Journal of Financial Planning: February 2022
Dennis R. Hammond is head of responsible investment at Veriti Management, which offers institutions and wealth management firms customized direct indexing strategies that are built to do good.
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Keeping abreast of the ever-changing issues in the forefront of clients’ thinking is a constant challenge for every financial planner. It is especially critical to have ready, thoughtful answers to issues most likely to be surfaced in upcoming client meetings. Three of the top socially responsible investing questions financial planners may be asked in 2022 are provided below, with insight as to how they may be answered.
What is the single most important ESG issue to address in 2022 and why? According to MSCI, it is climate change. In its recent paper, “2022 ESG Trends to Watch,” MSCI states, “Climate is eclipsing governance and social issues at the top of the ESG agenda, reflecting both the existential threat of global temperature rise and the race against time to rein it in.”
Generally, climate change is thought of as the weakening of the earth’s ability to maintain a stable global temperature suitable for our ecosystems and ourselves. The greatest threat of catastrophic climate change comes from the continuing rise in global temperatures. Common concerns, depending on location, include a reduction in average daily sunlight, an increase in annual rainfall or drought, increasing glacier melt, rising sea level, increases in hurricanes, reduction in forestation, or even the decline in the ratio of oxygen to carbon dioxide molecules in the air (so-called oxygen depletion) (Ho n.d.). Scientists believe the average global temperature has risen by 1 degree Fahrenheit over the last 100 years, quite likely as the effect of the industrial age. However, the global temperature rise per decade has doubled in just the last four decades, such that the warmest 10 years on record have occurred since 2005 (Lindsey and Dahlman 2021).
The UN’s 26th annual Conference of the Parties, and its resulting Glasgow Climate Pact, made Earth’s rising temperature its most critical focus, continuing to push all 153 signatory nations to tackle climate change mitigation, finance, and adaptation. The Glasgow Climate Pact was the agreement that all signatories would continue to act, both in concert and unilaterally, to limit their “nationally determined contributions” to achieve a near-global net zero emissions by 2070 (two decades later than originally forecasted). The question is how to get there?
Essentially, “net zero” requires countries to limit their emissions of carbon each year to the amount of carbon they can absorb through carbon capture or forest absorption. This requires mitigation of greenhouse gases (GhG). These gases include carbon dioxide (CO2) released through burning fossil fuels (thermal coal, oil, and natural gas); methane (CH4) produced during the production of fossil fuels, from livestock, and organic waste decay; nitrous oxide (N2O) released in the treatment of wastewater and during combustion of fossil fuels and some solid waste; and other synthetic gases emitted from certain industrial processes. Most (80 percent) of the GhG emissions from human activities are from carbon dioxide released into the atmosphere, which, in turn, are created during the transportation of people and goods (35 percent), from generating electricity (31 percent), and from industrial processes (16 percent) (EPA 2019).
Together, financial planners and their clients will want to consider whether, and to what degree, these issues matter. Large-scale exodus by climate-conscious investors from companies owning thermal coal, oil, and natural gas reserves, or that produce a large carbon footprint from emissions of one or more greenhouse gases, could easily result in the long-term devaluation, and concomitant decline in returns, in those companies. In that regard, the Glasgow Climate Pact specifically states a goal of “accelerating efforts toward the phase-down of unabated coal power and phase-out of inefficient fossil fuel subsidies.” If successful, this will undoubtedly impact companies with substantial fossil fuel reserves on their books or producing copious amounts of noxious emissions.
For clients concerned about climate change, planners may wish to use one of the many socially responsible mutual funds or ETFs addressing the issue. These funds typically use negative screening to reduce their exposure to fossil fuels, including energy generation from thermal coal, and to reduce and limit the release of GhG. Companies within the funds can be rated by a variety of metrics, including the intensity of their emissions per tons of carbon emission, either per million dollars of sales or relative to enterprise value. For clients wanting more individualized customization, together with the ability to employ tax-loss harvesting to mitigate income taxes, a separately managed account (SMA) may be a preferable choice. Using an SMA, investors may establish one or more direct indexed portfolios targeting a given domestic or global index, screen the index to exclude targeted companies, and optimize the surviving portfolio to an acceptable tracking error relative to the original index.
What can I do to avoid investing in companies complicit in modern slavery, human trafficking, child labor, or genocide factories? Modern slavery, human trafficking, child labor, and genocidal factories are pernicious evils, ensnaring over 200 million people, including 150 million children globally (Hammond 2021). Many investors have come to view investing in companies harvesting oppressive labor as neither ethically nor morally responsible. Laws of most developed countries, including the United States’ Victims of Trafficking and Violence Protection Act (U.S. Congress 2000), address these practices as corporate and individual crimes committed in furtherance of unlawful gains. Oppressive labor practices may be the second most pressing ESG factor commanding investors’ attention.
The United States Conference of Catholic Bishops (USCCB) seems to agree. Recently, the USCCB updated its socially responsible investing guidelines adding a new provision that states, “The trade in human persons constitutes a shocking offence against human dignity and a grave violation of fundamental human rights. . . ” (USCCB 2021). The Conference recognizes “sexual exploitation of women and children is a particularly repugnant aspect of the [human trafficking and forced labor] trade, and must be recognized as an intrinsic violation of human dignity and rights.” Far from being outside the mainstream in this approach, we may see the USCCB policies mirror the approach many conventional investors determine to adopt in 2022.
