How to Wield Two Tools in ESG Investing

Alyssa Stankiewicz: Hi, my name is Alyssa Stankiewicz. I'm a sustainability analyst within Morningstar Manager Research. At Morningstar, we've identified six distinct approaches to sustainable investing. These include applying exclusions, limiting ESG risk, seeking ESG opportunities, practicing active ownership, targeting sustainability themes, and assessing impact. Today, we're speaking with Hortense Bioy, who is the global director of sustainability research within Morningstar Manager Research.

Hi, Hortense.

Hortense Bioy: Hi, Alyssa.

Stankiewicz: Today, we're here to talk about two of these approaches: divestment, which is related to applying exclusions, and engagement, which is one form of practicing active ownership. Both of these movements are growing, which is leading to a debate, especially in the context of the climate crisis. What can you tell me about that?

Bioy: Yes, you're absolutely right, Alyssa. And I think this is absolutely fascinating because both movements are growing, are really growing fast. Today, there are more than 1,300 institutions globally representing over $14 trillion that have committed to some form of for social divestments. A recent prominent example is three New York City pension funds, which announced that they were going to divest $4 billion worth of for social companies. At the same time, more asset managers and asset owners are saying that they are engaging with companies to try and improve the ESG practices and, in the context of the climate crisis, to accelerate the transition to a low carbon economy.

Stankiewicz: Let's talk about the advantages and disadvantages of these approaches. Why might investors choose to divest?

Bioy: Well, there are several reasons why a sustainability-aware investor might want to divest from a stock or a particular sector. The first and most common reason is ethical. They want to avoid complicity with companies that don't align with their values. Other investors may want to divest to influence companies by increasing the cost of capital. This strategy seeks to hamper the companies' ability to pursue investments in the activities that the investor dislikes.

Stankiewicz: Are there financial reasons to divest?

Bioy: You're right. There are financial reasons also to divest. Some investors divest to reduce risk in the portfolio, especially if they think that those risks haven't been priced in by the market properly. For example, investors might divest from fossil fuel companies because of the various risks associated with climate change. And finally, an opportunistic argument to divest is to free up capital so you can invest in other, possibly more profitable companies.

Stankiewicz: What are the arguments against divesting? I know there is one big concern about forgoing investment returns.

Bioy: Yes, that's right. There's always the possibility that the companies that you sell out of end up performing better than the companies you've bought with your divestment money. You could also miss out on opportunities. So, if you avoid all oil and gas companies, for example, you might miss out on those companies that are transitioning to be competitive in a low carbon economy.

Stankiewicz: And how effective is divestment at actually driving change?

Bioy: Well, so far, actually, there is little evidence to show that divesting is influencing companies or increasing their cost of capital. Some research found that 20% of a stock would need to be sold for the cost of capital to increase. But that would set a high bar for effective divestment campaigns. There's also another counterargument to divestment. It's that when investors sell the shares of a company, they are bought by other investors. So, divesting from an oil and gas company doesn't do anything to reduce its carbon emissions. Selling dirty assets could actually make things worse if these assets end up in private hands because there is much less transparency in private markets than there is in public markets.

Stankiewicz: So, a solution would be to stay invested in these companies and engage?

Bioy: Yes, if, of course, it makes financial sense to stay invested in these companies. In this case, a responsible manager with the appropriate resources should engage with the companies, try and influence them so that they improve their practices and mitigate the risks that the asset managers would have identified. Engagement now can take many forms. Asset managers and asset owners can engage with companies through letters to CEOs, conversations with investor relations people, meeting with top executives and the board members. They can also do collaborative engagement to give more weight to their conversations.

Stankiewicz: What are some hallmarks of a good engagement strategy?

Bioy: Well, what's really important when managers and asset owners engage with companies is that they set measurable expectations for improvement and that they put in place a clear escalation strategy. For example, if a company doesn't make sufficient progress towards the goals set by a manager, then the manager may vote against a company management and the board of directors, signaling the lack of confidence in the leadership's ability to address the company's risks. That's actually an increasingly popular strategy.

Stankiewicz: I know voting is a powerful tool, but what if that alone doesn't prove effective?

Bioy: Yeah, it's true that voting doesn't always work, and I think that's why divestment or at least the possibility of divestment remains an important tool to have in the tool kit. The absence of divestment threat would render engagement toothless. Now, I think to conclude what we can say is that, far from being mutually exclusive, engagement and divestment can be mutually reinforcing, and if a manager does decide to sell, a noisy exit is preferable and more impactful than a silent one.

Stankiewicz: Ultimately, it's not that one approach is better than the other. The two actually go hand-in-hand. Thank you for your insight today.

Bioy: Thank you for having me, Alyssa.