To Be or Not to Be? A note on Responsible Investing
In any moment of decision, the best thing you can do is the right thing. The worst thing you can do is nothing.
If you were to spot a plastic bottle on the pavement in front of your house, would you walk straight past it or would you pick it up? Maybe ten years ago you would have ignored it, but I would guess that today, many of you would feel compelled to pick up the bottle and dispose of it in your recycling bin at home.
What has changed? For sure, the media have made us much more aware of the negative impact of plastic waste, with images of remote, pristine beaches littered with plastic and horrifying statistics immediately popping into our heads. It is estimated that of the over one million single-use plastic bottles produced every minute, up to 70% are not recycled, with most ending up in landfill or in the ocean – the latter creating a plastic tsunami destroying marine life [SIX Magazine, March 2020].
These types of images and statistics have woken many of us from our slumber and resulted in a heightened sensitivity to the environmental and social implications of our actions across all facets of our lives. This sensitivity is arguably amplified for other headline issues, such as climate change and racial inequality – particularly post COVID-19 – and the Black Lives Matter movement. It is therefore only natural that, as an investor, you should also be questioning the environmental and social implications of your investments.
The good news is that you are not alone in asking yourself these types of questions. 70 senior executives at 43 leading global investing entities, including CalPERS, CalSTRS, the government pension funds of Japan, Sweden and the Netherland as well as the likes of BlackRock, Vanguard and State Street, were interviewed by the Harvard Business Review in the spring of 2019. Environmental, social and governance (ESG) considerations were almost universally at the top of these senior executives’ minds [The Investor Revolution, Harvard Busines Review, May-June 2019]. A recent RBC Global Asset Management survey found that the pandemic has led more than a quarter of professional investors to place even more importance on these considerations.So, what are the steps you need to take to determine if you should convert to responsible investing (RI) or not? And, if you opt to be a responsible investor (which you may have already decided to be), what ‘shade’ of RI should you adopt? By the way, when I mention ‘you’, as an ARP+ reader, you could be any type of investor, ranging from a large institutional asset manager to an individual investor. The steps provided in the following are applicable to all investors. Exhibit 1 provides some insight as to the rationale some of your peers have given for becoming a responsible investor.
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Step 1: Step back and reflect on your values, beliefs and priorities
The two key questions you need to ask yourself at this stage are why you might consider becoming a responsible investor and what it means to you. A brainstorming session is recommended at this early stage with the key items to be considered highlighted in Exhibit 2.
This first step is arguably the most important part of the entire exercise and will require a high degree of introspection. For example, your ethical values may clash with some of your business objectives. Such conflicts need to be discussed and hashed out from the very beginning – not always an easy feat. We have seen many investors getting stuck at this early stage and struggling to proceed any further. It is important that you persevere! As this process has a number of interconnected questions to ask yourself, which may be quite specific to your own views and requirements, we have added a discussion on these in the Appendix:
- Where to position yourself on the RI spectrum?
- What areas should you avoid?
- Which environmental and social issues should you focus on?
- How patient should you be- engagement vs. divesting?
- What are you stakeholders telling you?
To provide you with some insight as to how other investors have addressed these questions, peer statistics have been included in some instances.
Step 2: Understand what regulators have decided you need ‘to be’
If you think it is complicated to determine what kind of investor you would like to be (Step 1), add to the equation that you also need to follow what the regulator has decided you need to be, and the whole issue gets even more complex.
Generally speaking, Europe is ahead of the rest of the world with regards to sustainable investment rules and regulations (the ‘to be’ camp), whereas the Trump administration has dug its heels in and argued that it is all ‘fake news’ (the ‘not to be’ camp). This will undoubtedly change with Biden’s “tackling the climate emergency” as one of the key tenets of the Biden Plan. So, if you are a US investor you should prepare yourself for an overhaul of the current situation.
