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December 16, 2021 at 04:32 PM
What You Need to Know
- Advisors often hesitate to talk to clients about the subject.
- Explaining the distinctions between terms should be an important aspect of the advisor-client dialogue.
- The terms SRI and ESG are often used interchangeably but can be very different in application.
Sustainable and responsible investing is a polarizing topic. Although investor dollars are flowing to the many product offerings launched by fund companies, advisors often hesitate to talk to clients about the subject. Definitional confusion contributes to heated debates between proponents and skeptics.
Commonly used terms such as environmental, social and governance; socially responsible investing and impact investing mean different things to different people, with terms often twisted to fit a favored narrative.
Definitions Matter
Explaining the distinctions between terms should be an important aspect of the advisor-client dialogue. Exclusionary approaches, often described as SRI strategies, eliminate individual holdings or market sectors that investors wish to avoid. “Personalization” is an emerging description of strategies designed around personal preferences.
Commonly implemented exclusions include “sin stocks” such as alcohol, tobacco and gambling companies; climate-focused investors have embraced “fossil-fuel-free” strategies that exclude traditional energy and utility companies.
The terms SRI and ESG are often used interchangeably but can be very different in application. ESG considerations go beyond the purely exclusionary focus of SRI.
ESG investors believe that today’s nonfinancial considerations, such as carbon emissions, water use, labor practices, and regulatory/compliance track record, often become tomorrow’s material financial factors. Many ESG-focused investors integrate ESG analysis into research evaluating traditional financial metrics.
Impact investments are intended to generate a measurable and beneficial social or environmental impact alongside a financial return. Impact investors direct capital to companies seeking to solve some of the world’s greatest problems, such as climate change, income and wealth inequality, diversity, equity and inclusion.
Exclusionary Approaches
Harvard University is one of many universities that plan to phase out all investments tied to oil, gas and coal; Boston Mayor Michelle Wu’s first bill signing was an ordinance requiring the City of Boston to divest from fossil fuel, tobacco and private prison industries by the end of 2025.
Some investors divest to align their portfolios with personal values; others cite economic reasons including the risk that conventional fossil fuel companies will be stock market losers given “stranded assets” that will need to be left in the ground. Opponents of divestment challenge climate change assumptions or expect the transition from fossil fuels to renewables to take decades to unfold.
Fossil fuel divestment is a controversial topic. Fossil fuels represented more than 80% of primary energy consumption in 2019, with renewables (such as wind and solar) and other non-fossil fuels (such as nuclear) slightly above 15%.
Absent significant shifts in government policy or near-term breakthroughs in clean-energy technology, traditional and clean energy sectors may coexist for many years before the world can fully rely on alternative energy sources.
Wind and solar costs have fallen dramatically but continue to be intermittent sources of energy. For values-focused investors, issues related to the supply chain for batteries and manufacturing of alternative energy technologies may also raise questions around environmental impacts, potential resource constraints, labor practices and geopolitics.
Advisors should understand the trade-offs implicit in exclusionary approaches. Some of the commonly excluded industries are a relatively small part of the market, mitigating the potential opportunity cost of avoidance. For example, the energy sector is the best-performing S&P 500 sector year-to-date but now represents less than 3% of the S&P 500 Index.
