How to Implement an Ethical Lens on Your Investments

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CAER is an independent research provider that helps investors and asset managers implement a responsible investment approach. Responsible investment (RI) is the process of assessing environmental, social, governance and ethical issues during the selection and monitoring process of investment activities. We help investors imbed a RI lens in all processes of investment. This post will explain the nature of the research we conduct and how this research can be integrated into investment processes.

When considering the implementation of an RI approach, a number of questions need to be answered. We begin by looking at each company within an investment portfolio to pinpoint where money is invested. Once we have identified the different companies, we can then start asking questions relating to each company’s services, operations, systems and behavior.

 

What does the company produce or provide?

Companies may be diversified, and produce many different products and services within different branches of their organisations. Companies may also be extremely specified and operate in a very ‘niche’ market.

In order to assess whether a company’s performance matches the values of an investor, it’s important to know what products and services the company offers. In other words, how does this company make money?

 

Where does the company operate?

Companies can have really complex organisational structures which make them difficult to track. For example, a company listed on the Australian Stock Exchange could have subsidiaries that are incorporated overseas. Companies may also be involved in joint ventures with other companies or governments, which they could have an operating or non-operating stake in. These subsidiaries may be operating in contexts where corruption or human rights risks are high.

 

How does the company conduct its operations?

Core questions which address how companies conduct their operations include:

  • How does the company treat its employees?
  • How does the company treat its stakeholders?
  • How is environmental, social and governance risk managed across the company’s supply chain?

Research providers look into all of these components of a company, and more. These components are commonly referred to as ‘environmental, social, governance’ (ESG) risk. There are varying methodologies available which assess different companies on a range of ESG criteria. This assessment can then help investors benchmark and monitor the companies in their portfolio.

It is important for companies to manage ESG risk across their own operations and throughout their supply chain. If a company is negligent in doing this, it may become complicit in issues such as human rights abuses, bribery, corruption and other negative activities.  Issues such as these could then impact the company’s reputation, their legal liability and their monetary returns. Examples of best practice with regards to managing ESG risk across a supply chain include: auditing; codes of conduct; and due diligence processes that extend to business partners and suppliers.

Now that we understand how each company within a portfolio operates, we can implement this knowledge into an investment strategy. It is vital to understand whether the answer to these questions correspond with your personal ethics and what you feel comfortable investing your money in. There are different ways that superfunds and other investment managers can then embed this information into your investments.  A systematic method of monitoring the portfolios performance against the chosen responsible investment approach should be implemented. The approach should also be reviewed regularly to ensure its relevancy.

 

What are the different methods to implement an RI approach to investments?

 Screening

Screening is a common method for implementing a RI approach. These screens are activity-based or norms-based. Screening can be either positive – and focus on including investments with certain activities or commitments in portfolios, or negative – and focus on excluding investments from portfolios.

 
Activity-based screening

Applying exclusions or inclusions to an investment portfolio based on company activities, which are valued as positive or negative through the investors values, is commonly referred to as activity-based screening.  A screen that includes a focus on renewable energy and green building is an example of a positive screen. A screen that excludes gambling, alcohol and tobacco is an example of a negative screen.

Thresholds can also be applied to screens. For example, a threshold can be set at excluding companies with over 5% of revenue generated from tobacco production. Specifying the exact activity which you would like to screen out is vital. For instance, are you concerned with tobacco production and retail – or just production? What about the packaging of tobacco products? When applying an activity-based screening approach, it is important to be clear what your definitions and thresholds are.

 

Norms-based screening

Norms-based screening is an investment approach which is informed by international conventions and norms. Norms based screens have most commonly been negative, but are increasingly used for positive screening purposes. For example, international norms banning the use of cluster munitions, anti-personnel landmines and nuclear weapons have influenced many investors to implement a controversial weapons screen on their investments.

Other ways you could map a norms-based screen could be on international conventions and protocols such as the Geneva Conventions or the International Labour Organisation Conventions. It has become more common recently to apply positive screens on a norms-basis through instruments such as the United Nations Sustainable Development Goals. Organisations that have made a public commitment to international norms should ensure their investments line up to these commitments.

 

ESG Integration       

ESG Integration refers to different methods and indicators used to embed the ESG performance of companies into the selection and monitoring of a portfolio.

Investors can utilise a structured methodology to assess the ESG performance of companies. Methodologies are created with a risk framework and company share price valuation in mind. The issues considered in these methodologies depend on the time horizon and the investment teams’ opinions relating to the materiality of ESG issues and when they will impact on the actual pricing of a company. These methodologies must be consistent to ensure year on year analysis, yet be adaptable to changes in international developments and ESG issues. The information needed to assess the ESG performance of companies is gathered from public company documents, news articles, information from NGOs, public government disclosures, and through engagement with companies.

The materiality of ESG issues is different from sector to sector making the criteria used in the methodology sector dependent. For example, a medical research company would not have the same exposure to environmental problems as a mining company. Therefore indicators such as CO2 emissions may not have as much weighting on the final assessment of a medical research company as they would for a mining company.

The materiality and weighting of issues can also be adapted depending on the individual investor’s values. This is because some people may place more importance on an issue like climate change than say occupational health and safety or vice-versa.

Investors can then utilise this methodology to create a ‘best of sector’ approach to responsible investment – meaning investors can choose to invest in companies that perform above their sector peers. Alternatively, this research can aid the implementation and monitoring of thresholds and activities for screening.

 

Carbon Footprinting & Offsetting

Another way of considering your investments is to check the carbon footprint of your portfolio.  A carbon footprint is an estimated calculation of the amount of carbon dioxide released into the atmosphere as the result of the (direct and indirect) activities of a company. A portfolio can monitor its carbon footprint, and set targets to reduce this footprint overtime. Increasingly investment funds are not only looking at the footprint itself, which is a snapshot of the past, but also consider forward-looking assessments, such as how well a company is prepared for the energy transition to renewables.

There is also an option to offset the carbon emissions of your portfolio. This means that you reduce emissions of carbon in another area, to compensate or ‘offset’ emissions elsewhere.

 

Impact & Community Investment

Impact and community investments focus on financially supporting projects that aim to create a positive impact for individuals and the broader community. These projects also provide financial returns for investors. The size of these projects can range from large Green Bonds targeted at the development of extensive renewable energy infrastructure projects to smaller community based projects run by not-for-profit groups.

Impact and Community investments are increasingly growing asset classes.  Investors can identify companies within their portfolio that are involved in impact and community investment products or directly invest in these products.

 

Interested in discussing any of this issue further? Feel free to get in touch

Nina Haysler

Author: Nina Haysler

Nina Haysler
Research Project Manager