Ethical funds that screen out sectors or companies that breach defined environmental or social standards have been available in the marketplace for many years. With a history rooted in upholding religious values, today ethical screening is more commonplace, serving the needs of a growing number of investors who are aware of the possibilities of aligning their savings and pensions with their beliefs.

Screening is used as a tool to assess companies on Environmental, Social and Governance (ESG) factors, thereby enabling investors to take a responsible approach to portfolio construction and management. However, they are not the only option for investors looking to reflect their values in their investments. Approaches incorporating active, committed company engagement offer the opportunity to put assets to work to create real-world positive impact.

Divestment decision-making

Historically, the most common sectors subject to divestment on ethical grounds have been those involved in the production of tobacco and weapons. A significant shift in recent years has been towards divestment related to fossil fuels as investors have become increasingly more conscious of how their investment decisions might be putting the future of our planet in danger. This movement has been spurred on further by the ambitious Paris climate agreement goals of keeping the global temperature rise to well below 2°C and better still to 1.5°C, while recent climate activism shaped by Greta Thunberg’s ‘School Strike for Climate’ has brought these issues to the forefront of media attention like never before. Divesting from energy and fossil fuels has, therefore, become an increasingly common method for ensuring pension funds are aligned to the rising importance investors are placing on protecting the planet.

However, screens can create pitfalls because of their very nature of offering binary outcomes – permitting or excluding investment. This can ignore potentially important nuances in the underlying strategy of a company, which can obscure opportunities and therefore be counterintuitive to building responsible portfolios. This is best highlighted through an example:

In a huge strategic shift, energy company Ørsted evolved from an oil and gas extractives firm to becoming the world’s largest producer of offshore wind energy.1 But in 2019, within its power generation business, coal still accounted for 9% of the generation, which could see it excluded under a simple screen. However, beyond its structural shift so far, the company has also committed to carbon neutrality in its energy generation and operations by 2025, and carbon neutrality in its total carbon footprint by 2040.2 This highlights how a screen can potentially miss important, forward-looking data that could influence an investor’s decision that the company offers an opportunity to invest in a company committed to ensuring a sustainable future.

To be credible, screening also needs to be sophisticated enough to pick up issues that may not be immediately apparent from a company’s public profile. One recent example is fashion giant Boohoo. This was a company with favourable ratings from ESG data providers, and was a holding in many ethical funds. However, look a little closer and the red flags were there – particularly the company’s lack of disclosure on its supply chain labour management, including its approach to modern slavery risks. BMO’s own funds did not hold the company as our analysts had identified these weaknesses, and judged that it failed to meet the standards for our funds.

Why engagement matters too

One disadvantage of divestment is the loss of opportunity to engage directly with a company.

Engagement allows investors to evaluate how seriously a company is considering ESG issues by assessing how their actions match up to their policies, which are often what a company discloses and reports on to achieve a certain ESG rating. Investors can determine whether a company has set itself realistic targets for achieving ambitious ESG goals, and gather evidence of these being acted upon within the business strategy. Returning to the Ørsted example, engagement around the company’s emissions goals would help an investor to decide whether the company offers genuine solutions to the energy problem, rather than just an impressive policy without much evidential action.

Moreover, investors can take engagement further and ultimately encourage a more sustainable future for us all by using their influence as stewards of capital to motivate positive change at the companies they invest in through constructive dialogue. Collaboration with other investors and initiatives, as well as proxy voting, can be used to press for change more urgently if required.

Concluding remarks

Screening is a widely used form of ethical investment but it’s not the only option, and choosing not to screen a fund no longer automatically makes it unethical. Company engagement can also be used to help align investment with investor values, and can be applied across many different fund types, screened or not. It is also important to emphasise that there is not necessarily an either/or choice between divestment and engagement. The two can work very well together in aligning values with investment decisions. Screening offers an effective starting point for investors to avoid the companies which most obviously breach values, but no company is perfect, so engagement can be used on portfolio holdings to build momentum for positive change. Through the considered use of these tools, investors can build portfolios that not only mitigate risks and generate good financial performance, but also ultimately create positive impacts on society and the world around us.