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    The (Ash) Grey Zone

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    Stockholm (NordSIP) – Tobacco has long been off-limits for most ethical investors. It is hardly surprising, as smoking is one of the leading causes of preventable death worldwide, killing more people than alcohol, illegal drugs, and car accidents combined. Tobacco-tainted ‘sin stocks’ get singled out by a typical negative screening and feature prominently on many exclusion lists.

    Once investors have taken a moral stance, however, things tend to get complicated. Navigating the evolving world of tobacco-related products can be rather baffling. Ranging from smokeless alternatives like snuff and snus to e-cigarettes and heat-not-burn tobacco, many of these options are marketed as less harmful than good old cigarettes, or promoted as a means to quitting the addiction. Add an increasingly intricate web of companies in the industry’s supply and distribution chains, and it gets even more confusing.

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    Even regulators seem to be having trouble keeping up with tobacco companies’ innovative moves. Vaporiser Heating Products (VHP) are a perfect case in point. Although these devices are used for heating tobacco, they are currently classified as consumer electronic products in the EU and, therefore, not subject to any restrictions or taxes from tobacco control laws.

    The curious case of Nolato

    To illustrate the complicated reality of making ethical choices, let’s have a look at a very local, very specific example. For several years now, Swedish company Nolato has been the preferred VHP manufacturing partner of British American Tobacco for its best-selling glo product. Nolato has been open about this profitable business area, taking much pride in its market-leading position. Last month, the company announced that VHP-related sales will account for less than 5% of total group sales going forward. Those following the company over the years would know, however, that VHP-derived sales and revenues have been much higher historically.

    Yet, Nolato’s successful tobacco-related business has hardly kept professional investors away. Browsing through the list of the company’s largest shareholders, you will notice a mix of institutional investors, predominantly from Sweden. Even if you disregard the ones professedly agnostic to the ethics of tobacco investing, e.g., the Swedish AP Funds and Nordea, the list still contains a number of fund companies with clearly defined tobacco exclusion policies, such as Lannebo, Didner & Gerge, Handelsbanken, and Öhman.

    Ethics ≠ sustainability

    A reminder about the subtle difference between ethical and sustainable investing might be warranted at this point. Ethical investing involves a judgment call based on values that might vary between organisations and individuals. Professional sustainable investing, on the other hand, strives for a systematic, comprehensive, and objective assessment of investments based on several factors, often organised in a framework such as ESG. It is not crystal clear whether companies involved in producing and distributing tobacco should automatically be out-of-bounds for a responsible, aka sustainable, aka ESG investor.

    Tobacco companies’ main value proposition aside, you might argue that the industry’s carbon footprint is substantial, or lament the dire straits of workers exposed to toxic chemicals. You could also point out that tobacco farming, mostly in developing countries, causes deforestation and soil erosion. Yet, there are companies trying to address some or all of these issues, more or less successfully.

    Essentially, the drug itself is still legal, and those catering to the millions of addicts worldwide don’t seem to have any problem justifying their own existence. Some even have high sustainability aspirations, adding welcome arguments to the arsenal of anti-ESG advocates. “Our compelling case for harm reduction from smokeless tobacco is being arbitrarily overlooked when we are categorised just as any tobacco company with all the health issues from smoking,” complains, for instance, Lars Dahlgren, the CEO at Swedish Match.

    The choice is yours

    And so, it is up to each investor to draw the line, balancing ethics vs. sustainability to the best of their ability. On top of this, asset managers need to reconcile the tobacco decision with their overarching fiduciary duty. After all, it is a common argument that outright exclusions, which reduce the investment opportunity set, are detrimental to future returns and, thus, to be avoided. When it comes to tobacco, this effect is quite limited, however. No prudent steward of capital can disregard the bleak long-term outlook of the industry and the multiple risks ahead.

    Still, it is not an easy choice, even for highly qualified professionals. Take, for instance, the venerable Council on Ethics, the sustainability hub of Sweden’s largest institutional investors, the AP Funds. Despite being universally acclaimed as responsible investors, they have decided not to exclude tobacco from their investable universe. “With the support of the international convention on tobacco control, which Sweden has signed, the Swedish Parliament has decided that it is legal to manufacture, sell and use tobacco in Sweden,” they declare. “Therefore, the Council on Ethics of the AP Funds deems that there is an acceptance that companies may manufacture and sell tobacco.”

    It’s complicated

    Back to our Nolato case, it is interesting to hear how fund companies that, unlike the AP Funds1, have actively chosen to exclude tobacco from their investment universe reason regarding their holdings in Nolato. The asset managers we contact are all forthcoming with information and acknowledge the complexity of the issue.

    “Initially, we reasoned that the VHP business was not entirely unproblematic from an ESG perspective, but the argument that the product can be seen as a less harmful substitute for smoking cessation weighed heavily,” explains Kristian Åkesson, portfolio manager at Didner & Gerge. “However, after following the developments for a couple of years, we have come to the conclusion that we think Nolato should discontinue its VHP business. Possible positive relative health effects do not appear to be fully investigated, and we believe that marketing from various players in the segment (not specifically Nolato’s customer) does not indicate that it is presented as a primarily smoking cessation aid. We have communicated our position to the company,” he adds.

