Bradley and Will - 2021 - ESG Investing For Dummies_Ch07_approach esg investing.pdf

IN THIS CHAPTER »» Surveying socially responsible investing »» Investigating impact investing »» Checking out faith-based investing Chapter 7 Approaches to ESG Investing I n Part 1 of this book, you get a good understanding of why investing in ESG is an important consideration for your portfolio. Th...

IN THIS CHAPTER »» Surveying socially responsible investing »» Investigating impact investing »» Checking out faith-based investing Chapter 7 Approaches to ESG Investing I n Part 1 of this book, you get a good understanding of why investing in ESG is an important consideration for your portfolio. This part of the book focuses on the approaches to ESG investing that different investors may employ, and the types of instruments that they use to implement their strategy. This chapter, in particular, emphasizes that many terms have been used interchangeably to describe the incorporation of ethical, environmental, and social factors into investment fund management, such as ethical investment, green investment, and socially responsible investment. The definitions of these various terms all overlap, and many have particular significance for different industry participants. With the growth in investing in recent years, these industry terms have proliferated. However, distinct differences exist that influence how client portfolios should be structured as well as which investments meet social or environmental impact goals. CHAPTER 7 Approaches to ESG Investing 119 Understanding Socially Responsible Investing As outlined in Chapter 1, the integration of ESG factors is used to augment traditional financial analysis by recognizing potential risks and opportunities beyond technical valuations. While there is an overlay of social awareness, the main purpose of ESG valuation remains financial performance. Socially responsible investing (SRI) — the subject of this section — moves a step further than ESG by actively removing or choosing investments that correspond to particular ethical guidelines. The underlying motivation could be personal values, political ideology, or religious beliefs. Unlike ESG analysis, which influences valuations, SRI uses ESG factors to direct negative or positive screens on the investment universe. The definitions for SRI given by industry representatives include the following: »» The UK Social Investment Forum (SIF) defines SRI as an “investment which combines investors’ financial objectives with their commitment to social justice, economic development, peace or a healthy environment.” »» Eurosif defines SRI as an investment that “combines investors’ financial objectives with their concerns about social, environmental and ethical (SEE) issues.” Looking at reasons for SRI Regardless of the various definitions, there appear to be three common motives for SRI: »» To avoid investor participation in activities that they object to »» To inspire companies to improve their impact on society, the environment, or the economy »» To generate investment outperformance The first of these motives has historically provided the inspiration for SRI, but more recently, the other two factors have become increasingly important and are now the primary motivation for many SRI investors. Nevertheless, different SRI strategies are selected to respond to different investor motives, and each strategy could deliver a different result depending on the focus outcome, but traces of each motive are generally found in every strategy. 120 PART 2 Investing in ESG through Different Instruments Therefore, the key consideration is to view SRI as a long-term investment approach that integrates good ESG practices into the research, analysis, and selection process of securities within your investment portfolio. It combines fundamental analysis and engagement with an evaluation of ESG factors to identify companies with sustainable business goals (positive screening), while avoiding those with questionable practices (negative screening), in order to better capture long-term returns while benefiting society. Consequently, SRI promotes corporate practices other than profit maximization through capital investment. SRI strategies tend to follow the political and social dynamics of the time. This is an important factor for investors to recognize, because if a strategy is focused on a particular environmental, ethical, or social value, the investment may suffer if that particular value isn’t considered as relevant among investors in the future. Moreover, given that interest has grown in socially conscious investing, numerous funds and pooled investment vehicles are available to investors, including mutual funds and exchange-traded funds (ETFs), allowing exposure to multiple companies across many sectors with a single investment. However, investors need to read carefully through fund prospectuses to establish the precise philosophies that are employed by the fund managers, in order to ensure that they meet their own intended goals. It’s important to emphasize that there is a difference between SRI — which involves actively excluding or choosing investments based on explicit ethical guidelines — and impact investing, which looks to help an organization to complete a project or develop a program or do something positive to benefit society. (I cover