Investing to generate genuine impact

Sus­tain­able invest­ing is enjoy­ing its moment in the sun. After years of plat­i­tu­di­nal rhetoric, invest­ment mar­kets at last appear to be putting their mon­ey where their mouth is. The wolf of Wall Street has dis­cov­ered its soft side.

ESG, the acronym du jour, is every­where. Investor webi­na­rs, invest­ment indices, man­age­ment reports, ana­lyst notes, all are now singing the virtues of envi­ron­ment, social and gov­er­nance themes.

It’s not just pub­lic-rela­tions spin, either. Cold, hard cash is find­ing its way into sus­tain­able invest­ing. New research from the US Forum for Sus­tain­able and Respon­si­ble Invest­ment indi­cates that around one in every three dol­lars of the $51 tril­lion in assets under man­age­ment is now sub­ject to at least one ESG cri­te­ri­on.

This shift in cap­i­tal allo­ca­tion should be see­ing invest­ment dol­lars mov­ing away from irre­spon­si­ble com­pa­nies and into those cham­pi­oning a more eth­i­cal form of cap­i­tal­ism. But is it? And, if not, what changes might help it to do so?

Relying on ESG indices can be counter-productive

Amid the ESG excite­ment, scep­tics abound. One is Lynn Forester de Roth­schild, chair­man of the UK wealth man­age­ment fund E.L. Roth­schild and a fer­vent con­vert to “con­scious cap­i­tal­ism”. For Forester, the lack of exac­ti­tude as to what qual­i­fies as ESG has left the door open to a num­ber of anom­alies.

She gives the exam­ple of Air Prod­ucts and Chem­i­cals, a US firm ded­i­cat­ed to the sale of car­bon-inten­sive gas­es and chem­i­cals. But because the firm is com­mer­cial­is­ing hydro­gen, it’s a dar­ling of ESG mar­kets. In con­trast, Den­mark-based Ørst­ed, the world’s lead­ing off­shore wind pow­er pro­duc­er, is marked down because of some lega­cy fos­sil fuel assets.

The exam­ples point to how coun­ter­pro­duc­tive rely­ing on ESG indices can be. “Unfor­tu­nate­ly, when you look into what is owned by the major­i­ty of ESG-brand­ed ETFs [exchange-trad­ed funds], they are vir­tu­al­ly the same stocks as con­ven­tion­al ETFs, so they make pre­cious lit­tle dif­fer­ence,” she says.

It is a ver­dict endorsed by a recent research brief­ing on sus­tain­able invest­ment funds by mar­ket ana­lyst firm Mas­sif Cap­i­tal. The report argues the hotch­potch approach to stock selec­tion means investors remain exposed to the non-finan­cial risks that ESG sup­pos­ed­ly pre­vents.

Unfor­tu­nate­ly, what is owned by the major­i­ty of ESG-brand­ed funds is vir­tu­al­ly the same as con­ven­tion­al ones

Worse, it keeps mon­ey from going to the prob­lem-solvers. Take cement, which giv­en its huge foot­print, most ESG investors agree is a major no-no. As a result, how­ev­er, cap­i­tal for pro­gres­sive firms in this in-demand $312-bil­lion indus­try to look into clean alter­na­tives is effec­tive­ly being choked off.

Accord­ing to Mas­sif Capital’s man­ag­ing part­ner Will Thom­son, investors need to adopt a more tran­si­tion­al mind­set. Instead of iden­ti­fy­ing benign com­pa­nies, he argues, impact-mind­ed investors should be pick­ing firms in prob­lem­at­ic sec­tors that boast a clear strat­e­gy for change.

“We can­not recre­ate the econ­o­my with­out car­bon-inten­sive busi­ness­es as if we had a blank sheet of paper; it is cru­cial to work with the busi­ness­es we have,” he says.

Data deficiency problem for investors

Part of this more selec­tive approach is an upgrade in data. Recent years have wit­nessed a boom in the mar­ket for ESG rank­ing and ana­lyt­ics, but deter­min­ing which stocks are gen­uine­ly com­mit­ted to sus­tain­abil­i­ty issues is still a stab in the dark for many investors.

