11-04-2022 • Insight

To divest or not to divest – that’s not the question

One of the most fierce debates when it comes to sustainable investing today is surely the engage-or-divest topic.

Authors

Head of Active Ownership

Summary

There's a need for both engagement and divestment
Acceleration to Paris program started to boost impact
Traffic light approach helps monitoring progress during the engagement

For some stakeholders such as NGOs or environmental activist groups, the picture is crystal clear. They want investors to divest from companies and whole industries that threaten the future of our planet, and move their money towards climate-positive sectors. The time for talking, they argue, is over, because change is happening too slowly if at all.

For asset managers, however, the picture is complex. The question is not: to divest or not to divest. The question is: at what point does an unsuccessful engagement result in divestment? Our core belief is that by engaging with companies – fossil fuel companies, petrochemical companies and the like – asset managers can help steer them towards a more sustainable future, whereas if you divest from those companies, you lose any kind of say in the matter and other shareholders who care less about sustainability will jump in and take your place.

It’s a thin line indeed, especially for Peter van der Werf, senior manager engagement, and Nick Spooner, climate change engagement specialist, as they also have to handle client demands and cooperate with investment teams. In November 2021, they introduced the Acceleration to Paris program (see textbox).

Spooner: “There's certainly a need for both engagement and divestment. And this is what we're trying to bring through in our Acceleration to Paris program. We want to avoid the false dichotomy of engagement and divestment, and instead ask the question: how do you use these tools together?” In contrast to NGOs and activist groups, an asset manager engaging with companies is, by the nature of the industry, both trying to change the world for the better – and meet a clear financial objective.

Acceleration to Paris

This engagement program focuses on triggering climate action at 200 companies that have a large carbon footprint and are lagging in their efforts to transition towards a low-carbon business model. The active engagement element concentrates on around 15 of those companies, enabling the engagement team to aim for maximum impact. They encourage the companies to take climate action, and secure their long-term license to operate. Eight engagement objectives have been articulated, which are aligned with the Net Zero Benchmark of the Climate Action 100+ initiative. In addition, for those companies identified to be developing new coal power generation plants, a ninth engagement objective will prioritize the transition to clean energy sources.

Two types of engagement

So, how does engagement start? First of all, it’s important to realize that there are basically two types of engagement at Robeco, says Van der Werf. “Most of our engagement is what we call value engagement, where the engagement specialists try to add value to the investment approach by either reducing sustainability risk at companies and therefore reducing risk of the securities in portfolio, or by capturing more information that leads us to better-assessed investment decisions.”

“In some cases, engagement lays bare issues that the financial analyst hadn't incorporated, so that might affect their view,” Van der Werf explains. “When we close a value engagement case unsuccessfully, the portfolio managers review our conclusions and evaluate this negative signal in their ESG integration process. However, this is one of many factors that play a role in the decision of the portfolio manager to hold, buy or sell the position. The majority of our engagement program is scoped in that way.”

But there’s also another type of engagement, enhanced engagement. And that's where there is a consequence if it’s unsuccessful. Van der Werf: “For the majority of the last sixteen years our team has done engagement that was mainly connected to global controversies, breaches of the UN Global Compact or OECD guidelines. More recently, we have expanded that scope, for instance, to palm oil, where we’ve identified a higher risk of companies not meeting our minimum standards on sustainability. So, we've made meeting our explicit minimum standards consequential to engagement. And now we have added climate as our latest topic where we have connected specific consequences to companies not meeting our enhanced engagement objectives.”

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Multiple stakeholders

The number of stakeholders pushing for change is increasing, with regulatory powers being the main driving force. Does this help engagement processes, or does it cause conflicts, because some stakeholders want to move faster than others?

Spooner: “I think across the asset owner and asset manager landscape, there has been an increasing focus on stewardship activities over the last three years. Partly, this is indeed driven by progress from a regulatory perspective, with the Shareholder Rights Directive within the EU and stewardship code in the UK as well. And we do see those markets where stewardship codes are available to be more stringent in terms of the practices of asset managers and asset owners.”

“We try to educate and bring the quality of engagement across the investor universe to a higher level. Because as more asset managers and asset owners enter the market, there's a lot of organizations that don't have the history and experience that Robeco has. And so by being able to work collaboratively with these investors, we can improve the quality of engagement and challenge the status quo around engagement activities by being innovative and advancing new practices within the engagement sphere.”

