Why lack of action on SRI is the biggest market failure ever.

Even though environmental and social governance is gathering acceptance and momentum within the asset management industry, the question remains: why are the majority of capital owners and asset managers still standing aside?
Global warming is probably the most important issue of the century and different industries are developing their own answers for to the question sustainable development. However, the asset management industry has so far taken a conservative approach, to say the least. In addition, just a handful of capital owners have clear rules for environmental, social and governance issues (ESG). The vast majority is doing nothing. This is a great problem because who has more to say about corporate behaviour than the owners? By shouldering the responsibility that follows from investment, the asset management industry has greater potential than most to effect change in companies and consumers for healthy environmental benefits that could have a positive effect on future revenues. But, as so many times before, we face a battle between short- and long-term revenues andperspectives. Can ESG aspects be objectively incorporated without jeopardizing an investor’s fiduciary responsibilities? Looking at the percentage of investors that actually incorporate ESG into their investments, one is tempted to draw the conclusion that the industry does not believe so. I believe this is wrong. There are many different views on how to engage with companies – negative/positive screening, etc. – and funds should be able to decide what approach suits them. However, I believe that there should be a minimum level of engagement where all companies follow the declarations, covenants and conventions adopted by the United Nations General Assembly. The reasons why UN agreements are a sound basis for most investors are two-fold. First and foremost, they have been commonly, and in a sense democratically, decided upon. There are very few professional asset managers that can claim the United Nations agreements do not reflect the views of their clients. Secondly, most countries have a domestic legal system to cope with national laws. However, there is no international court with a mandate to enforce global
agreements. This leaves the field open to companies and people with low moral values. Solving, or at least minimizing, this problem would ensure a minimum level of ESG that we all, under the auspices of the UN, could agreed upon.
The Seventh Swedish National Pension Fund (AP7) implemented ESG guidelines in 2000. By ensuring that the approximately 2500 companies the fund invests in globally follow UN agreements the fund has succeeded in achieving a good return, while at the same time following ESG considerations. About 30 companies have been excluded from our portfolio on the basis of failing to meet the conventions. All exclusions have been based on court decisions, official investigations by governments (or government agencies) or international organisations like the United Nations, and even confessions by companies themselves. This makes the ESG policy as objective and legitimate as possible. The funds experiences so far from its ESG policy are:
1. The return and risk are unaffected, i.e. the characteristics of the screened global indices are the same as the unscreened ones.
2. Companies have been open to dialogue and change, partly because they have found our ESG policy objective and legitimate.
3. Companies have adapted to the result of the policy and hence the policy has had a real effect.
4. The policy has given AP7 goodwill with stakeholders, and has hence been economically sound.
Despite our findings, a clear majority of asset owners do not have a clear ESG policy. Why not?There are three traditional investor arguments against engagement. The first derives from what is traditionally referred to as modern portfolio theory. By diversifying investments into assets not fully correlated, the risk adjusted return can be improved. This is a fact, but it has also been proven, decades ago, that the benefits of diversification are large in the beginning and actually insignificant after having invested in a certain number of companies. For a global investor following a global benchmark the fact is that excluding a few companies simply does not affect the risk in a significant way.

“The asset management industry has so far taken a conservative approach, to say the least.”

The second argument is often referred to as “The business of business is business” or put another way: everyone should focus on what he or she is good at and assigned to do and not take initiatives outside this since such initiatives might be in conflict with the assigned task, or worse, with democratic rules. Milton Friedman wrote an article on the subject in The New York Times Magazine, in 1970, which has been used as a case against ESG. One might suspect many people had never actually read the article, because they would realise that Friedman actually supports an ESG policy based on international law.
He said: “there is one and only one social responsibility of business: to use its resources and engage in activities designed to increase its profits so long as it stays

within the rules of the game, which is to say, engages in open and free competition without deception or fraud.” AP7’s ESG policy only excludes companies that do not follow the commonly decided “rules of the game” and hence do not engage “in open and free competition without deception or fraud”.
The “rules of the game” that AP7 demands companies follow are what is commonly referred to as the UN Global Compact. These include:
• Declarations on human rights
• ILO-conventions
• International conventions on environment
• Conventions against bribery and corruption

These are really just minimum requirements. We do not demand companies to be best in class. We simply require them to follow global principles that the vast majority of people – consumers, employees and other stakeholders – have agreed upon. To permit anything less would be to ignore the democratic principles of our society and violate fiduciary responsibilities. A couple of examples of companies that have been excluded for failing to meet minimum global standards are:
• Marriott. Case: Sexual exploitation of children. In 2002 the Supreme Court of Costa Rica found an individual guilty of aggravated pimping of minors. The verdict included testimony of the illegal activities transpiring on Marriott’s premises and involving Marriott employees.
• Yahoo. Case: Imprisonment of a Chinese journalist. Yahoo has passed along Internet user information of a Chinese journalist to China’s state security. In 2005, this lead to a ten-year imprisonment for the journalist. The transformation of information has beenconfirmed by Chinese court documents as well as from statements made by Yahoo.
• PetroChina. Case: Chemical contamination and inadequate safety procedures. In 2005, a major industrial accident occurred at a Chinese chemical plant owned by PetroChina. The explosion killed five workers, injured over 70 others and lead to approximately 100 tons of pollutants leaking into the Songhua river. The accident was covered up by the company and the authorities for nine days. The State Environmental Protection Administration (SEPA) places the responsibility for the explosion on PetroChina.

“By following international agreements, the question of subjectivity and objectivity is rendered obsolete.”

If one asked members of a pension scheme, I believe it is fair to assume they would not support their savings being invested in these companies without any action being taken by the investor.
This leads to the third argument against ESG: subjectivity. Investors tend to look at ESG as subjective moral values, and yes, there are a number of funds sold as such. It may be that they do not invest in tobacco, weapons or alcohol.
Some people feel these types of funds represent their values so they meet a demand. But for the vast majority of fiduciary managers it would be as wrong to try to impose a restriction on alcohol (wine for example), since

it is legal and might actually be good for your health in a certain proportion, as it is wrong to invest in the production of anti-personal landmines, since there is a global convention against the production of them. By following international agreements, the question of subjectivity and objectivity is rendered obsolete.
In summary, the arguments traditionally used by investors against ESG are weak when one scratches the surface. The arguments for engagement would not be as obvious if companies did not “engage in open and free competition without deception or fraud”, but unfortunately that perfect and free economy is a utopia. As long as the world looks and acts as it does today fiduciary responsibility is abused if investors do not take ESG into consideration. The sooner investors come to realise this, the sooner ESG can move into the mainstream and have a significant positive impact on corporate behaviour.The consequence of the concept that “the market is always right” is a cynical and irresponsible approach that belongs to a past when we did not have global common guidelines, or democracies for that matter. The seriousness of global warming is one example where the market has proved flawed. Climate change is the biggest market failure ever. Relying on market forces has so far led us into a dangerous situation where it is hard to see how investors could argue they had taken their fiduciary responsibility seriously. I am not suggesting that ESG guidelines would have solved the problem, but they would at least have given the investment community a greater chance to be part of a solution. What responsible investors and other stakeholders now need to contribute to solving climate change is political will and commitments manifested in both national laws and international agreements that they can follow.