Taking steps in the right direction
Climate change, the habitat destruction of palm oil farming, animal agriculture, ocean plastic, zero contract hours, child labour and income inequality are amongst the many challenges that we face in the world that need to be addressed. Yet, some of these issues are not as clear-cut as they initially seem. To some, zero contract hours are exploitative, yet to others they provide useful flexibility; child labour may be seen as a scourge by many, yet some families in lower income parts of the world rely on their children working simply to survive; and some oil companies are amongst the largest investors in renewable energy. Clear thinking, patience, empathy and a degree of practicality is required to begin to resolve these issues. But resolve them we must, however challenging.
Our attention has increasingly been drawn to the issue of ‘sustainability’ by campaigners such as Sir David Attenborough and Greta Thunberg and the governmental efforts of COP26. Most of us – in our heart of hearts – know that the human race is doing a pretty poor job at present of balancing the claims of the present on the world and its resources against the claims of future generations.
It is not an easy balance to get right. Rapid economic growth in the emerging economies over the past couple of decades – for example – has had a major positive impact on its people, raising two billion people out of abject poverty and halving infant mortality. This has been driven by capitalism, sometimes in an extreme and uncontrolled form, with material consequences for the environment and wider stakeholders, not least employees. Abuses in many forms lie beneath the surface in slave labour, corruption, pollution, habitat destruction and a loss of biodiversity in the pursuit of profit.
Figure 1: Real, important and in some cases urgent challenges face the world
We can either respond to these challenges and become part of the solution or bury our heads in the sand. They will not go away. Many people have already made changes that affect their daily lives that can and will make small yet meaningful differences. These range from running more fuel-efficient cars to buying more locally produced products and avoiding companies with poor records on employment or pollution. One area that has largely been ignored, both by families and the investment management industry – until recently – is the opportunity to improve the ‘sustainability’ of their investment portfolios and the companies they own within them.
Figure 2: Being part of the solution
The term ‘sustainability’ is bandied around as if everyone knows what it means. In essence it means making the world a better place by coming together and defining a more balanced use of the natural resources available, tackling the issue of climate change and the knock-on effect that this will have on desertification, economic migration and the impact on the ecosystems of the world. It also means building a fairer society, where there is less income inequality, employees get treated fairly and that corporate governance improves the level of corporate responsibility in the drive for profits. The UN has established 17 sustainable development goals, which few would disagree with1.
Figure 3: What is ‘sustainability’?
Source: United Nations
Figure 4: Incorporating sustainability in an investment portfolio using ESG metrics
In real life, we make trade-offs around the choices we face when it comes to improving the sustainability of our lifestyles. Take for example the issue of recycling. Most people rightly make an effort to recycle their household waste, sorting plastics and paper into their green recycling bin and wheeling the bin out for collection on a Sunday night. Yet we are still prepared to jump into our diesel or petrol-driven cars and head off on our long-haul holidays. We balance out these trade-offs and live with them.
Figure 5: Understanding the trade-offs we all face
For many investors considering sustainable investing, their natural instinct is to want to avoid ‘bad’ companies. Fossil fuel producers being a case in point. ‘I don’t want any oil companies in my portfolio’ is a common theme. Excluding them (divestment) might tick a box, but the issue is more subtle than that. If you sell the shares of oil companies, you will be doing so in what is known as the secondary market, where sellers and buyers come together to transact. If you sell, someone else has to buy those shares. By definition, they probably care less about oil companies than you do. They may offer you a lower price, as you are selling on preference, not due to risk. You have washed your hands of the issue. Job done. Or is it?
The other approach is to retain ownership as this gives you a right to be a nuisance, by getting your fund manager to put pressure on the firm to change and to vote at AGMs to steer the company in a better direction.
Figure 6: Own and engage or divest?
An example of positive engagement
In May 2021, a little-known hedge fund called Engine No.1, despite only owning 0.02% of ExxonMobil, put forward a motion at the latter’s AGM to vote its nominees onto the board of directors to drive a more robust approach to transitioning to a post-oil world. It gained three of twelve seats. So how did such a small investor have such a large impact on this behemoth? Simple. It co-opted major pension investors, such as the California State Retirement System, and the giant fund managers Blackrock, State Street and Vanguard – representing the investors in their funds – to vote in its favour.
Figure 7: The power of engagement
On the other hand, if the investor had simply divested of Exxon shares, then someone else would have bought the shares in the secondary market, who probably cared less.
Figure 8: The challenge of divestment
The important thing to remember is that buying and selling in the secondary markets does not provide or denude a company of cash. Cash transfers occur between buyers and sellers, via their brokers. More important to understand though is that while not owning Exxon may reduce the carbon footprint of your portfolio, it does not directly reduce Exxon’s greenhouse gas emissions into the atmosphere. A pack of cards provides a good analogy. Let’s pretend that the pack represents all the companies in the market. Each card is a single company, and that company has a carbon footprint. A common measure is ‘carbon intensity’, which is emissions per US$1 million of sales. Red cards (hearts and diamonds) have a lower carbon footprint than black cards (clubs and spades). An investment fund can reduce its carbon footprint by selling all the clubs and spades to create a portfolio of red cards only.
Figure 9: Shuffling the pack has no direct impact on emissions
Changing the ownership of, say, Exxon to someone else may mean that you do not own the emissions – satisfying your values-based preferences – but it does not directly deal with those emissions. They do not simply vanish into thin air. The aggregate emissions of the pack are unaltered. The mechanism that may make a difference, over a much longer time scale is far more subtle. Offloading shares based on preferences means that someone else needs to own them to allow the trade to settle. They may need to be induced to own these ‘bad’ companies, via lower prices. Lower prices mean that the cost of raising funds for the company, if and when they need to, becomes higher. This ‘cost of capital’ is effectively like a hurdle rate that new projects need to exceed if they are to be undertaken. A higher cost of capital may result in fewer oil field projects, for example. Although it may well also result in these companies undertaking fewer more sustainable projects. The flip side of the higher cost of capital is higher return for an investor providing that capital.
