Exclusive article by Katia Coudray, CEO Asteria Investment Managers
Sustainability has become a hot topic for investors willing to give purpose to their wealth. Nevertheless, the ways to implement this decision is often complex. The reason for the inconsistency of sustainability concepts is the lack of a universally valid definition. This often results in confusion regarding the different concepts, so doesn't this confusion have to prevail even more in portfolios of listed equities?
Difference between ESG investments and impact investments
ESG scores are intended to assess the extent to which companies integrate environmental, social and governance aspects into their manufacturing processes. This assessment is limited to the behaviour of companies and does not include an analysis of their business operations.
For investments to have a positive impact, it is necessary to consider a company's contribution to addressing environmental or social issues through its operations. In other words, the environmental or social impact of the goods produced, or services provided.
No impact investments without a return target or intentionality
An impact investment always contains at least one element - intentionality. The investment is intended to make a transformational contribution to a predefined issue, such as decarbonisation, pollution reduction, inclusion, diversity or meeting vital needs. The aim is to identify companies that produce goods and services that contribute to solving these problems. To do this, the companies' revenues are analysed to determine the absolute and relative share of revenues of goods and services that generate a positive impact for each predefined goal. The result of this analysis is a score or contribution that can be used to identify all companies that generate a positive impact, including companies with multiple business lines. Subsequently, the players with the highest impact score are selected.
ESG strategies are usually limited to a single objective: generating investment performance by considering behavioural criteria or even by excluding companies or sectors. Impact strategies go much further, pursuing a dual objective, one financial and one non-financial, whose implementation is more complex, and investing in an investment universe that differs significantly from that of market indices.
Only investments whose impact can be measured are considered impact investments
The fact that investments have a high impact score does not provide a clear picture of how much a portfolio contributes to achieving the goal. Consideration of ESG criteria makes an even smaller contribution, as they rarely consider a company's business activities. Thus, one finds companies that have very high ESG scores, but whose operations at the same time have a negative impact on the environment and health.
In this regard, the question is whether decarbonisation is linked to a targeted reduction in portfolio emissions and a time horizon. If this is the case, an impact strategy must be implemented, as the integration of ESG criteria is not helpful in this implementation.
The reduction of the carbon footprint of a diversified allocation can be achieved in the bond component, through the direct financing of projects via green bonds, or through direct participations in renewable infrastructure projects. For the equity portfolio, different key figures can be used to achieve the envisaged goal. First, the carbon intensity of the portfolio can be considered by quantifying current emissions. This metric does not provide a projection for the future, and the intention of the companies in the portfolio regarding their emissions can also be influenced to a significant degree by the sector allocation. Indeed, it is sufficient to limit the weighting of polluting sectors to reduce their carbon intensity. This type of "low carbon" strategy is not aimed at finding and supporting companies that are intending to achieve a sustainable solution to the decarbonisation problem.
One way of identifying positive-impact companies is to combine a top-down and bottom-up approach. Top-down, identifies impactful business activities based on products, services or technologies creating a positive impact. And bottom-up, within the identified positive-impact activities, a companies’ top-line exposure to impactful business activities can be used to score the impact. Under such an approach, pure-players and large companies with a significant positive contribution are highly ranked.
Challenges for such a top-down bottom-up approach include data availability and management and understanding impactful innovations and opportunities.
The current trend of increasing disclosure and data coverage help to overcome the first of these challenges. A systematic approach to impact scoring helps to avoid emotional biases when ranking companies on perceived impact.
Impact investing does not stop at the score. It is important to measure the positive impact an invested company is generating, for example by measuring the tons of CO2e avoided, GWh of green energy produced or litres of water treated.
There are two ways to approach impact measurement. One way is to assess what is disclosed by each company. Another way is to approach impact measurement systematically from a top-down perspective. To be interpretable, both ad hoc and systematic impact measurement need to be linked to a baseline scenario.
A combination of top-down and bottom-up impact scoring leads to a systematic way of identifying positive impact investment opportunities. However, the score does not tell us exactly the impact generated by the activities of the invested companies. Impact can be measured in two ways, either ad hoc line-by-line or systematically from a top-down perspective. The former is useful for clearly defined projects, whereas the latter provides a solution for measuring impact systematically and coherently by incorporating the economic activity of a company across the entire supply chain.
Decarbonising equity portfolios through a combination of emissions reduction and avoidance
Two complementary investment strategies can be used to achieve the climate targets set out in the Paris Agreement: the first aims to integrate a decarbonisation pathway into the portfolio, while the second invests part of the capital in financing the transition to green energy.
The strategy based on decarbonisation consists of defining a path and taking it into account in the selection of individual stocks. It must be flanked by an engagement strategy, i.e. constructive dialogue with the management of polluting companies so that they implement sustainable practices. It is worth recalling that the international stock market index has a temperature path of over +3°C - like a low-carbon strategy. This confirms that measuring current carbon intensity does not show a future perspective.
Focusing exclusively on simply reducing corporate CO2 emissions is not enough to achieve the goals of the Paris Agreement. The target must be a 7% reduction in CO2 emissions per year from the 2015 level, but such a reduction was only achieved in the year of the 2020 pandemic, when the global economy came to a standstill for several months.
This is where an environmentally focused impact strategy for decarbonisation can come in, to finance innovation and channel capital into companies that offer solutions to avoid CO2 emissions. An impact portfolio of international equities can generate more - and decarbonise - energy than a comparable traditional portfolio.
With international equities, decarbonisation can be achieved without sacrificing returns
In summary, an ESG strategy that analyses corporate behaviour is thus not geared towards achieving a positive impact. Impact investments, on the other hand, pursue an explicit intention, namely the achievement of a quantifiable, non-financial return, which must be measured in order to speak of an impact investment. If the decarbonisation of a portfolio is defined as a declared non-financial goal, this goal can be achieved through two manipulated variables: First, emissions can be reduced through the selection of securities for core investments in the equity portfolio by investing in listed companies that have explicitly committed to reducing their emissions.
Secondly, innovation and future economic growth can be financed by focusing on technologies that contribute to the avoidance of emissions for satellite investments in the equity portfolio. Measuring the generated impact starting from the development of the temperature path of the core investments and the avoided tonnes of CO2 of the satellite investments is the prerequisite for avoiding greenwashing. Promoting the transition through investments also opens very attractive financial prospects in the equity universe - without sacrificing returns.
