Lifting the lid on responsible investing

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If the finance sector doesn’t change the types of projects and companies that are getting funding then the world’s ability to address urgent environmental challenges will take a huge hit. (File photo)

OPINION: There’s been a huge focus in the global investment industry recently on looking beyond financial measures of success and assessing the broader impact of what companies are doing.

Call it responsible investing, sustainable investing, or ESG (environmental, social and governance) integration. Whatever the label, it is now a significant force in the investment world.

While there are many social and environmental challenges under the spotlight, the urgency of the climate crisis has underpinned much of this trend. To recap, by 2030 we need to reduce global carbon emissions by half. Immense investment is required for this transition – the International Energy Agency estimates that by 2030 over US$4 trillion annually is needed for the energy sector alone.

Much of this funding will come from the private sector – that is, from households and businesses changing the things that those lucky enough to have spare cash are investing in.

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For most investors, this change will come via the investment managers we trust our savings to. It means our KiwiSaver managers will be investing more in renewable energy, rather than fossil fuels. Across other industries from supermarkets to technology, investment funds will flow to companies that are de-carbonising.

The impact of companies on biodiversity – a huge risk for the stability of the natural environment and our food sources as the world warms – will be closely assessed. And investment managers will spend more time analysing companies’ social impact – employment conditions across the supply chain, diversity of workforce, charitable activity, indigenous engagement.

There are two important problems with this, however. Firstly, the vast majority of investment managers already claim to be assessing impacts on communities and the planet. According to the Responsible Investment Association, in New Zealand 89 per cent of investment managers are at least partially applying a responsible investment approach, and there is a similar picture in Australia.

Secondly, it is very hard for outsiders to assess how thorough an ESG or responsible investment approach is. Is it a crucial part of assessing every company they invest in, and of creating an investment portfolio? Or is the work on environmental and social impacts more of a box-ticking exercise to convince – or greenwash – customers that the investment manager is doing the right thing?

This is a critical question for all of us. If the finance sector does not change the types of projects and companies that are getting funding – then the world’s ability to address urgent environmental and social challenges will take a huge hit.

Faced with this, many of the world’s biggest economies are moving quickly to make investment funds more transparent. Alongside emissions disclosures, one new tool being rolled out already in the EU, UK, and China is a set of labels that will help address investment greenwashing.

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Alongside emissions disclosures, one new tool being rolled out already in the EU, UK, and China is a set of labels that will help address investment greenwashing. (File photo)

The idea is to create defined criteria covering all the different activities that occur in an economy – from making cement, to working in an office, to delivering a pizza – that attempt to determine objectively whether these activities are sustainable or not. The somewhat clunky term used to refer to these labelling systems is a “taxonomy” (it has nothing to do with tax).

“Green” taxonomies classify the environmental impact of activities. “Social” taxonomies are also being developed – these classify the social impact of what businesses do.

Without diving into the technical detail, one of the key results from a green taxonomy is a traffic light system. Activities effectively get labelled “green” (positive environmental impact), or red (negative impact; unsustainable activities); or orange – something in between. Businesses can still achieve a green label for high-emission activities, but only if they can show they are amongst the best in their industry at doing that.

The key intended audience for this information is investors (there are other frameworks around sustainability disclosure for everyday consumer products). Companies will for example report the share of their revenue that comes from green (and red) activities. In turn, fund managers will report what share of investment portfolios is green or red. Clients could then compare one fund that has 10 per cent invested in “green” activities, to another that has 40 per cent, or zero per cent.

Of course the system will not be perfect – there will be problems and technicalities on how different businesses classify different products and services. A significant new audit industry will need to develop. Criteria will change and get harder over time.

The hope though is that these disclosures will go a long way towards allowing consumers to reliably assess how “green” an investment fund is. Rather than waiting to develop a perfect system, major economies overseas are pushing ahead now to attempt to help shift financing flows immediately.

Here in NZ, the Centre for Sustainable Finance is working with both the private and public sector to help transition the way financing occurs in our economy. Voluntary agriculture standards have been developed and work is underway in other sectors.

As with other aspects of the sustainable finance sector there is a huge amount of work to be done, but huge potential and imperative for positive change ahead.

David Lewis is the author of the working paper on the EU Taxonomy for Toitu Tahua: Centre for Sustainable Finance, and ex Deputy Chief Investment Officer, Milford Asset Management.