ESG screening is a complex business. Here’s how longtime ESG manager Parnassus is adapting.

Parnassus Investments, one of America's oldest and most respected ESG boutiques, is adding once off-limits market segments such as oil and gas to its investment opportunity set, even as executives there warn that the hurdle for including such companies in its portfolios remains high.

Amid the politicization of ESG investing in recent years, the $47 billion San Francisco-based money management firm has stopped using hard-and-fast exclusionary screens in building client investment portfolios, in favor of more flexible guardrails.

The latest evolution in the long-standing ESG firm’s investment approach followed the introduction three years ago of a “restricted list” to complement the exclusionary screens Parnassus had been deploying since its founding in 1984.

That change left the firm with two parallel processes — one which excluded by prospectus companies in sectors such as tobacco, firearms, gambling or fossil fuels and the other … "a tool that we used to narrow the investable universe, to cull out the ones that we don't believe will meet our standards and our quality thresholds,” Marian Macindoe, the head of ESG at Parnassus, told Pensions & Investments.

Then, on May 1, “we took the exclusionary screens (based on revenue thresholds we had) out of the prospectus,” moved every company that was excluded to the restricted list, and renamed that list “the ‘caution list’ because we wanted to make sure people understood that it's not rules-based,” Macindoe said.

“Essentially, we made the change because it’s more efficient and effective to have one set of tools to narrow the investable universe, and exclusionary screens by prospectus limit our flexibility to apply analysis to a complex set of issues,” such as the energy transition, Macindoe said.

The maturation of the ESG sector helped make that change possible, said Randall Dobkin, a product marketing specialist at Parnassus. The industry has evolved — with vastly more information, data and resources today to evaluate sustainability factors — and the changes Parnassus put into effect from May effectively modernize the firm’s approach, he said.

Political winds, maturing ESG industry

Some see the recent uptick in political headwinds facing ESG-focused managers in big U.S. states such as Texas and Florida as a factor in the firm's decision to retire exclusionary screens.

Parnassus, one of the industry's first managers focused on sustainability, “is doing this in a very politicized environment,” noted Hortense Bioy, Morningstar’s London-based head of sustainable investing research, adding “I don’t think it’s a coincidence.”

Just two months ago, an interim report by the Judiciary Committee of the Republican-led U.S. House of Representatives contended that environmental groups, pension funds, asset managers, proxy-advisory firms and activist investors were coordinating a "climate cartel" to force U.S. companies to "decarbonize."

With a heightened focus on fiduciary duties making wholesale write-offs of market sectors problematic for some investors, dropping exclusionary screens from legal documents like prospectuses could prove “a smart move politically (and) commercially,” Bioy said.

Morningstar previously provided ESG commitment ratings for asset managers but stopped doing so earlier this year. Parnassus had been rated "very highly,” she said.

Macindoe said while Parnassus remains “very aware of the policy environment,” political considerations weren’t the main driver for dropping exclusionary screens.

“ESG is grounded in the belief of materiality and how these issues can impact a company’s ability to deliver value," Macindoe said. "Having rules-based screens is not compatible with that philosophy,” she added.

By way of example, she pointed to Paris-based luxury goods maker LVMH Moet Hennessy, with the 8% to 9% chunk of its revenues coming from alcohol sales just below the 10% ceiling Parnassus sets.

“So, the question is, would we sell that company, which has performed well for us, if it went one percentage point over the 10% threshold? And the answer is, that’s not good for clients. It’s not good for our funds, and it limits our ability to effectively evaluate a company’s suitability,” Macindoe said.

“So, we took the screens out and now, if LVMH goes over 10% ... we do an in-depth analysis of its mitigation strategies and engage the company” regarding how it’s managing the personal, societal, environmental risks associated with being an alcohol manufacturer, she said.

Oil and gas

Macindoe said the anti-ESG backlash of recent years hasn’t entirely bypassed Parnassus.

“We’re on the Texas comptroller’s list,” and probably others as well, she said. But Parnassus has been “defined by our principles and performance brand for so long” that those political headwinds, broadly speaking, haven’t had a big impact on the firm, she said.

The comptroller's list was launched in 2023 to identify money management firms judged to be boycotting Texas's energy industry, with the state's public pension funds required, by statute, to terminate those managers.

