The headlines regarding sustainable investing’s ascent have been seemingly ubiquitous in recent years. Between 2018 and 2020 alone, total U.S. assets applying environmental, social and governance (ESG) criteria ballooned by 42%. Bloomberg analysts predict that global ESG assets will surpass $50 trillion by 2025.
Amid this surge of activity, a lingering question remains: is this reallocated capital actually making a difference? As industry onlookers (rightfully) decry cynical greenwashing, and as grave projections emerge concerning the scale of the climate crisis, there is an ongoing debate as to the optimal and most effective approach for environmentally and socially minded investors to take. Let’s dive into three of those most commonly used by Ethic clients to address ESG issues:
One approach, often referred to as impact investing, involves actively seeking out companies whose mission and business activities are perceived as beneficial to the environment, society or both. An investor that’s keen to accelerate adoption of “green” technologies might build a portfolio that intentionally drives capital toward companies pioneering renewable energy, electric vehicles, sustainable agriculture or recycling solutions.
Of course, it’s important that investors have visibility into the methodology and data inputs being used to assess a company’s sustainability credentials. Otherwise, they run the risk of unwittingly ploughing money into a company that is only taking cosmetic measures to appear more sustainable—or one that has positive impacts in a given area yet a poor track record elsewhere. For example, an investor might be dismayed to find they had allocated capital in support of corporations that are leading the way on curbing carbon emissions, only to find those same companies embroiled in egregious human rights abuses.
Much of the sustainable investing conversation to date has focused on divestment, also known as negative screening. This process involves using a specific set of criteria, usually informed by the investor’s own values and preferences, to determine which companies, sectors or business activities should be excluded from a portfolio. Some investors might opt to eschew entire industries, whereas others might exclude a mere handful of securities that have a poor track record on certain issues relative to peers.
Evidence suggests that this exercise represents more than just a feel-good endeavor and may, in fact, shield investors from undue risk. As various real-world examples have illustrated, companies’ failures to adequately manage environmental, social and governance concerns can render them exposed to reputational, regulatory and physical challenges that may yield noteworthy financial consequences.
The divestment movement actually seeks to place downward pressure on stocks, making it more challenging (and therefore more expensive) for certain companies to raise new capital. Activists have long called for major institutions to rid themselves of fossil fuel investments and their efforts may be paying off, as research indicates that oil companies are finding it increasingly difficult to secure financing. Furthermore, high-profile divestment campaigns can have a snowball effect: where one influential institution treads, others may follow.
Divestment has certainly served as an important awareness tool, spurring important conversations about the role of investors, and the broader financial services industry, in fostering more sustainable outcomes. However, despite its ability to capture broad attention, divestment is just one potential means of effecting real change. In recognition of this reality, some values-aligned investors are choosing not to walk away from all corporate bad actors, but in many instances, to remain firmly in the fight.
As we alluded to above, some ESG investors are reconsidering divestment and instead knowingly opting to maintain their shares of “problematic” companies. While this may seem counterintuitive to some, there is a growing school of thought that active shareholder engagement is key to achieving socially and environmentally favorable outcomes. Support for this tack, particularly when it comes to catalyzing climate action, is picking up steam in the wake of high-profile shareholder campaigns effectuated in 2021.
The principal idea behind shareholder engagement is that, as a partial owner of a company, an investor gets to have a say in how it conducts its business. This generally takes the form of voting on shareholder proposals (or resolutions) that press company leadership to take a specific action or disclose certain information. These proposals are placed up for a vote at the company’s annual general meeting, with most investors opting not to attend in person but instead completing a proxy ballot that authorizes another party to vote on their behalf.
Advocates for shareholder engagement might contend that the divestment movement does little to address the underlying economics of “dirty” industries such as Big Oil. That is, for every fossil fuel stock dumped by an investor, there is more than likely a less climate-conscious investor willing to snap it up for a bargain price. In effect, this means that the environmentally minded seller has given up their seat at the table and can no longer use it to urge more responsible company behaviors. And there is indeed encouraging evidence that shareholder engagement may drive more positive corporate actions, in part because companies are responding to targeted, specific demands rather than broad societal pressure.
Institutional investors, who own the bulk of company shares and therefore wield outsized influence, are more active in proxy voting than individual investors. But these institutional investors often manage assets on behalf of retail investors, and are increasingly coming under pressure to align voting activity with their public commitments on hot-button issues such as climate change. In fact, in 2021, investors demonstrated record support for environmental and social shareholder proposals, demanding more transparency around companies’ political donations and lobbying, diversity and inclusion initiatives, and efforts to combat greenhouse gas emissions.
Where Do We Go From Here?
There is also much to be said for the role of regulatory oversight when it comes to tackling issues as consequential and far-reaching as climate change. However, in the absence of substantive government intervention, it’s up to investors to weigh the merits of the choices available to them: directing more capital toward impact leaders, ditching bad actors entirely, and/or using their voices as shareholders to exert influence on key issues.
Given the lack of compelling evidence that any singular method represents a panacea, we see impact-minded individuals embracing a multi-pronged, “carrot and stick” approach to sustainable investing. Just investing in “good” companies can be tricky because while a business may “do well” on carbon emissions, for example, they could be fraught with other questionable practices. Just divesting from “bad” companies ignores the potential improvements an industry can make, and silences an investor’s ability to voice their opinion. One thing is clear, though: sustainable investors of all stripes are impelling companies to evaluate their impacts on people and the planet.
We are at a critical juncture in our fight against pressing issues such as climate change, and the gravity of the moment demands that we employ all tools available to us. While the jury’s out on the most efficacious approach, what we do know is that we can’t stand idly back and do nothing.
Alex Laipple is head of business development, and Emma Smith is director of communications, at Ethic. Ethic is an independent provider of custom direct indexing solutions. Its scalable platform enables financial advisors to deliver passive equity portfolios that meet investors’ growing demand for personalized, values-aligned solutions.