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• Step 1
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Approaches in practice – support, avoidance and engagement

Once you have identified the key social, environmental and ethical issues that are of concern to a client, the suggested next step is to work out the approach to green and ethical investment that will best suit the client's needs and wishes. We break these down into three main approaches.

In addition to covering a diverse range of issues, different funds/fund management houses and product providers employ different approaches or 'tactics' that aim to meet the needs of their respective investor bases and/or target markets. The main types of green and ethical investment approaches are:

• Positive screening – or support.
  

• Negative screening – or avoidance.
  

• Engagement.
  

Many funds combine all three approaches (support, avoidance and engagement), while others only use one or two. Product provider literature should make it plain which of the three approaches apply to which of its products or funds.

This information should be set out clearly in a provider's marketing material, as is encouraged by the Eurosif Transparency Guidelines for the Retail SRI Fund Sector (1). This is explored further in Step 5.

Positive screening or support seeks to invest in those companies with a commitment to responsible business practices, positive products and/or services. This is often a less visible approach than the other main techniques but can manifest itself in a number of ways. Broadly:

• Funds may want to support companies that sell positive products – for example, educational materials, safety products, products for the renewable energy sector, or products that are necessities of life such as food, clothing, electricity, water or housing.
  
  
• Funds may favour companies with positive policies and practices (perhaps irrespective of the company's line of business), such as good equal opportunities policies, supply chain management, environmental management practices or community involvement and charitable giving.
  

Approaches and their impact on stock selection vary, but a notable variation is themed or thematic investment, where a fund might major in a particular 'positive' industry to the exclusion of all others – for example, a fund that focuses on environmental technology.

Other funds prefer not to exclude entire sectors and so adopt an alternative approach. Rather than blanket exclusion, companies are selected on a 'best in class' or 'best of sector' basis. This approach is a technique that fund managers use to rate companies according to a green and ethical investment policy. Fund managers apply the policy guidelines where they can, and they bias their investment decisions towards higher rated companies. Fund managers select investments or portfolio weightings that take into account how closely a company meets the policy.

This approach allows fund managers to mix ethical and financial criteria. If several companies have a similar rating according to the conventional financial criteria of risk and return, the manager can rate them against the chosen responsible investment criteria and then select the company with the better all-round performance. So, for example, a fund manager who invests in oil stocks may adopt a 'best in class' approach and select the oil company with the best environmental management.

The most commonly recognised form of green and ethical investment is negative screening or avoidance. This approach involves avoiding companies or industries that do not meet the social, environmental or ethical standards by which the fund is run.

• Most funds, for example, do not invest in tobacco, alcohol or armaments production.
  
  
• The degree to which an industry or a particular behaviour is avoided may vary from fund to fund (eg they may allow 3%, 5% or 10% of a company's turnover to comprise the questionable activity). The fund's de minimis limit may or may not follow the stances outlined by research agencies or other commentators.
  
  
• Companies may be excluded by virtue of the industry in which they operate (eg financial services, mining, making or selling pornographic material), or because of the way they do business (eg poor relations with suppliers or employees, pollution-related convictions, offensive advertising).
  
  
• Although there is a degree of commonality, different funds consider different issues and exclude companies in accordance with their own policies.
  
  
• There is no single, correct 'black and white' approach to any issue. Approaches may vary between being very strictly against something, to having no concern about a given issue. However, where there is a wide public consensus about an issue, the approach adopted by different funds may be very similar.
  

Fund managers or product providers should publish their exclusion criteria, and the details should reflect how the fund is run in practice, and in particular the stock selection practices.

Engagement aims to encourage and support more responsible business practices. It may also seek to improve investment returns by encouraging companies to manage social, ethical and environmental risks or to address new social or environmental business opportunities.

Engagement relies on the influence of investors and the rights of shareholders as owners of companies. It mainly takes the form of dialogue between fund managers and companies on issues of concern and may also extend to voting practices.

Historically, there has been a degree of dialogue between ethical funds and the companies in which they invest. However, activity levels have increased substantially over recent years, to the extent that some providers and fund managers now offer this as a 'stand alone' approach – ie without an overlay of positive or negative screening.

Different fund managers engage on different issues, sometimes operating unilaterally and sometimes in collaboration with other fund managers – for example, through the Institutional Investors Group on Climate Change. (2)

The issues covered tend to be less contentious than some screening issues. Examples include:

• Climate change

• Access to essential medicines

• Inappropriate executive remuneration

• Labour standards

• Bribery and corruption

Engagement may be separate from screening or may be combined with it. It may apply to screened and unscreened funds.

