Some key responsible investment concepts

Terms like “responsible investment”, “ethical investment”, or “ESG” (environmental, social, and governance) might resonate differently with you. This variety can lead to confusion, making it hard for consumers, financial advisers, and product providers to navigate the landscape without falling into the trap of greenwashing.

This blog aims to cover key concepts in responsible investment to help you understand where your superannuation or investments might sit and whether you are comfortable with that.

I will note, there are ways I have defined things that some professionals in this space could contest or challenge, but that also highlights the issue I previously mentioned.

Traditional investment

First, it’s important to clarify that responsible investment managers consider all traditional factors that non-responsible managers do. This includes:

• Fundamentals: the financial health and performance of an investment.
• Macroeconomic factors: the broader economic conditions affecting the investment.
• Technical factors: price movements and trends.
• Quantitative factors: statistical and model-based analysis.

ESG integration

ESG integration refers to considering additional risks related to environmental, social, and governance issues. It’s essentially a risk management framework that adds new dimensions to the traditional due diligence process.

ESG integration is becoming standard practice, with 80–90 per cent of investment managers considering ESG factors in their processes, regardless of whether they market themselves as responsible investment funds.

The term has also become a catch-all phrase for responsible investment leading to a lot of misunderstanding, particularly as it becomes more politicised.

Screening in responsible investment

Screening is the process of arranging investments from the possible options to invest in if based on specific criteria or certain criteria.

This process can be based on what the company does (how it makes money, how and where it operates), and can be:

• Negative: remove companies that don’t meet definitions.
• Positive: include companies based on “desirable” definitions.
• Norms based: include/exclude companies based on widely recognised standards across ESG.
• Best in class: similar to positive, but taking the best companies based on desirable definitions of each group (be that sector, country etc).

When most people think of responsible or ethical investment, negative (remove) screening is what comes to mind.

Think if your adviser has asked you: “Which of these items would you not want to invest in?”

Think if your super fund advertises: “This investment option does not invest in...”

There are a few major criticisms with screening that definitely have validity but have nuance.

Definitions: The first is how a screen is defined. This is where a lot of investments have come into trouble with the Australian Securities and Investments Commission (ASIC) for greenwashing. They may state they have a fossil fuel screen, but in the fine print, they only remove companies with more than a third of their revenue from fossil fuel activities. I’m sure as an investor, expecting not to have any fossil fuel companies in your portfolio, you’d be horrified to find out that your super included a company that made a quarter of its revenue from a coal plant!

No seat at the table: When you own shares in a company, you get a say in how that company runs. This can be communicated either at company votes, or if your investment manager has a large enough holding – they may get direct contact with the leadership of the company and can communicate their concerns directly. This is known as active ownership and when you just exclude, you may miss the opportunity to engage. This is often seen in a binary sense, where there is a lot more complexity.

For example, two similar companies:

• Whitehaven Coal: Owns multiple coal assets; only making money out of digging fossil fuels out of the ground. There is no engagement here outside of a complete operation and name change.
• BHP: Over the last few years, BHP has been divesting (selling off) their fossil fuel investments, moving out of the area altogether. BHP generates money from a variety of sources, so you can engage with this company to shift how it operates.

Investment fundamentals: there is also concern that a portfolio that cuts out or invests more into specific lacks exposure and isn’t as well diversified. This can be true, but again, is more complicated than a yes or no.

For example, in the calendar year of 2022, investments that held no oil assets underperformed investments that included oil. This underperformance will affect not only that one-year return but show up in their three-, five-, seven-year timeframes, until it is evened out by other factors.

This year was important because it is when Russia invaded Ukraine, driving oil prices up. Oil companies made more money, so people who invested in oil made more money than people who didn’t, but they did so profiting off the invasion of Ukraine.

This is not right or wrong, but is a great example; as an investor you should ask yourself: “Am I comfortable profiting off this war?”

Stewardship in responsible investment

Stewardship is as it sounds, how an owner takes care of its investment. It is not so much a style of investment as a tool in a manager’s tool kit. I will dive into this in more detail in another post, but as mentioned above, investors generally get a say in how a company or asset runs.

This can be through:

• Voting: Either at the annual general meeting, or ad hoc votes investors can vote on whether a company adopts approaches to their business such as aligning to the Paris Accord, or whether or not to approve executive remuneration, i.e. do they give their CEO a bigger pay?
• Active ownership or engagement: as an investor, if you hold enough of a company, they will definitely want to speak to you (else you sell out and their share price falls). This seat at the table gives you a direct line (usually through your super fund or manager) to leadership. In this conversation, you can raise issues of concern such as the gender pay gap in an organisation, or if it is taking steps towards reducing its carbon emissions.

The amount of earnings calls (conversations between investors and leadership) that included either an environmental, social or governance topic have increased sharply since 2020.

This is one advantage of active investments over passive investments. Active investments choose which companies they invest in based on their research and opinions. Passive investments invest based on a set of rules or an “index”. Because of this, active investors have a lot more power as they can back up their conversation by investing more or divesting from companies that do not respond to their engagement.

Impact investment

This is where the investment case is an impact case, that is that the investment or theme a fund invests in can both generate a great financial outcome as well as a measurable social or environmental outcome.

With impact investment, the investment considerations are still very much front of mind usually equally weighted with the social or environmental benefit. This can be contrasted with philanthropy where the social or environmental case takes the front seat.

Examples of impact investments can be:

• Electric motor components: Investing in companies that make parts for electric cars, thus supporting the reduction of global emissions while making money out of a growing industry.
• Social (blue bonds): bonds that fund social good projects, such as housing support for women over 55, offering strong returns and societal benefits.

In closing

Now that you have a better understanding of responsible investment, consider how these concepts align with your values when selecting your super fund or investments. Think about whether you want to invest purely for financial returns or also for broader societal benefits.

Consider the greater beneficiary approach: if your investments can meet your life and retirement goals while also benefiting society, is that something you’d want to consider? Compare how aligned your super fund and investments are with your values and contrast that against fees and performance to make an informed decision.

Nathan Fradley is a specialist financial adviser at Nathan Fradley Advice.