What is Responsible Investing (“RI”)? Definitions vary widely, and it can take a number of different forms. But in general, RI involves focusing on more than just financial profits. It recognizes that an investment is more than just transactions and numbers… behind the financial statements there are always going to be real-world effects on people, on communities, and on the planet. RI tries to take a more holistic view of the far-reaching implications of our investment decisions.
The most commonly used RI approaches are:
- ESG: This approach considers a company’s environmental, social and governance practices as additional factors within the traditional investment analytical framework. The investor’s focus remains on financial profitability, with the view that poor ESG practices are likely to increase risk or detract from investment returns, while good ESG practices are likely to reduce risk and improve returns.
- SRI: Socially responsible investing evolved earlier than ESG, and goes further by actively excluding (or including) investments based on non-investment criteria (e.g. ethical, religious or political beliefs). Making a profit is still an important factor, but it is constrained by the investor’s social conscience. SRI screens may categorically exclude tobacco or alcohol producers, or include renewable energy producers or organic food producers, based on considerations that have little or no regard for the company’s return potential.
- Impact Investing: Impact investing is a more recent innovation, and it goes further still, such that the primary objective is generating some positive outcome for society or the environment, while making an investment profit is only a secondary objective.
In conjunction with Northwood’s annual diligence review of all our external managers, we included a review of each manager’s approach to Responsible Investing. We asked each manager to:
- Explain if and how they incorporate Responsible Investing into their investment approach,
- Forward a copy of the firm’s formal policy documents regarding Responsible Investing, and
- List any associations, initiatives, or protocols to which they are a member or signatory.
None of our managers practice Impact Investing (prioritizing social outcomes over investment returns), nor do they employ SRI screens (excluding companies or sectors for reasons unrelated to investment returns).
All of our external equity and fixed income managers incorporate some form of ESG considerations into their investment process. A majority of the managers provided us with their formal ESG policy documents. The balance are signatories to the UN Principles of Responsible Investing (UNPRI), a global organization which promotes an ESG approach to Responsible Investing.
How does ESG investing work in practice? Consider BP plc (formerly British Petroleum) as a case study. In 2010, the company’s Deepwater Horizon offshore drilling rig was destroyed by a natural gas explosion which resulted in 11 fatalities, numerous injuries, and the largest offshore oil spill in history, causing billions in economic and environmental damages. As a result of this disaster, BP’s shareholders saw their investment lose more than 1/2 of its value.
How could these investors have possibly anticipated this freak, catastrophic event? Well, if they had adopted an ESG approach to investing, they very well might have.
In the three years prior to the Deepwater Horizon disaster, BP’s workplace safety record was a major red flag. The Occupational Safety and Health Administration (OSHA) had cited the company on 760 occasions for “egregious, willful” safety violations, where they determined that the company demonstrated “intentional disregard for the requirements of the [law], or showed plain indifference to employee safety and health.” For comparison, over the same time period, the next two most prolific offenders, Sunoco and Conoco Phillips were tied with only 8 such OSHA safety violations each.
For investors to have seen these glaring warning flags, they would have had to look beyond the company’s financial statements. An examination of the company’s workplace safety records, would have allowed investors to appreciate the much higher risk that BP posed relative to its peers, and the heightened potential for losses, ranging from fines for non-compliance to major disasters. A decision to avoid BP, based on its safety record would have been highly advantageous to investors, and if enough like-minded investors adopted that view, it would signal to the company that their poor safety standards were increasing its cost of raising capital.
Workplace safety is just one ESG factor that can be considered in estimating a company’s investment prospects and return expectations. What are some other ESG issues? There is no definitive or exhaustive list, and different investors are likely to include and weight factors differently, but below are some of the most common issues.
- Environmental Issues: Climate change, water scarcity, pollution, unsustainable resource depletion, biodiversity, habitat loss, pesticide and herbicide use, nuclear risk, ozone depletion, etc.
- Social Issues: Diversity, human rights, discrimination, income inequality, employee health and workplace safety, labour standards, consumer protection, privacy, price gouging, hazardous products, weapons, predatory lending, animal welfare, conflict zones, etc.
- Governance Issues: Bribery and corruption, executive compensation, director nominations, board diversity, shareholder protections, political contributions, lobbying and regulatory capture, anti-competitive conduct, cyber security, tax evasion, etc.
If you have any further questions about how Northwood views Responsible Investing, please don’t hesitate to contact us.