The pros and cons of ESG screening

By David Burrows

Over the past three or four decades, those looking to invest in line with their principles have had to contend with a variety of labels that, unfortunately, may only have succeeded in confusing the issue. ‘Environmental, social and governance’ or ‘ESG’, ‘ethical’, ‘impact’, ‘positive future’, ‘responsible’, ‘SRI’ and ‘sustainable’ – not to mention more specific options such as ‘biodiversity’, ‘circular economy’, ‘climate change’ and ‘energy transition’ – how, if at all, do they differ?

Further nuances, such as ‘light’, ‘mid’ and ‘dark green’, and ‘positive’ and ‘negative screening’, may not always have made the available choices any clearer. With green funds, for example, the general rule of thumb has been the darker the shade, the stricter a fund’s ethical criteria. 

Over the years, however, funds have not always been what they seemed. For instance, a ‘green fund’ might have a huge overweight in a sector such as information technology. Avoiding fossil fuels, tobacco, gambling, cosmetics and so on may indeed tick the necessary boxes, and yet, to all intents and purposes, this would be a tech fund packaged as something else. 

A ‘light green’ fund, on the other hand, might be well diversified across a broad number of sectors – but only exclude, say, oil stocks. 

And then consider the words ‘climate change’ in the name of an index fund containing one of the world’s biggest oil companies as well as a car manufacturer. When pressed, the manager could well justify these inclusions on the basis the companies in question have clearly acknowledged the goals of the Paris Agreement and are actively promoting sustainability – and yet that explanation might not satisfy every investor.

Suffice to say, clarity has not always been a word one can associate with what, for the rest of this piece, we will lump together as ESG investing – but that is starting to change. For one thing, ESG investing is certainly no longer ‘niche’ – ESG-oriented funds attracted a record $51.1bn (£37.3bn) of net new money from investors in 2020, more than double the prior year, according to Morningstar data.

As ESG investing has become more mainstream, so the number of investors wanting a better idea of how their money has been invested has multiplied – and, in March 2021, the European Union set out to oblige them. Whatever criteria investment companies use in their stock selection, the Sustainable Finance Disclosure Regulation (SFDR) is intended to clarify the process, while the UK is also looking at it’s own fund labelling.

Negative and positive

But let’s first take a look at what investors may be looking for – or avoiding – in portfolios and how screening can help. To some extent, portfolio screening has always had contentious elements. Take, for example, ‘negative screening’, which aims to weed out companies that score poorly in such areas as their environmental record, workers’ rights, gender equality and corporate governance. Relying on negative screening to build a values-aligned portfolio could potentially lead to below-market returns if, as an investor, you are excluded from the best-performing stocks in a market index such as the FTSE 250 or S&P 500. 

Negative screens generally eliminate investments in traditional ‘sin’ industries, such as tobacco, gambling, alcohol, pornography and weapons manufacture yet exclusions can be specific to
individual clients and their own values. As such, a fund manager’s screening criteria cannot accommodate everyone’s preferences exactly. 

For his part, Insight Investment portfolio manager Damien Hill says that, while negative screening has its uses, it can also carry risks when used in isolation. Investors should instead consider a broader approach, he argues, combining other responsible investment techniques and strategies – such as conducting detailed analysis of companies and targeting materially positive-impact allocations via green bonds and other impact-based investment instruments.

Commenting on the specific pros and cons of negative screening in credit markets, Hill notes: “If investors screen out whole sectors for ethical reasons, this can expose them to more concentrated sector allocations. This means that, if they are left with large allocations to, say, the banking or insurance sectors, they may be exposed to more risk than they think. While the banking sector may seem a benign place to invest, it has not been without its governance red flags over the years.

“Rather than just adopting negative screening, we believe there is a greater need for investors to engage with underlying bond issuers and build detailed analysis and increased scrutiny of companies they invest in across all sectors. When looking at the banking sector, for example, investors need to pay particular attention to the carbon footprint of issuers’ lending books.”

At the same time, so-called ‘positive screening’ – where companies are ranked on ESG factors relative to their peers and only the ‘best of breed’ businesses are backed – has its own shortcomings. What if the ESG record of most of the companies in a sector leaves the bar especially low? Does the ‘best of breed’ argument really work here? 

No, is the definitive response of RLAM’s Fox. “We think all companies must meet a minimum hurdle rate, so we agree good ESG must be judged both relative to a sector and in absolute,” he argues. 

“In a sector with low ESG standards, ‘best of breed’ just does not stack up.”

As for how screening processes might evolve further, Fox believes they will need to become more sophisticated as the availability of ESG information increases. “This will allow more detailed work to be undertaken and more nuanced judgements to be made,” he adds. “Ultimately this will allow screening processes to identify companies where sustainability is truly embedded versus those where it is more superficial.”