If you are a US investor …
There has been significant regulatory pushback against ESG investing in the US. In June 2020, the US Department of Labor set out plans for a rule that would require private pension administrators to prove that they were not sacrificing financial returns by putting money in ESG-focused investments. The plans require fiduciaries to provide evidence that ESG-like investments have been chosen solely on “objective risk-return criteria”. The Department of Labor stated that the proposed rules would reduce pension funds’ expenses by “giving fiduciaries clear directions to refrain from spending workers’ retirement savings to research and vote on matters that are not expected to have an economic impact on the plan”.
Some investors claim US companies complain about shareholders’ focus on ESG and the use of annual meetings to pile pressure on boards over environmental and other issues. During the 30-day comment period which ended on July 31, the proposed rule drew over 8,000 comments with some 95% of the comments opposing it [the authors of the analysis included representatives from the Intentional Endowments Network, Morningstar, US SIF, Ceres, the AFL-CIO, Impax Asset Management and the Interfaith Center for Corporate Responsibility]. The Labor Department hasn’t issued its ruling yet.
… or a European investor
On the other hand, in Europe (and, despite Brexit, the UK is still very much part of Europe), regulatory demands on investors in relation to ESG are on the rise. Two key pieces of regulation, the EU Taxonomy and the Sustainable Finance Disclosure Regulation (SFDR), target conformity and transparency. At a high level, the EU Taxonomy establishes the conditions and the framework to create a unified ‘classification system’ – essentially what can be considered an environmentally sustainable economic activity. Meanwhile, SFDR introduces, amongst other, disclosure obligations on how institutional investors and asset managers integrate ESG factors into their risk management processes. Delegated acts will further specify requirements on integrating ESG factors into investment decisions. This is part of institutional investors’ and asset managers’ duties towards investors and beneficiaries. Other regulations are being introduced and/or reviewed, including the EU Climate Benchmarks Regulation (which amongst other creates a new category of benchmarks comprising climate transition and Paris-aligned benchmarks). EU regulators are also moving to embrace the Task Force for Climate-Related Financial Disclosure (TCFD) system.
UK was the first G7 country to commit to be climate neutral by 2050 and is keen on adhering to high standards. As a result, the UK’s regulatory approach is shifting from voluntary to mandatory. From October 2019, pension trustees in the UK were required to update their scheme’s Statement of Investment Principles (SIP) to set out their policies on ESG, climate change and stewardship activities. Since then, schemes have faced additional ESG reporting requirements within their SIP, while also publishing annual implementation statements on how they have followed through on their ESG and stewardship policies.
To ensure pension schemes drive change to a sustainable, low carbon economy, the UK government has put forward proposals to require the 100 largest occupational pension schemes – those with £5Bn or more in assets – to publish climate risk disclosures by the end of 2022. The proposals will mean trustees of such schemes are legally required to assess and report on the financial risks of climate change within their portfolios. The government said that, following this first round, a further 250 schemes with £1-5Bn in assets would have to meet the same requirements by 2023.
We do not have the space to cover all the regulatory frameworks around the world, but if you have not done this already, it is vital that you do your homework on the existing and upcoming regulations which might impact your firm as well as your various stakeholders.
Step 3: RI vis-à-vis performance and risk mitigation
In order to come to a decision on whether you should or should not be a responsible investor, you will also need to come to a view as to whether you believe investing in a responsible manner results (or not) in improved investment performance and/or reduced risk. A large number of studies have been conducted on the topic and you may already have read a number of them, many with differing results. McKinsey have aggregated the results of over 2000 studies on the impact of ESG considerations on equity returns and have found that “a strong ESG proposition correlates with higher equity returns” and “with a reduction in downside risk”.
While the aggregation of the analysis seems quite conclusive (see Exhibit 3 above), it is extremely difficult to provide robust empirical evidence on this topic, as much depends on the time horizon, variety of ESG approaches and other assumptions. For instance, a Morningstar study conducted in 2020 showed that sustainable funds outperformed traditional funds during the COVID-19 market fallout in the first quarter of 2020 by an average excess return of up to 1.83%. However, much of this outperformance can be attributed to ESG funds’ low exposure to oil and gas, at a time when energy stocks fell significantly. Saying that, examining the long-term performance of a sample of over 700 Europe-based sustainable funds, Morningstar also concluded that that the majority of strategies had done better than the non-ESG funds over 1, 3, 5 and 10 years.