impact investing later in the section “Evaluating Impact Investing.”) The main factors motivating SRI are primarily linked to investors’ desire to, for example, address climate change, the use of renewable energy, and water management, along with other environmental and social issues. Meanwhile, where exclusion screening persists — it’s still the most prominent strategy in terms of assets under management in Europe — tobacco is seen as the most popular exclusion criteria. Comparing a best-in-class strategy to an exclusion strategy One way to determine which companies may have the greatest positive impact is to adopt a best-in-class (BIC) strategy, which allows investors to choose those companies that have the best ESG scores in a particular industry sector. This also allows investors to choose a given criterion or target, and the final rating realized can be connected to the weighting of the criterion, which can depend on the sector. A BIC portfolio usually incorporates companies that meet both SRI/ESG and CHAPTER 7 Approaches to ESG Investing 121 conventional financial evaluations. However, some BIC portfolios don’t differ meaningfully from non-SRI portfolios, and so investors are increasingly searching for benchmarks or indexes that can be applied to implement a BIC approach. In short, getting best relative performance in terms of ESG scores doesn’t guarantee positive impact. The oldest SRI strategy is the exclusion strategy, which traditionally focused on the avoidance of “sin stocks,” such as companies concerned with the production or sale of alcohol, pornography, tobacco, and weapons. This approach systematically excludes companies, sectors, or countries from the acceptable investment universe when they are involved in activities that are considered questionable or unethical. This strategy can be applied at an individual fund or mandate level, but progressively even more so at an asset manager or owner level, across the entire product range of assets. However, some investors believe that for an exclusion strategy to be meaningful, it could be applied together with some attempt at engagement and stewardship policies, which implies that investors should hold symbolic amounts of stock in exclusion companies to be able to exercise voting rights. This allows active investors to show their commitment to creating a positive impact and better sustainability in portfolio companies. If they just sell the stock, the company may simply continue to operate in an unsustainable way that goes unchecked, which isn’t positive; however, they have to weigh any reputational risks that may be associated with continuing as an investor. Therefore, divestment may still be the best route with certain companies. Weighing the potential return on SRI decisions Some investors presume that integrating ESG factors into an SRI process will lead to lower returns, but there are growing indications that SRI could lead to greater returns. The principle is clear: The corporations that are most likely to operate effectively in the future are those with convincing social responsibility profiles, that trade in an objective and progressive way, with an executive team that tackles short-term risks while ensuring that the business is positioned to adjust to longterm transformational changes. Conversely, you shouldn’t expect that the returns from SRI indexes will be constant in the short term. There are likely to be short-term divergences in performance relative to the point in the economic cycle or market conditions. For example, SRI emerging market indexes have a fundamentally lower allocation to China than their non-SRI equivalents. This could cause return on investment (ROI) to diverge between these two indexes or portfolios if the Chinese equity market experiences strong gains or losses. 122 PART 2 Investing in ESG through Different Instruments In addition, there are concerns about the potential lack of diversity offered by ESG shares, given that many companies that meet the SRI criteria are predominantly large-cap stocks, which can limit the potential for diversification within investor portfolios. This could entail that investors find fewer opportunities within smallcap, mid-cap, and emerging market domiciled companies, while potentially excluding entire sectors, which enhances the risk of concentration within given sectors. The counterargument to this is that ESG incorporation into the SRI process allows investors to screen out companies engaged in unsustainable practices; this will exclude companies expected to underperform their competitors and result in a smaller but higher-quality investment universe. This suggests that any loss of portfolio efficiency will be more than offset by the more appealing investment characteristics of the remaining companies. Moreover, there are concerns over the ROI repercussions of limiting the universe of asset managers by excluding those that don’t observe a predetermined threshold of ESG integration. Many smaller asset managers have the ability to generate persistent alpha (in other words, consistently finding excess return in their portfolio) but haven’t fully incorporated sustainable investing strategies or integrated ESG factors into their processes. Meanwhile, larger traditional asset managers will increasingly integrate SRI principles into their investment process in order to boost