The prob­lem is two-fold. On the one hand, lack of stan­dard­i­s­a­tion means investors are fre­quent­ly left com­par­ing apples with oranges. And because dis­clo­sure of non-finan­cial infor­ma­tion is still large­ly vol­un­tary, they often find them­selves with too few apples or oranges even to count, let alone com­pare.

Change is afoot, how­ev­er. A col­lec­tion of recog­nised stan­dards is begin­ning to emerge – the Sus­tain­abil­i­ty Account­ing Stan­dards Board is a good case in point – while leg­is­la­tors are also get­ting tougher on dis­clo­sure require­ments. In the UK, for instance, fidu­cia­ry reg­u­la­tions enable pen­sion funds to specif­i­cal­ly accom­mo­date ESG fac­tors.

Time hori­zons are equal­ly impor­tant. At present, finan­cial infor­ma­tion looks almost exclu­sive­ly back­wards. But to exert impact, sus­tain­able invest­ing needs for­ward-look­ing data as well. So says Amer Khan, Euro­pean man­ag­ing direc­tor at Entel­li­gent, a data plat­form that inte­grates cli­mate-risk infor­ma­tion. It is impor­tant to have hard data on how a com­pa­ny will reduce emis­sions in the future, not just on how it has reduced them in the past.

Khan is also an advo­cate of inno­va­tion in trad­ing mech­a­nisms them­selves. He points to the exam­ple of smart beta ETFs, which use a rules-based sys­tem for select­ing invest­ments to be includ­ed in the fund port­fo­lio. To date, those rules typ­i­cal­ly apply to pre­de­ter­mined finan­cial met­rics. So how about a “cli­mate beta” equiv­a­lent for list­ed equi­ty stocks?

Time to take a more active approach

His sug­ges­tion gets to the crux of sus­tain­able investing’s cur­rent lack of impact: name­ly, pas­siv­i­ty. The great appeal of track­ing funds is its hands-off approach. Investors opt for an index that meets their man­date, issue instruc­tions to the index man­ag­er and then essen­tial­ly sit back and twid­dle their thumbs.

Impact doesn’t work that way. It requires investors to be more proac­tive, ask­ing ques­tions of man­age­ment, exer­cis­ing their vot­ing rights, pulling out of cer­tain sec­tors, invest­ing in oth­ers. The upside of equi­ty indices is the tril­lions of dol­lars at play; minus­cule shifts can cre­ate enor­mous waves.

Tribe Impact Cap­i­tal is one of a grow­ing num­ber of invest­ment hous­es deter­mined to take a more explic­it­ly active posi­tion. The UK wealth man­age­ment firm invests exclu­sive­ly in high-impact firms. With the sat­is­fac­tion of mak­ing a tan­gi­ble dif­fer­ence, how­ev­er, comes high man­age­ment over­sight and a small pool of cap­i­tal.

It may not be Tribe’s cho­sen strat­e­gy, but Fred Kooij, the firm’s chief invest­ment offi­cer, still believes sus­tain­able invest­ing can make a mark in main­stream invest­ment mar­kets. He takes heart from advances in trans­paren­cy and report­ing, as he does the emer­gence of “well thought-through, informed and man­aged indices”.

Oxy­moron­ic as it may sound, these devel­op­ments hold out hope for those who want to do more in the pas­sive space.

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Understanding sustainable investment definitions

ESG

Now a fixed part of the investor lex­i­con, the acronym ESG stands for envi­ron­men­tal, social and gov­er­nance issues.

Accord­ing to the Finan­cial Times Lex­i­con, ESG is “used by investors to eval­u­ate cor­po­rate behav­iour and to deter­mine the future finan­cial per­for­mance of com­pa­nies”. The base assump­tion is that how com­pa­nies behave with respect to non-finan­cial issues impacts on their future prof­itabil­i­ty.

What con­sti­tutes a mate­r­i­al ESG issue is yet to be defined. The Euro­pean Fed­er­a­tion of Finan­cial Ana­lysts Soci­eties sug­gests nine broad areas, includ­ing ener­gy effi­cien­cy and green­house gas emis­sions (envi­ron­ment), employ­ee train­ing and absen­teeism (social), and lit­i­ga­tion risks and cor­rup­tion (gov­er­nance).

