Climate change is currently the most pressing issue uniting socially responsible investors globally. Responses by different investors have varied from outright divestment of fossil fuel producers, engagement through shareholder resolutions seeking further disclosure, to measuring the direct carbon exposure of investment portfolios.
Each of the approaches used by large institutional investors has advantages and disadvantages in trying to effect corporate change. This blog post attempts to summarise these issues, weighing the arguments and counterarguments from a range of sources. Ultimately, the most appropriate course of action will differ on a case-by case basis.
However, the present debate on divestment has largely ignored individual investors. The existing investment architecture needs a rethink to enable individuals to have a stronger say in how their investments are managed when it comes to environmental, social and governance (ESG) issues.
Innovation is possible and necessary, and I suggest three approaches to aid engagement by individual investors, namely: a “building blocks” approach, look-through proxy voting and standardised ESG exposure metrics. Responsible investing is simultaneously personal and universal. The investment industry has an important role to play in evolving its infrastructure to let the voices of all investors be heard.
Dynamics of divestment
The campaign to encourage divestment from fossil fuel producers, and coal miners in particular, has won the support of many large investors including university endowments, large pension funds, insurers and foundations. The issue has garnered much press coverage in addition to greater attention from academia.
Not all are convinced that divesting from companies that utilise irresponsible practices is the best way to influence corporate behaviour. Articles in the Financial Times and New Republic question the efficacy of the approach. Meanwhile, Rolling Stone and the Guardian have countered with more positive views. Further still, researchers at the University of Oxford have published a very comprehensive report on the issue.
Bringing together a lot of the different perspectives was a recent event on divestment hosted by the UNPRI. The debate emphasised that the decision to divest cannot be taken lightly and needs to consider the specific effects and alternative courses of action.
The key question discussed at this event was whether divesting from a company actually achieves its goal? For example, by transferring assets from the environmentally aware to those who are less concerned about environmental issues, corporate behaviour could get worse, not better. It may be better to keep the ownership of these assets in the hands of those actually concerned with the issues.
There’s a lot to take on board and consider. I’ve summarised my take on the various arguments and counterarguments in Figure 1 below.
Figure 1: Arguments and counterarguments of divestment
It’s worth elaborating on a couple of these points a little further. PRI Chair Martin Skancke rightly pointed out that divesting from fossil fuel assets for an individual investor simply shifts the exposure, rather than reducing overall exposure to the industry. If a pension fund is reducing their exposure to fossil fuels, another investor is increasing their exposure by the same amount. The net effect at a global level doesn’t actually change.
To address this issue, Skanke’s work with the Norwegian Government Pension Fund, the world’s largest pension fund, looked at methods for reducing the total stock of carbon related assets. One solution used was to encourage companies to pay higher dividends and returning cash to investors, rather than reinvesting profits in further acquisition of fossil fuel reserves.
Also discussed was shareholder engagement such as the “Aiming for A” initiative which focussed on shareholder resolutions to get more disclosure so that investors can understand their exposure. Alarmingly, even though the vast majority of energy companies are listed in US and UK, exchanges don’t require disclosure of climate change as an investment risk despite the potential impact on financial performance for these firms.
On the contrary, the arguments for divestment tend to fall into two main categories: the signalling or stigmatising message from investor actions; and the effect on a firm’s ability to raise capital. The positive aspect of the latter is that investors are able to divert existing and future capital to industries which have more sustainable business models. It’s important to recognise that these decisions do not only impact existing investment balances – future additional investments can also be put to better use. This is consistent with ShareAction’s comprehensive approach to “disclose, disrupt, divest, divert and demand”.
A full video of the UNPRI event is provided below:
Easy for some, practically impossible for others
For larger investors such as pension funds and university endowments, implementing a decision to divest from a given set of companies or industries is relatively straightforward. The large size of invested assets for these groups means that most fund managers will be willing to run separate investment accounts with specific restrictions placed on their investment guidelines. Alternatively, some larger investors manage their portfolios internally allowing direct control over their investment and divestment choices.
By contrast, the reality for individual investors is far more challenging. Yes, individuals can decide to devote significant amounts of time constructing their own portfolios and divesting of companies that operate contra to their personal values. However the vast majority of smaller individual investors invest through mutual funds or through their employer’s designated pension provider.
In the UK, both The Guardian and ShareAction have developed campaigns for individuals to lobby their pension funds to provide investment options that are free of fossil fuels. Unfortunately, the existing investment product infrastructure is ill-suited to empower individual investors to express their views through their investments – this is an area which is ripe for innovation and disruption.
