Excluding companies from investment portfolios is not how you transition an economy

Jean-Baptiste Vaujour is a Professor of Practice at emlyon business school where he teaches about consulting and green finance. He is an energy economist and a registered expert at the EU Commission and for the World Energy Council. He has recently published a book on the decarbonisation of the economy.

 

Exclusion lists have become an increasingly prominent tool for investment funds aiming to enhance their environmental performance. These lists, also known as negative screening, involve the deliberate exclusion of certain sectors, companies, or practices from an investment portfolio based on environmental, social, and governance (ESG) criteria. This method aligns investment strategies with ethical values and sustainability goals, addressing the growing demand for responsible investing.

Advantages to creating exclusion lists

Historically, investment funds have maintained exclusion lists based on so-called “sin stocks” such as those of companies operating in industries related to alcohol, gambling, drugs, weapons, etc. The approach is increasingly extended to include environmental and social standards.

Typically, fund managers and ESG analysts collaborate to identify industries and companies that engage in practices harmful to the environment. This might include companies involved in fossil fuel extraction, deforestation, or heavy pollution. The criteria for exclusion are often derived from international environmental agreements, scientific research on environmental impact, and stakeholder input. For instance, a fund might exclude companies that significantly contribute to carbon emissions or fail to adhere to environmental regulations and standards. For example, some funds have very extensive exclusion lists that include fossil fuels, palm oil or pesticides.

If the principle is rather straightforward, the application of these lists becomes extremely complex in real life as situations are rarely clear-cut. Dilemmas arise when for example a company owns a subsidiary that is on the exclusion list, or when the activity represents only a small percentage of the global income. If coal is excluded, are investments in shipping companies that carry coal among other raw materials across the oceans also excluded? Exclusion lists often have very detailed exemption rules that allow investment funds to manage these situations.

Once these lists are established, they are integrated into the investment decision-making process. Fund managers use these lists to filter out undesirable investments, thereby ensuring that the fund’s capital is not allocated to companies or sectors that fail to meet the predefined ESG criteria. This approach not only mitigates environmental risks but also aligns the fund with the broader goals of sustainable development. Moreover, it sends a message to the market, encouraging companies to adopt more sustainable practices to remain attractive to investors.

Aside from the obvious ESG impact, exclusion lists help manage financial risks associated with environmentally detrimental activities. Companies that disregard environmental regulations or engage in unsustainable practices often face legal penalties, reputational damage, and operational disruptions, all of which can negatively impact their financial performance. By excluding such companies, investment funds can protect their returns and enhance long-term stability.

They also promote corporate accountability and transparency. By publicly disclosing the criteria and companies excluded from their portfolios, investment funds can exert pressure on companies to improve their environmental performance. This, in turn, can drive positive changes across industries, fostering a culture of sustainability and responsible business practices.

Most importantly exclusion lists provide an easy-to-implement and inexpensive solution to demonstrate compliance with the regulatory requirements from the Sustainable Finance Disclosure Regulation (SFRD) and promote article 8 funds.

Drawbacks

Despite these benefits, exclusion lists have significant limitations. One major drawback is that they can lead to a false sense of accomplishment. While excluding certain companies or sectors can reduce direct exposure to environmentally harmful activities, it does not necessarily contribute to broader systemic change. The impact of exclusion lists is often limited to the specific portfolios that implement them, leaving other investors free to continue funding unsustainable practices. Therefore, exclusion lists alone cannot drive the comprehensive shift needed to address global environmental challenges.

Additionally, exclusion lists may lead to unintended consequences. For example, by excluding entire sectors such as fossil fuels, investment funds might miss opportunities to support companies within these sectors that are actively working to reduce their environmental impact. Some companies in traditionally harmful industries may be making significant strides in sustainability, and blanket exclusions fail to recognize and support these efforts. This can hinder the overall progress towards sustainability by not incentivizing positive change within high-impact sectors.

Moreover, exclusion lists can be somewhat rigid and inflexible. The criteria for exclusion are typically based on current understanding and data, which can evolve over time. As new information emerges and the environmental landscape changes, exclusion lists may become outdated or overly restrictive, preventing investment in innovative solutions that could contribute to environmental improvement. This rigidity can limit the adaptability of investment strategies, making it challenging to respond to dynamic environmental challenges effectively.

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In conclusion, while exclusion lists are a valuable tool for enhancing the environmental performance of investment funds, they have inherent limitations that must be acknowledged. They play a crucial role in reducing direct exposure to environmentally harmful activities and promoting corporate accountability. However, they cannot drive the large-scale systemic changes needed to tackle global environmental issues on their own. To achieve a truly sustainable economy, exclusion lists should be complemented with other strategies, such as positive screening, active engagement, and impact investing. By adopting a more holistic approach, investment funds can more effectively contribute to the environmental sustainability and resilience of the global economy.