Having more stakeholders also helps to address environmental and social issues, Spooner thinks. “That is only going to be a good thing. We do learn a lot from working with them and these perspectives can be really helpful in terms of understanding and building our own views as well. We benefit a lot from the research that NGOs do. We also benefit from the regulatory development as well. So I think that pluralism is really important, also in achieving net zero in 2050. Clearly, there are sometimes tensions between the ambitions and goals of the NGO community and the investment community. Those need to be worked out. I think it is not a tension around what our ultimate outcome is. It's just a tension around what is the means or what is the journey in terms of how we get to that end goal.”

Spooner says the engagement versus divestment question is a good example of the potential tension in terms of the methods that investors want to deploy versus what NGOs want. And this is due to an oversimplification around what needs to be done to get to net zero. The transition isn't going to happen overnight and divesting doesn't necessarily have a large-scale impact on the actions of oil and gas companies.

“We can have the greatest real-world impact through our engagement activities. And we do have a duty to do that engagement and to drive these real-world outcomes. We are among a small set of investors currently doing this sort of time-bound engagement but it ought to be the norm. So the debate should be: how do we create more conditions and accountability around our engagement to achieve the outcomes that we want to achieve?”

“And so the pressure that has been coming from the NGOs on investors to divest, has both pressured companies to make these conditions, and also has increased the quality and stringency of the engagement activities as well. I don't think we would see as active a stewardship community without some of the pressure that's been coming from the NGOs to divest as well.”

The fossil fuel industry is undoubtedly the most prominent example of that, with a number of big Dutch pension schemes deciding to divest in the past year. Robeco has decided to stick to its guns and continue engagement with the industry. Van der Werf follows the debate carefully. “It's a very lively debate among asset owners. And the decision to divest was a response to the pressure from their pension fund beneficiaries, which were informed and mobilized by pressure groups and NGOs for some years already, calling upon the pension fund boards to make these type of decisions as their preferred instrument in decarbonizing portfolios.”

“But obviously those portfolios also are still reliant on the real economy, where that need and demand for energy still exists. So I think those are all very realistic parts of the whole puzzle that every decision-making body needs to assess. As a global asset manager we have a very different group of stakeholders that we are accountable for. I think that it is very clear that for us the way to create real-world impact is by engaging.”

At least to a certain point, because Van der Werf agrees that talking for the sake of talking makes no sense. “We do realize that if you keep on talking for three, four years and you're not seeing any results, then obviously that instrument loses its effectiveness and credibility if you say, ‘We're going to add another five years of talking and maybe by 2030, we'll getting somewhere’. So somewhere you need to draw a line.” And that is precisely the process upon which Robeco is now embarking more clearly, Van der Werf says. “Drawing that line then becomes a restriction in our investment policy. That obviously has implications for a large range of investment strategies.”

Net zero

This is where Robeco’s recently published Roadmap to Net Zero plays a role. Van der Werf: “This roadmap lays out the long-term strategy for Robeco and shows how engagement plays a role in decarbonizing our portfolios. We have top-down decarbonization targets for Robeco strategies, but there’s also bottom-up objectives based on engagement. We focus our engagement on high carbon-emitting companies that are very important constituents of relevant benchmarks for our investment strategies. We want to continue to be able to invest in these companies if they are able to decarbonize.”

“In the end, it is the ultimate win-win if the majority of our enhanced engagements are successful and we continue to be able to invest in these companies, which will give us the most opportunities to generate alpha while also decarbonizing our portfolios. The risk is that as an asset manager at a certain point in time, some of these companies will disappear from your investment universe because your decarbonization targets do not give you sufficient carbon budget to still hold some of those high carbon-emitting companies. So I think that's why that two-pronged approach will support us over time to maximize the investment opportunities while also achieving our decarbonization goals.”

This tension between maximizing investment opportunities while executing our sustainable investing strategy will continue to build in the future. Spooner: “The first divestment decisions are due to come after two years of engagement. The way in which we've selected companies is based on a formulaic methodology. We work with a traffic light score which is going to be updated over time, so a year or 18 months in advance of that first divestment decision, the portfolio managers will be able to see how well the companies are performing and from a more objective, more quantitative perspective, see whether they meet the criteria for divestment or inclusion over time.”

“This should give the basis for a quite robust discussion between the portfolio managers and the engagement team members.” This decision should be based on facts and risks, not a subjective one, Spooner says. “And this is acting in the best interests of the portfolio managers as well. Because if we're getting to a point where we are going to have to divest a company, these are serious concerns that we have with the management of climate-related risks. And so if we have such severe concerns, we see the potential that that's going to have a negative impact on the share price and on profitability going forward.”

