Understanding Responsible Investment


Definition

Responsible Investment is a young industry that lacks widely-acknowledged and precise norms, guidelines and definitions. So far, there is an understanding that Responsible investment is a generic term that refers to a wide range of approaches that integrate ecological, social and governance (ESG) criteria in the investment process. Beyond that, Responsible Investment has a variety of forms.

Two main approaches of Responsible investment can be identified:

Strategies

In terms of Responsible Investment (RI) strategies, funds are often invested in shares, bonds and/or monetary securities. Issuers are generally companies or countries selected because of a favorable environmental, social and governance (ESG) performance. Different overall strategies can be distinguished:

Impact

Today, the debate regarding the impact of responsible investment on investment process is not yet settled and is still at an early stage. In general, investors pursue two strategies to have a sustainable impact: selection and engagement.

Targets

Investors often have many targets: these are classified below:


SRI products

This approach encompasses all financial products that have a specific socially responsible (SRI) investment strategy. The investor understands ESG criteria as a tool to ensure that the investments he/she makes reflect his/her moral values. Consequently, he/she wants to align investment with ethics, social or environmental purpose in order to improve the sustainable impact of investment decisions. Therefore, issuers with low ESG performance or issuers that are active in controversial sectors and/or activities are considered as problematic investments. Specific SRI products are designed for investors for whom ethical considerations play a major role in their investment strategy (for instance church banks, foundations, etc.).

ESG integration

This approach refers to the integration of ESG criteria in the investment process. The investor understands ESG as part of his/her fiduciary duty or risk management: ESG aspects have a material impact on the economic value of portfolio holdings. These aspects have to be integrated into the financial analysis of all assets under management in order to optimize the risk-return profile of holdings and portfolios. A specific ethical motivation is possible, but not essential. In the last years, a growing number of asset managers and owners have adopted different types and scopes of these practices. Details about these practices can be found in own or third-party investment (for instance PRI statement) reports.

ESG selection

This strategy consists in selecting issuers with the best Environmental, Social and Governance (ESG) practices. ESG selection can take different forms: best-in-class (selection of the best ESG-rated issuers of an industry), best-in-universe (selection of the best ESG-rated issuers irrespective of their industry), best effort, ESG benchmarking or ESG weighting.

Norm-based exclusions

Investors applying this strategy exclude from the fund’s portfolio issuers that do not respect norms or international conventions. These norms include violating human rights, using child labor or severely polluting the environment, etc.

Sector-based exclusions

Investors applying this strategy exclude issuers in controversial industries such as alcohol, tobacco, weaponry, gambling and pornography, Genetically Modified Organisms (GMO), nuclear etc. More recently, environmental considerations like climate change have also led to the adoption exclusion of sectors such as coal power plants or mining.

Thematic funds

Thematic funds focus on companies that are active in sectors that favor the sustainable development of renewable energies, water, medicine, or more generally deal with climate change, energy efficiency, health or the aging population.

Shareholder engagement

Shareholder engagement consists in influencing companies to improve their environmental, social and governance performance. Investors can achieve this by dialoguing with companies, exercising their voting rights at Annual General Meetings or, should the dialogue fail, by pushing for shareholder resolutions.

Selection

An investor puts in place selection proceedings which allow him to invest only in the most sustainable, best ESG rated issuers. Companies with a low ESG performance are not considered eligible. Issuers should be incentivized to show strong sustainable performance in order to enter the eligible investment universe of the investor. The Best-in-Class or Best-in-Universe approach is based on this philosophy. The measurement of specific ESG Key Performance Indicators is a method to show the overall sustainable impact of the portfolio.

In practice, this approach is used very differently with selectivity rates ranging from almost zero to 80 to 90%. Therefore, a further analysis of a fund’s selection process is mandatory in order to fully understand the impact the fund has. For the French market, Novethic’s research centre has identified several levels of impact. For further information, please read the 2015 market survey.

In parallel to ESG selectivity, using thematic selection also generates sustainable impact. Several kind of impact measurement may arise from such approach, especially depending on the theme chosen. The most frequent impact target is currently the volume of CO2 emissions that can be avoided thanks to e.g. renewable energy investments; job creation can also be a sustainable objective pursued by specific thematic approaches.

Engagement

An engagement approach can be considered as active equity ownership. The investor enters in direct contact with the issuer and seeks to improve the sustainable performance. There are different degrees of engagement. First, an investor can raise awareness for ESG topics: he/she can execute his/her voting rights and requires ESG disclosure from issuers. This transparency helps issuers understand their weaknesses and to work on them. Second, he/she can address these topics at direct meetings with companies or at Annual General Meetings. Third, an investor can closely work together with the issuer, alone or in collaboration with other investors. The aim of these engagement processes is to improve specific ESG aspects that are poorly developed, for instance working conditions in the supply chain of textile companies, sourcing of certified palm oil in the food industry or long term risk associated to climate change and stranded asset in the energy sector.

Today, the impact of these dialogues is difficult to measure. Voting records or shareholder resolutions may show a certain impact on companies, in particular in the oil and gas industry. However, direct dialogue disclosure with companies concerning ESG topics remains under-developed. Most investors claim confidentiality or do not engage. Nevertheless, in some engagement reports or via collaborative engagement platforms greater transparency has been established over the last years. This should facilitate the impact measurement of engagement activities in the near future.

Understanding ESG risks

Responsible investment should help to identify and to mitigate investment risks. Using ESG data helps investors avoid controversial companies or industries exposed to material economic risks, for instance the coal industry. Furthermore, ESG research helps identify growth opportunities in companies or industries. In particular, companies and sectors that commercialize eco-friendly products, companies that dispose of resource-efficient production lines or companies that are able to easily adapt to new customer demands or economic obstacles could have stable long term revenue and earnings.

Proactive reputation management

Investing in controversial companies could bear a reputational risk for investors. Non-Governmental Organizations and journalists are regularly screening financial institutions’ funding activities against the involvement in controversial industries. The results could be a threat to the investor’s reputation. ESG research could figure as a pre-warning system in order to avoid any exposure to these reputation risks.

Complying with fiduciary duty

The integration of ESG data is perceived as essential in order to execute correctly an investor’s fiduciary duty. More and more national and international legal frameworks and guidelines ask investors to take ESG criteria into consideration and to report on aspects which are not directly linked with financial performance. In order to comply with these guidelines, ESG research is seen as the most appropriate tool as a recent UNEP-FI study revealed.

Reconciling SRI with ethics

For some financial actors, SRI is a tool to that can be used to invest in companies that share similar values to those of the investors or to their clients. Accordingly, extra-financial analysis must enable investors to exclude from their investment universe certain industries like tobacco, alcohol or weaponry that are not in line with their moral values. 

Internationally, the number of large investors (banks, insurance companies, pension funds, etc.) adopting SRI approaches is increasing. Private investors also have the choice to invest their savings in financial products with SRI approaches, such as SRI funds. Even though these products are rarely promoted to individual clients, most of the large banking and insurance networks have specific offers.