Investors’ ethical values have always informed their investment choices. From medieval lords endowing almshouses to the 19th century industrialist Robert Owen, who built a model community around his Scottish cotton mills, the line between good business sense and philanthropy has often been blurred.
But as the ownership of companies fragmented in the 20th century, and was placed in the hands of a professional money management industry, the scope for individuals to exercise their own ethical judgements — and to influence the behaviour of the companies they own — was drastically reduced.
Reinforcing that trend has been the advance of academic economics. Almost all financial professionals have been schooled to understand markets as a strictly rational set of interactions between parties motivated only by financial gain.
This model looks a lot neater if the role of the investor is simplified to making profits, while governments set the rules to achieve socially progressive outcomes.
Responsible investing, in all its varied forms, is a challenge to that paradigm. The large and growing responsible investing industry is bent on making it respectable again for investors to consider the wider good of society.
“It’s the idea that environmental, social and governance issues can be material to a company’s performance, and that investors have a responsibility for the behaviour of the companies they invest in,” says James Gifford, executive director of PRI Initiative, the organisation that runs the UN Principles for Responsible Investment. “When there are problems at the companies you invest in, you need to try to fix them. That is the essence of the term responsibility — to be an active owner.”
Few believe that investors can replace the government as primary bearer of the burden of improving society. The great social advances — ending slavery and child labour, banning racial and sex discrimination, health and safety in the workplace, mass education, healthcare and housing — have come through legislation, often in the teeth of opposition from private capital.
In recent decades, nations and international bodies have imposed standards protecting against discrimination on sexual orientation and age, obliging companies to monitor working practices at overseas suppliers, clamping down on bribery and curtailing tobacco and alcohol advertising.
But in nearly all these areas, governments have acted partly because of public campaigns. “Think about some of the pressure Nike came under 10 years ago over its inability to account for labour issues in its supply chain, or longer ago when Greenpeace were campaigning outside B&Q about sourcing wood from tropical rainforests,” says Justin Keeble, who leads Accenture’s sustainability services practice in Europe, Africa and Latin America. “These were triggers [for change] — the consumer was saying this was not acceptable.”
On issues like these, fear of bad publicity is a big motivator for companies, which know they are expected to do better than the minimum legal standards.
So far, shareholders and bondholders have not often been seen waving placards outside the doors of offending companies, or abseiling down buildings carrying banners. On the contrary, they have usually sat tight and kept collecting their dividends and coupons, while NGOs and sometimes the media did the clamouring.
That is beginning to change. “We are trying to mobilise the investment industry to be part of the solution, rather than a drag,” says Gifford.
Clock is ticking
One issue in particular demands the engagement of investors — climate change. The global threat to human health, wellbeing and life is far more severe than any yet encountered, assuming nuclear war is avoided.
While incremental improvements may arguably do in the fields of governance and labour relations, on the climate, something more like a revolution will be needed.
Corporate fear of getting involved in a scandal and being splashed on the front pages will not work. The carbon-fuelled economy is a systemic issue, in which every company is implicated. BP is not suddenly going to be seen as worse than Shell because it produces more oil.
Yet even though almost every corporate business model is based on using energy in a way that climate scientists agree is radically unsustainable, many parts of the corporate sector have shown themselves willing to move much faster towards a lower carbon economy than most governments.
Of course, plenty of businesses still lobby behind the scenes to stop carbon rationing or taxes. But in public, many have lined up to endorse the need for environmental sustainability, and even called on governments to do more.
Jeff Immelt, CEO of General Electric, for example, has long argued that the US needs a mandatory carbon pricing system.
The World Business Council on Sustainable Development is a group of some 200 CEOs, dedicated to finding a way for 9bn people to live well, within the planet’s resources, by 2050. Halving carbon emissions, they say, is a must-have.
Nearly 7,000 companies have joined the UN Global Compact, which commits them to 10 principles on human rights, labour, the environment and corruption.
Feeling the heat
Businesses themselves may be better than governments or investors at grasping the risks posed by climate change because they are closer to the action.
“I can’t imagine how sustainability could not be part of how we do business,” says Claude Nahon, who for the past 10 years has been in charge of sustainable development at Electricité de France.
Her previous job at the French state-controlled power group had been head of its hydropower division — Nahon’s seniority showed how seriously EDF took the issue.
A company with many dams and nuclear power stations needs to have risk management in its bones, and part of Nahon’s job has been to develop a climate change adaptation plan. This is no remote concern. In both 2003 and 2012, exceptionally hot summers meant EDF had to use warmer water to cool its nuclear reactors, potentially reducing production — a risk that EDF had foreseen and invested to ward off.
Keeble at Accenture is convinced companies themselves — at least the better ones — are leading the way on sustainability. “Government policy overall has been relatively weak, it’s not a major driver,” he says. “There is regulation and public pressure, and to some extent investor pressure, but it’s still quite niche. The strongest driver is about this being a business opportunity.”
Step forward, investors
Nevertheless, it is clear that companies on their own have not put the world economy on to a sustainable path yet. Governments, too, are lagging behind what nearly all informed parties regard as necessary.
Therefore, if investors have accepted the idea that they are responsible for the actions of the organisations they invest in, there is an onus on them to act on climate change. Even if they deny this responsibility, self-interest should dictate that they begin to recognise global warming as a source of risk.
“There is a growing sense that eventually the stocks of oil companies are going to have to start pricing in the fact that they can’t burn all their oil reserves,” says Joe Keefe, CEO of Pax World Management, an investment manager based in New Hampshire that integrates environmental, social and governance (ESG) factors into its decision making.