Traffic light

Now, how does the traffic light approach work, in the enhanced engagement program? It’s basically focusing on the worst performers and trying to get them to improve their score. Spooner explains: “We started off with the top 200 emitters based on the Trucost investment universe, looking at the full scope of emissions, not just the emissions that the company has generated themselves, but also throughout the full value chain as well. Most of these companies are active in high-emitting sectors: the petrochemical sector, the chemical sector, steel is highly represented as well. And there is a high degree of oil and gas exposure. And we analyzed that top 200, giving companies a score of one to four.”

The engagement specialists looked at a number of considerations that form our analytical framework: greenhouse gas targets, whether companies have 1.5°C targets, a company's capital expenditure, issues around governance and whether the right frameworks are in place for oversight and management of climate-related risks. To do this, a range of third party datasets such as the Climate Action 100+ benchmark was used, as well as the Transition Pathway Initiative and other third party data providers.

By using this framework, they were able to score companies from one to four, or in traffic light terms: dark green, light green, amber and red. And this methodology was used to select companies for engagement programs where we focus on the worst performing companies. Spooner: “We wrote a letter to all 200 of the companies in January 2022 to inform them of our expectations around managing climate-related risks and their emissions going forward.”

Van der Werf: “So we then look into what the drivers are for companies to move from red to amber and ultimately promote amber to a light green. We want to see them move along that type of trajectory. So we will do a reiteration of the traffic light snapshot every year, to monitor progress over time. In 18 months’ or two years’ time, we should have a clear view in every specific case if a company is about to move from red to amber, or from amber to light green, or perhaps not improved at all.”

Consequences will then follow, Spooner confirms. “Our intention is to develop the methodology and broaden its scope so that we can use it to report on the alignment of our portfolios over time. We initiated this Acceleration to Paris program at the end of last year by sending them a letter informing them that they've been included within our engagement program, why they've been included, and that they're potentially exposed to divestment if we don't see significant progress during the engagement.”

What will such an engagement process look like? Spooner thinks he will be in contact with the companies at least three to four times a year. “Keep in mind that these are companies that potentially aren't directly incentivized to talk to investors about ESG and climate. And so it may take a few attempts knocking on the door to get those initial meetings set up. But within a few weeks we've had positive responses from around half of companies.”

For most of these companies the engagement team has nine objectives in place, ranging from greenhouse gas targets to looking at the climate transition, climate governance and capital expenditure. Spooner: “The main outcomes we want to see are around the management and the reduction of greenhouse gas emissions in line with the goals of the Paris Agreement: Scope 1, 2 and 3 emissions. And for chemical or petrochemical companies those Scope 3 emissions are incredibly important, both with regard to the upstream emissions related to the extraction of oil and gas, but also with regard to the downstream emissions related to waste and recyclability.”

“This would be for instance a chemical company moving towards bio-based materials or the use of hydrogen as a feedstock or within energy generation. So these are large expenditures that these companies are going to have to bear. And so that capex would demonstrate that they are serious about meeting those emissions targets rather than just sort of setting and forgetting them, or setting a net zero target that is going to be a future CEO's responsibility.”

Better world?

Now, how ambitious are these goals? Will these carbon-intensive industries be able and willing to change in the coming three years? Spooner remains realistic. “Perhaps my hopes and ambitions are very different from what will actually happen. My ambition would be for these companies to become climate leaders as a result of our engagement, but I have to manage my expectations in terms of how much change we could see over a limited period of time, particularly for some of these companies that currently lack a clear awareness around climate risks. I would hope after the first two years, we would see an acceleration, such as we've seen over the past few years in terms of more net zero targets being set.”

Van der Werf: “Active ownership is a long-term game. You don't achieve results overnight, but I think asking the right type of questions persistently and consistently and driving companies in the right direction will help us to show there are real-world outcomes. I hope that the traffic light approach makes progress measurable and quantifiable, and makes it easier for us to show that what we began in 2021 will start to yield results in 2024 and beyond.”

Spooner adds: “Divestment is typically the tool we have in our toolbox as investors, but which we don’t want to use. So we want to use up all the other tools before we let go of our ability to exercise our shareholder rights to effect change as shareholders when we divest. And so part of this enhanced engagement is to use those tools quite actively to drive change at these companies.