Alternatively, you can tackle this question from a more conceptual basis. In the long-run, do you believe that there are structural tailwinds to profit from (e.g. energy transition, future of mobility, circular economy, diversity of decision making) and investment risks to be avoided in your portfolio (e.g. stranded assets), all of which could mitigate downside risk? Similarly, do you believe that a firm that has strong ESG credentials with a commitment to various stakeholders, including customers, employees, suppliers, shareholders and local communities, will end up with a more robust business model in the long-run than its non-ESG peer in the same industry? Even conceptually, this is not so straightforward. As an example, if you were to invest in Tomra (Norwegian recycling and optical sorting company) today at a PE ratio in excess of 75 times, you would be excused for not being confident that this will be a profitable investment in the long-run (although it may well be).
If knowing what your peers think assists you in coming to a view, according to a 2020 survey by RBC Global Asset Management, ‘only’ 74% of US financial groups think that ESG boosts performance, compared to 93% in Asia and 96% in Europe.
Step 4: Create your own RI policy
Now that you have established your values and beliefs, and you understand the regulatory requirements you are subject to, it is important that you establish an RI policy. Putting words down on paper not only helps you to understand and articulate your own values and beliefs better, but also assists you in sharing those beliefs with your stakeholders. The policy is also an important ‘live’ document, which you will need to regularly update, as your views or understanding of what constitutes RI may change.
You may have thought that this step has already been taken by most institutional investors by now but, according to a 2019 survey by Aon, less than half of all institutional investors worldwide have developed an RI policy (Exhibit 4). Amongst smaller institutional investors, even fewer have an RI policy with only 35% of those with $500Mn or less of AuM having a policy. This is in contrast to 69% of the $5Bn+ cohort.
Step 5: Put in place processes and infrastructure
Now you are ready to implement your RI policy, but it is not as easy as you may think. You will need to create processes to integrate RI within your research and create the relevant governance structures to address various RI concerns. What actually constitutes RI can be very opaque and complex, and you may need additional resources that can assist you in this process.
Such resources can be costly. According to the Financial Times (May 12, 2019), “access for the full suite of sustainability data can cost up to $50,000 (compared with the $25,000 approximate annual fee for a single Bloomberg terminal)”. The fees quoted on MSCI’s website are even higher. According to MSCI, “the fees for each of MSCI ESG Research’s services range from $7,500 to $2,000,000 per year”.
Hiring specialist in-house teams are an additional layer of costs. In a 2019 survey by IPE, the top 400 asset managers were questioned on the number of dedicated specialists on ESG issues and found that asset managers with the larger RI teams have over 15 specialists (Exhibit 5). If you are a small or even medium-sized investment management firm, this is prohibitive. Therefore, the robustness of RI processes will need to be adapted to the resources that you have at hand. This means finding a best-fit approach to incorporating RI – balancing the cost pressures with the need to build up specialist knowledge.
Step 6: Educate, participate, engage and collaborate
Should you be undertaking the RI journey on your own? The answer is a definite, resounding “NO”! The RI space is constantly evolving, and there are many initiatives spearheaded by a large number of organisations which you can benefit from, facilitating you to implement a more effective RI strategy.
Many of these initiatives provide you with opportunities to expand, share and update your knowledge through conferences, investor tools, working groups, consultations, training and research. Also, and very importantly, they provide the ability to collaborate with other investors to engage with entities and promote positive environmental and social outcomes, which is key to drive change.
Some of the initiatives may be more applicable to you than others, depending on factors such as your jurisdiction, the type of investor you are, and the asset classes you are exposed to. The growing number of initiatives can seem like an intimidating alphabet soup of acronyms to a new entrant in the space. As a first step, many investors decide to become signatories of UN PRI, where there are six guiding sets of investment principles. Amongst other, signatories must also file an annual report to the organisation, detailing their progress.