ESG invest­ing cov­ers almost all asset class­es, from equi­ties and fixed income through to high­ly tai­lored pri­vate invest­ment vehi­cles. It con­tains with­in it a panoply of dif­fer­ent sub-cat­e­gories, includ­ing social­ly respon­si­ble invest­ing, impact invest­ing and val­ues-based invest­ing. One of the stand-out char­ac­ter­is­tics of ESG funds is their long-term focus, with ESG investors work­ing to mul­ti-year cycles rather than quar­ter to quar­ter. Far from sac­ri­fic­ing prof­its, how­ev­er, research indi­cates that ESG funds fre­quent­ly out­per­form the mar­ket over the medi­um and long term.

SRI

SRI stands for social­ly respon­si­ble invest­ing. One of the more estab­lished forms of ESG invest­ing, it grew out of the con­cerns of eth­i­cal­ly-mind­ed investors, start­ing with the Quak­ers and lat­er cham­pi­oned by the likes of church pen­sion funds and uni­ver­si­ty super­an­nu­a­tion funds.

Giv­en its ori­gins, SRI is his­tor­i­cal­ly asso­ci­at­ed with a tac­tic known as neg­a­tive screen­ing. This prac­tice sees indus­tries deemed uneth­i­cal or irre­spon­si­ble removed entire­ly from port­fo­lios. Typ­i­cal exam­ples include com­pa­nies deal­ing in tobac­co, gam­bling, alco­hol, pornog­ra­phy and arms. These became labelled as “sin stocks”.

Over the last few decades, SRI investors have adopt­ed more nuanced approach­es. One pop­u­lar tac­tic is to select the most eth­i­cal or respon­si­ble per­form­ers in spe­cif­ic indus­tries, so-called best-of-class com­pa­nies. Anoth­er approach is to con­struc­tive­ly engage with firms, offer­ing them an oppor­tu­ni­ty to change key poli­cies or prac­tices rather than imme­di­ate­ly exclud­ing them.  

These devel­op­ments reduce the moral asso­ci­a­tions of the term “respon­si­ble”, which have his­tor­i­cal­ly made main­stream investors uncom­fort­able, but which share­hold­er activists have embraced. The vogue over recent years has been towards less deter­min­is­tic descrip­tors such as sus­tain­able and resilient.

Cen­tral to SRI is a belief that cap­i­tal can gen­er­ate pos­i­tive social and envi­ron­men­tal out­comes as well as, not instead of, finan­cial returns. Debate con­tin­ues regard­ing the prof­itabil­i­ty of SRI. A recent sur­vey of exist­ing research by RBC Glob­al Asset Man­age­ment con­cludes that SRI does not nec­es­sar­i­ly result in low­er returns, but evi­dence for its gen­er­at­ing above-aver­age returns remains incon­clu­sive.

Impact investing

As the term sug­gests, impact invest­ing rep­re­sents a high­ly active form of ESG, with a par­tic­u­lar focus on gen­er­at­ing pos­i­tive social and envi­ron­men­tal out­comes. Depend­ing on their man­date, impact investors may often set­tle for a low­er-than-aver­age or slow­er rate of finan­cial return in exchange for high impacts. 

“You can delib­er­ate­ly choose to go into low­er-return funds to gain a high social return,” says Stephen Muers, chief exec­u­tive at UK impact investor Big Soci­ety Cap­i­tal. “Although some asset class­es such as afford­able hous­ing funds offer a finan­cial return sim­i­lar to main­stream asset class­es.”

Giv­en their focus, impact investors typ­i­cal­ly choose much more spe­cif­ic social or envi­ron­men­tal met­rics than con­ven­tion­al ESG investors. The very first social impact bonds, for exam­ple, were issued a decade ago with the goal of reduc­ing reof­fend­ing by for­mer pris­on­ers in the UK. Around 138 sim­i­lar social impact bonds have been issued since then.

Moves are under­way by the Impact Man­age­ment Project to design an agreed frame­work for mea­sur­ing and assess­ing the out­comes of impact invest­ments. Vet­er­an UK investor Sir Ronald Cohen is also cham­pi­oning an approach to valu­ing com­pa­nies, known as impact-weight­ed account­ing, that incor­po­rates social and envi­ron­men­tal costs or exter­nal­i­ties.

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