Environmental, social and corporate governance
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Historical decisions of where financial assets would be placed were based on various criteria, financial return being predominant. However, there have always been plenty of other criteria for deciding where to place your money – from Political considerations to Heavenly Reward. It was in the 1950s and 60s that the vast pension funds managed by the Trades Unions recognised the opportunity to affect the wider social environment using their capital assets - in the United States the International Brotherhood of Electrical Workers invested their not inconsiderable capital in developing affordable housing projects, whilst the United Mine Workers invested in health facilities.
In the 1970s, the worldwide abhorrence of the apartheid regime in South Africa led to one of the most renowned examples of selective disinvestment along ethical lines. As a response to a growing call for sanctions against the regime, the Reverend Leon Sullivan, a board member of General Motors in the United States drew up a Code of Conduct in 1971 for practising business with South Africa. What became known as the Sullivan Principles attracted a great deal of attention and several reports were commissioned by the government, to examine how many US companies were investing in South African companies that were contravening the Sullivan Code. The conclusions of the reports led to a mass disinvestment by the US from many South African companies. The resulting pressure applied to the South African regime by its business community added great weight to the growing impetus for the system of apartheid to be abandoned.
In the 1960s and 1970s, Milton Friedman, in direct response to the prevailing mood of philanthropy argued that social responsibility adversely affects a firm’s financial performance and that regulation and interference from "big government" will always damage the macro economy. His contention that the valuation of a company or asset should be predicated almost exclusively on the pure bottom line (with the costs incurred by social responsibility being deemed non-essential), underwrote the belief prevalent for most of the 20th century. Towards the end of the century however a contrary theory began to gain ground. In 1988 James S. Coleman wrote an article in the American Journal of Sociology entitled Social Capital in the Creation of Human Capital, the article challenged the dominance of the concept of ‘self-interest’ in economics and introduced the concept of social capital into the measurement of value.
There was a new form of pressure applied, acting in a coalition with environmental groups, it used the leveraging power of its collective investors to encourage companies and capital markets to incorporate environmental and social challenges into their day-to-day decision-making. The Ceres coalition today represents one of the world’s strongest investment groups with over 60 institutional investors from the U.S. and Europe managing over $4 trillion in assets.
Although the concept of selective investment was not a new one with the demand side of the investment market having a long history of those wishing to control the effects of their investments, what began to develop at the turn of the 21st century was a response from the supply-side of the equation. The investment market began to pick up on the growing need for products geared towards what was becoming known as the Responsible Investor. In 1998 John Elkington, co-founder of the business consultancy SustainAbility, published Cannibals with Forks: the Triple Bottom Line of 21st Century Business in which he identified the newly emerging cluster of non financial considerations which should be included in the factors determining a company or equity’s value. He coined the phrase the "triple bottom line", referring to the financial, environmental and social factors included in the new calculation. At the same time the strict division between the environmental sector and the financial sector began to break down. In the City of London in 2002, Chris Yates-Smith a member of the international panel chosen to oversee the technical construction, accreditation and distribution of the Organic Production Standard and founder of one if the City of London’s leading Branding Consultancies, established one of the first environmental finance research groups. The informal group of financial leaders, city lawyers and environmental stewardship NGOs became known as The Virtuous Circle, its brief was to examine the nature of the correlation between environmental and social standards and financial performance. Several of the world’s big banks and investment houses began to respond to the growing interest in the ESG investment market with the provision of sell-side services, among the first were the Brazilian bank Unibanco, and Mike Tyrell’s Jupiter Fund in London which used ESG based research to provide both HSBC and Citicorp with selective investment services in 2001.
