ESG and Charities
Earlier this year the Charity Commission, the registrar and regulator of charities in England and Wales announced it would be revising guidance on responsible investments. It conducted a listening exercise last year, which found that the way responsible investment was outlined in its original guidance was not giving some trustees confidence to use this approach to investment. It has now drafted updated guidance and has opened a consultation making it clear that trustees of all charities can decide whether or not to adopt a responsible investment approach that reflects the charity’s purposes and values, and not just focus on the financial return. Trustees’ decisions about responsible investments must always be made in the best interests of the charity, and in line with its governing document. They have been increasingly considering the factors affecting the longer-term financial sustainability, including environmental sustainability, of their investments. Over 23,000 charities on the register have the ‘environment’ in their charity objects or activities so this is an area where they already have an interest.
Growth in responsible investment is being driven by three factors: (i) increasing recognition that ESG factors can materially impact the risk and return of an investment, (ii) growing demand from investors, helped by this recognition, and (iii) higher levels of regulatory guidance that incorporating ESG factors into portfolio management is part of a firm’s duties to its charity clients.
Environmental, Social and Governance (ESG) are three non-financial risks faced by an investment or company. Lack of ESG considerations could negatively impact the financial position, and share price, of an investment and therefore the returns achieved by a charity. Historically, generating profit has been considered a company’s top priority. However, an increasing number of people want investments that do more than make money. This includes the public who think that the way charities go about meeting their purpose is as important as whether they fulfil it or not. A business that focuses narrowly on the immediate interests of its shareholders, and fails to manage its non-financial risks, could reduce longer-term shareholder value and may materially damage the sustainability of its business model. Failure to consider ESG factors is more likely than ever before to be found out, with all the sanctions, reputational damage and loss of licences, customers and revenues that can follow.
One of the more confusing things about responsible investing is the jargon and inconsistent terminology. As well as financial returns, investors adopting a responsible strategy are seeking to mitigate risky ESG practices, often in order to protect value. Authorities also recognise the taxonomy problem with the regulation around labelling and ‘greenwashing’ becoming increasingly onerous. In particular the incoming EU Sustainable Finance Disclosure Regulation, will bring with it additional disclosure obligations for products or portfolios as ‘sustainable’ or ‘ESG’. The Investment Association (IA) has been doing good work in trying to reach an industry consensus on how to use these terms and in November 2019, published its Responsible Investment Framework.
The Charity Commission is proposing to refer to responsible investment rather than ethical investment and their examples include negative screening, positive screening, stakeholder activism and investments that would damage a charity’s reputation, reduce donations and not be in the charity’s best interests.
Traditional ethical investors exclude certain types of activities that are deemed harmful, or unethical and therefore the process of ‘negative screening’ shrinks the potential investment universe, by excluding whole sectors. This carries the risk of adversely impacting investment performance. The Charity Commission have clarified in the draft that a charity with investments which are permanent endowment must aim for the best financial return within the level of risk but trustees can still take a responsible investment approach
Traditional ethical investing and ESG integration are actually two completely separate approaches. It is entirely possible for ‘sin’ stocks – tobacco, alcohol and weapons manufacturers – to score highly on ESG. This is possible because ESG ratings focus more on how a company is run, rather than simply what it makes, and also because ratings typically operate on a ‘best in class’ approach. This means companies are rated against their peers in the same sector, rather than against companies in different sectors. Unless a charity has separately stated any ethical or values-based restrictions, ‘sin’ stocks can still be included in portfolios that take ESG risks into account.
There is no binary in/out selection of investments for ESG investors. Instead, these investors assess the opportunities and risks that the E, the S, and the G factors pose to an investment in any sector. This is often done with the aim of identifying those companies that are better placed than their peers, or ‘best-in-class’ within their sector. For example, a polluter with the lowest (or a rapidly declining) carbon footprint may have a higher ESG rating than its competitors, and an investment firm considering ESG risks will factor this into its decision making when deciding whether an investment in the company represents good long-term value for the charity’s portfolio.
Environmental, social and governance (ESG) risk is being explicitly recognised in the draft “When considering which companies and organisations to invest in, all charities can take into account such factors as impact on climate, employment practices, sustainability, human rights, community impact, executive compensation and board accountability.”
ESG is delivering profit and returns
There is a growing body of academic research to support the use of ESG criteria which should provide reassurance to those trustees who perceive that by investing responsibly they are sacrificing financial returns. An analysis* of more than 2,000 studies on how ESG factors affect companies’ financial performance found “an overwhelming share of positive results”. Just one in 10 showed a negative relationship. Similarly, shares in companies with better ESG ratings are more likely to score high on Quality and low on Volatility. The findings from these studies are mostly based on correlations. Of course, correlation is not the same as causation. There always could be other factors at work, and there probably are. However, in the round, the research suggests that consideration of ESG factors improves investment decisions and leads to slightly better long-term risk-adjusted returns.
Investor scrutiny also encourages the corporate sector to raise its game and to do its part for the wider good and we see many companies looking to improve their own Corporate Social Responsibility and environmental impact in order to achieve a better ESG rating. Two-thirds of corporate and NGO respondents (67% and 63% respectively) to the C&E Corporate-NGO Partnerships Barometer 2020 indicated that business practices have improved because of their engagement in partnerships. So, in theory, charity investors can marginally improve financial performance while also having a positive impact on corporate behaviour.
We look forward to seeing conclusions from the Charity Commission’s consultation on its draft guidance and in the meantime, hopefully this article has provided Trustees with insights to support meaningful discussions ahead of final guidance being issued this summer.
*Source: Deutsche Asset and Wealth Management, ‘ESG and Corporate Financial Performance: Mapping the global landscape’, December 2015
Jane Bransgrove is director of asset management at Charles Stanley