Going beyond exclusions: the merits of integrated ESG research

It's not just demand for ESG investment strategies that is moving on a positive trajectory. The companies in which these strategies invest are also developing on a path of their own, making progress towards their sustainable goals and responsible objectives – a fact often overlooked by some ESG approaches.

Speaking to Columbia Threadneedle Investments’ head of global responsible investment policy, Iain Richards, we delve into some of the nuances defining the group’s integrated rather than exclusion-based approach that underpins Embarks’ Horizon multi-asset range, alongside several other themes influencing adviser-client conversations on the subject.

Historically, funds once described as ‘green’ adopted a purely exclusion-based approach, screening out entire industries for negative connotations certain investors hoped to avoid.

While these still exist, times have changed, with approaches now considering such metrics as limits, thresholds, tilts or demonstrable corporate engagement. Integrated approaches recognise black-and-white exclusion methods as rather blunt tools, failing to account for levels of inclusion, or longer-term purpose.

Integration applied to energy transition

More dogmatic approaches to exclusion might request percentage reductions in carbon emissions, for example. The resultant shifts into less carbon-intensive industries might tick particular boxes but they don’t support the requisite economic or social developments needed to respond to climate change.

Rather than blanket-banning fossil fuels – given the collective dependency still in place – Columbia Threadneedle engages with companies and understands their plans for energy transition, for instance.

“In understanding the effects of climate change, its impact, changing regulations, technology and industry dynamics, we can understand the characteristics of that particular aspect of industry and allocate our capital accordingly, so we can back the future winners,” Richards said.

A major rationale for an integrated approach is that many themes often associated with ESG investing, such as climate change, are neither immediate nor binary, he added. These are prolonged, complex and multi-faceted societal and geopolitical shifts and need to be invested in with that same mindset. Reducing a company to a fixed position of either ‘in’ or ‘out’ is too simplistic, with some of yesterday’s losers having the potential to become tomorrow’s winners.

The current energy crisis is a stark reminder that pragmatism should prevail over absolute ESG ideals. Redressing the global energy mix is essential, but reform must maintain our economies and societies without seeking, notionally, to shut down entire industries overnight.

Richards said: “The realisation over how reliant we are on Russian gas supply has refocused debate around energy security, which – when looked at in relation to energy transition – is through a very different lens to an idealised version of what the energy mix should be.”

He added: “I think it is important to differentiate between investment categories that represent idealised end games versus investments responding to change and heading in the right direction.”

Understanding the path of progress

Given the pace at which ESG assets are gathering, many investors – and advisers – may still feel confused or overwhelmed at the choices available. Industry taxonomy is unhelpfully inconsistent and full of jargon, meaning there’s a basic education job to be done before the investments themselves can even be discussed.

How can we help? There are a multitude of terms used in this space, but the starting point for Columbia Threadneedle and the Horizon fund range, is defining ESG and sustainability. The adviser can then take each of these concepts and apply it to a client’s frame of reference, helping to clarify their decision-making.

“For me, ESG is about the internal standards of operating practices within a business. How are they responding to the material risks given the industry they’re in and the business model they have? How are they managing their exposures? Sustainability is about whether they are future-proofing their business model and adapting to the changes taking place in the world,” Richards explained.

The research capability that comes with being a large global institution enables not just deep-dives into multiple asset classes across global universes but a more accurate forward-looking scenario analysis, as opposed to being backward-looking.

“As investors we are interested in the future trajectory of a business over time; where their strategy is taking them, their investment in technology as well as the cost of change.”

This depth of analysis presents early warnings that an exposure might warrant a closer look, in turn helping Richards’ team understand the scenarios, merits and risks of an investment opportunity, capturing less obvious ideas that might be missed on a pure exclusion basis.

Clean energy isn’t just investing in wind farms, for instance. Richards suggested an integrated approach might equally identify an industrial wind turbine manufacturer, providing the balance of risk and reward where the ESG criteria stacks up.

Looking at a broader Horizon

Remember also, opportunities exist beyond equities. Sustainable fixed income is a less mature, yet rapidly advancing area of the market.

Richards suggests many investors sidestep green bonds for their perceived complexity, effectively swerving huge potential funding opportunities that feed into the ESG agenda, failing to recognise the changing business model and economics of whole industries.

“On first glance, a business with high carbon emissions ought to not feature in an ESG strategy. Yet take a shipping company that issues a green bond, established to fund scrubbers to address the emissions from its ship’s engines or to adapt those engines for more eco-friendly fuels. Isn’t the use of that capital important to climate change adaptation even though it is in a shipping business?”

Investors may feel uncertain choosing between a mainstream fund with ESG elements versus a purer play. Increasingly groups are offering dedicated ESG or sustainable investing propositions in addition to their mainstream ranges. One might draw a comparison with McDonald’s, which is now promoting a vegan range as a separate offering to its original menu.

For Richards, this type of analysis is relevant to all investments, with the degrees of “intensity” varying between more traditional or specialist strategies.

“For some an exclusion-based approach may be appealing, but in a world driven by megatrends shifting economic, social and geopolitical dynamics, we believe in a more nuanced approach that can navigate such an environment, underpinned by the robust and integrated research approach that is employed within the Horizon fund range.”

Editors Notes

Past performance is not a guide to future performance. The value of investments can go down as well as up, so your client could get back less than they invested. Columbia Threadneedle Investments is the investment manager for the Horizon Multi-Asset funds.

Embark Investments is a trading name of Embark Investments Limited. This document is issued by Embark Investments Limited. Embark Investments Limited is authorised and regulated by the Financial Conduct Authority. Registered in England and Wales under company number 3383730. Registered Office: 100 Cannon Street, London, EC4N 6EU.

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