Last year the UN Principles of Responsible Investment (“PRI”) saw signatories increase to over 4,400 asset managers and asset owners. Two years ago it was nearly half that number. Responsible investment has hit the mainstream, what was once the reserve of impact investors is now being embraced by all investors.
Many people hear words like responsible investment, ESG or sustainability and assume it’s all about sacrificing return to do some good. That is not the case, Larry Fink (CEO of Blackrock) described responsible investment in his 2022 letter to investee CEOs as “capitalism, driven by mutually beneficial relationships between you and the employees, customers, suppliers, and communities your company relies on to prosper”. In other words, responsible investment enhances returns.
Like most forms of capitalism, responsible investment is a market that needs a degree of regulation in order to operate efficiently and be trusted. Regulation is the stage of the responsible investment journey that we are at right now. The PRI launched in 2006 as a voluntary, international organisation. They have become the byword in responsible investment, making the case for it and they have succeeded. Society wants its money to be a force for good, forcing pension funds and retail offerings to adopt responsible investment and in turn asset managers have had to adapt too. Governments have picked up on the scale of this activity and are now rolling out regulation.
The purpose behind regulation is two-fold. Firstly, to ensure fair, trustworthy markets that protect investors. Secondly, to achieve broader policy aims like achieving net zero to halt climate change. The EU tackled this through the Sustainable Finance Disclosure Regulation. Without going into detail (much has been written on that elsewhere) one of the key features is the classification of investment products into those that do not take a responsible investment approach, those that do and those that seek a specific and deliberate beneficial impact. A consequence of this is that most investors look for products that adopt a responsible investment approach but stop short of becoming a fully-fledged impact investment. So what does that look like?
Mainstream responsible investment is integrated into an underlying investment strategy, it isn’t a strategy in itself (that would be an impact investment such as investing in renewable energy). Instead, there are specific steps an asset manager might incorporate into their investment and ownership approach. Negative screening or exclusionary lists are a typical first step. These are red lines the asset manager will adopt so that they don’t invest in anything on the list. Common examples are firearms or tobacco manufacturers. These ought to be tailored to the investment strategy. For example, an asset manager with strategies focused on the apparel sector doesn’t need to add tobacco or firearms to their exclusionary list – instead they should focus on red lines within their sector of focus. These can be jurisdictional (because of a lack of labour laws or other human rights concerns) or they may be based on certain harmful materials etc. Whatever the red lines are, they should be relevant.
Once an opportunity is through the screening process it then comes down to due diligence. This is a familiar step from a financial or legal perspective but sustainability due diligence is rapidly becoming mandatory across firms for all investments. It requires a materiality assessment of the target to identify the specific sustainability risks and opportunities for that company. This is where the potential for value creation resides. The transition of a company from poor to good sustainability performance can enhance exit values. The due diligence should serve to inform future ownership activity as well as identify risks that potentially can’t be addressed (and would therefore throw the deal into doubt).
Once acquired the ownership phase kicks in. This is the engagement the investor has with the investee to address their sustainability performance. This might include plans to reduce greenhouse gas emissions to net zero for example. Whatever the material sustainability issues are, addressing them is the key to unlocking value.
Adoption of this process is now widespread. Spurred on by regulation in Europe, the UK and soon in the US and other key markets. Responsible investment is a capitalist agenda focused on creating value and regulation is coming into place to build trust in that process.
If you would like to find out more, please contact Harry Briggs on firstname.lastname@example.org