Listed energy companies’ fossil fuel reserves, if burnt, would release 760bn tonnes of CO2, according to research by Carbon Tracker and the London School of Economics — at least three times more than the planet is estimated to be able to tolerate, if global warming of more than 2°C is to be avoided.
“If you had a [regulatory] price on carbon you’d be seeing the beginnings of the transition right now,” Keefe adds.
With carbon control legislation weak or non-existent, however, climate risks remain an externality — a cost of economic activity that is not borne by its creator.
The policy vacuum demands that investors and companies start to try to price in the externality themselves.
Barclays and MSCI, announcing in June a new family of ESG indices for bond investors, quoted a survey of institutional investors by Oxford University and Towers Watson. Every one of the investors believed ESG factors would impact investment risks and returns in the long term, and 59% in the short term. But 91% of them believed the market was not yet accurately pricing in these externalities.
A contrarian’s dream
From one perspective, that is a serious failure of the market. But the flip side is a massive opportunity. Whenever the market fails to price in an aspect of reality, investors who do spot it can outperform.
“If there is more demand for the stock of company A than company B because company A has a reputation as a strong ESG performer, over time that should be reflected in its share price,” says Keefe. “That should incentivise the company to continue improving its ESG performance, while the laggards get punished. A virtuous circle takes place.”
The notion that performing well on ESG issues is not just good in itself, but actually helps a company’s financial performance is not universally accepted, but is on its way to becoming a new business school orthodoxy. Certainly, all involved in the responsible investing industry repeat this argument.
David Russell, co-head of responsible investment at the Universities Superannuation Scheme, one of the UK’s largest pension funds and a founder signatory of the UN Principles for Responsible Investment (PRI), says the scheme’s fund management arm “believes that ESG issues can and do impact the value of the assets in which the fund invests. As a result, it is sensible for the fund to take steps to reduce any risks, and gain any opportunities, that these issues present. Olympus and governance, BP and safety management, Vedanta Resources and stakeholder management: such companies provide real examples where poor management of ESG issues has directly and significantly impacted shareholder value.”
Calls for deeper change
Whether at companies or investment firms, the practice of engaging with ESG issues is largely about having the will to get started, getting organised and then seeing it as a value driver.
But there is more to it as well. Responsible investors, says Gifford, need to work towards “creating a sustainable financial system”.
The world’s uncontrolled lurch towards climate change can be seen as a symptom of a collective action problem inherent in financial markets.
“Shareholding is very diffuse, so it costs too much for every investor to monitor companies they invest in and bother having an intense dialogue with them,” Gifford says. “This means the whole economic theory behind how capital markets are supposed to work doesn’t function. Even the notion that companies are accountable to shareholders is unrealistic.”
With investors divided among themselves rather than acting together, centralised, managerial capitalism allows CEOs — who know more about the business than their diverse investors — to run companies for their own advantage and surround themselves with compliant directors.
The PRI runs a clearing house to help investors communicate with each other when persuading companies to improve their ESG performance. Investors can use the system to form coalitions, pooling expertise and strengthening their voice.
The organisation has just launched a new work programme on overcoming barriers to a sustainable financial system, but Gifford ruefully acknowledges that even among the $34tr of assets managed by PRI signatories, a lot of the investment managers are still focused on companies’ quarterly earnings, rather than any longer term performance metrics.
As Keefe says, companies are supposed to take signals from investors on what to do — but Gifford admits: “There is no doubt the majority of signals still coming from the investment community are not responsible investing signals.”
Still early days
Perhaps because of that, companies have also made only patchy progress. Accenture has built an iPad app for internal use that examines the sustainability performance of 50 companies since 2002.
“We can take a basket of companies through successive metrics, examine their trajectory over 11 years and compare their performance with peers,” says Keeble. “We can index the data, normalise it versus revenue or headcount or metre squared of real estate.”
No one, he believes, has previously looked back in such a structured way to see how companies have delivered on their sustainability targets. “You can look at certain industries and see significant improvements,” Keeble says, “but the overall improvement has been modest, and some companies have got worse.”
| The Principles for Responsible Investment | ||
| 1. We will incorporate ESG issues into investment analysis and decision-making processes 2. We will be active owners and incorporate ESG issues into our ownership policies and practices 3. We will seek appropriate disclosure on ESG issues by the entities in which we invest 4. We will promote acceptance and implementation of the Principles within the investment industry 5. We will work together to enhance our effectiveness in implementing the Principles 6. We will each report on our activities and progress towards implementing the Principles |
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His conclusion is that “we are not seeing the step change in performance that people aspire to deliver. Sustainability is still at an incremental stage. People aspire to it being transformational for companies, but we’re not seeing that transformation yet.”
If capital markets — in partnership with companies — can organise themselves to analyse and exert pressure on companies’ ESG performance, putting a value on what are now unpriced externalities, that transformation could accelerate.
“I think what could help sustainable development,” says Antoine Sorange, head of extrafinancial analysis at Amundi in Paris, “is that fund managers and asset owners that are less convinced about ESG criteria start to take it into consideration. If managers who are less convinced by the added value of ESG integration start to take it into account, we could have a strong impact on the future of the planet. Everyone has to start integrating ESG criteria.”
All agree that there is a long way to go. The foundations have been laid, but the house is not yet built.
And as Gifford warns: “Responsible investing is not a silver bullet. It’s part of a whole societal move. Take a company that might have issues in Sudan — it’s mechanistic to ask whether responsible investing makes a difference to its behaviour. But if you have NGOs campaigning, politicians asking questions and 20 pension funds also send a signal, then we’re being supportive.”