However, as you move forward on your RI journey, it is important you cast your net wider and become a signatory to other initiatives which would complement your own RI objectives. For instance, if climate change is one of the areas you have highlighted as wanting to make a positive impact on, you may want to join Climate Action 100+, where investors lobby the largest greenhouse gas emitters to address climate change at the board level and set targets to cut emissions. To date, more than 500 investors with more than $47 trillion in assets have signed on to this initiative.
Step 7: Be wary of the ‘Emperor’s New Clothes’ syndrome
If you do decide to become a responsible investor (assuming you are not one already), you will most probably at some point suffer the ‘Emperor’s New Clothes’ syndrome, i.e. you will invest in a particular manner with the belief and expectation that you are acting very responsibly, but in reality this may not be the case.
This is likely to reflect the fact that assessing whether an investment should be considered responsible or not is quite complex, not to mention the significant limitations in the availability, quality and standardisation of data. To fully understand the environmental and social implications of an investment, an investor needs to consider the full life-cycle, supply chain, and other implications, many of which are unintended. The recent ownership by many ESG funds of Bohoo, a UK fashion company that was later rocked by allegations over its working conditions in its supply chain, is an example of finding out that you are in fact walking naked every now and then.
The complexities of RI are also exemplified in the different scores given by the ESG rating agencies. According to estimates in a 2019 working paper from MIT Sloan School of Management, using a dataset of five ESG ratings providers, correlations between scores on 823 companies were on average only 0.6. This is a far cry from the correlations of credit ratings from Moody’s Investors Service and S&P Global Ratings which are 0.99.
In some instances of greenwashing, doing a little bit of your own homework can pay off. For example, if you invest in ETFs marketed as ex. fossil fuels, you can easily check whether any of the underlying holdings have exposure to fossil fuels. The SPDR MSCI EAFE Fossil Fuel Reserves Free ETF has been in the media for containing shares of RWE, a German energy company that runs several coal-fired power plants.
Step 8: Are you practising what you preach?
If you do decide to be a responsible investor and you are part of an organisation, aspects such as equal opportunities and diversity, will need to be reflected in your internal employment policies, procedures and initiatives (if not already). Although more difficult, steps should also be taken to measure the environmental implications of your business, such as carbon emissions from the office and business travel. Furthermore, your ability to improve your own standards should be monitored and measured. If you have external stakeholders, regular reporting on these metrics is essential.
Step 9: Remember the big picture
If, after walking through all these steps, you have decided that opting to be(come) a responsible investor is too cumbersome and costly, at this point, I will ask you to always remember the big picture.
There are many environmental and social issues confronting society today, such as water scarcity, deforestation, rising sea levels and reduced biodiversity. Given how the world is increasingly interconnected, there is no doubt that these issues will eventually mutilate certain financial assets and markets. I firmly believe that, if the investment community doesn’t tackle the bull by the horns, these issues will come back to haunt us all.
The World Bank estimates that the asset management industry globally managed around $124Tn in 2018 – significantly more than the c.$87Tn of global GDP in 2019. As a member of this investment community, we need to join forces and leverage the colossal power of the financial industry to address these issues. Whether you are a large or a small investor, if we all collaborate on this, the environmental and social issues can be addressed or, at the very least, mitigated. For this to become a reality, you have to take action now, based on the information you have and evolve as a responsible investor as far your values and business constraints allow you to. The worst thing you can do is nothing.
Alison Major Lépine
19 November 2020
Appendix – More on Step 1
Where to position yourself on the RI spectrum?
One of the initial outputs from your brainstorming exercise should be where you will position your investments along the RI spectrum, i.e. whether you will pursue a negative/exclusionary screening approach or a more real-world impact investing type of approach (where there is an additional, intentional and measurable positive environmental and/or social outcome), or somewhere in the middle, such as an integrated or best-in-class approach, or a combination of these. Where you can position yourself on this spectrum will be strongly influenced by the asset class of your investments.
According to KPMG, most RI strategies follow integrated or exclusionary/negative screening approaches (Exhibit A1). The expectation is that the exposure to the positive screening and impact end of the spectrum will increase over time.
What areas should you avoid?