A spokesman at the Texas comptroller’s office declined comment. A Parnassus spokesman couldn't immediately be reached for comment on whether the list had impacted the firm's business.

At the end of the day, the switch to a “caution list” should not be considered “a material change” to Parnassus’s investment process - just a change to one of the tools the firm uses to narrow the investment universe, Dobkin said.

And there has been no discernible impact on Parnassus’s portfolios.

“We haven’t invested in anything yet that came off the exclusionary screens,” noted Macindoe. “This wasn’t us chomping at the bit to have a new strategy for our investments. This was us saying, hey … these screens have served us well for a long time and now it’s time for us to transition to something more sophisticated,” she said.

By way of example, while previously excluded oil and gas-related companies now fall within Parnassus's opportunity set, "the hurdle is high for any potential investment in the energy sector," Macindoe said.

Potential investments now "might include oil equipment services companies that help integrated companies produce energy in a more efficient and environmentally appropriate way," such as those involved in carbon capture, or software companies that help energy companies run in a more clean and efficient manner, she said.

But over the three months since Parnassus dropped exclusionary screens, its investment team has examined only one potential oil equipment services company and "it did not pass our sustainability lens," she said.

If underweighting or avoiding energy companies facing potential stranded asset challenges could prove a winning strategy over the long term, for shorter time periods it could prove a double-edged sword - for years where the market's sizable oil and gas sector experiences cyclical upswings.

For example, Parnassus's second biggest fund, the $4.9 billion Parnassus Value Equity fund, trailed its Russell 1000 Value benchmark by an annualized 2.04 points for the latest three years — hurt by its lack of exposure to energy stocks when energy was the only sector spared in the steep market sell-off of 2022. Even so, the strategy enjoyed annualized outperformance of 6.37 points for the five years through June 30.

The firm's biggest investment strategy, the $37.4 billion Parnassus Core Equity fund, trailed its S&P 500 benchmark index by an annualized 1.06 percentage points for the three years through June 30, and by 25 basis points for the past five years.

Meanwhile, executives say their firm’s most important constituency, Parnassus’ clients, have remained supportive.

“It was an important item. It required board approval. So, we wanted to be really thoughtful about it,” said Joe Sinha, the firm’s chief marketing officer.

Parnassus “reached out to 50 clients in a wide variety of segments — individual people, home offices and broker dealers and institutional clients, including consultants” and 48 said “sounds right, sounds like what sustainability looks like in the year 2024,” Sinha said. Two clients on the retail side expressed concerns that they could end up getting exposure to industries they were looking to avoid, he said.

Following other ESG managers

Parnassus’ decision to drop exclusionary screens brings its approach closer to that of other big ESG-focused firms, including Calvert Research and Management, Morgan Stanley Investment Management’s $38.8 billion responsible investment affiliate, and Impax Asset Management Group, the $46.7 billion London-based sustainable investment boutique.

Calvert adopted a principles-based framework for its investments in 2015, focused on global norms, noted Anthony Eames, the firm’s managing director of responsible investing strategy.

Before then, Eames said, “we used ‘criteria,’ which was sort of code for exclusions.”

“We would generally say we’re not going to invest in tobacco manufacturers or gambling companies, etc., and so we didn’t necessarily call them exclusions, but to be clear, we pivoted away from even criteria, full stop, in 2015,” he said.

For roughly the past decade, then, principles such as “reduce the negative impact of operations and practices on the environment” and “diminish climate-related risks and reduce their carbon emissions” have guided Calvert’s 22-member ESG analyst team, instead of prescriptive constraints.

Exclusionary frameworks obstruct analysts from making qualitative decisions on whether or not to invest in a company that could be progressing toward a more sustainable business model, Eames said. “The principles framework allows us to do that,” he said.

Meanwhile, from a global perspective, it’s hard to conclude that exclusionary screens are going the way of the dinosaur, market veterans say.

For the broader industry, there’s no clear move in the direction of phasing out exclusionary screens, noted Miriam Benarey, London-based head of sustainability client advisory with Impax Asset Management.

Some geographies, some jurisdictions — including France, Belgium and Norway — not only use them but embrace them, she said, adding that in Europe over the past five years the regulatory landscape has become decidedly more prescriptive.

For Impax’s team, “we’ve always been more focused on ‘screening in’ — so positive screening, rather than negative screening,” said Benarey.