Demystifying Impact Part 2: Good Day for Humans, Sad Day for Robots
Authors: Anas Attal, Isabelle Pierotti; Editors: Massiel Valladares, Saeyeon Kwon; Managing Editor: Jaishree Singh
“We cannot solve our problems with the same level of thinking that created them.”
-Albert Einstein
17AM’s previous mini-series “ESG is not Enough” underscored the increasing capital flowing into “impact investments” and demonstrated the financial benefits it yields. The series also highlighted the rising trend of ESG-washing resulting from opaque disclosures and rating systems. An individualized impact portfolio strategy offers actionable measures investors can implement to promote sustainable economic growth and prosperity. The second edition of the mini-series “Defining Impact” will examine the screening process investors use to vet and pick companies in their pre-investment stage and will introduce methods and common challenges in measuring post-investment impact. An intentional selection process and monitoring system will motivate companies to optimize their human and planetary impact to attract public and private investments.
Negative vs. Positive Screening
Traditionally, individual and institutional investors use a positive or negative screening process to select companies for their ESG portfolios. The negative screening approach has historically omitted companies in specific sectors such as tobacco, liquor, or weaponry. Today, investors increasingly exclude companies with large carbon footprints or poor social/corporate governance practices. Under this common technique, only 15% of Russell 1000 companies would qualify for inclusion, according to global investment consultant Indefi’s managing partner Jonathan Doolan. In a 2021 BNP Paribas survey, more than 50% of institutional investors said they still use negative screening to vet companies, confirming the popularity of this pre-investment origination method among investors. Depending on the criteria for exclusion that investors have, this type of screening might exclude companies in certain sectors that would categorically fall under “negative” industries, ignoring that some of these firms might be trying to improve their operations to become more compliant and sustainable.
For example, Dutch energy company SLB, formerly known as Schlumberger, made a new commitment to decarbonize the oil and gas industry, achieve net zero by 2050, and invest in renewable energy sources. Arguably, large firms such as this, especially in carbon-heavy industries where decarbonization would lead to an important net-zero reduction in carbon emissions globally, have the greatest potential within the private sector to generate a systemically positive impact. Subsequently, negative screening processes that automatically exclude these types of companies are flawed because they ignore companies with great potential for positive impact, which in turn, might disincentivize companies to ambitiously pursue sustainability in their operations and business models.
PC: Patrick Hendry on Unsplash
The flip side of negative screening is positive screening, a more inclusive yet flawed process. Current positive screening typically does not perform sufficient or appropriate due diligence to ensure that companies included in portfolios have a measurable, positive impact. For instance, the commonly used Russell 3000 index includes public companies that pass a basic ESG screening. However, ESG rating systems do not look at companies' external impact; they merely check for certain risk measurements (read more about this here).
Paint manufacturer Sherwin Williams is included as an ESG-compliant company, but a simple review of their website reveals their ambiguous sustainability commitment, weak DEI statements, and no evidence of positive externalities. One of the company’s state energy goals is to use 50% renewable energies by 2030, but in their same sustainability report, they show a whopping increase in renewables usage from 0.03% in 2019 to 0.06% in 2021. Additionally, their goal is to increase women in management roles to 30% by 2030, but again between 2019 and 2021, the percentage of women in management increased from 26.3 to 26.4%. This 6% increase from 24% to 30% over 10 years is not an ambitious goal. Also, paint as a product has little to do with sustainable development. Investment firms will run afoul of genuine impact investing if their selection process ends with this basic vetting, as some companies may be taking advantage of a flawed rating system to artificially pose as ESG-friendly.
The dearth of analyses examining companies' negative externalities and overall stakeholder impact hinders investors’ ability to make long-term investment strategies and decisions that authentically allocate capital to companies with real sustainability and social ambitions. One potential solution to induce better, more thorough analysis in company vetting and selection is to utilize human intelligence and the United Nations’ Sustainable Development Goals (SDG) as criteria for selection.
The Need for Holistic Human Screening
By only focusing on companies allegedly minimizing harm, investors may overlook industry innovators, new markets, and growth opportunities. Instead, asset managers should look at the external impact of their investments because impact is also tied to long-term positive financial performance. For example, companies with B-Lab certification, which designates stringent internal and external policies related to community impact, fare better than their non-certified competitors in times of economic downturn. Under current societal pressures, businesses are increasingly scrambling to prove their social consciousness and goodwill to maintain consumer relations and spending –and finance firms will not be immune to these same pressures for long. As Gen Zs and Millennials become the largest investor class, the pressure on finance firms to be more transparent and diligent about their sustainable investing screenings will grow as well. Screening processes must move beyond a dependency on ESG ratings and internal corporate governance policies toward a holistic evaluation of companies that create “shared value” as a part of their business models.
For many investment firms, this will require engaging consumers or consumer data in company screening, as opposed to relying on software. True positive impact screening requires human-driven qualitative analysis that has traditionally been sidelined or undervalued in the field. Every industry influences the world in different ways and every company uniquely tells its story and shares its practices.
PC: Graham Ruttan on Unsplash
Evaluating these characteristics requires investors to dive into all aspects of a company’s business model, beyond current financials and forecasts. Questions should include, how does the product or service impact society, how is this company poised to solve consumers’ problems, and do they do so without exploiting their consumers or workers? If the company has a foundation or philanthropy, have they developed their own programs like Best Buy’s Teen Tech Centers or ConAgras partnership with Feeding America, or do they simply donate money to buttress their public relations and draw attention away from the harm they otherwise cause? What lobbying or political endorsement does the company or its affiliated trade associations take part in? The bigger the company, the deeper the dive must go, and the stricter the investment standards should be.
Closing Thoughts
Investors should consider using the U.N. SDGs as positive pre-investment criteria for deeper, more intentional screening. Companies can be assessed against a specific SDG goal such as No Poverty (SDG-1) or Climate Action (SDG-13), using the indicators or KPIs provided by the United Nations. This method allows for a concrete analysis of how a company interacts with society and the planet. A community bank, for example, might not qualify under SDG-13, but its products aimed at making banking more accessible to prospective low-income members could qualify under SDG-1. Additional screening lenses could include a comparison to B-Lab standards or analyzing a company’s Brand Advocacy, a strategy that evaluates how well a company embraces an issue in its operations. Overall, screening strategies need to include multiple human approaches that aim to reveal sector-specific environments and actions.
17AM’s team is embarking on this journey to place people, not just computers, at the heart of portfolio screening. While we recognize its resource intensity and complexity, our research suggests that a holistic, human-led screening pre-investment approach is key to creating intentional, trustworthy investment products that deliver both financial returns and societal impact.
Follow us on LinkedIn to read the next article in this series, “Demystifying Impact Part 3: The Best IMM is Scientific and Intentional.”