As you just saw in Exhibit A1, most of the the RI approaches in the spectrum incorporate an element of negative screening, so another key objective of the initial brainstorming sessions should be to select the areas (sectors, countries or other) which, from an ethical and cultural perspective, you deem unacceptable. Exhibit A2 details what the most typical exclusions areas are for European investors, according to a 2018 Eurosif survey.
Again, this is not a straightforward exercise, and investors often conclude at this stage that exposure to a potentially controversial area (e.g. fossil fuels) is acceptable if below a certain threshold, and/or where there is positive direction of travel (e.g. falling fossil fuel exposure).
According to the same Eurosif SRI study, the most common norm-based screen was to comply with the UN Global Compact (10 principles on human rights, labour, environment and anti-corruption), followed by the ILO Conventions and the OECD Guidelines.
Which environmental and social issues would you like to focus on?
At this stage, it is also important to sit down and determine which environmental and social issues you would like to prioritise and are material. Factors to consider in making this decision include which issues you believe present:
- the strongest long-term tailwinds to profit from (e.g. energy transition, food security, future of mobility, demographic shifts, circular economy);
- the most significant investment risks which should be avoided in your portfolio (e.g. systemic stranded assets, specific stranded business models); and/or
- the potential for the most positive impact from a more ethical approach.
The World Economic Forum (WEF) publishes its Global Risk Report annually (Exhibit A3). In the 2020 report, respondents to the Global Risks Perception Survey ranked climate change and related environmental issues as the five biggest risks in terms of likelihood – the first time in the survey’s history that one category, in this case the environment, occupied all five of the top spots. Social issues such as water and food crises, ranked highly as well.
Exhibit A4 corroborates that, from an active equity owner perspective, climate change is one of the areas investors have been most vocal about in recent years. More traditional governance issues, such as corporate activity, labour & equal employment rights and executive pay, continue to be at the top of the agenda as well.
If you employ more of an impact type of strategy, you will also need to determine how the environmental and social issues you have chosen to focus on align to the UN Sustainable Development Goals (Exhibit A5) or other initiative. A growing number of investors today actually use these as their starting point on the RI journey.
Many investors are also aligning themselves with specific goals, with alignment to the Paris Climate Agreement goals becoming particularly popular more recently. Over the last few months, a number of announcements have been made in the UK, for example a declaration from the BT Pension Scheme (BTPS) stating it is to target a net-zero strategy by 2035, aligned with the goals in the Paris Agreement. I have also noted that the South Yorkshire Pensions Authority have indicated their intention to be carbon neutral by 2030; that Nest has stated its plan to have a net-zero portfolio by 2050, and that the Northern LGPS announced their intention to invest 100% of their assets in line with the Paris Agreement.
How patient should you be- engagement vs. divesting?
One of the other key considerations to explore at this early stage is the horizon for which your investments need to meet your standards. This will of course be dependent on the investment horizon of your investment, but it is also a deeper question. Do you need all investments to meet your standards now, or are you comfortable with certain investments which may currently be at a less desirable point but have a well-defined set of objectives in place? In other words, is there a positive direction of travel?
For instance, if you have concluded that diversity is one of the key issues you would like to focus on and, upon requesting for the diversity profile of one of the investment managers in your portfolio, you become aware there is minimal diversity, do you divest or engage with the investment firm in question to introduce policies to increase diversity? And, if you do decide to engage, how long are you willing to wait for the positive developments of their stated initiative (potentially triggered by your engagement) to become evident?
What are your stakeholders telling you?
So far, you will have brainstormed on what is important for you, requiring a high degree of introspection. It is crucial that you also look outwards – reach out to all your stakeholders and listen very carefully to their views. For instance, if you are managing a university endowment, you will need to immerse yourself in the issues from the perspective of your students and the faculty. Today, almost all of Britain's top universities have committed to selling their shares in fossil fuel companies which, according to People & Planet (a student campaign group), amounts to around £12.4bn of endowments across the sector that have been divested. This change in investment strategy came about in most part only after significant pressure from eco-conscious students who recurred to occupying buildings and carrying out hunger strikes. You do not want to wait until your stakeholders need to take such drastic measures!