returns. Nevertheless, there is a growing need to boost the supply of SRI investment proposals to meet the expected demand with more familiarization among finance professionals to engage successfully with clients when distributing information about SRI opportunities. Conversely, although fund fees have dropped in recent years, the fees for SRI strategies are naturally higher than passively managed funds as managers charge higher fees to counterbalance their need to monitor corporations’ activities to ensure that the criteria of the fund are being maintained. Higher fees can have a material effect on performance. Still, in general, the SRI momentum has influenced the adoption of responsible or impact investing strategies by several institutional investors, and numerous quasi-sovereign institutions have well-defined SRI policies: »» The Canadian Pension Plan completely integrates ESG into its investment decision-making approach. »» The Norwegian Sovereign Wealth Fund (Norges) deploys exclusionary screening and active corporate engagement to enhance the practices of its investee companies. »» Adoption in the United States has generally been slower than Europe; nonetheless, a notable exception is the Ford Foundation, which has pledged to invest US$1 billion of its endowment into mission-driven impact investments. CHAPTER 7 Approaches to ESG Investing 123 »» In his 2020 annual letter to company CEOs, BlackRock founder Larry Fink, as head of the largest asset management company in the world, publicly demanded that every company show how it makes a positive contribution to society. »» Morgan Stanley has created the Institute of Responsible Investing, which is tasked with integrating SRI strategies across all departments of their business. »» Many conventional asset management firms have launched impact investment funds, including Apollo, Bain Capital, KKR, TPG, and Wellington. However, investors need to differentiate between those strategies that they feel have been created as asset gathering tools versus those with a discernible track record of creating genuine impact. At the extreme, Chapter 6 covers issues around greenwashing and what needs to be monitored for that issue. Otherwise, undertaking some due diligence on the SRI or impact credentials of a fund can highlight what track record or experience it has in the field or whether it’s jumping on the bandwagon. Evaluating Impact Investing The demand for impact investing — covered in this section — has resulted from the continuation of substantial societal challenges (for example, demographic changes, inequality, social exclusion, and unsustainable development) and the failure of current institutions, such as governments, charities, non-governmental organizations (NGOs), and philanthropic organizations, to meet those challenges. Unlike SRI or ESG investing, impact investing isn’t just about sidestepping sin stocks or “doing no harm,” but also actively employing capital to tackle social and environmental objectives while creating financial returns for investors. It requires purpose, where portfolio companies must proactively track, measure, and report on their social and environmental impact. Where successful, impact investing is releasing significant capital from mainstream investors. Defining and tracking “impact” Despite the growing interest in such goals, more recently driven by the identification of the UN Sustainable Development Goals (SDGs; see Chapter 1), there is still no agreement on what impact investing specifically covers, which is reflected in the wildly different estimations in the size of assets under management from industry representatives such as the Global Impact Investing Network (GIIN) and the Global Sustainable Investment Alliance (GSIA). The SDGs are commonly 124 PART 2 Investing in ESG through Different Instruments highlighted as part of the impact frameworks that investors are creating, using them as a road map to help recognize where investment opportunities lie or how their current investment methodology aligns. They help investors communicate the contribution that they are making to provide solutions for the biggerpicture questions that society faces and to facilitate a unified stance for the industry. Impact investing is an approach to investing in initiatives, organizations, and funds that pursue the development of both financial returns and quantifiable social and environmental impact. Investors pursuing financial returns and impact refer to this as the “double bottom line,” borrowing an accounting term to convey how both facets need to be measured and reported. Impact investments are frequently made through closed-end private equity and venture capital funds, whereby debt funds have seen increasing popularity, more recently among impact investors. A number of traditional private equity firms have opened dedicated funds, introducing billions in new capital and pulling in institutional investors. Furthermore, this interest isn’t only coming from the “usual suspects,” such as foundations and health- or faith-based organizations, which have a natural disposition to consider impact. Mainstream institutional investors, including corporations and pension funds, are also showing real enthusiasm to be involved. In the UK, the private Social Impact Investment (SII) market peaked in 2019; however, the pandemic has hit