Engagement may also apply across a product provider's entire equity portfolio and may therefore apply automatically, no matter what fund is purchased from that company. In instances where a fund manager is committed to engagement with companies on behalf of all their equity assets, the manager may not specifically highlight this for all their retail funds under management.

Normally, engagement with a company only takes place when there is a business case for change. In general, a company would not comply if there were no business benefit.

Engagement itself does not normally alter stock selection, and mainly takes the form of dialogue, negotiation and gentle persuasion. This is often conducted away from the public eye, although voting at AGMs and EGMs – and in extreme cases using the media to 'shame' a company – sometimes takes place.

Engagement is less frequently employed across non-equity holdings, but it sometimes applies to bonds and property investments.

It is increasingly being adopted by occupational pension funds.

Many screened funds combine all three approaches (support, avoidance and engagement), while others only use one or two. An engagement-only fund will, as it implies, apply the third approach only.

• Screening Within screened ethical funds, the issues tend to be relatively static, because funds have to be mindful of their existing client base. However, additional criteria may sometimes be added and some policies may change over time as the fund manager seeks to stay up to date with what is happening in the world. For example, one of the earliest exclusion areas was 'Companies with operations in South Africa' – a criteria well worth reviewing in the post-apartheid world. Screened funds tend to be referred to as 'ethical' or 'green' funds. Funds described as 'ethical' normally address a diverse range of issues, although it is obviously important to understand the criteria for each. Funds described as 'green' may range from a general ethical fund, perhaps with an emphasis on environmental criteria, through to a fund with a thematic environmental solutions proposition and no additional negative screening. Journalists and other commentators may sometimes use the terms 'ethical' and 'green' completely interchangeably.

• Engagement Engagement programmes tend to be more fluid, changing as issues in the news (and of concern to fund managers) change. An engagement-only fund should therefore not be sold on the basis of engagement on a particular issue, unless the fund manager has agreed to continue that engagement on an ongoing basis. Funds that use an engagement approach but do not screen stocks in or out of their portfolio are not traditionally marketed as green or ethical funds, although this has recently started to change to some degree.

Step 5 describes how to understand the application of screening and engagement by particular funds.

Buying collective investments is not the only route to green and ethical investment. There are a number of other possibilities that clients might want to consider.

Some smaller banks have specialised and differentiated themselves as 'ethical banks' by using social, environmental and/or ethical criteria for their lending and other activities. As with green and ethical funds, they may focus on investing positively in certain areas or emphasise instead the activities or operations not permitted for their business customers; they may also offer a combination of these.

Major banks are increasingly aware of the social and environmental impact of their lending activities, particularly in the developing world, as some have come under criticism for their involvement in controversial projects (for example, the construction of dams for hydroelectric power). It is becoming increasingly common practice for banks to have guidelines for their staff and customers on major ethical issues that arise during lending, such as third world debt, the arms trade, human rights and oppressive regimes, environmental issues, and support for the community.

A global initiative, the 'Equator Principles' (3), is a framework that banks can use to manage environmental and social issues in project financing and is supported by some leading high street banks.

Many investors wish to back individual projects or causes through carefully directed investments. The sector is currently dominated by authorised financial institutions such as the smaller specialist banks, although it also includes ethical companies who raise money directly from stakeholders. (4)

Community development finance is the term given to the range of approaches taken by community development finance institutions (CDFIs) to develop and create wealth in disadvantaged communities and under-invested markets.

CDFIs are sustainable independent financial institutions that provide capital and support to individuals and/or organisations that cannot obtain mainstream finance. They aim to help social enterprise create local jobs, develop services and reverse downward spirals of under-investment in under-served communities. Some are specialist banks, while others do not hold banking licenses and may be industrial and provident societies or use other legal forms.

Financial returns are mainly provided through a special tax incentive available to investors in accredited CDFIs, but this is sometimes complemented by interest from the CDFI. By investing in the CDFI sector, investors can gain a reasonable return and know that their money is being used directly to achieve social gains. 

The tax incentive for investment into accredited CDFIs is called community investment tax relief (CITR). Its key characteristics are:

• The CITR reduces the investor's income tax (or corporation tax) liability.
  
  
• The tax relief is spread over five years (5% a year) and is worth an annual 8.33% gross for higher rate taxpayers.

Venture capital, or private equity, provides long term, committed share capital to help unquoted companies grow and succeed. Most venture capital is not undertaken on a responsible investment basis, but there is a small portion which does adopt responsible investment principles.

Footnotes

1        See Eurosif Transparency Guidelines for the Retail SRI Fund Sector

2        See www.iigcc.org.

3        See http://www.equator-principles.com.

4        See www.eiris.org.

5        See report Inside Out 2005 – the state of community development.