Clare Wood
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Get in touchI was talking to a friend this lunchtime who works in sustainable investing. He has a great job working in the stewardship team of an institutional asset owner who is large enough to have their own investment team.
When I told him that I am developing a training course to help people understand investing, he surprised me by saying that he would love to take that course! I had assumed that as he was working so closely with the investment team, he would already know. But it turns out that a lot of people who work in responsible investment don’t come from an investing background. They are skilled in understanding the risks and issues of a firm, but not in the nuts and bolts of investment decisions.
As the sustainable investing evolves, bridging this knowledge gap is becoming more important. What started as a nice to have for investors with a conscience has transformed first into a core risk management tool before becoming into a driver of long-term sustainable returns. This history gives a great framework for looking at the different ways that sustainability can be integrated into investment decisions.
The simplest approach is called negative screening. The sustainability team creates a “no-go” list of companies, like thermal coal miners or weapons manufacturers, that the investment team can’t invest in. For any company not on the list, the financial analysts are free to run their traditional models. While this works well for avoiding obvious harm, it’s a blunt instrument. Companies are very rarely all good or all bad so this approach misses that nuance.
The next level sees the investment team embedding return in environmental, social and governance risks into their financial models. The still run models to calculate company growth rates, which tells them how much it should be worth, but they adjust the assumptions in these models using research from the sustainability team. For example, they may decide that a textile company will grow handsomely, but it’s processes use a lot of water in an area with severe water shortages, so won’t buy it at its current price.
Going a step up from this requires a much closer integration of the two teams, or even where financial and sustainability analysis is done by the same person. In this case, sustainability is not just about managing risk, but finding companies where their revenue is actually being driven by issues related to sustainable development.
This could be healthcare companies addressing unmet need by opening up new markets, it could be industrial companies innovating new efficient ways of manufacturing products or it could be financial companies benefiting from increasing financial inclusion. It’s not about looking at what not to invest in but actively seeking out those companies that are set to grow because of environmental and social factors. This approach is used in many thematic portfolios that focus on areas with structural long-term drivers such as clean energy, food production or demographic change.
Layered on top of any of these approaches is the idea of engagement. Using the power that a shareholder has to push companies towards better practices. Even the companies that are innovating to address the most pressing needs of the future are rarely perfect; there is always an area they can improve on. Shareholders can vote at their Annual General Meeting. They also have meetings with the company management, sometimes even the CEO, where they can voice their concerns.
None of these approaches is perfect. Not all of them will be right for every investor. There have been challenges with greenwashing, where investment teams claim they are integrating much more sustainability data than they really are. There is also widespread confusion among retail investors who understand sustainable investing to be much more than just including some risk factors into a financial model. Not to mention the many problems of getting timely, complete and accurate data from companies on their sustainability practices.
But it’s also true that the problems in the world are not going away. Demographic shifts and climate change are structural, long-term changes in the way the world operates. Even as the risks are growing, the payoff to innovation is also increasing. Sustainable investing is going through a difficult time right now, where its early promise is being called into question. But people, and finance, are incredibly adaptable, so both will evolve to address the challenges we face.
That means that people like my friend will need to understand investments just as much as investment teams will need to understand sustainability.