The landscape of sustainable investing is complicated and often confusing in its terminology. A simple framework can help in assessing intention and success in execution.
Navigating the concepts behind responsible and sustainable investing
There is a wide array of terminology used to describe funds that all have in common a purpose. That purpose is often described as being over-and-above the consideration of financial returns. In fact, it is about understanding the effects of an investment, and either avoiding certain effects or positioning positively towards others. The impact on financial returns is a separate question which relates to a cost-benefit analysis of those effects. The framework outlined below allows investors to differentiate between funds, based on their environmental, social or governance (ESG) investment objective.
The framework allows investors to differentiate between funds, based on their ESG investment objective
The ABC Framework
The framework comes from the Impact Management Project’s investment classification guide. It sets out an ABC that allows investors to align their investments with their intentions: ‘Act to avoid harm’, ‘Benefit stakeholders’ and ‘Contribute to solutions’.
‘Act to avoid harm’ covers many of the traditional products that exist in the market. Historically, harm was seen as a value judgement: ethical funds would be based on a list of screens that depended on what the investor determined a harm, based on ethical or moral principles. Gradually, avoiding harm evolved to include risk-based assessment of a company’s activities from an ESG perspective. Many portfolio managers talk about integrating ESG into the investment process, which may simply mean awareness of the risks. Funds in the A category go beyond that, seeking to avoid companies where those risks are deemed too high or which have negative effects to which, on ethical grounds, investors do not want exposure.
‘Benefit stakeholders’ goes a step further. At a minimum, it requires that investors avoid harm but it also asks that they consider positive impacts. Companies in this category would be classed as ESG leaders or sustainable leaders, but it is important to distinguish between those that lead in risk management and those that lead in driving positive outcomes. To illustrate the difference, consider a company such as Inditex, an international clothing manufacturer and retailer. Minimising risk would mean considering safety and human rights practices in the supply chain, as well as water and energy efficiency practices. Benefiting stakeholders would take into account their target to have 25% of garments under the sustainable Join Life brand by 2020. This is an emerging area within ESG or sustainable investing, but it is one with significant potential. It recognises that sustainability is not just about risk: it creates opportunities for companies. There are structural growth opportunities to be captured, as well as opportunities to improve supply chains in a way that creates a competitive advantage over the long term.
‘Contribute to the solution’ builds on taking into account positive impacts, but requires that the overall impact of the investment is a significant positive outcome for an otherwise underserved population or for the planet. This is generally referred to as impact investing. Inditex may be moving towards a more sustainable model but the purpose of its business is to sell clothes not to contribute to solving the world’s problems. This category of investments covers those who start with that intention, usually framed in terms of the UN’s Sustainable Development Goals (SDGs). But it requires more than just intention. Measurement and quantification of outcomes are important elements of impact investing, and one of the biggest challenges. There is a significant role for investors to play in engaging with companies and encouraging them to provide better data that will allow for improved measurement of outcomes. This category is also about opportunity, but it goes further than benefiting stakeholders - it is targeted at investors who are looking to contribute to addressing the world’s long-term challenges. As an example, Kornit Digital operates within the clothing supply chain using printing technology with zero waste-water and a low carbon footprint. This directly addresses SDG 6 relating to sustainable water management.
The ABC framework should be seen as a scale. There is not a clear line where minimising risk ends and benefiting stakeholders or contributing to solutions begins. The important thing is that it gives investors a tool to look past a portfolio’s label as ‘ethical’, ‘responsible’ or ‘sustainable’ and to try to understand what the portfolio is designed to achieve. This allows the investor to align their own intentions with their investments. Flows into ESG, sustainable and impact funds have been increasing, but confusion about the differences between them persists. Analysing funds in terms of their intention can help distinguish them by purpose. Understanding purpose also allows for a better analysis of outcomes, and measuring those outcomes will be crucial in understanding how they interact with financial returns.
Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.