Some Challenges For Investing Sustainably

Includes: BIRKX, ESG
by: Markus Unterhofer, CFA

Early-stage problems of sustainable investment industry - related to definition, inclusion and delineation, potential misrepresentation, and measurability - are not resolved yet.

The arrival of large-scale banks and asset managers on the sustainable investment scene is positive, but potentially exacerbates those problems.

Investors looking to gain exposure to sustainable investing should complement the traditional investment policy statement with specific information about the targeted positioning on the spectrum of revenue models.

In a second step, the traditional selection/due diligence process needs to be complemented by specific criteria considering the sustainability aspects of the investment process, track record and the provider's organization.

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Sustainable investing has witnessed strong growth during the last years, both absolutely and in relative terms, compared to the overall professionally managed assets globally. According to the Global Sustainable Investment Review 2016, global sustainable investment reached $22.9 trillion at the beginning of 2016, compared with $18.3 trillion in 2014, representing an increase of 25%. This has been driven by both institutional and private investors, who are asking for more and more transparency and greater consideration of environment, social and governance (ESG) issues. The signature of the Paris Agreement in 2015 (to limit the global average temperature increase to well below 2 degrees Celsius, and to strive to limit it to 1.5 degrees Celsius) has been an important cornerstone. It helped raise awareness and concern over climate change, and the longer-term environmental and investment risks associated with fossil fuels and a +4 degrees Celsius - i.e., much warmer - world.

Large institutional investors like pension and superannuation funds, sovereign funds, endowments, insurance and reinsurance companies are increasingly incorporating sustainability criteria in their analysis, selection and portfolio construction process. A notable example includes the world's largest sovereign wealth fund in Norway publishing publicly the observation or exclusion of specific companies on a production-basis or conduct-basis. Another example includes the French insurance giant AXA announcing in December 2017 the quadrupling of their green investments target by 2020, the acceleration of divestments from carbon-intensive energy producers, and the phasing out of insurance coverage for new coal construction projects and tar sands businesses.

It is common understanding that all sectors of the global economy will need to contribute to achieve the sustainability goals. The financial industry has only a minimal direct environmental footprint compared to other industries. However, the financial services sector plays a pivotal role in this transformation through its capital transmission function to other sectors of the economy. The central role of the financial sector is also reflected in the Paris Agreement. It is stated as one of the three main objectives, as "making finance flows consistent with a pathway toward low greenhouse gas emissions and climate-resilient development."

The paradigm shift has not remained unnoted by the large banks and asset managers as financial intermediaries. In the last few years, almost all large participants in the financial industry have stepped in and launched a vast array of products in the sustainable space, ranging from highly liquid exchange traded funds (ETFs) to longer-term private equity/debt solutions. As an example for the latter, Swiss-based Partners Group has announced in March 2018 to launch a global $1 billion social and environmental impact fund aimed at investing in line with the United Nations' Sustainable Development Goals.

The arrival of these large-scale banks and financial firms on the sustainable investment scene is seen as positive by most respondents in a survey recently conducted by Global Impact Investing Network in the impact investing space. But most of the respondents highlight the potential for the heightened risk of mission drift or impact dilution. More broadly speaking, the entrance of the large market participants exacerbates some of the early-stage challenges of the sustainable investments industry. These challenges include the problems of definition, inclusion and delineation, related issues such as potential misrepresentation (e.g., green-washing) and issues pertaining to the quantitative measurement (and comparability) of the social and/or environmental impact.

To illustrate these challenges from the perspective of an investor, let's consider an investor well versed with investing in traditional assets and with a desire to foray into sustainable investing. We assume the investor is interested in generating an extra-financial (e.g., environmental, social) return beyond the regular financial return on the investments. As noted already, he will realize that there is a huge array of diverse investable products in the sustainable space he can choose from. The investor will also note that several different terms and acronyms are used in the financial industry, like investing for impact, responsible and socially responsible investing, sustainable and responsible investments, which are often not clearly defined and delineated.

Our investor will then try to get some standard or official definition, and will come across the inclusive and very broad definition of sustainable investing, as defined by the Global Sustainable Investment Alliance (GSIA), the international collaboration of membership-based sustainable investment organization. GSIA defines sustainable investing as follows:

... an investment approach that considers ESG factors in portfolio selection and management, [encompassing] the following activities and strategies:

1. Negative/exclusionary screening

2. Positive/best-in-class screening

3. Norms-based screening

4. Integration of ESG factors

5. Sustainability themed investing

6. Impact/community investing, and

7. Corporate engagement and shareholder action.

Based on this definition, our fictitious investor will find out that his portfolio composition may vary widely depending on which of the seven included activities and strategies he might choose to focus on. He will also realize that relying solely on some of the above-listed strategies to construct the portfolio might result in a portfolio that is hardly distinguishable from a traditional portfolio.

