ESG as an investment approach has undeniably caught the attention of the investment world, and has moved beyond the confines of the Ethical and Socially Responsible Investment (SRI) approaches from which it emerged, and into the mainstream.
While adoption of SRI approaches helped put ESG-based strategies on the investment radar, the incorporation of environmental, social and governance factors into investment decisions has become marketed as the mainstream investment industry's response to the challenge of responsible investment. The mainstream adoption of ESG has been driven, in part, by the activities of actors such as the UN Principles for Responsible Investment, but largely by academic studies showing that it can help investment managers in the elusive search for alpha.
The growth of ESG investing for charities
One might be justified in thinking that there is no reason why charities should not engage with this trend. Indeed, official guidance on the matter points to the conclusion that ESG is the new normal in investing for Charities. Take for example the recent changes made by the Office of the Scottish Charity Regulator, which in November 2018 released its Guidance and Good Practice guidelines, highlighting that:
"Regardless of whether charity trustees decide to apply any negative or positive screening... ESG factors are something to be aware of in the process of making decisions about the charity’s investments. If a company you are investing in does not take a responsible approach to its impact on the environment, its employment practices or how its board operates, these factors could affect the financial performance of that company. This could affect the value of your investment and/or impact on the charity’s reputation."
Moreover, in March 2019 a coalition of 20 charities sent an open letter to the attorney-general and the Charity Commission for England and Wales, seeking a ruling on whether the public benefit of charities means they should be required to align their investment policies with their own objectives and commitments to wider society.
The hidden risks of ESG integration
Unfortunately, all that glitters isn’t gold in the world of ESG.
ESG research, and the application of its results to investment decision making, can be undertaken in many different ways, and the adoption of ESG as a catch-all marketing term is obscuring the consequences of these differences for investors. Some research methodologies can, for example, produce ESG scores favouring companies that are better at reporting their ESG impacts than mitigating or reducing them. Such "box-ticking" approaches can potentially conceal risks that might be relevant for mission-driven clients such as charities.
Guidance from the Charity Commission for England and Wales on when charities can consider non-financial issues (such as moral/ethical judgements) in their investment process allows for the avoidance of investments which conflict the aims and objects of a charity. The judgement of what constitutes a conflict can be hard to define and can change over time. The open letter sent to the Chair of the Charity Commission (referred to above) challenges the guidance for being outdated, vague and potentially misleading as it pre-dates subsequent legislation and emerging climate change concerns, stating:
"...it seems likely that, if a judge were to consider the question of conflict with objects today that a range of other forms of conflicts would now be relevant and, in the light of climate change and the comprehensive nature of it, the potential for conflict now seems far from exceptional".
Presented with the same question, the court of public opinion works in a similar way, but is less forgiving and offers fewer protections for the accused.
More and more cases of funds which label themselves "Responsible" investing in stocks with dubious environmental credentials have recently come to the public attention. For example, the annual update of the US NGO Rainforest Alliance "Banking on Climate Change" report revealed that the world’s largest investment banks have provided more than $700bn of financing for the fossil fuel companies most aggressively expanding in new coal, oil and gas projects since the Paris climate change agreement.
At the same time, market actors have expressed doubts about the functioning of some of the most widely used ESG rating systems, citing anecdotal evidence pointing at the fact that substituting companies helping to fight cancer with tobacco producers might in fact improve a fund's ESG score.
Other questionable examples can be found in the holdings of "Sustainability focused" collective investment funds. Examples have been found that hold the likes of Rio Tinto and BHP. Rio Tinto won plaudits from certain investors by selling out of coal mines, but its current coal power plant project at Oyu Tolgoi in Mongolia did not warrant a mention. BHP is also in the good books of some funds, despite still owning coal mines, for saying it had "no appetite" for expanding coal exposure. Both companies receive high ESG scores from a number of ratings providers, but are completely incompatible with some investors' view of a sustainable company, and possibly in conflict with the aims of charities with an environmental focus.
To be clear, we believe the problem is not with the ESG scores per se, they can provide useful information provided the methodology by which they are derived is clear; the processes for integrating ESG into investment decisions is transparent; and you understand clearly what the score represents. The problems result from opaque methodologies and processes, and falsely equating a good ESG score with good ethical and/or sustainability performance.
Such issues present clear risks for charities from a regulatory and, maybe most importantly, a reputational perspective. According to a survey published by insurance company Ecclesiastical in March 2019, reputational risks are high on charities' agendas, with 26% of leaders claiming it poses the biggest threat to their charity over the next five years.
Examples of the reputational risks associated with charities investments are numerous, for example the recent announcement by the National Trust of its plans to divest from all fossil fuel companies. This followed an investigation by the Guardian newspaper, which found the charity held more than £30m of investments in oil, gas and mining companies held indirectly through a portfolio fund. At the time of the investigation, the charity’s investment policy excluded companies which derived more than 10 per cent of their turnover from the extraction of thermal coal or oil from oil sands. In this case, the problem was not the amount of fossil-fuel related investment permitted by the policy, but the fact that, in an era of social media and with the fight against climate change in full force, a conservation charity which pledges to reduce its consumption of fossil fuels and makes statements about the risks of climate change faces a reputational risk from any association with oil and coal producers.
How to manage the risk
The answer to the problem outlined above lies in a systematic approach using managers and advisors that understand the issues, and with the right tools to manage the risks:
- Identify the reputational risks that relate to the charitable aims and objects, and write a coherent Sustainable Investment Policy which addresses those risks. Revisit the policy regularly, updating it as circumstances change.
- Conduct a robust due diligence process in the choice of Investment Manager, ensuring they can work within the policy, either using their own research or the services of an external research provider; and that they understand that ESG investing is not a proxy for Ethical/Responsible/Sustainable investing. If they try to sell you ESG as an off-the-shelf solution to your reputational risk concerns, proceed with caution...
- Engage with the Investment Manager on relevant issues. This can include ensuring that the research upon which investment decisions are based is up to date and suited to the specific goals of the investment policy; and monitoring investment managers’ voting and documenting investment decisions taken.
Of course, this cannot be a one-size fits all process. The development of policies and the subsequent activities must take into account the specific situation of each charity, together with the character of the companies it could invest in. Investing in a company that is on the right track towards the energy transition could potentially be acceptable, so long as its performance is strictly monitored and the charity's policy clearly states it.
Conclusions
For charities, reputational risks are manageable if trustees can identify where they are, and recognise the false equivalence of ESG investing with Ethical, Responsible, and Sustainable investing as one of those risks. For investment managers and research providers, opportunities exist for those that understand this false equivalence to provide a viable alternative approach which guides charities through the ESG minefield.
Ethical Screening has the expertise and tools to help charities advance their aims through their investment; and help investment managers to provide such services to their own charity clients. Please contact us for further details.