A recent report by the Responsible Investment Association Australasia (RIAA) found that nearly half of Australia's professionally managed assets (comprising some $980 billion) apply a responsible investment approach.
This pool of responsible investment may be set to rapidly expand, according to Larry Fink, CEO of the world's largest asset manager BlackRock, who recently published an Open Letter to CEOs forecasting a 'fundamental reshaping of finance'.
Below, we provide a refresher on some of the main approaches to responsible investment increasingly adopted by institutional investors.
What is responsible investment?
Responsible investment is a label for an approach adopted by institutional investors – such as superannuation funds, insurance companies, pension funds, sovereign wealth funds and privately managed investment funds (including by some of Australia's largest institutional investors) – that incorporates environmental, social, and other governance (ESG) issues into their investment identification, decision-making and stewardship processes.1
Some common ESG considerations used by investors to frame decisions about long-term value and future risk and determine where to invest responsibly include:
- climate change;
- diversity and human rights; and
- broader integrity concerns.
Approaches to responsible investment
There are currently three common approaches to responsible investment:
- ESG integration.
- Screening approaches that rule in or out investments by reference to the sector or industry of the investment (e.g. ruling out investments in controversial or unethical sectors and industries).
- Impact investments that actively invest for positive social or environmental outcomes.
Some investors use a combination of these approaches.
In our view, there is little doubt that concerns about climate change – which is just one element of responsible investment – directly contribute to the acceleration in the growth of responsible investment. In his recent Open Letter, Larry Fink wrote of the need for investors to promote long-term value:
"Our investment conviction is that sustainability- and climate-integrated portfolios can provide better risk-adjusted returns to investors. And with the impact of sustainability on investment returns increasing, we believe that sustainable investing is the strongest foundation for client portfolios going forward."
If Mr Fink is correct, an increased focus on various responsible investment approaches by investors will lead to material changes in the capital allocation of institutional investors. Businesses that seek capital from these investors (or indeed any companies listed on indexes on stock markets covered by the public equities allocation of institutional investors) will need to position themselves for this shift.
We set out a refresher on the three common responsible investment approaches below:
- ESG integration
By far the most common responsible investment approach, comprising 45% or approximately $440 million of the Australian responsible investment market,2 ESG integration refers to the evaluation of risks posed by ESG factors as part of an investment process.
ESG 'factors' change over time. Climate today, for example, presents a fundamentally different risk to what it did 50 years ago. The same applies to modern slavery and human rights (including wage theft), and integrity risks such as anti-bribery and corruption. ESG integration does not always address or necessarily look at the same issues as 'legal compliance'. For example, an investment into a business that complies with current environmental laws and permits does not necessarily pass a sustainability frame of reference.
Historically, ESG issues have often been classified as 'non-financial risks' associated with business operations or investment activities. However, it is clear that when things go wrong, reputational and brand damage, combined with exposure to litigation, can have very real financial and commercial consequences.
Negative screening sees an investor exclude/screen investments they view as undesirable, typically by reference to the sector or industry of the investment. Many of Australia's largest investors apply negative screens, with those screens commonly applying to the tobacco, weapons, gambling and animal testing industries.3
Other negative screens applied by institutional investors go further than that. They may consider a company's response to risks such as climate change, or exclude investments in 'pornography', 'junk food' or GMOs. For example, HESTA's 'Eco Pool' superannuation fund investment option excludes investments in companies with 'material' involvement in fossil fuel activity, the mining or processing of uranium and those that produce or manufacture tobacco products.4
A negative screening approach may apply to divestments as well as investments. That is, an investor may have a policy of strategically divesting ownership in certain companies or industries. An interesting example of such a policy is Future Super's commitment to divest fully any interest it has in any company that mines, burns, extracts, services or finances the fossil fuel industry.5
Positive/best in class screening and sustainability themed investing
Another prominent responsible investment approach is positive screening, which is closely associated with sustainability themed investing. When employing a positive screen, an investor will actively target investments in companies that they determine meet ESG-related performance standards.6 Often, these investments relate to themes or assets that are environmentally friendly and/or socially responsible.
Some common examples of positive screens are investments in clean energy, education and social enterprise funds. For instance, Pendal's sustainable fund applies a positive screen to invest in companies that deliver over 20% of revenue from sustainable technologies.7 Further, more and more investors are seeking out the tech giants. Microsoft is one of those benefitting as investors seeking positive social or climate-related attributes in their investments, with ESG funds holding $2.3 billion worth of stock at the end of 2019.8
An investor may also employ a 'best in class' approach to positive screening. This means they could invest in a mining or resources company that is demonstrating leadership in its industry in other ways, as it is considered 'best' in its class by reference to ESG-related performance or undertakings.
