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Ethical investment: using negative screens to avoid ‘sin stocks’ is a thing of the past



Regina Schwegler and Judith Reutimann, of Switzerland-based sustainability rating agency Inrate, discuss the role of exclusion screenings in sustainable investment.

Excluding certain stocks from an investment universe due to violation of minimum standards is a widely used practice for socially responsible investments (SRI). It can be valuable for financial, risk and sustainability reasons. However, exclusion screenings need to be complemented by more encompassing sustainability assessments to fully reflect relevant sustainability issues and investors’ values.

Exclusion screenings as an SRI approach

Exclusion screenings systematically exclude companies, sectors or countries from a permissible investment universe, if involved in certain activities. To this end, investors define specific exclusion criteria, the most common being weapons, alcohol, tobacco, nuclear energy and the violation of labour rights. Investors do not want to be associated with such activities because they involve high societal risks, serious human rights infringements or irreversible ecological damages.

From religious motivations to today’s SRI practice

Exclusion screenings are the oldest practice for SRI. Their roots date back to the Quakers – the Religious Society of Friends, founded in 1758 – who prohibited members from participating in the buying or selling of slaves and war efforts, because such practices contradicted their fundamental beliefs about peace and nonviolence.

In 1928, the first responsible investment fund, the US Pioneer fund, was launched. Strongly motivated by the prohibition era, it excluded investments in alcohol and tobacco.

During the civil rights and peace movements in the 1960s, excluding certain companies from investments began to be motivated by politics and public awareness for social topics. Later, the environmental movement of the 1970s and 80s brought about growing concerns over environmental degradation and limited natural resources.

Another milestone that contributed to the development of SRI was the groundbreaking report Our Common Future published by the United Nations’ Brundtland commission in 1987 and postulating ‘sustainable development’.

As sustainability came to the forefront of society, it slowly emerged as its own market for sustainable investments. In addition to exclusion screenings, broader sustainability assessment approaches that measure a company’s contribution to sustainable development also gained importance.

The practice of excluding certain stocks in order to avoid investing in so-called ‘black sheep’ has continually grown until today (see figure 1).

Figure 1. Source: Eurosif 2012

The role of exclusion screenings within the world of SRI

Today, exclusion screenings are an important element of SRI. Investors view exclusions as an investment tool to avoid criticism of their legitimacy and social usefulness. But should investors rely on exclusion screenings as their main SRI strategy? What role do exclusion screenings play within the world of SRI?

To answer these questions, we need to acknowledge that exclusions serve two main purposes within SRI:

– To measure a company’s sustainability impacts and encourage it to improve its sustainability performance
– To allow an investor to reflect their values, e.g. by avoiding investments that do not correspond with their belief systems

Exclusion screenings generally focus on issues with severe and often irreversible adverse sustainability impacts (e.g. infringement of fundamental human rights) or are associated with major or incalculable risks (e.g. nuclear energy production). Thus, exclusion screenings improve the sustainability impacts of investments.

However, they are not able to capture all relevant sustainability issues facing a company; they simply serve as minimum ethical standards, and as such focus on the highest sustainability risks.

Furthermore, exclusion screenings tend to apply criteria that are relatively easy to assess, such as alcohol, tobacco or gambling. Even though these issues are undoubtedly relevant, they tend to be overrated, compared to other relevant but more complex issues such as human rights. At the same time, exclusion screenings are hardly applicable to cover other highly relevant issues our society faces today, such as climate change, and the sustainable use of freshwater resources.

Similarly, exclusion screenings can only partly be used to fulfill the second purpose of SRI: to reflect an investor’s values. Asset owners mentioned a variety of reasons for the use of environmental, social and governance (ESG) criteria for their investments: from sustainable development to long-term risk management, protection of reputation and financial performance (see figure 2).

Although exclusion screenings are generally effective in evading important sustainability impacts and investment risks, relying solely only on them is not advisable. It bears the risk that investors overlook other relevant investment risks such as the carbon-intensity of an investment, and investment chances such as energy-efficient technologies.

Figure 2. Reasons to use ESG criteria with investments. Source: Novethic 2013.

Sustainability assessments and exclusion screenings

Inrate is aware of the above mentioned limits of exclusion screenings, and therefore combines them with further sustainability assessments.

The Swiss Raiffeisen Futura funds are based on Inrate’s sustainability ratings. The methodical approach combines a sustainability assessment (positive filter) which thoroughly determines a company’s contribution to sustainable development with an exclusion screening (negative filter) that guarantees no involvement in especially harmful products and activities.

The sustainability assessment of Schneider Electric SA for the Raiffeisen Futura Fonds illustrates the relevance of the two rating pillars that Inrate applies.

The company’s sustainability assessment indicates that the company is on the path to sustainability, with an overall sustainability performance above the average of its industry peers (environmental rating: 50% over average; social rating: 101% over average; see table 1).

Table 1. Source: Inrate 2014

The exclusion screenings around Schneider Electric reveal that the company currently has some minor involvements with exclusion criteria, because the company supplies products that can be used in the defence (dual use goods) and nuclear energy sectors. But turnover generated from sales of such products remain below the thresholds applied for exclusion.

However, in the past the company provided crucial parts for nuclear weapon systems and could potentially do so again in the future. Even when generating a low share of total turnover, such services are considered a significant involvement and therefore used to trigger an exclusion of the company from the investment universe.

The example of Schneider Electric shows that an exclusion screening reveals highly relevant, but much focused information. In contrast to that, a sustainability assessment draws a more complex picture of the company, and reveals valuable information for an investor. The combination of both methodological approaches – exclusion screening and sustainability assessment – will in most cases be best suited to an investor’s needs.

Table 2. Source: Inrate 2014

Exclusion screenings are best combined with sustainability assessments

Generally speaking, exclusion screenings are effective tools in evading important sustainability impacts and investment risks. However, they are limited when it comes to reflect complex but relevant sustainability aspects of a portfolio and to fully reflect investor values.  For these reasons, investors have to overcome the possible temptation of using them as half-baked solutions.

Applying exclusion screenings successfully requires that they are used the correct way:

– As part of a coherent and formal responsible investment position
– Based on criteria that are scientifically founded, purposefully selected and consistently applied
– Ideally in combination with a more holistic sustainability assessment that is able to assess complex sustainability issues in more detail

Regina Schwegler and Judith Reutimann are senior analysts at Switzerland-based sustainability rating agency Inrate. This article is a summary of their recent paper, Exclusion Screenings: Highways or dead ends? It’s your choice!, where you can find references for all of the above.

Further reading:

From ethics to sustainability: shifting the investment debate for 2014

One day soon, we hope all investment will be sustainable, responsible and ethical – before it is too late

Sustainable investment is about optimisation, not maximisation

‘Saints’ reap better returns than ‘sinners’ in new sustainable investment analysis

The Guide to Sustainable Investment 2014


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