activity in the SII market harder than the broader investment market, with a 25 percent drop in the number of announced deals completed in the UK in the first half of 2020, compared to the same period in the previous year. Nevertheless, greater activity is expected to rebound as impact investors look to support the economic recovery post-pandemic. The difficulty in tracking “impact” is an issue that still hampers the development of this market, as uncertainty remains with respect to precise definitions of positive impact. Such definitions vary as investors tend to track outcomes with their own distinctive metrics based on specific objectives, which may also vary at different parts of the investment cycle. Following are some of the measurement methods used to determine impact: »» Expected return method evaluates the estimated benefits against the projected costs to determine which investment yields the highest impact. »» Theory of change method outlines the projected process to realize social impact, using a tool that maps the connections between input, activities, output, outcomes, and ultimately impact (logic model). »» Mission alignment method measures the implementation of the project against its mission and end objectives over time, using scorecards to scrutinize and govern key performance metrics on finances, operational performance, organizational efficiency, and social value. CHAPTER 7 Approaches to ESG Investing 125 »» Experimental and quasi-experimental methods represent after-the-fact assessments that use randomized control trials to conclude the impact of an intermediation compared to the situation if the intermediation hadn’t taken place. Measuring social and environmental outcome targets Investing for return and impact is complicated, as many projects targeted at social and environmental challenges are relatively expensive without having immediate or explicit financial returns for investors; as a result, compromise is typically expected between returns and impacts. Consequently, international best practices and models for impact investing should be categorized and analyzed. Based on insights from past projects, sound methodologies can be created to facilitate identification of prospects that can produce measurable market rate financial returns and social and environmental impact. Practical lessons should also be drawn from past projects to determine how to fruitfully engage with optimal opportunities. For an impact evaluation, it’s difficult to categorize projects that are both realistic and measurable. Focusing on overly elaborate projects may be counterproductive as it may take many years and require a controlling stake in the entity in order to achieve meaningful impact. Therefore, rather than chasing multifaceted targets, it may be better to emphasize projects with a higher probability of success that can be achieved in a relatively short time frame. In addition, targeting impact goals that can be certified and audited by third-party entities and adhere to ISO (International Organization for Standardization) standards is important in the long run. (Examples can be found in this article: www.responsible-investor.com/articles/ the-world-s-official-standards-body-has-begun-writing-sustainablefinance-rules.) For impact investing to scale, products must be able to address the breadth of institutional requirements, comprising the capacity to absorb large pools of capital, and provide sufficient liquidity and stringent risk management practices, while producing measurable return and impact. These have usually been provided by investment strategies targeting blue-chip securities, primarily bonds. However, this results in directing funds to investments where it’s harder to proactively produce impact, as bondholders and minority shareholders have fewer opportunities to directly influence senior executives of large corporations. Moreover, bluechip securities are concentrated in mature markets, whereas the maximum need for impact capital is in emerging markets or less established areas. 126 PART 2 Investing in ESG through Different Instruments Conversely, research shows that specializing in fixed income does allow opportunities to scale up impact investments. In particular, a focus on emerging markets, servicing principally undercapitalized small and medium-sized enterprises (SMEs) in developing countries, highlights the opportunities in less efficient markets where better arbitrage opportunities may be found. Calculating impact metrics Although the commercial world has several universally acknowledged tools, such as the internal rate of return, for evaluating a potential investment’s financial yields, no equivalent exists for calculating social and environmental rewards in dollar terms. Projecting returns is often a matter of conjecture. For example, the reporting of ESG issues is now standard practice at the majority of large and midcap corporations, but this is usually restricted to information about commitments and process, and seldom scores actual impact. Impact investing has been described as the “third stage of responsible investment,” succeeding the stages of ESG integration and risk management. Nonetheless, the measurement of positive impact of products and services is still comparatively new, with methodologies and protocols still being established. There are a series of methodological