Of special note is the heinous forced labor exacted by the People’s Republic of China of their indigenous Uyghur and other Turkish Muslim minorities. According to the U.S. Department of State’s 2020 Report on International Religious Freedom: China—Xinjiang, as many as 1.6 million ethnic Muslims and some Christians are currently forcibly interred in specially built internment camps in the Xinjiang Uyghur Autonomous Region (XUAR). The report states, “Authorities subjected individuals to forced disappearance, political indoctrinations, torture, physical and psychological abuse, including forced sterilization, forced labor, and prolonged detention without trial because of their religion and ethnicity.” It concluded these practices amount to genocide. To add insult to injury, the Australian Strategic Policy Group exposed U.S. and other multinational corporations that have, for years, worked with Chinese authorities to employ these political prisoners as cheap labor (Xu et al. n.d.). One of the most recent events caught in the light of China’s ongoing genocide is the Beijing Winter Games, which are being diplomatically boycotted by the United States, United Kingdom, Australia, and Canada over concern for these egregious violations of fundamental human rights (Ljunggren and Tian 2021).
It is entirely conceivable companies complicit in oppressive labor and Chinese genocide will find themselves caught in legal and regulatory actions, both civil and criminal in nature, in 2022. Shunning companies complicit in oppressive labor may therefore gain prominence for investors as a central ESG grievance. Financial planners interested in learning more may find the Global Fund to End Modern Slavery (GFEMS) of interest. However, as before, perhaps the easiest way of avoiding these practices is through using separately managed accounts (SMAs). The resultant portfolio can serve as an oppression-free portfolio with acceptable tracking error to the index targeted.
How can I shift from simple negative screening to positive impact? Perhaps the third top ESG question financial planners may hear from investors in 2022 will be: how can I do well while doing good? Increasingly, investors wish to produce one or more positive impacts in their portfolios. Unlike negative screening, which simply eliminates non-socially responsible companies from a portfolio, positive impact investing actively seeks companies to which to tilt, optimizing the portfolio to ensure the positive and beneficial societal impact sought by the client.
But which factors should investors tilt to? At the end of the day, this is an individual question for each investor. Some investors have turned for answers to the United Nations’ Sustainable Development Goals (SDGs), a list of 17 positive goals targeted for achievement by the global community by 2030. Interestingly, SDG Goal 13 is climate change, described as “Take urgent action to combat climate change and its impacts,” which lines up well with our most pressing ESG issue for 2022.
Moreover, the recently updated USCCB guidelines recommend positive impact investments to “promote the common good” in five areas: companies owned by people of color and women, companies whose practices demonstrate diversity and racial justice, companies that generate positive social and environmental change, companies that promote and strengthen communities, and companies whose business models are consistent with the emission reduction goals of the Paris Agreement.
Portfolios constructed for positive impact will be more actively managed than passive, and their opportunity set will be much more idiosyncratically selected than a passive indexed portfolio. As a result, portfolio performance will reflect the cost or benefit of the positive impact engineered into the portfolio. Mutual funds and ETFs constructed with positive impact considerations are available, although planners are cautioned to ensure the criteria used to engineer these are in sync with the specific objectives the client seeks. Positive impact SMAs, although rare, are entering the mainstream.
Through time, financial planners have discovered they earn the respect and confidence clients place in them by taking the time and effort to understand their clients’ questions and concerns, and providing thorough and thoughtful responses. 2022 will be no different. Being able to navigate these top three ESG questions and concerns—together with all the others clients bring to bear—may winnow top financial advisers from the rest of the pack.
References
Hammond, Dennis R. 2021, September 24. “Modern Slavery, Human Trafficking, and Child Labor in Corporate Supply Chains: Creating Oppression-Free Portfolios.” https://ssrn.com/abstract=3930247.
Ho, Mae-Wan. n.d. “O2 Dropping Faster than CO2 Rising: Implications for Climate Change Policies.” Science in Society Archive. www.i-sis.org.uk/O2DroppingFasterThanCO2Rising.php.
Lindsey, Rebecca, and Luann Dahlman. 2021, August 12. “Climate Change: Global Temperature.” NOAA Climate.gov. www.climate.gov/news-features/understanding-climate/climate-change-global-temperature.
Ljunggren, David, and Yew Lun Tian. 2021, December 7. “UK, Canada Join Diplomatic Boycott of Beijing Winter Games.” U.S. News. www.usnews.com/news/world/articles/2021-12-07/australia-joins-diplomatic-boycott-of-beijing-winter-games.
U.S. Conference of Catholic Bishops. 2021, November. “Socially Responsible Investment Guidelines for the United States Conference of Catholic Bishops.” www.usccb.org/resources/Socially%20Responsible%20Investment%20Guidelines%202021%20(003).pdf.
U.S. Congress. 2000. Victims of Trafficking and Violence Protection Act of 2000, Pub. L. No. 106–386. www.congress.gov/106/plaws/publ386/PLAW-106publ386.pdf.
U.S. Environmental Protection Agency. 2019. “Inventory of U.S. Greenhouse Gas Emissions and Sinks.” www.epa.gov/ghgemissions/overview-greenhouse-gases.
Xu, Vicky Xiuzhong, Danielle Cave , Dr James Leibold, Kelsey Munro, and Nathan Ruser. n.d. “Uyghurs for Sale.” Australian Strategic Policy Institute. www.aspi.org.au/report/uyghurs-sale.