Reintroducing ethics to responsible investment

Responsible investment (and its earlier incarnations in ‘socially responsible investment’) was originally seen as a means of harnessing the capital markets (or the finance sector in general) in support of the goals of sustainable development. While there was – and remains – inevitable discussion about its precise objectives, at its heart responsible investment was seen as a way of minimising the negative and maximising the positive social and environmental consequences of investment practice. Responsible investment was not seen as an individual style or strategy but rather as encompassing a range of strategies, including engagement, voting, best-in-class, positive and negative screening, fundamental analysis, thematic investment and public policy. Yet, both of these points – that responsible investment has as its ultimate purpose the delivery of better social and environmental outcomes and that it encompasses a range of strategies – seem to be in the process of being lost. At conferences, in the investment press and in client presentations, responsible investment is primarily described in terms of the potential for the analysis of environmental, social and governance (ESG) issues to contribute to investment performance (‘the search for alpha’). In many ways this is hugely
encouraging: it should ensure that valuations properly reflect companies’ impacts on society and the environment, and it should send a clear signal to company management that these issues are seen as important by investors (and so need to be managed accordingly).There are also benefits to those individuals charged with leading their organisation’s responsible investment activities; a strong focus on investment research may mean that they are seen as valuable by the organisation (in particular, by their investment colleagues) and it may strengthen their engagement with companies by enabling them to point to the investment relevance of ESG issues. Of course, it goes without saying that investment performance is important. Delivering appropriate risk-adjusted returns is a core objective for investors, and properly valuing ESG issues is widely seen as integral to delivering on this objective. However, the overwhelming emphasis on the financial implications of ESG issues raises critical questions about the social purpose of responsible investment. These include:

• Does the focus on financially material ESG issues mean that issues that are not seen as financially material are seen as less important by companies and their investors?

• Does the emphasis on investment research mean that resources are diverted away from company and public policy engagement?.

• Does analysis of the financial implications of ESG issues result in portfolios that are more ethical or have better social and environmental characteristics than portfolios where these sorts of issues are not taken into account?

• Does responsible investment mean that companies with poor social and environmental performance struggle to attract capital relative to their better performing peers?

• Does an investment focus on ESG issues mean that companies respond by seeking to improve their performance on these issues?

Answering these questions would require investors to be much more transparent about what they do under the umbrella of their responsible investment activities and about the outcomes that result from these activities. More precisely, it would require investors to:

• Specify what they invest in. For example, how much of their investments are in renewable energy and how does this compare to their investments in other parts of the energy sector such as nuclear power generation, fossil fuel-based power generation, coal mining and oil and gas?

• Describe, in quantitative terms, the environmental and social characteristics of their investment portfolios.

The measures that could be reported include:

• The carbon footprint of their funds.

• The numbers of deaths and injuries in the companies in which they are invested.* The number of companies in which they invest that have a significant proportion (e.g. more than 40%) of women on their boards?

• The number of companies that they invest in that have committed one or more serious violations of human rights in the past three years.

• State whether they have engaged with the companies and other entities in which they have invested and, if yes, the outcomes that have been achieved from this engagement.

• State whether they have engaged with policy makers on environmental and social issues and, if yes, the outcomes that have been achieved through this engagement.

Of course, this is a demanding agenda and there are a series of important practical reasons why it may be seen as unrealistic at this point in time. The main objections to the argument presented here include the technical difficulties in reporting ( given that we are still in the very early stages of developing and applying ESG-related portfolio measurement tools, and that most of the tools that have been developed have significant methodological and data limitations), the apparent lack of interest in responsible investment in key markets such as the United States, and the immaturity of the market for responsible investment which means that there is probably limited demand for or interest in the types of information outlined above. While these are all valid objections, they should not be seen as permanent
obstacles to progress. For example, significant resources are being invested in the development of ESG evaluation, measurement and reporting tools, the PRI’s new signatory reporting framework will encourage signatories to report on asset allocation and on company and public policy engagement outcomes, investors (e.g. through the CDP’s Carbon Action programme and the IIGCC’s public policy engagement) are increasingly pressing for improvements in company performance and policy frameworks, and the interpretation of fiduciary duty is being progressively broadened to allow (or maybe even require) that social, ethical and environmental issues are taken into account in investment practice. These developments suggest that we are on the cusp of addressing some of the most important challenges to a more holistic approach to responsible investment.While the technical challenges and obstacles are acknowledged, this article is not primarily about transparency. Rather, transparency is simply a tool to enable us to make progress towards a performance-oriented rather than process-oriented approach to responsible investment. The critical first step is for us to be much more explicit about the goals and outcomes we wish to see from responsible investment. If responsible investment is not about the delivery of social or environmental purposes (beyond investment returns), then I suggest we retire the term ‘responsible investment’, and return to talking about investment (or, at a stretch, ‘enhanced analysis’) and wait for a new generation to take on the challenge of ensuring that the capital markets make a meaningful contribution to the goals of sustainable development.
Dr Rory Sullivan is an internationally recognised expert on corporate responsibility, climate change and investment-related issues. He is Strategic Adviser, Ethix SRI Advisers and a Senior Research Fellow at the University of Leeds.