The choice of exclusion or engagement when seeking to achieve ESG investment
According to findings from our eighth annual Charity Investment Survey, which received input from 82 UK charities with combined investment assets of £8.8 billion, charities have never felt it more important that environmental, social and governance (ESG) investment factors are considered in the management of their investment portfolios.
In 2021, 85% of charities felt that ESG factors are either very or quite important in the management of their portfolio. This represents a 3% rise year on year, but more striking is the growth over the longer term; from 2015 to 2021, the proportion of charities that feel that ESG factors are important has grown from 61% to 85%.
Climate change has continued to grow as an issue in the minds of charities with 82% of charities now believing that it is their responsibility to think about climate change specifically, a figure which has risen 18% over the last two years. Furthermore, 50% of charities in 2021 state that they are prepared to accept compromised levels or patterns of return in exchange for sustainable, responsible investment practices.
Patience for engaging with companies on climate change appears to be waning, with a significant shift from preferring engagement to divestment when ensuring climate change factors are considered in the management of portfolios. From 2019 to 2021, the proportion of charities considering engagement to be the best approach has fallen from 70% to 54%, while the proportion believing that divestment is the best approach has increased from 24% to 35% over the same period.
Most commonly barred
While the proportion of charities with ethical exclusion policies in place appears to have plateaued, the nature of these policies has broadened. Tobacco remains the most commonly barred type of investment, excluded by 87% of those charities with exclusion policies. Armaments, gambling and pornography are also each excluded by a majority of policies, while 48% of policies now exclude fossil fuels, up from 36% in 2020.
However, there has been a significant decline in the number of charities looking to further add to these exclusions. One explanation worth considering is charities’ desire to look beyond exclusions and towards broader ESG and sustainable investment factors.
Charities have been at the forefront of embracing ESG factors in their investment strategies for many years. Initially driven more by avoidance of obvious conflict with charitable purposes, or perhaps reputational risks, “ESG acceptability” has broadened into wider areas, particularly around social and environmental responsibility. Relatively simplistic exclusion has given way in many cases to more nuanced considerations of engagement for “real world change”.
More broadly, in the 2019 survey, we started trying to gauge charities’ views of, and approach to, responsible investment. The most recent survey clearly shows that the vast majority of charities invest responsibly, beyond basic exclusions, and that there has been a significant increase since 2019 in the proportion of charities which are aware of their climate responsibilities.
With regards to the above two different approaches, there is a live debate as to what will drive meaningful change in corporate behaviour and ultimately on climate change in particular. Remaining invested in heavy emitters without engaging with them to change clearly is not going to make any difference. On the other hand, simply divesting is unlikely to have a significant effect on the environment, assuming that those shares are then bought by an investor who is not going to engage and push for change.
Each charity’s own decision and responsible investment framework will have unique drivers, and one answer will not fit all. Investors can achieve more impact through active engagement, that is remaining open to the possibility of investing in companies which are currently heavy emitters where management is open to change and able to transition to a more sustainable business model in the future.
Realistically, their own survival beyond the fossil fuel era and the huge investment that is required in energy infrastructure demands their involvement, and as asset owners, charities have a role to play in bring appropriate pressure to bear.
Interestingly, however, the survey also reveals that charities’ patience for engagement is beginning to wear thin. It is likely that this reflects the reality that as the global economy is structurally reliant currently on fossil fuels rapid change is unrealistic. But perhaps also it reflects the somewhat average job that fossil fuel companies (and asset managers) are doing in communicating targets and the investment being made in the transition.
There is a need for investment managers to continue working hard both to engage with companies, but also to communicate milestone achievements with charity investors so that they understand how the transition is evolving, and to assure that their ownership of assets can be used as a force for change.
On the specifics of labour practices, there are the standards as set by the UNGC (UN Global Compact corporate sustainability initiative). And concerning the nuances around climate change, a sustainable approach should attempt to establish whether a company is Paris Agreement (on climate change) aligned or working towards alignment. However, as disclosures in this area are still relatively new, and data incomplete and in many cases delivered in forms which render comparisons difficult.
Look in detail
it is really important that charities, through their investment managers, look in detail in order to be able to make well informed decisions rather than relying solely on third party ratings, whose methodologies can and do give a wide variance of rating to the same companies.
In summary, after excluding areas running contrary to a charity’s purpose, being overly strict and having broad exclusionary policies, whilst perhaps optically good for clearing investors’ consciences, is unlikely to be the optimal approach in terms of promoting real world change in important areas of climate and social responsibility. Taking a more nuanced, engagement led approach leaves open the greater possibility of changing corporate behaviour for the better.
Turning to the other end of the ESG spectrum, one must also consider what can be deemed as being effective monitoring of investments which are classed as “ESG acceptable” but which might change at a later date.
Just as any investment case will continue to be evaluated post purchase, so the ESG side of the investment case should also be revisited on a regular, if not constant, basis.
There are a number of screening services available to charities that can help flag controversies around ESG issues in these more nuanced areas. However, it requires an active approach to dig into the necessary detail and engage with management to understand the issues, to get an idea of management’s direction of travel and to assess a strategy to bring about positive change can be beneficial.
Alarm bells should start ringing if these issues are constantly low down on a management team’s list of priorities, and an assessment as to management’s intentions will help inform the decision as to whether a holding should be retained or sold.
The two sides of the long term investment case cannot be separated. If ESG risks and concerns are becoming material then this will, in all likelihood, have a significant effect on a company’s long term prospects and therefore its attractiveness as an investment.
Question of timing
Then, of course, there is the question of timing once the decision has been made to exit an investment. Much will be dependent on the reason for divestment of course. A fundamental breach of a “red line” exclusion may warrant more precipitous action than the gradual realisation that a company’s management isn’t giving adequate priority to an ESG risk or factor.
Consideration must be given as to what extent is it reasonable that a charity investor should wait before selling in order to minimise or avoid a loss, if that would be the end result of a sale. Thinking in line with the following framework may be helpful:
- Consider the options of splitting out purely ethical decisions, versus the more nuanced sustainable/responsible decisions. The former is likely to be clearer cut, the latter will be less so and likely require a more considered approach.
- For ethical decisions, this will really come down to each individual charity in weighing up the risk of continuing to hold and the potential consequences of reputational damage versus the risk of exiting at an inopportune time. Discussion with the charity’s investment manager and setting clear expectation will be key.
- For the less clear cut responsible/sustainable decisions, where an engagement approach is being taken, companies will need to be given the opportunity to rectify issues once they have arisen, but if engagement is ineffective and patience runs out it will again likely become necessary to sell.
- Time frames given to sell vary on a case by case basis. In some instances, on balancing up the various risks, it will make sense to sell as soon as practicable. At the other end of the spectrum a manager may be asked not to add to current positions and to sell out over a defined timescale, or opportunistically. More usually a window of somewhere between 3-12 months is often given to exit fossil fuel companies, for example.
Clear time frame
Where there are sustainable and screened pooled funds investment managers should provide charities with a clear time frame to exit from companies which fall below the required standard. For segregated charity investors it is about understanding the charity’s motivations, then working together to come up with the best course of action and time frame.
Charity investors increasingly believe they have a role to play to ensure their investment policies are focused on making a positive impact. ESG investment factors can be expected to remain a dominant feature for charities for many years to come.