- Impact/community investing
Impact investing is different to positive screening because it means allocating investments and engaging in stewardship and/or dialogue with policy makers with the intention to increase positive and/or reduce negative sustainability impacts. By contrast, positive screening requires investment products to be environmentally or socially responsible but not necessarily have a direct impact.
In impact investments, social and environmental impacts are commonly measured by reference to the United Nations Sustainable Development Goals (SDGs). In our view, the SDGs are becoming the global reference point for sustainable directed activities of many large institutional investors. Although the RIAA finds that impact investment is only a small fraction (~1%) of the responsible investment market in Australia, we expect this will change with increasing focus on impact investing from both the public and private sector.9
In 2019, the Australian Government commissioned a Task Force to report on necessary policy changes to facilitate social impact investment in Australia. The Taskforce released its Interim Report last month following consultation superannuation funds, and a cross section of social enterprises. The report noted the Taskforce's Final Report will address ways Government can assist social enterprises to attract impact related investments from mainstream institutional funders who have an 'emerging appetite' to invest in social impact. Its final report is set to be released in mid-2020.
Impact investments are made across all asset classes, including fixed income, infrastructure, venture capital and private equity. Impact investing can range from an equity investment into a sustainable fund (e.g. one that provides access to health products in developing countries), to the provision of private debt or equity to a social enterprise (e.g. childcare services for disadvantaged children).10
The private sector in Australia has seen pockets of growth in the impact investment market. For example, Christian Super has made $140 million in what it describes as impact investments, representing 10% of its funds under management. It estimates that its impact investment activities have helped provide (among other things) power to one million Australian households with clean energy for a year and education to 3,000 Australian students. It also estimates it has helped over 90 million people access microfinance loans aimed to alleviate poverty in the worlds least developed countries through investments in impact managers who invest in a range of banks and finance providers.11
Offshore, KKR has recently been in the headlines for closing its Global Impact Fund at US$1.3 billion – the fund is targeting private equity style returns in companies that contribute measurable progress towards one or more of the UN SDGs.12 Examples of thematics the fund will reflect include water sustainability and waste management.
The road ahead
Consumers are increasingly interested in where and how their money is invested.
A recent study by the RIAA showed that 9 out of 10 consumers expect their money to be invested responsibly, and Australia's financial regulators (APRA,13 the RBA14 and ASIC15) are increasingly commenting on issues like climate change, which is likely to drive further adoption of certain responsible investment approaches.
Globally, governments are increasingly legislating for the private sector to incorporate human rights considerations in their planning processes. This is evident in modern slavery laws in the UK and Australia, transparency laws in California and France, child labour laws in the Netherlands, and consideration of human rights due diligence regulation across Europe.
Investor led initiatives are also creating pressure on companies to reduce greenhouse gas emissions in line with Paris Agreement targets. One such initiative is the Climate Action 100+ , which is comprised of investors with more than US$35 trillion in assets under management who, among other things, commit to working with companies they are investing in to 'ensure that they are minimising and disclosing the risks and maximising the opportunities presented by climate change and climate policy'.
Read together, these movements may signify, as Larry Fink predicts, signs of a fundamental reshaping of finance and capital allocation. Finding ways to protect against ESG risks and indicators while also striking a balance between stakeholder demands and attracting investment will be an ongoing challenge for business in the years to come.
1 See UNPRI 'What is Responsible Investment':
2 Ibid. p 3.
3 Ibid. (n. 1) p 12.
4 See here.
5 See here.
6 UNPRI 'Responsible investment overview' (available here).
7 See here.
8 According to EPFR data quoted in here.
9 Ibid p 3.
10 See 'Examples of Impact Investment' ImaQt: for an overview of some significant impact investments in Australia.
11 See Christian Super, Impact Report:
12 See here.
13 See here.
14 See G Debelle, Reserve Bank of Australia, 'Climate Change and the Economy' (Speech, Public Forum hosted by the Centre for Policy Development, Sydney, 12 March 2019).
15 See address by ASIC Commissioners Sean Hughes and Cathie Armour where it was stated that ASIC considers it misleading for directors to discuss a company's prospects without referring to business risks, which could include climate change; see here.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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