“Why do financial markets rate Amazon as one of the world’s most valuable companies but the value of the vast region of the Amazon appears on no ledger until it is stripped of its foliage and converted into farmland?”
Mark Carney: The Reith Lectures 2020
In the struggle to protect the Earth’s environment we are all responsible for its current plight and ongoing protection. When contemplated as a whole, the enormity of the sea-change necessary on a personal and wider level to avert environmental disaster can be paralysing. However, as with all great human undertakings, change will not come through one giant leap but a series of small steps in a better direction.
Charities, including those whose objects do not explicitly include ‘the advancement of environmental protection or improvement’, are becoming increasingly aware of their role in trying to prevent further damage to the environment and improvement of the human condition. This has extended to charity investments and the growth of targeted Environmental Social and Governance (ESG) investing that seeks to do good with funds at the same time as generating financial returns.
Investing for ESG purposes is not a new concept. A number of charities have long avoided investing in companies whose activities run contrary to their own objects (commonly known as ‘ethical investing’). However, only more recently has it been possible for charities to actively target investments that seek to create material, measurable and positive impacts on people and the planet. Despite the ideas and aims of ESG investing finding a wider audience in recent years, there remain a number of concerns and misconceptions that have left many charities wondering whether ESG investing is possible and appropriate.
In this article, Edward Harper-Masters, an associate in the private client team at Penningtons Manches Cooper, and Louisiana Salge, senior sustainability specialist at EQ Investors, explore the legal considerations for charities wishing to engage with ESG and sustainable investing as well as some of these common misconceptions.
The legal aspects of ESG investing
ESG investing is, in many senses, little different from more traditional investments and, as such, the trustees have the normal duties with regard to investing charitable funds. As with any question as to the extent of trustee powers, the first place to start is a charity’s governing document.
Most unincorporated charities contain a general power of investment for funds (other than those held as permanent endowments) that goes as far as or further than the powers contained in statute. Incorporated charities that may not have the luxury of a general power of investment will need to rely on any powers contained in their constitution.
Charity trustees will be familiar with their duties regarding investments under the Trustees and Charities Acts. In particular, the duties to ensure that any investment made for the benefit of the charity has regard to the standard investment criteria and that appropriate advice is sought.
Until recently this was often construed as a duty to maximise the return. Many charitable trustees will have had the 1991 High Court case of Harries v Church Commissioners for England at the forefront of their minds as a cautionary tale for charity investment policies. A claim was brought against the Church Commissioners by the then Rt Rev Richard Harries, Bishop of Oxford and others in relation to the management of the investments under control of the Church Commissioners which, at the time, were invested with a view to maximising returns. The plaintiffs argued that the investments should have regard to the “promotion of the Christian faith”, even at the expense of financial returns.
It was held that the comprehensive investment policy of the Church Commissioners was sound and that the trustees were under a duty to maximise the return from the charity’s investments without consideration of other factors, ethical or otherwise. However, to interpret this decision as a rejection of the possibility of ESG investing would be a mistake. As ever, balance is key.
While trustees who pursue one form of investment to the detriment of returns will remain in breach of their duties, it was accepted that there could be instances where other considerations could be taken into account. These included where an investment conflicted with the aims of the charity or would hamper the charity’s work.
Unsurprisingly, in the now 30 years that have passed since the Bishop of Oxford decision, a lot has changed. Principally - and as explained in more detail below - the belief that ESG investing and the best available returns are mutually exclusive has been largely shown to be incorrect as more and more sustainable funds have entered the market.
In addition, the Charities (Protection and Social Investment) Act 2016 introduced an explicit statutory power permitting incorporated and unincorporated charities to make social investments. These are defined as acts which are carried out with a view to furthering the charity’s purposes and achieving a financial return.
For the purposes of the Charities (Protection and Social Investment) Act 2016, “achieving a financial return” goes beyond generating the greatest possible return to encompass any investment where the “outcome is better for the charity in financial terms than expending the whole of the funds or other property in question”. The Charity Commission accepts that “the definition is wide and may include some actions which would not ordinarily be thought of as investments”.
While charities should take advice to ensure that any action they wish to take will constitute a social investment, permitting actions which only contemplate a return on capital has opened the door to many investments that would previously have fallen foul of the need to yield the best financial return.
Some common misconceptions
Despite the law beginning to catch up with the wishes of many charities to actively reflect their objectives in their investment policy, a number of misconceptions and concerns that may prevent charities engaging with ESG investing remain. Louisiana Salge explores four of these.
Misconception 1: All sustainable investment approaches are the same
LS: There are a variety of ways in which sustainability considerations can influence investment mandates and portfolio management. Below are the three most common approaches:
- Traditional ethical investing focuses on excluding a set of industries or companies based on controversial behaviour, often called the ‘sin stocks’. To do this, investment strategies will apply a values-based negative screen on industries like tobacco, alcohol and pornography. The rest of the strategy is then managed with traditional investments.