    Erik Durhan, Head of Corporate Governance and Sustainability at Öhman, points out Nolato’s evolving product mix. “We see Nolato primarily as a company that produces medical equipment, and VHP devices are relatively agnostic about what goes into them. Hence, we have concluded in our discussions that the company as a whole is ok to own,” he says. “At the same time, we now see how the share of earnings from these specific products as part of the company’s product mix has decreased significantly and will almost certainly continue to do so. But, of course, this is not an easy question, and it has required internal discussions,” he admits.

    The magical 5%

    At Lannebo, the exclusion policy per se does not ban tobacco-related products and services like Nolato’s. Yet, they emphasise that there have been many long discussions about where to draw the line, both internally and with the company, urging Nolato to reduce exposure to the sector. “The exposure is now less than 5%, and we see this as very positive,” says Maria Nordqvist, a senior sustainability expert at Lannebo.

    This brings us to the intriguing 5% threshold, a leeway that most tobacco-excluding asset managers allow for. There are several reasons for that. Many investors have learned the hard way that a total ban on companies with revenues from tobacco distribution, for instance, would mean excluding most retailers from their portfolios. It would also entail looking into paper and plastic producers. With a 5% limit, however, there is some wiggle room up- and down the industry’s extensive value chain.

    The specific limit certainly makes life easier for quantitative analysts and for managers relying on data from third-party providers. This seems to be the case for Handelsbanken, where the investment in Nolato is made through their index fund range. “Our index-managed funds follow indices based on sustainability data from an external independent provider, according to extended investment criteria,” explains Aurora Samuelsson, Head of Sustainability. “Nolato has revenues from what is defined as tobacco-related services (i.e., not production or distribution of tobacco) within our permitted limits, and therefore the company is included in our index funds.” And yes, Handelsbanken, too, deems a maximum of 5% revenue from tobacco acceptable.

    A successful engagement case?

    Petter Löfqvist, portfolio manager at Humle Fonder (part of Atle), another tobacco-excluding fund that has been red-flagging Nolato in their ESG research framework, points out the importance of identifying both ESG risks and potentials. “We don’t shy away from controversial investments provided that we can see a financial potential from companies changing their ESG footprint in a positive way and that we see that we have the potential to actually affect that,” he says. “In the case of Nolato, we have identified a positive financial potential from Nolato reducing their VHP exposure and preferably totally exiting their VHP-related businesses. Since the release of the restructuring, Nolato’s shares are up 14%,” he adds.

    “We have engaged with both CFO and CEO and shared our view that we advocate an exit from the VHP business since we see it beneficial for us as shareholders, both from a risk minimisation perspective and value creation perspective,” explains Löfqvist who believes that critical questions from owners were partially behind Nolato’s recent decision to reduce the VHP-derived sales to below 5%.

    As several of the investors we have talked to mention discussing the issue with Nolato’s management, the hypothesis of the efficacy of engagement does sound plausible. The method has suffered its fair share of criticism lately, so a successful case like this would be more than welcome.

    However, according to Per-Ola Holmström, Nolato’s Executive Vice President & CFO, the decision to reduce VHP’s share of the sales is purely demand-driven. “Our customer […] evaluated and changed their sourcing strategy in the VHP area last year,” he explains. “Since the second half of 2022, this has led to Nolato sharing the manufacture of new products with another supplier after previously being a so-called ‘single source supplier’. As the total volumes in the end-customer stage have decreased significantly since Russia’s invasion of Ukraine, the current decision has gradually emerged.”

    The VHP business line has been a headache for Nolato for a while. Last year, China, where the Swedish company’s factory is located, introduced new regulatory requirements for manufacturing VHP products in the country. By the end of 2022, Nolato had obtained the Chinese license required to resume production, but by then, the customer had gotten wiser and decided to diversify their supplier base to avoid future disruptions. Meanwhile, end-customer demand is not what it used to be.

    So much for the power of active ownership; it turns out that the main reason for a reduced exposure to tobacco is as old as capitalism itself, a simple case of diminishing business opportunity.

    It’s complicated indeed

    Responsible investing is full of dilemmas and complex gey zones, and it is, of course, naïve to expect tobacco to be the exception. Clearly, there are choices to be made at every junction. Although legal, is it morally justifiable to keep investing in an industry so obviously detrimental to humanity?

    For those whose conscience allows it, being as accommodating as the law, or in the spirit of free choice and just transition, the question remains whether a company catering to this addiction can ever be considered sustainable.

    For investors who decide against investing in tobacco, on the other hand, it is not obvious where to draw the line. How far along the value chain should they stop looking? And is it prudent to rely on an imperfect classification system which feeds into algorithms assigning reassuring ESG scores, or should they make their own analysis on what is or isn’t perpetuating the business of tobacco?

    When is it worth engaging with a company to nudge it in the right direction, and how patient should you be? Ultimately, how do you measure the success of engagement?

    So many difficult decisions that all require just the right amount of financial pragmatism combined with an unwavering moral compass.

    1. Note that despite the non-committal recommendation of the Council, individual AP funds have put tobacco on their exclusion lists, though.

    Image courtesy of Ralf Kunze from Pixabay
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