Sustainable investing muddle?

4 minute read

Keep calm and try a doughnut

For those of us who work in the sustainable investing space, it’s all too easy to forget just how jargon-filled and confusing it can be, even at the best of times. From a client perspective, having an adviser that is confident explaining the various sustainable investing options is crucial, but this is no easy feat.

This challenge is currently the preserve of a few advisers who specialise in sustainable investing and advising on ESG (environment, social and governance) options. But new rules called the MIFID II suitability requirements will come into force very soon, and all advisers will have to demonstrate they have considered their clients’ attitudes to ESG and sustainable investing as part of the advice process.

But how exactly do you frame and explain such a dynamic process to clients in a way they can grasp quickly and without tearing their hair out?

Well, here it would be wise to turn to the world of Development Economics and borrow an excellent idea from the British economist Kate Raworth – the doughnut model. Originally presented in her 2012 paper entitled A safe and just space for humanity, and later turned into the bestselling book, Doughnut Economics, the model is an approach to conceptualising the dual challenge of ensuring that nobody falls short of life’s essentials without over-shooting earth’s planetary boundaries.

The inner ring represents the social foundations and the vital needs of societies including food, water, health, social equity and so on. The outer ring represents the environmental ceiling, earth’s planetary boundaries. Each country, state and municipality can have its own doughnut, depending on how well they are fulfilling these dual goals. This framework provides policy makers with a challenge to target the sweet spot in between where humanity can thrive.

And policy makers are taking note. Raworth is now advising the authorities in Amsterdam on how they should rebuild the city’s economy post Covid-19 and we have seen the doughnut idea becoming more and more prominent, particularly amongst our European neighbours. Image of Kate Raworth's doughnut model

Source: Kate Raworth 2012

But not only is this a revolutionary way of understanding the problem of providing for the global population without harming the natural environment, it could provide an excellent way of conceptualising what sustainable investing is all about, and in particular what fund managers are trying to achieve when they build their sustainable portfolios.

As a conceptual tool, the model is great at explaining, in an accessible way, what the purpose of sustainable investing is and why it is so important. By presenting the global challenge of sustainable development in this way, the doughnut shows why an investment focus on companies offering solutions to the global challenges of delivering ‘more with less’ for a growing population with finite resources is absolutely necessary.

At a practical level, too, rather than each country having its own doughnut, each company, and indeed each fund, can be classified with its own doughnut based on the impact it has on the society and the natural environment.

The problem faced by fund managers becomes clear. They want to select companies that hit the sweet spot, or the “just and safe space” as Raworth calls is. Managers achieve this by ‘negative screening’ companies, avoiding those companies generating revenue from controversial sectors of the economy and pushing on the environmental ceiling, and ‘positive screening’ companies, selecting those that are contributing to meeting society’s needs.

From a portfolio perspective, the positive investment themes seen on the inner ring of the doughnut of energy, food, health, resource management and water should be at the heart of the stock selection process. To warrant inclusion in a sustainable fund, companies must offer solutions to these challenges by delivering ‘more with less’, without breaching the environmental ceiling, the outer ring of the doughnut.

One of the great challenges the advice sector will face over the coming years will be figuring out how to explain ESG and sustainable investing to their clients and how to incorporate their preferences into the investment process. From a sustainability standpoint, the doughnut model provides a neat way of framing the stock selection challenge and could be a vital tool for explaining to clients what sustainable investment managers are trying to achieve and how they go about making an investment decision.

Author

Claudia Quiroz

Head of Sustainable Investment

I lead the sustainable investment team at Quilter Cheviot, dedicated to serve clients who would like to invest in companies offering solutions to the economic and environmental problems of urbanisation, climate change and resource scarcity.

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