- ESG investing introduces information on how well companies manage relevant operational ESG factors into the investment decision-making. Investment strategies can integrate this information differently. Common approaches may overweight or set inclusion thresholds based on company ESG performance relative to peers.
- Impact investing focuses on creating material, measurable and positive impacts on people and planet. Instead of being a relative assessment such as ESG, the focus here is on maximising the absolute positive impact associated with investments. Investment strategies can do this by positively targeting sustainable themes like clean water, renewable energy or accessible healthcare.
All these approaches, when properly executed, include active engagement with a charity’s investment managers. Terminology is not yet standardised but, as summarised, there are clear distinctions in available approaches tailored to reflect different client mandates and objectives. It is important to look further than the fund title when choosing between strategies that differ significantly in their objectives and outcomes.
Misconception 2: Sustainable investing will sacrifice investment returns
LS: There is mounting evidence that sustainable investing does not sacrifice performance. In fact, incorporating ESG factors into investments can help boost financial performance. Overall, businesses that demonstrate greater operational sustainability (ESG) and sustainable products and services can perform better.
Evidence indicates that the positive correlation between sustainability and performance holds both at the corporate accounting and investment performance levels. The reasoning is that businesses managing E, S and G better than peers demonstrate better risk control and compliance, suffer fewer severe incidents such as fraud and environmental spill litigation and, ultimately, carry lower tail risk. Additionally, ESG leaders invest more in research and development, foresee future risks, and plan ahead to remain competitive.
Impact investing also offers the opportunity to capture the potential upside from competitive advantage, sustainability trends and legislative support. Impactful companies are those that have turned the largest societal challenges into profitable business opportunities. These companies benefit from the growing global demands for their products and services; greater regulatory support; and avoidance of reputational and stranded asset risks. A recent example is the EU pandemic recovery package that demarcates special financial support for green economic activities.
Market evidence is also accumulating and reveals the superior returns of many sustainable strategies over their traditional equivalents. For example, Positive Impact Portfolios are frequently the best performing portfolio range, beating their benchmark for each of the eight years since their inception.
Misconception 3: Sustainable investing is too risky for a charity
LS: It is true that many high-impact investments can be located in more volatile markets such as emerging markets but real opportunities exist from small to large companies, equity, debt and real assets – and risks vary between these. For example, social housing investments can provide reliable government-backed income streams while providing significant societal benefits. Water utilities prevent industrial wastewater from polluting natural ecosystems and also provide defensive investment characteristics.
Therefore, portfolio managers are able to adhere to normal risk categories and create portfolios for different ‘risk appetites’ of charity endowment mandates, as well as tailor these to sustainability preferences.
While long track-record data is not yet available across all risk categories for the aggregated impact investment sector, there is evidence that Positive Impact Portfolios have shown better risk-adjusted returns than their conventional benchmarks since their inception when factoring in volatility.
This supports the opinion that by investing in well-managed businesses that target long-term needs, some potential higher short-term volatility is worth the sustainable returns. However, trustees should be aware that past performance is not a guide to future performance and that the value of investments and any income derived from them may go down as well as up and they may get back less than was invested.
Misconception 4: Sustainable investing cannot actually make a positive impact
LS: When investing a charity endowment through traditionally managed portfolios, disregarding the impact of investments on people and planet can contribute to business activity that actively works against the charity’s mission. On the other hand, investing a charity endowment through a positive impact mandate, the output of companies and that associated with an investment can align with the charity’s core values and support its purpose.
Even in listed markets, allocating equity capital or investing in bond issues of businesses that create positive sustainable impact will support their share price and provide easier access to capital thereby producing a license to operate. Using capital to invest for positive impact will signal to the market that such non-financial impacts are valued and nudge laggards in the right direction.
Additionally, sustainable investors will use their company relationships to engage boards on any sustainability weaknesses and thus create change. They can also use voting rights to back or block strategic decisions that concern the company’s ESG performance.
It is important to note that, when investing an endowment with the dual objective to create financial and sustainability outcomes, the investment reporting that trustees receive should not solely cover the financials. In order to bring the impact that portfolios have to life, investment managers must demonstrate that they are delivering on their clients’ positive impact objectives.
For example, an interactive impact calculator can show investments’ associated positive impacts such as renewable energy generated or hours of education provided. Managers should also transparently disclose alignment with the UN Sustainable Development goals and how portfolios are aligned to climate change scenarios.
While it is trite to say that the events of 2020 have made individuals, organisations and charities reconsider their position in society and their responsibilities, it is hard to see how the growing pressure for charities to reflect their ideals in their investments will ease.
While previously pursuing an investment policy that sought to achieve environmental, social and governance benefits risked allegations that charity trustees were not satisfying their duties, it is not hard to envisage a future point where only considering financial returns and not the wider impact of an investment policy could lead to a similar claim. As with any change a charity wishes to make, careful consideration and specialist advice are key. However, as this article shows, charities are now more able than ever to make financial decisions that reflect their aim to benefit and improve both society and the environment.