To divest or not to divest? We believe that’s the wrong question.
Originally published in partnership with the Association of Governing Boards of Universities and Colleges (AGB).
A number of colleges and universities, as well as their affiliated foundations, are under significant pressure from students, faculty and advocacy organizations to reduce their carbon footprint—both across the organization and within their investment portfolios. For many years, divestment has been seen as the fastest, most effective way to lower a portfolio’s carbon footprint—and many universities and affiliated foundations continue to grapple with the question of whether to divest or not. We believe, however, that divestment is a rather blunt, overly simplistic approach for the following reasons:
- If you aren’t an owner, you lose the ability to influence change via shareholder engagement activities such as proxy voting or introducing resolutions.
- There are a number of traditional fossil fuel companies who are actively engaged in green energy development—and you’ll miss out on exposure to those opportunities.
- You can underestimate the impact of carbon emissions / fossil fuel exposure from companies outside of the fossil fuel industry on your investment portfolio.
For universities and affiliated foundations seeking to balance their desire to lower their investment portfolio’s carbon footprint with the desire to maintain returns and invest in companies who will benefit from the green transition, we don’t think asking yourself whether to divest or not is the right approach. Instead, we believe that approaching this topic with materiality in mind is the better solution.
Materiality is the weighting of ESG characteristics, such as carbon exposure, in proportion to how materially they will impact the financial outcomes of a specific industry. For example, if a bank pledges to cut their use of fossil fuels by 50%, that doesn’t have nearly the same material impact on their business as it does on that of an airline or trucking company. The great thing about materiality is that it doesn’t stop at carbon. You can also apply it to water, business model resilience, greenhouse gas emissions, etc.—and it can allow you to be incredibly specific in how you approach the incorporation of ESG characteristics within your portfolio.
Let’s use two examples to showcase how using a materiality score can change how you might view a particular company within your portfolio.
Example 1: Movies and entertainment company
Under the old scoring system, which didn’t take materiality into account, a movies and entertainment company scored as low risk. Upon applying our materiality methodology to our review of this company, we increased our focus on management rather than exposure, which resulted in a significant reduction of the company’s score. Under our materiality scale, 1 is the worst, 10 is the best, and this company’s score was reduced to 1 out of 10. This company scored poorly on material issues such as customer welfare and corporate governance and has also experienced a high level of controversies. This change in score was a direct result of our scoring methodology allowing us to not just focus on the company’s disclosures but also their performance.
Example 2: Industrial conglomerate
In a second example, an industrial conglomerate was given a high risk rating by the old scoring system. This rating was influenced by the non-material ESG issues being mapped to the firm’s sector. This meant that even though the firm had robust ESG disclosures including manager explanations, narratives, quantitative metrics and KPIs, it was still rated poorly. By incorporating a materiality lens, the firm received a 9 out of 10. This was driven primarily by the firm’s strong energy management, corporate governance and employee health and safety scores. For example, the firm has a strong environmental management system and an air-emissions reduction program in place to help manage its exposures. Being able to take things like this into account, which are specific to this company rather than generalizations across a broad industry, give us much more precision in how we’re able to incorporate ESG into our clients’ portfolios.
The bottom line
So, why does all of this matter? Because materiality helps investors incorporate relevant, impactful ESG considerations into their portfolios, thereby potentially better enhancing returns. This approach allows fiduciaries to ask themselves which ESG characteristics they care about the most and how they can measure them in a material way. We believe these are the right questions to be asking.