challenges in the data, including concerns over the borderlines of corporate reporting and the capacity for “double-counting” of impact data, reporting over consistent time frames, and correctly evaluating or guesstimating product- and service-level impacts. Consequently, a number of obstacles need to be overcome first. Methodologies need to be standardized, and data quality and equivalence need to be substantiated, as more than 130 impact measurement initiatives need to be considered. While widespread research has been conducted in this area, the evaluation of impact normally incorporates a number of identifiable metrics that the investors consider to be applicable to the social or environmental issue being tackled. Both impact funds and traditional asset managers are initiating annual reports that monitor the development of such metrics during the life of the investment. One example of the research undertaken in this field is that conducted by the Impact Management Project, a collaborative, multi-stakeholder endeavor facilitated by Bridges Fund Management, an impact investment firm founded in 2002, and funded by such large institutional investors as BlackRock, Hermes Investment Management, and PGGM. They have considered five dimensions of impact: what, how much, who, contribution, and risk. Another example is the Harvard Business School Impact-Weighted Accounts Project, which aims to drive the creation of financial accounts that reflect a company’s financial, social, and environmental performance (visit www.hbs.edu/impact-weighted-accounts/). CHAPTER 7 Approaches to ESG Investing 127 In addition, NEF (the New Economics Foundation) has developed a framework based on cost-benefit analysis, social accounting, and social auditing, with the goal of capturing social value by transforming social objectives into financial and non-financial measures. Social return on investment (SROI) analysis is a process of understanding, measuring, and reporting on the social, environmental, and economic value that is being created by an organization. SROI measures the value of the benefits relative to the costs of achieving those benefits by creating a ratio between the net present value of benefits and the net present value of the investment. This provides a further framework for exploring an organization’s social impact, in which tangible monetization plays an important, but not exclusive, role. You can find information on how SROI could help organizations better understand and quantify their social, environmental, and economic value here: www. nefconsulting.com/our-services/evaluation-impact-assessment/proveand-improve-toolkits/sroi/. Focusing on Faith-Based Investing In many ways, faith-based investing — discussed in this section — was the original forerunner of socially responsible investing and subsequently impact investing. Therefore, the exponential increase in assets under management and a general interest in ESG principles and framework have naturally led to increasing awareness of faith-based strategies. Reviewing religious principles of finance Investors looking to invest in a manner coherent with Christian values frequently consider avoiding investing in companies that support non-Christian approaches — for example, from supporting abortion to building controversial weapons. Alternatively, they often favor firms that support human rights, environmental responsibility, and fair employment practices via the support of labor unions. The top three SDGs that faith-based investors seem to favor include decent work and economic growth (Goal 8), affordable and clean energy (Goal 7), and reduced inequalities (Goal 10). These SDGs also appear as top themes for impact investors in the GIIN’s flagship research report summarizing the largest industry survey of impact investors. The harmony between faith-based investors and impact investors’ concentrations in the same SDGs implies that there are opportunities for these entities to collaborate on common social and environmental goals. 128 PART 2 Investing in ESG through Different Instruments This is particularly true where impact investors can support faith-based investors in mobilizing more of their capital to realize positive, measurable, social, and environmental impact results. Multiple entities now provide assistance in investing in a manner that supports Christian values, and mutual fund firms and other funds are committed to such parameters for investors who don’t want to take the do-it-yourself approach. Indeed, faith-based investors are often ahead of the game when spotting potential alpha in certain trades because they are engaged earlier than other investors in issues such as climate change, where they consider the issue to be morally unacceptable. Before such investments appear on the radar of ESG investors as materially relevant, faith-based investors may have already excluded such entities from their portfolios or begun an engagement exercise. Meanwhile, investors specifically looking to pursue Islamic religious principles normally avoid so-called sin stocks, such as those issued by firms that profit from alcohol, pornography, or gambling, and investments in pork-related businesses are also prohibited. They are also forbidden from owning investments that pay rates of interest on their funds, or companies that receive a significant part of