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Sustainable investing – how to implement it across asset classes

Sustainable investing – how to implement it across asset classes

Investors who have been following our series on sustainable investing will know by now that there are three main approaches to sustainable investing: exclusion, ESG integration, and impact investing. Of the three, exclusion is the most popular among investors; it’s unfortunately also the least desirable.

Once a company is excluded from your portfolio, you as an investor no longer have any say in how the company is managed. In other words, you lose active ownership.

Active ownership: voting and engagement are powerful tools for change

Active ownership (voting and engagement) is when investors use their influence as providers of capital to a company to persuade its management to act responsibly.

Investors who are unhappy with a company’s policies can vote against them at shareholder meetings. They can also file proposals to demand change or block resolutions that they don’t like. While individual shareholders with only a small percentage of the stock may not be able to make a difference unilaterally, many investors now bank together to object to unsustainable practices collectively. This has been seen in the growth of investor associations taking a common stand on bigger issues.

A good example of where a joint resolution achieved positive change was seen at McDonald’s, which in 2017 agreed to phase out the non-therapeutic use of antibiotics in its chicken meat, and then extend this to pork and beef. This followed concerns that over-use of medically unnecessary antibiotics in farm animals was enabling bacteria to develop a resistance that was causing deaths in humans.

The more investors apply active ownership, the more effective it becomes. Active ownership can also be implemented as an overlay, which makes it one of the easiest ESG tools to apply across an entire portfolio.

Exclusion: sometimes investors have no choice but to walk away

Sometimes excluding a company is ultimately the right thing to do. A good example is excluding companies that structurally breach the terms of the United Nations Global Compact and do not show any sign of improving their practices after an intense engagement process over several years. Such breaches can involve matters such as human rights, corruption or environmental issues.

Exclusion without engagement is also preferable in certain industries, as is the case with the production of controversial weapons or tobacco, where no healthy alternative product or service exists.

Other than taking a moral stance, exclusion is also motivated by the investor’s desire to avoid companies that might suffer reputational damage and/or financial loss by inflicting environmental or social harm or whose weak governance structures prejudice its stakeholders.  As a result, these companies’ share prices run a high risk of being punished by the market, with potentially serious financial implications for the investor.

Integration: mitigating against risk without excluding

Like exclusion, ESG (environmental, social and governance) integration also has at its heart the drive to mitigate against risk. But instead of excluding certain stocks, it aims to improve the risk-reward profile of a portfolio. It does this by incorporating (integrating) ESG information that is considered ‘financially material’ to the sustainability of a specific company. What counts as material depends on the industry the company operates in.

For example, with banks, there is little point in assessing their CO2 emissions, water use or paper consumption, as there is little connection between these environmental factors and the banks’ long-term business models. Instead, it is much more useful to analyse their corporate governance, risk management processes and cybersecurity measures, as these are the factors that could affect a bank’s future success. For a utility or energy company, however, CO2 emissions are extremely important indicators, and they can have a major impact both on their long-term business models and society at large.

How is ESG integration implemented?

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