Ever since the early days of responsible investment (RI), the focus has been on the integration of material environmental, social and governance (ESG) issues in investment policies, decisions and ownership. This has been quite successful, even to such an extent that we have started to consider RI and ESG-integration as being equal.
The classic example is that of investors who recognised BP’s low safety policies, procedures and practices after the accidents in 2005 in Alaska and Houston and consequently divested or reduced their investments in BP. If those same investors, after the Gulf of Mexico incident and the drop in share price of 60%, following the Arianna Huffington advice ‘Buy, buy, buy’, stepped back in BP, they were again the ‘champions’ of responsible investment.
They had taken the material ESG-risk into account and made a good financial return. That is what we call first class responsible investment, although the wider audience will find it hard to see what is responsible about it. Responsible investment has become equal to integration of material ESG-risks. More than 10 years down the road we have to untangle that ‘marriage’. There’s more to RI than ESG-integration there’s ‘more to grey hair than old bones’ as the saying goes.
We should ask ourselves what we aim to achieve with ‘responsible investment’? Is it just a better risk return profile of our investment portfolio, or is it more than that?
Is responsible investment just a way to show traditional portfolio managers that they have neglected material ESG-issues for much too long, or is there more to it? Now that the integration of material ESG-issues is considered to be mainstream and those investors that are not doing it may be accused of breaching their fiduciary duty, we must acknowledge that this limited interpretation of responsible investment has not brought ‘our world’ the outcome that so many people outside the financial system, would expect from the concept of responsible investment.
The expectation, or hope, is that institutional investors contribute to solving some of the major challenges our world is facing, achieving sustainable economic development.
The recent adoption of the 17 Sustainable Development Goals (SDG’s) of the UN require us to think again: does our current understanding of responsible investment as being equal to ESG-integration make sure that institutional investors are delivering on society’s expectations? The answer is clearly, no! But what next?
The often neglected preamble to the UN-supported Principles for Responsible Investment (PRI) states ‘We also recognise that applying these Principles may better align investors with broader objectives of society’.The assumption behind ESG-integration in investment policy and decisions, is that it will ultimately affect the cost of capital, lowering the costs of capital for sustainable businesses and increasing the costs for non-sustainable businesses. As a result of the lower costs of capital, sustainable businesses will in the long run ‘crowd out’ non-sustainable businesses.
The assumption behind ESG-integration in active ownership is that engagement with investee companies will highlight the materiality of ESG-issues, convince businesses to adopt more sustainable products, services and processes and thus improve the risk return profile of the businesses. Research about the effects of integration of ESG issues in investment decisions and engagement show a positive, although limited, effect on investee companies’ efforts to become more sustainable businesses.
Actually, companies are usually much closer to accept sustainability challenges as a driver for their business strategies and activities, than their investors. Where normally investors want to be ‘ahead of the curve’, compared to companies they are (in general, far) beyond the curve and therefore not a real contributor, but sometimes more of an obstacle for sustainability.
Integration of material ESG-issues is important, but it is obviously not sufficient. Though fiduciary duty has been used as an excuse not to look at ESG, a recent PRI study and the US Department of Labor decision last year, brought clarity to this issue. Not taking material ESG issues into account may even be a breach of fiduciary duty. However, the underlying assumption still is that the ultimate beneficiaries define their interests as purely financial. With growing concerns among global citizens about the negative externalities of financial markets, is it still correct to assume that the interests of beneficiaries are purely financial? Although research is scarce, there have been surveys showing that beneficiaries have a wider definition of their interest including such matters as sustainability, ethical considerations and future wellbeing. This is also reflected in the recurring phenomenon in the financial industry of reputational damage, risks. Reputational damage can have many causes but clearly some reputational risks originate in the fact that ‘public opinion’ generally seems to have a higher ethical standard than most investors. Where investors may sometimes argue that ‘moral considerations aside’ or ‘leaving ethics out of the equation’, a certain investment or stewardship decision is acceptable, the public (basically the collection of ultimate beneficiaries) may vehemently disagree.
Therefore, responsible investment should take these ultimate beneficiary interests into account.
Late in 2015 the UN adopted a Resolution ‘Transforming our world: the 2030 Agenda for Sustainable Development’. The resolution commits member states, UN and affiliated organisations to pursue seventeen sustainable development goals (SDG’s). Parties to the UN recognize the need for partnerships. The recent ‘Paris Agreement’ to combat climate change (one of the seventeen SDGs) also mentions the importance of partnerships and the private sector. This highlights one other assumption that has largely remained implicit. While other codes, like the UN Global Compact, OECD guidelines, IFC-standards, provide desired outcomes (no child labour, lower GHG emissions, waste reduction, freedom of association etc.), the assumption underlying the PRI is that, for financial institutions to contribute to ‘broader objectives’, it is sufficient to agree on the six principles, implement procedures and processes.
It remains to be seen if the six PRI principles will stand the test of empirical research about their effects. At the same time some institutional investors, including some of the major pension funds, have already agreed on a strategy of explicitly decreasing their carbon or even wider environmental footprint and structuring their portfolios to create a positive ESG impact. We also see relatively new initiatives like the ‘Montreal Carbon Pledge’ (public disclosure of the carbon footprint) and the Portfolio Decarbonization Coalition (measure, disclose and reduce carbon footprints). This underlines the current development among some leading responsible investors to move from ‘processes’ to outcome, decrease their negative environmental and social impact and set targets for positive ESG-impact. With companies globally moving towards more sustainable business practices those investors are likely to be cutting edge and will potentially stay ‘ahead of the curve’, which also makes perfect sense from a risk return perspective.After ten years growth of the global responsible investor community and ESG-integration, we should ask ourselves how to revitalize the concept of responsible investment, beyond a process based approach of (material) ESG-integration, towards an outcome, or impact based approach that explicitly aims to contribute to solve the sustainability challenges put forward by the SDG’s? Of course always keeping in mind the need to achieve a reasonable return on investment (ROI). Addressing these questions is not an easy exercise and requires input from investors, beneficiaries, UN partners, academics and a wide range of stakeholders. Should this exercise lead to a change of the PRI Principles? I would say yes, it probably should. At least it should lead to a shift of the phrase ‘We also recognise that applying these Principles may better align investors with broader objectives of society” from the preamble to a new, a core ‘First Principle’: ‘We will seek to align our investment policies, decisions and stewardship activities to align with broader objectives of society as expressed in the UN Sustainability Development Goals’. That will guarantee that the PRI is worthy of its UN-label, will provide institutional investors with a renewed ‘license to operate’, also from their own beneficiaries, and shows the way forward for the next phase of ‘ truly’ responsible investment. Institutional investors will then re-position themselves ‘ahead of the curve’, exactly where they belong.
Kris Douma is Director of Investment Practice and Reporting at the PRI.