their revenue from interest payments. As an extension of this, many Islamic investors also try to avoid companies that carry heavy debt loans (and therefore pay considerable amounts of interest). Examining exclusion screening and divesting Faith-based investors from many faiths were at the vanguard of negative screening and divestment strategies, given that they were intentionally and publicly eradicating from their portfolios corporations whose practices were against their convictions. For example, in the 1970s and 1980s, such investors divested from Dow Chemical to protest against its production of Agent Orange, and from South African companies in response to their support of apartheid. Even more so today, considering the “no harm” principles of faith-based and ESG investors, portfolios are constructed to specifically exclude certain companies that produce goods or services considered to do social or environmental harm. These generally include sectors such as alcohol or tobacco, as mentioned in the previous section. Some large and well-known funds, such as the Norwegian Sovereign Wealth Fund, have their own exclusion list, which excludes firms engaged in “unacceptable greenhouse gas emissions,” due to their involvement in oil sands production, for example. CHAPTER 7 Approaches to ESG Investing 129 Moreover, when considering whether to include negative screening in an investment strategy (and which sectors or stocks need to be excluded), investors also need to determine the quantity of the portfolio that they are considering. Within a fund structure, this might only apply to the fund’s passive investments, or where they don’t have direct control. Alternatively, it might be related to all assets in the fund structure that require compliance of all the underlying active managers. Positive screening is a comparatively new, but progressively popular, investment approach that involves actively seeking values-aligned investments for your portfolio by using ESG ratings to identify best-in-class stocks. Negative screening is purely an exclusion process to remove unsuitable stocks, whereas positive screening allows investors to add stocks to their portfolio that are considered to be positively engaging with ESG factors. Advocating for values through proxy voting Shareholder advocacy calls for investors to use their voices as “part-owners” to influence demands for socially or environmentally responsible company policies and practices. Through discussion and meetings with company management, shareholders should directly support the adoption of good corporate governance and socially responsible approaches. Investors should also consider filing shareholder proposals that would be voted on at the company’s annual general meeting. Many faith-based investors are active participants in order to ensure promotion of corporate social responsibility. However, for those investors interested in bringing a company to task, there are minimum threshold levels that apply to ensure that a filing is submitted, which varies according to jurisdiction. The types of thresholds include a minimum monetary holding and/or percentage holding in the company or a minimum number of shareholders who support the proposal. The requirements to be met should be available on your local regulator’s website — for example, www.sec.gov/news/ press-release/2020-220. Investors should also actively vote on proposals submitted by management or other investors in advance of company annual meetings, or ensure that their proxy vote will be submitted by a delegate. Similar to exercising your democratic right to vote, investors should carefully review their annual proxy materials to consider how they should vote on given proposals. Historically, this has been something of a “rubber stamp” exercise to reinstate specific board members whose terms had elapsed, or to confirm the auditor company assuring the accounts. However, with increasing activism, those issues and others are being questioned. If you have concerns over the performance of a company, this is usually your main opportunity to make your voice heard, particularly with respect to topics such as executive pay. 130 PART 2 Investing in ESG through Different Instruments Central to ESG integration is engagement with the underlying asset managers to confirm that the managers are determined to improve their ESG integration practices over time, and also to ensure that the asset managers are engaging with underlying company management teams to influence their behavior in a way that is supportive of good corporate governance, environmental policies, and social practices. For further information, visit https://partners-cap.com/ publications/a-framework-for-responsible-investing. Alternatively, many large shareholders engage an external investment advisory service that, in addition to providing investment advice, will liaise with the thirdparty asset managers to scrutinize and foster adoption of policies in support of the investors’ desires for impact and ESG-related investing standards and engagement with company management. The primary advisory firms are Glass Lewis and ISS, but given that some firms play such an important role in shareholder voting, particularly in the United States, regulators have started to impose restrictions on some of their activities. CHAPTER 7 Approaches to ESG Investing 131