In the early years of the new millennium, the major part of the investment market still accepted the historical assumption that ethically directed investments were by their nature likely to reduce financial return. Philanthropy was not known to be a highly profitable business and Friedman had provided a widely accepted academic basis for the argument that the costs of behaving in an ethically responsible manner would outweigh the benefits. However the assumptions were beginning to be fundamentally challenged. In 1998 two journalists Robert Levering and Milton Moskowitz had brought out the Fortune 100 Best Companies to Work For, initially a listing in the magazine Fortune, then a book compiling a list of the best practicing companies in the United States with regard to corporate social responsibility and how their financial performance fared as a result. Of the three areas of concern that ESG represented, the environmental and social had received most of the public and media attention, not least because of the growing fears concerning climate change. Moskowitz brought the spotlight onto the corporate governance aspect of responsible investment. His analysis concerned how the companies were managed, what the stockholder relationships were and how the employees were treated. He argued that improving corporate governance procedures did not damage financial performance, on the contrary it maximised productivity, ensured corporate efficiency and led to the sourcing and utilising of superior management talents. In the early 2000s, the success of Moskowitz’s list and its impact on company’s ease of recruitment and brand reputation began to challenge the historical assumptions regarding the financial effect of ESG factors. In 2011, Alex Edmans, a finance professor at Wharton, published a paper in the Journal of Financial Economics showing that the 100 Best Companies to Work For outperformed their peers in terms of stock returns by 2-3% a year over 1984-2009, and delivered earnings that systematically exceeded analyst expectations.
In 2005, however, a quantum leap was taken in the integration of ESG considerations into the mainstream investment market. The United Nations Environment Programme Finance Initiative commissioned a report from the international law firm Freshfields Bruckhaus Deringer on the interpretation of the law with respect to investors and ESG issues. The conclusions of the report were startling. Freshfields concluded that not only was it permissible for investment companies to integrate ESG issues into investment analysis but it was arguably part of their fiduciary duty to do so. In 2014, the Law Commission (England and Wales) confirmed that there was no bar on pension trustees and others from taking account of ESG factors when making investment decisions.
Where Friedman had provided the academic support for the argument that the integration of ESG type factors into financial practice would reduce financial performance, numerous reports began to appear in the early years of the century which provided research that supported arguments to the contrary. In 2006 Oxford University’s Michael Barnett and New York University’s Robert Salomon published a highly influential study which concluded that the two sides of the argument might even be complementary – they propounded a curvilinear relationship between social responsibility and financial performance, both selective investment practices and non-selective could maximise financial performance of an investment portfolio, the only route likely to damage performance was a middle way of selective investment. Besides the large investment companies and banks taking an interest in matters ESG, an array of investment companies specifically dealing with responsible investment and ESG based portfolios began to spring up throughout the financial world.
The development of ESG factors as considerations in investment analysis is now widely assumed by the investment industry to be all but inevitable. The evidence supporting a nexus between performance on ESG issues and financial performance is becoming greater and the combination of fiduciary duty and a wide recognition of the necessity of the sustainability of investments in the long term has meant that environmental social and corporate governance concerns are now becoming increasingly important in the investment market. ESG has become less a question of philanthropy than practicality.
There has been wide uncertainty and debate as to what to call the inclusion of intangible factors relating to the sustainability and ethical impact of investments. Names have ranged from the early use of buzz words such as "green" and "eco", to the wide array of possible descriptions for the types of investment analysis - "responsible investment", "socially responsible investment" (SRI), "ethical", "extra-financial", "long horizon investment" (LHI), "enhanced business", "corporate health", "non-traditional", and others. But the predominance of the term ESG has now become fairly widely accepted. A survey of 350 global investment professionals conducted by AXA Investment Managers and AQ Research in 2008, led by Dr Raj Thamotheram, director of responsible investment at AXA, concluded that although both ESG and "sustainable" were the most commonly used names for the new data integrated into mainstream investment analysis, the vast majority of professionals preferred the term ESG to describe such data.
Threat of climate change and the depletion of resources has grown, so investors have to factor sustainability issues into their investment choices. The issues often represent externalities, such as influences on the functioning and revenues of the company that are not exclusively affected by market mechanisms. As with all areas of ESG the breadth of possible concerns is vast, but some of the chief areas are listed below:
The body of research providing evidence of global trends in climate change has led investors – pension funds, holders of insurance reserves – to begin to screen investments in terms of their impact on the perceived factors of climate change. Fossil fuel reliant industries are less attractive. In the UK, investment policies were particularly affected by the conclusions of the Stern Review in 2006, a report commissioned by the British government to provide an economic analysis of the issues associated with climate change. Its conclusions pointed towards the necessity of including considerations of climate change and environmental issues in all financial calculations and that the benefits of early action on climate change would outweigh its costs.
Responsible Investing often chose to deselect firms associated with the construction of nuclear power plants. The dual concerns of the speed of depletion of fossil fuels and CO2 emissions have led to a re-examination of the relative evils of nuclear power.
