Incorporating ESG into the everyday decision making is a difficult task for local authorities as it is a fast-evolving space that does not necessarily have one tried and tested, agreed upon best practice. One area that has seen lots of attention is the growth in ESG funds or the incorporation of ESG into existing funds’ strategies and the terms exclusions and engagement are often thrown around in this conversation. But is one better than the other?
For those that are not familiar, exclusion and engagement are two strategies employed to try and align the ESG goals of two parties, but the approaches are different. Engagement involves the investor influencing and encouraging the investee company through active dialogue and collaboration to improve their behaviour to better their ESG credentials. On the other hand, exclusion involves either avoiding investments in companies and sectors where the values or ESG credentials do not match that of the investor. This can involve divesting existing investments as well as avoiding new investments.
As with all approaches there are advantages and disadvantages to both. Engagement allows investors to work with organisations based on a relationship of trust and cooperation to influence their practices and policies which can lead to improved ESG performance. This can be used to tackle systemic issues in certain sectors and even encourage a wider level of best practice and improve industry standards.
This, of course, would be a best-case scenario but would require a significant investment of time and resources to achieve as it would involve ongoing dialogue and monitoring. The level of engagement from companies or organisations is also likely to depend the willingness of the investee company to change and on the size of the investor’s holding (or the collective holding of investors collaborating on the engagement) to exert pressure for change. Unfortunately, this means that lots of small investors are unlikely to have as much impact on engagement than fewer, larger investors.
Exclusion is a much more all-or-nothing strategy where an investor sets out their minimum ESG standards and will not invest in companies that do not meet them. Should an existing investment subsequently fall below these standards, the investor would disinvest in order to remain compliant with their pre-determined ESG threshold.
This is a useful and simple tool as the investor will only invest with organisations that align with their values and ESG goals by avoiding certain companies and sectors. However, negative screening also removes any possibility of stewardship, of engaging to improve the quality and standards of the company or industry and unless other investors follow suit, then there it is unlikely to have a material impact.
Historically, exclusions have been more popular as sustainable investment strategies, likely because they are the simplest to implement (but difficult to implement well!). More recently, ESG integration has gained ground as investors settle on a view that having a more holistic approach to sustainable investing is likely to have more impact than an approach based only on negative screening.
In that vein, there is no simple answer whether exclusion or engagement is better.; an investor can combine the two. There will likely be sectors that some investors choose to avoid, but there are also some organisations that would likely benefit from the engagement that comes alongside an investment more than simply being excluded from any consideration.
For local authorities, it is less likely that direct engagement would be undertaken, but this is certainly something you can look for in organisations that you invest money with such as banks and funds. ESG policies will differ between organisations; don’t simply replicate what others do but determine a policy and criteria that align with your values and sustainable investment objectives.
If you would like help in preparing a sustainable investment strategy or want to hear about Arlingclose’s ESG service, please email treasury@arlingclose.com.
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