To illustrate this further, let's look at two product examples. The Blackrock Impact U.S. Equity Fund (MUTF:BIRKX) invests in stocks with positive aggregate societal impact outcomes and carries an above-average Morningstar Sustainability Rating. As of the end of March 2018, the 10 largest holdings include Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Amazon (NASDAQ:AMZN), Alphabet (NASDAQ:GOOG)(NASDAQ:GOOGL), Facebook (NASDAQ:FB), PepsiCo (NYSE:PEP), and Cisco (NASDAQ:CSCO).

In another example, the FlexShares Stoxx US ESG Impact Index Fund (NASDAQ:ESG) is designed as a core equity portfolio with environmental, social and governance exposure. This ETF carries a "high" Morningstar sustainability rating. The investor will find Microsoft, Apple, JPMorgan Chase (NYSE:JPM), Alphabet, Bank of America (NYSE:BAC), Exxon Mobil (NYSE:XOM), Intel (NASDAQ:INTC), and Chevron (NYSE:CVX) among the top 10 holdings as of the end of March 2018. After reviewing these investment products, their underlying companies in the portfolio and their sustainability ratings, our investor might scratch his head and ask himself whether or not he has fundamentally misunderstood something about sustainable investing, and how he will be able to generate the extra-financial return he is looking for. Our investor will also learn from the product review that the name of the product is not a good starting point to initiate a product selection.

Things are getting even more complex for our investor in case he starts investigating which role sustainability is playing across the entire corporate structure and business activity of a specific product issuer/provider, usually a large bank or asset manager. For example, he will find out that several large providers in the sustainable product space are at the same time also very large players in the financing of extreme fossil fuels (according to the Banking on Climate Change report). Between 2015 and 2017, these 36 large banks financed more than $345 billion for projects and companies involving tar sands, Arctic and ultra-deepwater oil, liquefied natural gas export, coal mining and coal power.

While financing declined to $104 billion in 2016 (the first year after adopting the Paris Agreement) from $126 billion in 2015, it slid back to $115 billion in 2017, mainly driven by large increases by Canadian and U.S. banks. It seems that while large banks are fast in launching new investment products on new trends like sustainable investing, they are slow to systematically integrate sustainability into their core business. The pressure from stock markets and the demand to reach short-term financial targets is certainly a very important stumbling block for the consistent implementation of sustainability goals.

Given these challenges, a workable approach for an investor looking to gain exposure to sustainable investing is to complement the traditional investment policy statement - containing the client's investment objectives and restrictions, risk/return profile, liquidity requirements, strategic asset allocation, etc. - with specific information about the client's objectives regarding investing sustainably as a first step. The client needs to become very clear about his targeted positioning on the spectrum of revenue models, as exhibited below.

Source: Bridges Ventures

On the left side of the spectrum, there is the possibility to invest (usually through more traditional instruments with better transparency and liquidity) with no or little extra-financial return generation, typically linked to exclusions of specific companies and sectors. (This is called "responsible" in the illustration; however, this strategy is included in the comprehensive GSIA "sustainable" definition above.) Moving from the left to the right ("sustainable" and "impact" in the illustration, again all included in the sustainable definition by GSIA above), there are several blended models with an increasing opportunity for the creation of extra-financial returns for the environment and society. However, that's with decreasing liquidity through credit/equity placements into non-quoted companies and projects. Finally, on the right end of the spectrum, there is philanthropy ("impact only") generating only extra-financial returns.

Once the investor has gained clarity about his targeted positioning on the spectrum of revenue models, he then can narrow down the search for appropriate providers and products in a second step. For that purpose, the traditional selection and due diligence process, based on qualitative and quantitative criteria, needs to be complemented by specific criteria considering the sustainability aspects of the investment process, track record and the provider's organization.

One of these criteria on the provider level should be, for example, the above-mentioned systematic and consistent integration of sustainability across a provider's core business. As noted before with the investment policy statement, the traditional selection and investment process cannot be omitted. But it needs to be complemented by specific aspects considering the sustainability issues.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.