In every area of the debate from the depletion of resources to the future of industries dependent upon diminishing raw materials the question of the obsolescence of a company’s product or service is becoming central to the value ascribed to that company. The Long Term view is becoming prevalent amongst investors.
The level of inclusion in a company’s recruitment policies is becoming a key concern to investors. There is a growing perception that the broader the pool of talent open to an employer the greater the chance of finding the optimum person for the job. Innovation and agility are seen as the great benefits of diversity and there is an increasing awareness of what has come to be known as ‘the power of difference’.
In 2006 the US Courts of Appeals ruled that there was a case to answer bringing the area of a company’s social responsibilities squarely into the financial arena. This area of concern is widening to include such considerations as the impact on local communities, the health and welfare of employees and a more thorough examination of a company’s supply chain.
Until fairly recently, caveat emptor ("buyer beware") was the governing principle of commerce and trading. In recent times however there has been an increased assumption that the consumer has a right to a degree of protection and the vast growth in damages litigation has meant that consumer protection is a central consideration for those seeking to limit a company’s risk and those examining a company’s credentials with an eye to investing. The collapse of the US Sub-Prime Mortgage market initiated a growing movement against predatory lending has also become an important area of concern.
From the testing of products on animals to the welfare of animals bred for the food market, concern about the welfare of animals is a large consideration for those investors seeking a thorough understanding of the company or industry being analyzed.
Corporate governance concerns
Corporate governance covers the area of investigation into the rights and responsibilities of the management of a company – its board, shareholders and the various stakeholders in that company.
The system of internal procedures and controls that makes up the management structure of a company is in the valuation of that company’s equity. Attention has been focused in recent years on the balance of power between the CEO and the Board of Directors and specifically the differences between the European model and the US model – in the States studies have found that 80% of companies have a CEO who is also the Chairman of the Board, in the UK and the European model it was found that 90% of the largest companies split the roles of CEO and Chairman.
From diversity to the establishment of corporate behaviours and values, the role that improving employee relations plays in assessing the value of a company is proving increasingly central. In the United States Moskowitz’s list of the Fortune 100 Best Companies to Work For has become not only an important tool for employees but companies are beginning to compete keenly for a place on the list, as not only does it help to recruit the best workforce, it appears to have a noticeable impact on company values.
Companies are now being asked to list the percentage levels of bonus payments and the levels of remuneration of the highest paid executives are coming under close scrutiny from stock holders and equity investors alike.
The three concepts of social, environmental and corporate governance are intimately linked to the concept of Responsible Investment. RI began as a niche investment area, serving the needs of those who wished to invest but wanted to do so within ethically defined parameters. In recent years it has become a much larger proportion of the investment market.
RI seeks to control the placing of its investments via several methods:
- Positive selection; where the investor actively selects the companies in which to invest; this can be done either by following a defined set of ESG criteria or by the best-in-class method where a subset of high performing ESG compliant companies is chosen for inclusion in an investment portfolio.
- Activism; strategic voting by shareholders in support of a particular issue, or to bring about change in the governance of the company.
- Engagement; investment funds monitoring the ESG performance of all portfolio companies and leading constructive shareholder engagement dialogues with each company to ensure progress.
- Consulting role; the larger institutional investors and shareholders tend to be able to engage in what is known as ‘quiet diplomacy’, with regular meetings with top management in order to exchange information and act as early warning systems for risk and strategic or governance issues.
- Exclusion; the removal of certain sectors or companies from consideration for investment, based on ESG specific criteria.
- Integration; the inclusion of ESG risks and opportunities into traditional financial analysis of equity value.
One of the defining marks of the modern investment market is the divergence in the relationship between the firm and its equity investors. Institutional investors have become the key owners of stock - rising from 35% in 1981 to 58% in 2002 in the US and from 42% in 1963 to 84.7% in 2004 in the UK and institutions tend to work on a long term investment strategy. Insurance companies, Mutual Funds and Pension Funds with long-term payout obligations are much more interested in the long term sustainability of their investments than the individual investor looking for short-term gain. Where a Pension Fund is subject to ERISA, there are legal limitations on the extent to which investment decisions can be based on factors other than maximizing plan participants' economic returns.
