Responsible Investment: what lies beneath

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March 2022
 

Sometimes the complex sustainable factors involved in making an investment are not all obvious on the surface. Here, Kristina Church, head of Responsible Strategy at BNY Mellon Investment Management, considers how managers can look beyond the headlines or conventional understandings to uncover what companies are actually doing to address environmental, social, and governance (ESG) concerns.

Achieving long-term sustainability goals will require far-reaching societal change, engaging all sectors of the economy and society. That may seem a tall order, yet in an increasingly responsibly focused world, investments are routinely expected to deliver the benefits of financial returns and generate a positive impact on society and the planet.

Does that mean that to invest responsibly we need to divest immediately from all perceived ‘bad’ companies? No—because in order to drive the wholescale transition so urgently required, the effort will require not only engaging with critical industries to impact change but also to ensure that these businesses are not starved of the capital they so urgently need to achieve their objectives.

It is important to keep in mind that Responsible Investment is a spectrum of investing styles and that even the most sustainable investments can include companies which might today be scoring less well on the criteria checklist for investments that claim to have ESG-friendly status.

Further, for all those concerned, we need to see greater focus by investors on identifying companies that are not simply ‘best-in-class’ on ESG issues today but also those which are transitioning to align with a lower-carbon world, or better social values.

If we were to rely only on external providers of ESG data and static scoring systems, we might be limited to a small number of best-in-class or ‘ESG champion’ investments, while potentially missing out on the extensive opportunities others outside this classification might offer.

Investing solely in best-in-class investments risks attracting a disproportionate amount of inflows to this area, not only creating the risk of overcrowding in favored stocks and sectors but also risks directing flows away from sectors which are vital for future economic growth and most desperately need investment to achieve the necessary transitions.

If we take climate as an example, ‘dirty’ carbon-intensive industries (such as cement, heavy-duty transport, steel, and chemicals) face the most significant net-zero transition challenges and costs. We will continue to need these industries for future growth, therefore without financing their transition, net zero will be impossible to reach. Since the latest COP26 climate summit, 90% of global GDP now lies within some form of net-zero ambition,1 and just over one-third of the 2,000 largest publicly listed companies have similar commitments.2

To stay on track with the targets outlined in the UN’s 2015 Paris Agreement, carbon emissions need to be halved from their 2010 levels by 2030. The latest Intergovernmental Panel on Climate Change (IPCC) report3 on climate vulnerability underscores that addressing the climate challenge requires transition on an unprecedented scale and cooperation across all sectors of society and all nations.

The report also highlights that the most vulnerable people and systems will be disproportionately affected by climate change. Forward-looking investment management firms are beginning to move away from simply making low-carbon investments to investing in companies that are engaged in this wholescale clean-energy transition to address either climate mitigation or climate adaptation.

However, not all carbon-intensive companies have accepted the need to transition, nor are all able to do so profitably. To be investable, companies in carbon-intensive sectors need to have credible, public strategies to transition in line with the goals of the Paris Agreement and need to report their greenhouse gas emissions in line with recognized standards, such as the Science Based Targets initiative and Task Force on Climate-related Financial Disclosures. It is vitally important to understand the decarbonization pathway these companies are on, rather than just view their current carbon footprint. Investors also need to be able to track how success is measured and set limits that might eventually drive divestment if the criteria are not met.

Analyzing entities for investment often differs by geography. Emerging markets are already exposed to high risks from climate damage (unprecedented heat waves, rising sea levels, and destructive wildfires, to name just some threats) and desperately need to finance the infrastructure to adapt to further climate damage. Many of these countries have different pathways to net zero, and, as such, they cannot be treated uniformly by investors.

The decarbonization trajectory of a steel company in Europe, for example, may differ greatly from that of a competitor in Asia. There is often less data available on ESG issues in emerging markets, but this does not mean that investors should penalize EM-based companies, which urgently need to finance their transition. Against this backdrop, engagement will be key. Engagement with companies and issuers can focus on simply seeking information to support investment decision-making, or it can seek to drive change on issues which are material to long-term value creation, such as delivering more quickly on net zero goals.

Social issues

Social issues are also rising up among investment agendas. Investors no longer rank the pursuit of profit as a company’s sole motivation, recognizing that a strong culture and clear purpose to drive societal impact can be critical to long-term value creation. If a company does not have a clear social purpose, this deficit can affect a company’s social license with stakeholders, access to capital, and customer acquisition. Again, engagement with companies and other issuers is key to assess and influence the social factors that are material to their longer-term success. However, it is not just about selecting the companies already best aligned with a client’s social values: engaging for change involves dialogue with companies and issuers to drive impact and delivery on social goals.

For instance, as society and investors pay more attention to social needs, progress on diversity, equity, and inclusion (DEI) is increasingly becoming a differentiator for companies and can impact their ability to attract top talent, raise capital, and reflect the profile of their customers. Organizations with diverse experience, skills, and backgrounds are more likely to make optimal decisions and nimbly avoid the pitfalls of groupthink.

Yet, unfortunately, investors do not always have access to consistent data to analyze DEI factors. The most forward-looking asset managers are acknowledging the information and data gaps, are anticipating the changes that are needed, engaging with companies to actively try to fill the gaps, and are also focusing on companies that are delivering improvement on specific DEI credentials.

The same is true for other key social issues which are rising higher on investor agendas.

New opportunity

All of this presents potentially tremendous opportunities for the asset management industry, but only if it is prepared to satisfy the demands of increasingly aware clients who want to see their values reflected in their portfolios. Investing in companies and other issuers that are actively transitioning to more environmentally friendly and socially acceptable business models can deliver greater change to the wider environment and society than investing in entities already aligned to low-carbon or socially responsible models. Beyond this, stewardship can also play a key role in driving more consistency and quality in ESG data and determining the success (or not) of each transition model.

1 “CAT net zero target evaluations,” Climate tracker.org, November 11, 2021.

2 Companies table, Zero tracker.net; accessed March 2022.

3 “Climate Change 2022,” IPCC Sixth Assessment Report, February 2022.

 

All investments involve some level of risk, including loss of principal. Certain investments have specific or unique risks. No investment strategy or risk-management technique can guarantee results or eliminate risk in any market environment.

Recent market risks include pandemic risks related to COVID-19. The effects of COVID-19 have contributed to increased volatility in global markets and will likely affect certain countries, companies, industries and market sectors more dramatically than others.

This material has been provided for informational purposes only and should not be construed as tax advice, investment advice or a recommendation of any particular investment product, strategy, investment manager or account arrangement, and should not serve as a primary basis for investment decisions. Prospective investors should consult a legal, tax or financial professional in order to determine whether any investment product, strategy or service is appropriate for their particular circumstances. Views expressed are those of the author stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change.

This information contains projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or expectations will be achieved, and actual results may be significantly different from that shown here. The information is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

There is no guarantee that any strategy that considers environmental, social, and governance (ESG) factors will be successful, or that any strategy will reflect the beliefs or values of any particular investor. Because ESG criteria exclude some investments, investors may not be able to take advantage of the same opportunities as investors that do not use such criteria.

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