Divesting may not be the right ESG move

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When Tamara Close left her position at a well-known Canadian pension fund to open her own boutique ESG consulting business, the conversation she was having with clients was about divesting away from sectors such as resource extraction and oil and gas in order to have more environmentally friendly holdings.

Fast forward six years, and Close, founder and managing partner at Montreal-based Close Group Consulting, an environmental, social, and governance advisory for financial and capital markets, says this conversation has shifted away from divestment into something more active – and more productive.

“The narrative changed and it became much more about engaging: ‘Let’s engage with these companies. We’ll keep giving them our capital, but we will engage with them and we will help them to transform their business models into low-carbon business models,’” recalls Close.

Many investors turn to divestment or screening out

But this is a less common strategy ESG-conscious investors take when looking at having a much more ESG-conscious portfolio. Many still default to divesting away from, or screening out, companies or stocks that are in certain sectors.

“Sin stocks” was coined to describe stocks of businesses that make goods that are deemed damaging by the investor as being bad for both people and the environment, such as those associated with alcohol, tobacco, weapons or fossil fuels.

However, there is little to be gained from this solution, according to several investing experts. Instead, they say, money talks, so keeping these companies accountable and using one’s influence as an investor is likely going to have a more significant impact.

“For a company to really then take this capital and transform their business model, transition to a low-carbon business model, they need to feel the financial threat to do it,” says Close, adding that choosing a larger stake in a smaller company might allow investors to get the kind of impact they’re seeking.

Especially effective with small- or mid-caps

“Pulling out the 1-per-cent doesn’t hold as much sway as if you own 20 per cent of a company or 15 per cent of a company,” says Close. “Where you can have really great influence, though, are these small caps, mid caps, privately held companies – let’s say in private equity funds – where you have more access to management.”

While the idea of taking a stand against a particular sector by refusing to invest or pulling one’s investment may seem like a productive thing to do, the fact is, is that investors will achieve very little by doing this, as the company likely will not feel these effects, says Mindy Mayman, partner, chief compliance officer and portfolio manager at Richter, a business advisory and multi-family office firm.

“If you’re selling your shares into the market, somebody is buying them but we should be clear that that transaction in and of itself is not financially impacting the company,” says Mayman.

In fact, for many sectors, the move to go green or more sustainable comes with significant costs, so companies that want to change their behaviour need money to do it and that money comes from investors.

“The truth is a lot of this, whether we like it or not, is about money,” says Mayman. “Some of it’s about technology, but at the end of the day, no matter what it is, it requires investment and money, and we have to commit to that if we’re serious about the climate problem.”

Exercise ‘rights of control to change corporate policy”

The point of divestment is to make it harder for companies considered “bad actors” to raise capital. But what if that capital is being raised in an effort to make some significant changes that align with ESG-conscious investors?

“Me divesting of my shares doesn’t directly starve the company of capital, because if I sold them to you, that didn’t go to the company anyway,” explains Mayman. “If the company does come to the marketplace and say, ‘I need to raise money because I have projects and I am investing to be greener,’ and we say, ‘No, we’re not supporting that company,’ then I don’t know how they’re executing on that promise either.”

In a 2021 research paper from Stanford Business School, The Impact of Impact Investing, authors Jonathan Berk and Jules van Binsbergen found that, “to have impact, instead of divesting, socially conscious investors should invest and exercise their rights of control to change corporate policy.”

The paper also points out that socially conscious funds could buy stock in ESG-unfriendly or “dirty” companies and evoke change, for example, through the company’s shareholder meeting. In the example, 51 per cent of the votes are against a green initiative. If socially conscious investors control the remaining 49 per cent that is in favour of the initiative, they would need a little over 1 per cent more to win the vote. ESG-focused investors could be that 1 per cent and have a significant impact on that company’s behaviour.

‘Change does not happen overnight’

“I think keeping investments in these companies and engaging with them, surely will be more constructive in driving us to change. The decision on whether to take this route depends on circumstances and each unique situation,” says Wendy Smith, managing partner at Advanced Inclusion, a diversity, equity, and inclusion consultancy in Toronto.

She suggests investors take stock of what they want to see happen with companies they are considering investing in and if those kinds of changes are feasible.

“Some things to consider: What type of business is it? Can the business model adjust in your view? Can they incorporate more equitable [or greener] business practices? Can they actually do that? … Some businesses just can’t,” says Smith.

She suggests investors ask themselves: “Do you have the time and energy to do it? If you do, is this the one stock or industry where you want to focus on, or are there other ESG issues more personally important to you?”

If investors decide that divesting is the right decision, it is important to realize that change does not happen overnight and Smith recommends taking a “mindful approach.”

“You can’t just sell everything right away and change your portfolio immediately without it having a huge financial impact,” she adds. “You want to pick your spots, when you’re going to get out of certain securities.”

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