Can enhanced analysis deliver social and environmental benefits?

Insight’s Rory Sullivan studies the SRI quest for the ‘Holy Grail’.

For many in the SRI community, achieving the full recognition and integration of environmental and social issues in investment analysis has been seen as ‘The Holy Grail’. The hope is that ‘enhanced analysis’ would deliver not only better investment returns but also contribute to more positive social and environmental outcomes. The rationale is that companies will be less likely to behave in ways that are socially or environmentally harmful if their performance on social and environmental issues is properly reflected in their share prices. Are social and environmental issues already integrated?
This assertion presupposes that these issues are not presently being taken into account in investment research and decision-making. However, some social and environmental issues are already well understood and accurately analysed by the capital markets. For example, the risks of tobacco litigation – at heart, an issue of corporate ethics, transparency, and public health – and the implications of the EU Emissions Trading Scheme for the electricity utility sector have already been extensively researched. Notwithstanding these examples, it isprobably fair to say that many social and environmental issues have yet to receive the same level of investor attention. The reasons are complex: many environmental and social issues play out over the long-term; it can be difficult to assess their impacts on a company’s finances or balance sheets; the point at which they become relevant or material to a company’s fortunes can be hard to pin point. In some cases, regulation or consumer concern that would trigger companies to respond has been lacking. Are social and environmental issues material to financial performance?
While there is no universally agreed definition, financial analysts frequently use numerical thresholds – five percent of a company’s revenue or five per cent moves in a company’s share price are common rules of thumb – to assess the financial materiality of a particular issue. In this frame of reference, the vast majority of social or environmental issues – notwithstanding examples such as tobacco litigation and climate change – are simply not material. As a result, traditional financial analysts have tended to overlook these issues, focusing instead
on other potential drivers of investment value. Furthermore, if analysts conclude that the financial implications of, for example, supply chain labour standards or contaminated land clean up are relatively insignificant for a particular company in the near term, most mainstream investors will not pressure the company to take action on these issues. Companies therefore usually conclude that investors are not concerned about how they manage these (financially) non-material issues.
The issue of financial materiality is compounded by the fact that many social and environmental problems are actually the result of market failures, i.e. where the negative social or environmental impacts associated with an economic activity are not borne by the company who causes them, but by wider society. Where the prospect of government or other social action to internalise externalities (or otherwise correct market failure) is remote, investment analysts will have no financial reason to take account of these issues, and companies will have no incentive to address them. In such situations, the incentives for companies to take action will need to come from elsewhere – for example, new regulations, consumer demand, media or NGO attention.
Despite these limitations, enhanced analysis does offer the potential to encourage improvements in corporate performance on some material social and environmental issues. To maximise the benefits of this activity, it is essential that investors actively engage with companies to set out their expectations of how social and environmental issues should be managed and to explain exactly how these issues are taken into account in their investment analysis.Unless investors provide this feedback, companies will not understand the reasons informing the buy/sell or overweight/underweight decision, or whether or not these decisions were informed by environmental or social issues. Greater transparency of this nature would also help overcome one of the criticisms made by companies of investor engagement, namely that there is an apparent disconnect between the questions being asked by SRI analysts and the decisions being made by analysts/fund managers.
When combined with engagement, enhanced analysis offers the potential to deliver improvements in companies’ performance on at least a subset of the social and environmental issues that are of concern to SRI investors. However, some in the SRI community may not be comfortable with this relatively narrowly defined outcome, as the materiality focus means that many issues considered important from a social or environmental perspective may be disregarded in investment analysis and be excluded from the list of subjects discussed between investors and companies. That is, on its own, enhanced analysis is unlikely to be the Holy Grail that many in the SRI industry had hoped it would be. Therefore, if investors believe greater action is warranted from companies on these issues, they either need to assign a greater importance to social and environmental issues in their investment process (i.e. to broaden the definition of materiality beyond financial metrics) or to press for government intervention to require higher standards in these areas.

Rory Sullivan is Head of Investor Responsibility at Insight Investment.