As I write this, the media are full of the latest examples of the damaging consequences of companies’ drives to maximize short-term financial performance at any price. Barclays’ manipulation of Libor for the benefit of its own trading positions and its traders’ bonuses; GlaxoSmithKline being fined $3 billion for marketing anti-depressants for uses for which they were not licensed; investment banks overcharging pension funds and other clients for foreign exchange services; and banks rigging municipal bond auctions in the US and depriving cash-strapped local governments of interest payments they would otherwise have earned – presumably with knock-on impacts for underfunded public pension funds and their beneficiaries. But we’ve been here before. We take it for granted in the ESG/RI/SRI world (take your pick on the terminology – we know what we mean) that short-term performance maximization militates against longer-term value creation driven by (among other things) a fuller consideration of environmental, social and corporate governance factors. Research shows clearly that companies forego investment opportunities with positive long-term net present value in order to satisfy the market’s short-term performance expectations. Companies have little incentive to invest in serious emission reductions (beyond the lowest of the low-hanging fruit) if their shareholders would prefer short-term earnings or share buy-backs over capital expenditure or R&D with a longer-term payback that may be uncertain if carbon prices remain low or nonexistent. Why invest in human capital development when expenditure on training is a cost in the accountsand the markets salivate when you announce lay-offs? Short-termism in investment strategy can be seen in the well documented increase in portfolio turnover that has taken place across the market as a whole in recent years. High turnover, driven in part by investment managers’ incentives to deliver short-term performance to their clients to avoid being sacked, is both a symptom and a cause of short-termism. It can be seen as the transmission mechanism between the short-termism of investors and that of companies. Yet studies show that high turnover and momentum-driven investing contribute to asset mispricing and bubbles, and the inefficient allocation of capital from a long-term perspective. Some front-line portfolio managers acknowledge that the way they are often incentivized to behave is not aligned with their clients’ real long-term interests. The way the market currently works, through the investment chain from asset owners via investment managers (external or in-house) to companies, does not always serve the true long-term interests of the millions of ordinary people worldwide who save through pension funds or insurance products. Their financial interests are not well served in that returns are depressed by short-termism and financial instability. Their interests as citizens, employees and human beings with values are not served in that climate change, biodiversity loss, human and labour rights and other sustainability challenges are not adequately addressed. A double whammy of market failure.
The continuing convulsions and revelations in the wake of the financial crisis give the responsible investment community an opportunity – indeed a responsibility – to
address these challenges more strategically than we have done to date. We need to lift our sights from the stock-picking focus that has characterized so much ESG endeavour to date. We need to become more engaged with the nuts-and-bolts of the investment chain, with the portfolio-wide implications of environmental, social and governance externalities, and with the stability and health of the market as a whole. Firstly, we need to get closer to the core of investment practice and the investment chain. Portfolio turnover, performance monitoring periods, benchmarks, fees and real long-term alignment of interest between asset owners, asset managers and companies all need to be part of responsible investment’s territory. To inform this re-tuning of the investment chain, we need to understand far better how long-term externalities and market failures such as climate change will impact whole portfolios, across asset classes, and how investors can respond. The objective here is to ensure that the whole investment chain is focused consistently on long-term value creation. This should ensure that far greater account is taken of environmental and social sustainability issues than at present. We should also explore here how far it is in investors’ financial (and I stress financial) interests to encourage policy action to bring externalized sustainability costs on to companies’ books. For some years now investors have supported strong government action on climate change. We need to strengthen work on climate change, and explore applying the same principle to other issues. All this will not in itself change investors’ fundamental objectives, as called for by Rory Sullivan and Jay Youngdahl in previous articles in this series. But it will significantly increase the overlap between investors’ – long-term – financial interests and environmental or social objectives as seen from the public interest perspective. In all likelihood further policy and regulation will still be needed to close the gap between what is in investors’ financial interest and what is democratically determined to be in the broader public interest.Secondly, we need to address the functioning and stability of the financial system as a whole. The overriding purpose of pension funds and other long-term savings institutions is to deliver financial security in retirement, or income at other stages in life, to millions of ordinary people. To do this, these investors depend on markets that are stable, well regulated, transparent and fair. As we have seen, poor governance of the market as a whole can be hugely damaging to long-term investors’ interests.Some of the pathways into the issues at this level are familiar from the ‘conventional ESG’ perspective. For example, there is clearly a very strong case for sustained individual and collaborative engagement by asset owners with the ‘systemically important financial institutions’ – the banks that are ‘too big to fail’ – that were at the heart of the financial crisis. Asset owners as shareholders – and clients – of these institutions have a vested interest in ensuring that their executive remuneration, risk management, board composition and financial reporting truly serve their long-term interests. At the policy level, a small number of the largest asset owners are already engaging actively with policy-makers and regulators on the new market frameworks that are being put in place in response to the financial crisis. The more institutions become involved in work of this kind, the greater the chance that the re-modelled financial system will be fully aligned with their interests. This agenda calls for a whole new level of vision and courage from the responsible investment community. We need to apply existing research insights and experience better, develop new tools, re-engage with the leadership levels within investment institutions, collaborate more effectively, and be bolder in allocating resources. This is a challenge the PRI Initiative will address as part of its new strategic focus. Ambitious, certainly. But surely the prize of sustainable, fair, capital markets that genuinely serve the real needs of savers and investors, the environment and society as a whole is worth striving for?
Rob Lake is Director of Responsible Investment at the Principles for Responsible Investment.