Principles for Responsible Investment
The Principles for Responsible Investment Initiative (PRI) was established in 2005 by the United Nations Environment Programme Finance Initiative and the UN Global Compact as a framework for improving the analysis of ESG issues in the investment process and to aid companies in the exercise of responsible ownership practices. As of 2015 there were a total of 1354 PRI signatories, consisting of 288 asset owners, 882 investment managers and 184 professional service partners.
The Equator Principles is a risk management framework, adopted by financial institutions, for determining, assessing and managing environmental and social risk in project finance. It is primarily intended to provide a minimum standard for due diligence to support responsible risk decision-making. As at 4 June 2013, 79 adopting financial institutions in 35 countries have officially adopted the Equator Principles, covering over 70 percent of international Project Finance debt in emerging markets. Equator Principles Financial Institutions (EPFIs) commit to not provide loans to projects where the borrower will not or is unable to comply with their respective social and environmental policies and procedures.
The Equator Principles, formally launched in Washington DC on 4 June 2003, were based on existing environmental and social policy frameworks established by the International Finance Corporation. These standards have subsequently been periodically updated into what is commonly known as the International Finance Corporation Performance Standards on social and environmental sustainability and on the World Bank Group Environmental, Health, and Safety Guidelines.
Disclosure and regulation
The first ten years of the new century has seen a vast growth in the ESG defined investment market. Not only do most of the world’s big banks now have departments and divisions exclusively addressing Responsible Investment but boutique firms specialising in advising and consulting on environmental, social and governance related investments are proliferating. One of the major aspects of the ESG side of the insurance market which leads to this tendency to proliferation is the essentially subjective nature of the information on which investment selection can be made. By definition ESG data is qualitative; it is non-financial and not readily quantifiable in monetary terms. The investment market has long dealt with these intangibles – such variables as Goodwill have been widely accepted as contributing to a company’s value. But the ESG intangibles are not only highly subjective they are also particularly difficult to quantify and more importantly verify.
One of the major issues in the ESG area is disclosure. The information on which an investor makes his decisions on a financial level is fairly simply gathered. The company’s accounts can be examined, and although the accounting practices of corporate business are coming increasingly into disrepute after a spate of recent financial scandals, the figures are for the most part externally verifiable. With ESG considerations, the practice has been for the company under examination to provide its own figures and disclosures. These have seldom been externally verified and the lack of universal standards and regulation in the areas of environmental and social practice mean that the measurement of such statistics is subjective to say the least. As integrating ESG considerations into investment analysis and the calculation of a company’s value become more prevalent it will become more crucial to provide units of measurement for investment decisions on subjective issues such as degrees of harm to workers, or how far down the supply chain of the production chain of a cluster bomb do you go.
One of the solutions put forward to the inherent subjectivity of ESG data is the provision of universally accepted standards for the measurement of ESG factors. Such organisations as the ISO (International Organisation for Standardisation) provide highly researched and widely accepted standards for many of the areas covered. Some investment consultancies, such as Probus-Sigma have created methodologies for calculating the ratings for an ESG based Ratings Index that is both based on ISO standards and externally verified, but the formalisation of the acceptance of such standards as the basis for calculating and verifying ESG disclosures is by no means universal.
The corporate governance side of the matter has received rather more in the way of regulation and standardisation as there is a longer history of regulation in this area. In 1992 the London Stock Exchange and the Financial Reporting Commission set up the Cadbury Commission to investigate the series of governance failures that had plagued the City of London such as the bankruptcies of BCCI, Polly Peck, and Robert Maxwell's Mirror Group. The conclusions that the commission reached were compiled in 2003 into the Combined Code on Corporate Governance which has been widely accepted (if patchily applied) by the financial world as a benchmark for good governance practices.
One of the key areas of concern in the discussion as to the reliability of ESG disclosures is the establishment of credible ratings for companies as to ESG performance. The world’s financial markets have all leapt to provide ESG relevant ratings indexes, the Dow Jones Sustainability Index, the FTSE4Good Index (which is co-owned by the London Stock Exchange and Financial Times), Bloomberg ESG data and the MSCI ESG Indices.
There is some movement in the insurance market to find a reliable index of ratings for ESG issues, with some suggesting that the future lies in the construction of algorithms for calculating ESG ratings based on ISO standards and third party verification.
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