As most of us know, rapid population growth and expanding consumption levels are accelerating our world’s sustainability challenges. In recent years, climate change has been dominating the headlines and has become a watershed issue helping to expand awareness around a growing number of other problems. On the positive side, increasing sustainability interest has inspired us to think more about how we might improve. As simple examples, many of us are recycling, reducing plastic use, switching to electric cars and buying fair-trade coffee.
On the topic of consumption, some of us are also wondering how well our investments match our social and environmental values. This is worth considering since investments are like a two-sided coin, with risk and return on one side, and issuer financing on the other. Whenever we choose an investment, we are also choosing to support a financing vehicle. So not surprisingly, over the past few years, many investors have grown concerned that their ownership of fossil fuel stocks and bonds is helping to finance climate change. This concern has even resulted in a large and growing “Divestment Movement” across both private and institutional investors. Personally, I believe a fossil fuel free portfolio aligns better with environmental values and is also likely to get higher investment returns as the world moves toward more sustainable energy sources.
Unfortunately, the world of Sustainable Investing can be a bit confusing due to its complexity. Essentially, there are many different approaches, with many different labels, and even some marketing “green-washing”. In exploring Sustainable Investing, you will come across a variety of terms such as Socially Responsible Investments (SRI), Environmental, Social and Governance (ESG), Green, Screened, Ethical, Responsible, Engagement and Impact. As with most things, the best way to understand what’s happening is to look under the hood. Hopefully, the following points and definitions will expand your understanding of the different types of Sustainable Investing available.
Perhaps it makes sense to start by thinking about what Sustainable Investing isn’t. Historically, mainstream investing didn’t pay much attention to social or environmental issues. Instead, factors considered would almost always be comprised exclusively of financial and fundamental information, earnings growth, value of the securities relative to peers, management strength and competitive advantages. And while financial and fundamental factors are still hugely important, many modern and wise investment professionals now believe there’s much more that should be examined.
With the help of the United Nations, the Principles for Responsible Investment (UNPRI) were launched by a group of asset owners and asset managers in 2006. The key tenet of the UNPRI is that ESG information can be financially material. In other words, ESG can, and should be, used to help add investment returns and reduce investment risk. Here are the six UNPRI principles (Source):
One common Responsible Investment tactic is referred to as ESG Integration. This method typically ranks investment issuers using ESG scores then emphasizes high scoring securities and deemphasizes low scoring securities within the portfolio. Responsible Investing has seen massive growth in interest, mostly in the institutional pension space, with total global assets now exceeding $80 trillion US Dollars (Source: Principles for Responsible Investment)
While most Responsible Investment approaches focus on integrating ESG, many do not commit to avoiding, or screening out, certain industries or products. In other words, while ESG is considered with Responsible Investment, it may not be as a big a part of the strategy as you might like. Whether we like it or not, to some extent “money makes the world go ‘round” and companies need access to capital in order to operate. From this, it’s worth recognizing that the investments we select, or reject, can help play a part in which industries get more access or less access to capital, and the cost of that capital. As a result, many investors wishing to have values alignment prefer to include a Negative Screening element to their strategy. Popular Negative Screens often include things like weapons, tobacco and fossil fuels.
Another arrow in the sustainable investor’s quiver is called Shareholder Engagement. This tools essentially tries to use our power as shareholders to influence management and strengthen the choices they make. Shareholder Engagement tactics employed include things like shareholder resolutions, management meetings and proxy voting relating to ESG issues. In my experience, Shareholder Engagement can result in some important corporate improvements, but it tends to be difficult, if not impossible, to convince executive management to abandon their core business. For instance, it’s very tough to get a weapons manufacturer to stop making weapons. As a result, if values alignment is desired, it’s best to use Negative Screening in conjunction with Shareholder Engagement.
So far, we’ve discussed Traditional Investing (exclusively financial and fundamentally focused), Responsible Investing (incorporating ESG), Negative Screening (avoiding the bad stuff as you define it), and Shareholder Engagement (focused on corporate improvement). To me, however, the most exciting current trend in sustainable finance is called Impact Investing (sometimes also referred to as Mission-based Investing). This approach is all about achieving both financial goals and sustainability goals. Impact Investing aims to help solve sustainability problems by increasing funding available to businesses and government initiatives focused on improving the world socially and environmentally. One example of this would be where a government issues a Green Bond to finance a public transit project. As with the other approaches mentioned above, Impact Investing can be custom combined with other strategies. For instance, many people prefer a so-called Divest Invest portfolio that blends Negative Screening with positive Impact Investing. If you are interested in doing Impact Investing, I think the United Nations Sustainable Development Goals (UNSDGs) framework, shown below, is an excellent tool to help determine the areas of sustainability you wish to focus on (Source: https://sustainabledevelopment.un.org/sdgs)
While many of us care about sustainability and want our investment portfolio to fit our values, we also want to get good financial results. Fortunately, there is considerable strong evidence that Sustainable Investing tends to do as well or better than Traditional Investing. For instance, Société Général investment strategy research covering March 2013 to January 2019 found that high ESG companies tended to beat the broader stock market, and that companies recently puling up their ESG socks outperformed high ESG stocks (source: https://corpgov.law.harvard.edu/2019/03/21/esg-rating-and-momentum/)
In the future, I expect Sustainable Investing to outperform for a couple main reasons. First, internet-driven transparency is increasing awareness and concern around industries, products and services that harm people and the environment. As this continues, support and consumption in these areas will likely fall, leading to lacklustre business performance and underperforming securities. Additionally, several global sustainability challenges have been expanding faster than our ability to solve them. I believe that, going forward near-term, we will continue to fall further behind the curve and the gap between problems and solutions will widen. As this shortfall grows, sustainability challenges will become increasing apparent and demand for product and service solutions will accelerate. As a result, I think investments in positively impactful businesses will beat the broader markets.
If you would like to discuss Sustainable Investing, please feel free to contact me for a free consultation