ESG Investing

Supporting Democracy with ESG Investing


Democracy around the world took a turn for the worse in 2020, as the coronavirus pandemic prompted governments to impose restrictions on individual freedoms and civil liberties to keep the virus in check. It also gave authoritarian regimes a trump card they could use to take advantage of the situation.

The Economist Intelligence Unit’s Democracy Index provides a snapshot of this worldwide decline. During 2020, the index slid to 5.37 from 5.44 in the previous year, marking the lowest global democracy score since the index was first compiled in 2006. There were particularly large declines in regions where authoritarian regimes already dominated, namely Sub-Saharan Africa, the Middle East, and North Africa. While the Economist Intelligence Unit notes that this deterioration was largely due to restrictions related to COVID-19, this was not the only factor.

This threat to democracy also comes with several threats to the advancement of ESG, particularly in terms of transparency. Not only that, but ESG goals cannot be as effectively reached if democracy is not strong. Leading impact investing thought leaders have argued that impact investors simply cannot ignore core concepts like democracy and individual freedom if they are to have a positive impact on the world.

Adding “Freedom” to Your Portfolio

Taking an investment approach that excludes or favors countries based on their democratic credentials could ultimately have important implications for both nations and investment portfolios, and funds have already emerged to allow investors to do just that. The “freedom-weighted” emerging market equity strategy Life + Liberty Freedom 100 Emerging Markets Index uses personal and economic freedom metrics as primary factors in the stock selection process.

The result is that various emerging-market countries with questionable human rights records are excluded from the fund. For example, despite accounting for almost 32% of the MSCI Emerging Markets Index, China is entirely excluded from the Alpha Architect Freedom 100 Emerging Markets ETF, which tracks the total return performance of the Index. Russia and Saudi Arabia find themselves similarly excluded.

Earlier this year, Democracy Investments launched an index-based strategy using the Economist Intelligence Unit’s Democracy Index as its benchmark. It aims to allocate capital based on democracy scores to lessen the cost of capital for democracies and increase it for authoritarian states. It hopes to maintain a market-based incentive for democratic reforms by making investment proportional to democracy scores but never dropping investment in a nation to zero.

Taking an investment approach that excludes or favors countries based on their democratic credentials could ultimately have important implications for both nations and investment portfolios.

Investing in Civic Tech

Another way for impact investors to support democracy is to invest in civic tech, generally defined as technologies used to enhance the relationship between people and their government. This typically takes the form of technologies that give people more of a voice in public decision-making or improve the delivery of government services to people.

In the US, civic tech company Crowdpac was established in 2014 with the objective of helping unknown Democratic political outsiders raise money and run for office, as well as tracking political data from across the US.

UK-based firm Delib has developed digital platforms to improve democratic processes, claiming that more than 500 government organizations and public bodies around the world have used it to transform their citizen involvement.

Through an open-source platform, Alaveteli, another UK-based civic tech startup, claims to have helped citizens make more than 800,0000 freedom of information requests in 25-plus jurisdictions around the world, though for the time being it is dependent on charitable donations.

Unfortunately, many of the best civic tech startups tend to be found in leading democracies. Such firms find it harder to make headway in more restrictive countries like China and Russia, where their services would be of the most use. This raises one of the central conflicts of using democracy metrics to guide impact investing decisions. If impact investors write off authoritarian countries altogether, will they lose opportunities to support start-ups that could make life in those countries better or support democratic institutions?

This debate will likely intensify over the coming years as the world battles against the very real repercussions of climate change. If sustainable investors were to declare a de facto blanket ban on investing in countries such as China and Russia, sustainable companies in these regions may not get enough funding, making climate change goals less achievable.

It’s clear that promoting democracy can enhance progress on ESG issues. However, impact investors may need to apply a more nuanced positive screen to their investments to truly promote global democracy.

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