ESG Transgressors: Should investors engage or exit?
One of the fiercest debates around sustainable investing is whether to engage or to exit a position. Most activists believe that institutional investors should divest from companies that they consider to be engaging in what they perceive to be unethical activity, those who fail to consider their impact on the communities around them, or act in ways that threaten the future of the planet. However, the issue is more nuanced and we believe that an active engagement is a more constructive and effective strategy to achieve lasting change.
As sustainable or ESG (environmental, social and governance) investing has become more mainstream, this debate has become more heated. Divestment refers to the act of selling or removing investments from companies or industries – such as tobacco, fossil-fuel, petrochemical and mining companies for example – that are deemed to have unsustainable practices or fail to meet specific ESG criteria. Engagement on the other hand refers to instances where investors hold onto their stake in a company and use their superior stakeholder status to favourably influence corporate behaviour.
Making your voice count
“Our view is that by engaging with companies, asset managers can help direct them towards more sustainable practices, whereas if you exit from those companies, you lose your voice and risk that other shareholders who are far less concerned with sustainability, may take your place. If you want to have an actual impact and have a meaningful voice as a stakeholder, engagement is a more effective way of enacting change than sanctimoniously disinvesting.”, says Seeiso Matlanyane.
With ESG investing, it is sometimes tricky to achieve the right balance because as asset managers, we naturally have client expectations to fulfil, some of which are financial return based with relatively shorter time horizons. Sustainability goals on the other hand, such as achieving decarbonisation, tend to require longer time horizons to achieve.
Issues that we typically engage on with investee companies include how much carbon they’re emitting, whether they’re polluting large amounts of water during their operations or extracting fossil fuels in an unsustainable way. These are environmental considerations. Then there are also social factors, such as unfair labour practices, which we might challenge companies on. Lastly, there are governance issues related to the composition and the structure of the board, executives’ remuneration and whether their accounting practices are up to standard.
One study conducted by the Principles for Responsible Investment (PRI) in 2020 examined the impact of investor engagement on ESG issues. The study analysed data from over 6,000 engagements conducted by PRI signatories over a five-year period. It found that engagement efforts led to positive outcomes in approximately 80% of cases, such as improved disclosure, policy changes, and enhanced risk management. The study suggested that active ownership and dialogue with companies can be effective in influencing ESG practices.
Exiting: an easy cop-out
Essentially, there are two kinds of exit strategies. The first entails an initial assessment that is made by the asset manager about whether they want to invest in a company or not. If it is deemed to demonstrate unethical, unsustainable, or irresponsible behaviour, the manager may choose to exclude that company from their investment universe. This is considered the “no-entry strategy”. Alternatively, asset managers can divest by selling their shares in an offending company with the aim of aligning investment portfolios with ethical and sustainable principles whilst also depriving the offending company of capital to influence its practices.
While some asset managers perceive divestment as a platform for a higher moral ground, at Prescient, our view is that this route does not necessarily address the underlying problem and would likely require much of the investment community to adopt the same approach to be effective. We believe that active engagement is a more effective attempt at solving the underlying issues. This view is supported by evidence such as a study conducted by Harvard Business School (2017) which examined shareholder activism on climate change. The study found that institutional investors engaging with companies on climate-related issues were able to influence corporate behaviour and achieve positive environmental outcomes.
Three kinds of engagement
There are three ways in which Prescient engages with companies which is in line with our internal policies. These engagements play an integral part in informing our investment decisions, whether to buy, hold or sell a position in a company.
The first kind of engagement is to engage directly with investee companies. We convey our thoughts on matters, discuss the merits thereof, convey our views on ways in which these companies would need to change to conform with our expectations, and importantly the glide path to get there. The second is to engage by collaborating with the broader investment industry, either to educate the market, or to drive collective change through legislative or regulatory change. Lastly, we use our proxy rights to vote on behalf of our clients, which is a form of active ownership. This includes voting at AGMs and appointing new directors where needed, which requires shareholder approval. In all these ways, we are using our influence to bring about positive change.
More regulation needed
Currently, the majority of asset managers in South Africa are signatories to the United Nations-backed Principles of Responsible Investing (PRI) and have adopted the Code for Responsible Investing in South Africa (CRISA). These codes encourage ESG integration, stewardship and transparent governance, but they are entirely voluntary.
For the investment community to have a more profound impact on sustainability, codes like PRI and CRISA would need to become mandatory and enforced by regulators, because it’s unlikely that all asset managers will enforce the codes. Thus, unless the entire investment community acts in tandem, it is difficult, if not impossible, to effect material change.
Therefore, we recognise that active engagement is a long-term game. Although we don’t expect to achieve overnight results, we believe that by consistently asking the right questions and steering companies in the right direction, we will bring about the change we want to see in the world. Divestment is part of our toolbox, but one we don’t want to default to. We prefer to use active engagement to drive positive change in the companies we invest in, rather than turn a blind eye to ESG issues that we really care about as an investment manager. DM
Author: Seeiso Matlanyane – Head of Equities at Prescient Investment Management and ESG Committee Member
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