Deciding on a sensible way to invest sustainably
If we start from the premise that most investors own a portfolio to grow or protect wealth and create a source of current or future income, then the returns that their portfolio delivers are very important. Our traditionally structured portfolios are designed to deliver diversified, broad market returns, derived from risks that we are comfortable in taking because we understand what they are, and the likely characteristics they will deliver over time.
For many investors, making sure they receive broad capital market returns in return for taking on broad market risks in order to achieve their financial and lifestyle goals is important. If that can be achieved in a way that fulfils values-based preferences and makes a difference through a combination of active ownership and divestment – and the subtle ways these influence corporate behaviour for the better – that would be a good start. To do so requires some pragmatic trade-offs, such as maintaining sector weightings in the portfolio broadly in line with the market. That may mean owning energy, utilities and airline stocks. We call this approach systematic ESG investing. This is our preferred route.
Others may want to be fully true to their deeply held values and to see tangible and directly measurable impacts from how their money is invested in predominantly private market vehicles. They will need to resolve issues such as: concentration risk in securities or projects and sectors; liquidity and exit risks of private investments; and high levels of uncertainty about the financial returns they will receive, with the base case being a hope of return of capital. We would call this ‘impact’ investing. This a complex area, outside the scope of this document.
In the middle sit ‘thematic’ portfolios – such as those that focus on wind farms and renewable energy – which take on sector specific risks, often via smaller companies and lack broad, or even sector, diversification. This is simply a further shuffling of the pack in the secondary markets –now owning only hearts – but resulting in far lower engagement with recalcitrant firms.
Figure 10: Deciding on a sensible way to invest sustainably
Building a systematic ESG-focused portfolio
Our approach starts with identifying a suitable asset allocation that meets the financial goals and risk preferences of our clients. We believe that overlaying a broad values-based strategy is a reasonable next step. A portfolio reflecting more granular and specific values-driven preferences is likely to be near impossible to construct, may move the portfolio substantially away from the suitable target asset allocation, and – as explored above – may satisfy specific preferences but may not make a direct, real-world impact. It is a further shuffling of the pack.
Figure 11: Building a systematic ESG-focused portfolio
There are two important parts to implementing the strategy. The first is to identify systematic, low cost, diversified ESG-focused funds that employ a sensible construction approach, with an appropriate balance between exclusions and ownership. For the reasons given above, some ‘bad’ companies may be owned. As such, the second part is making sure that the managers of these funds are well-resourced and organised to engage with portfolio companies and vote appropriately on behalf of the investors in the fund. Where no suitable funds yet exist, it makes sense to use non-ESG-focused funds run by managers with these credentials.
It is important that there is a sensible level of consistency between fund approaches to avoid, where possible one fund divesting from a company, or set of companies, while another fund retains ownership.
At the fund level
In practice, ESG credentials, on a firm-by-firm basis, can be used to make judgements on companies, which can be reflected in the makeup of portfolios. Some firms e.g., in the oil and gas sector, have set out a strong vision for the future direction of the company and its transition to a carbon-neutral world and are leading investors and innovators in renewable energy. Better firms reduce the risks associated with their business and treat their broad stakeholders more equitably. Others in the sector lag materially. In a systematic ESG portfolio, the former are favoured through overweighting their holdings and the latter underweighted.
Figure 12: Overweighting best-in-class companies
In many funds, some of the worst ESG firms – such as those producing cluster munitions – will be excluded. This is specific at the fund level and needs to be taken into account when constructing portfolios.
At present, there are high-quality systematic ESG funds available in global and emerging equity markets. Other asset classes tend to have limited quality products available, but the good news is that there is considerable product development happening and regular new launches of products. Wearing our risk manager’s hat, we will only introduce a fund when it meets our high threshold for inclusion.
Moving to a more sustainable approach to investing is a journey to be taken in small, careful steps. Over time, corporate ESG data should improve, becoming deeper and wider in scope and coverage, along with the ability to measure the impact more insightfully at both a values-based and real-world level. New product development in the systematic ESG space is growing exponentially and the quality and availability of these products will also continue to grow. It’s an exciting time for investors who want to make a difference. It may be a long road, but the destination should be worth it.
Figure 13: The destination is worth it
If you ask yourself if you want your (or others’) children and grandchildren to live in a better world which has tackled climate change, reduced pollution on land and in our oceans, helped to abolish child labour and produced a more equitable society, the answer is obvious. For some, using their investment portfolios as one of the many ways in which they can make a small, yet meaningful difference alongside others, then systematic ESG-focused investing may be a choice worth considering.
If you would like to know more about our ‘Steps in the right direction’ portfolios, please feel free to contact us.
1) For more information: https://sustainabledevelopment.un.org/?menu=1300
All Figures unless otherwise indicated – Source: Albion Strategic Consulting.
This is a purely educational document to discuss some general investment related issues. It does not in any way constitute investment advice or arranging investments. It is for information purposes only; any information contained within them is the opinion of the authors, which can change without notice. All information is based on sources that Albion Strategic Consulting (Albion) believes to be reliable. No responsibility can be accepted for actions taken as a result of reading this document.
Past performance is not indicative of future results and no representation is made that the stated results will be replicated.
Errors and omissions excepted.