statement: every sector is different, facing different sets of challenges and opportunities to varying degrees, and so the definition and materiality of ESG factors will also differ accordingly.
From a societal standpoint, pricing of medicines is the most pressing issue. As the wealth gap and inequality increases, how is the company going to ensure the new treatments and vaccines are affordable?
Materiality is typically measured both in terms of likelihood and magnitude of impact and is a crucial part of the research stage of an ESG assessment of a stock, especially for the pharmaceuticals sector. The Sustainability Accounting Standards Board (SASB) framework and Sustainalytics (independent provider of ESG research) identify ‘product responsibility' and ‘product governance' as the most material risks to the Pharmaceuticals sector.
Reputational side effects
Exposure to patient litigation from unintended side effects is an ever-increasing concern for companies, along with large settlement fines; fines are frequently heavily publicised, and trigger class action lawsuits which can materially affect balance sheets. This "cost of doing business" brings increased damage to the brand and immeasurable reputational risk.
We consider the social and governance considerations to be the most important in overall ESG analysis of the sector. From a societal standpoint, pricing of medicines is the most pressing issue. As the wealth gap and inequality increases, how is the company going to ensure the new treatments and vaccines are affordable to the wider public, so not only the rich benefit?
And how do we discourage smart but unethical marketing from companies looking to boost their return on years of investment in R&D? Also, how can we improve regulatory processes to guide innovation and purchasing decisions to create the most value for society? All tough questions companies embroiled in controversies have failed to answer in recent history.
Balancing principle with profit
We have a risk management framework that looks to assess companies across a range of risk factors assigning a rating from A (best-class) to E (worst-class). As part of that framework, we look at if the company is providing a positive social impact to society with its business activities. The companies in the pharmaceutical sector unsurprisingly each receive an A.
This reflects the high positive benefits from the treatments and therapies that both extend life and improve quality of life. For each company, we also consider their approach to pricing and their commitment to innovation.
Another qualitative risk factor considered in our risk management framework is ‘management quality' which considers the governance framework, the implementation of strategy and the engagement with shareholders.
We study the board make-up and remuneration policies. It is vital there is a sufficient level of independence on the board and majority level of independence on the committees (especially audit), and we also check for controversies in previous roles.
Holding executive pay to account
With regard to executive pay, we deem a remuneration policy to be strong if it has a clawback provision in place. A clawback is essentially a provision which allows for companies to recover bonuses from employees which have already been vested.
The provision is more common in the financial services industry as it is often used as a response to discrepancies to financial statements or scandals. However, we feel they are equally as important in the pharmaceuticals sector. Strong governance requires employee accountability and alignment, and clawback provision is a good tool to hold employees accountable.
Understanding the prospects and risk exposure of companies within our portfolio is key to managing the fund for the long term, and each sector typically has an evolving and unique set of factors for us to consider. As investors, we want to have the confidence to ride out uncertainty and take advantage of the opportunities presented by macro developments.
This can only be done by remaining well informed of the risks our companies face and balancing these risks with the attractive implied returns, cash flow dynamics, strong balance sheets, and strong governance. This, we require from all our investee companies, in the pharma sector and beyond.
Chris Elliott is co-manager of the Evenlode Global Income Fund and Sawan Kumar is a stewardship analyst at Evenlode Investment
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