One attempt at dealing with this shortcoming is provided by EIRIS, a research group focussing on the analysis of ESG matters. For UK investors, EIRIS has developed a useful tool which provides an overview of over 70 investment funds, categorising each by the ESG issues addressed. While this certainly positive, the number of funds covered pales in comparison to the over 2,500 retail investment funds available to UK investors.
The major investment index providers (including MSCI, Dow Jones and FTSE) have developed broader ESG related indices and there are a range of investment products associated with these. Regardless, these indices tend to be broader in nature across a range of criteria, meaning that they are less useful for investors wanting to tailor their investment exposures to match their personal values.
Right idea, wrong architecture
Why is personalisation so important? The issue is one of consistency, as highlighted by SRI pioneer Amy Domini in her excellent book Socially Responsible Investing: Making a Difference and Making Money:
If you are, for instance, a high school teacher, then it might well strike you as inconsistent to invest in alcohol manufacturers that seem to advertise to youth. If your personal philanthropy primarily goes to environmental causes, then it is only being consistent to invest in a way that supports your philanthropic giving. Investing is a purchasing decision. Caring about it is like caring about what you eat or how you choose to lead your life.
As discussed above, the problem with personalisation is that the existing investment product infrastructure has not been developed with widespread customisation or tailoring in mind. Essentially, the investment architecture needs to evolve to include consideration of differing views on ESG issues. This includes, investment products, pension fund platforms and investment indices which are used as performance benchmarks.
The implementation challenge arises where multiple divestment choices are viewed as desirable. To illustrate the point, take the case of fossil fuel producers and fast fashion manufacturers where different investors may wish to express different views. Consider the preferences of the following 4 fictional investors which is also depicted in Figure 2:
- Investor A wants no exposure to either fossil fuel or fast fashion companies
- Investor B wants no exposure to fossil fuel companies
- Investor C wants no exposure to fast fashion companies
- Investor D has no exposure constraints
Figure 2: Venn diagram of investor preferences
The existing architecture obviously caters for Investor D and there are options available for Investor B (such as MSCI’s “Ex-Fossil Fuel Index”). What about Investors A and C who find the labour practices within the fast fashion industry unconscionable? How about the other myriad combinations of concerning industries ranging from tobacco and alcohol to firearms and companies using animal testing?
Evolution and innovation
The problem is extremely complex due to the sheer number of different combinations of values-based screens that can be applied to investment portfolios. Over and above the existing attempts outlined above, below I suggest three potential areas for the investment industry to explore, particularly with respect to pensions:
Building blocks approach:
- When investors join a pension fund, the pension provider could include a survey of which industries the investor wishes to exclude (and by implication, which they are happy to include).
- The pension provider would then tailor the individual’s pension investment by including those “building blocks” which reflect the person’s values. The building blocks would each represent a given industry or group of companies.
- For example, Investor D above would have exposure to all of the building blocks. By contrast, Investor A would have exposure to all of the building blocks apart from those which include fossil fuel or fast fashion companies.
- The technology to enable this approach exists, but the investment industry will only act if there is sufficient demand to warrant the expense of redesigning investment platforms in this way.
Look-through proxy voting:
- The existing architecture already enables institutional and direct individual shareholders to express their views through proxy voting. However there currently exists no systematic requirement for the views of fund investors to be reflected in voting on shareholder resolutions. Further, fund managers voting on behalf of their investors tend to side with management.
- To resolve this issue, fund investors should have ability to express their proxy vote views to fund providers and then funds can vote accordingly on an asset weighted basis. This should be straightforward using online tools which provide investors with a look-through schedule of investments, a list of upcoming shareholder resolutions and the option to “vote” on each.
- For instance, an investor in a pension or mutual fund may notice that their fund invests in energy firm Exxon. Rather than accepting the voting decision of the pension sponsor or fund provider on the recent climate change resolution, the investor may want to ensure that their share of the fund’s holding expresses their view.
Standardised ESG exposure metrics:
- France has recently introduced regulations for large institutional investors to disclose the carbon intensity of their portfolios.
- Individual investors would also benefit from increased disclosure and reporting requirements and these arrangements could be extended to a wider range of ESG issues.
- Another example governance metric could be disclosure relating to the weighted gender diversity of the boards of companies held by a given portfolio.
Providers of investment products would argue that implementing the suggestions above would be prohibitive from a cost perspective. However, the fund management industry continues to be extremely profitable and the changes suggested are modest when compared with other shifts in the regulatory landscape.
Rather than waiting for client demands or responding to regulatory requirements, the investment industry has a clear opportunity to innovate and evolve the existing architecture to enable greater engagement from the individual investors they serve. Not only will the industry be providing a valuable service with a demonstrable impact, they will also be building a deeper and more meaningful relationship with their end customers.