This blog is reposted from TruValue Labs blog site:
During the last decade or so one of the most rapidly growing investment strategies and philosophies has been in regards to a concept known as responsible investment (RI). Below we briefly review some of the major factors that have propelled this development and outline why this trend is expected to continue to grow.
It is important to distinguish between ‘socially responsible investment’ (also called ethical investment) strategies and RI. Although the terms are often used interchangeably, the underlying investment strategies are dissimilar. SRI/ethical investments are based on various moral or religious belief systems , and historically primarily involved negative or positive portfolio screening. RI instead focuses on the materiality of ESG (environmental, social and corporate governance) issues and incorporates them in firm analyses. The common ground between the two approaches is that often the former may foreshadow what later becomes widely accepted and may become material in some circumstances. For example, early SRI focused on serious pollution arguing it was ethically wrong, while RI would argue (although it may be ‘wrong’) it is both a negative externality (which may make it a material factor) and may also be wasteful to the polluting firm itself (but not recognized as such). Thus, while SRI focuses on the ethical perspective, it can act as a ‘canary in the coal mine’, an early indicator of what, for example, the impact of environmental issues would have once the issue is accepted from a broader social perspective.
Three critical factors that have driven the rise of RI.
The first factor is the global growth of institutional ownership. The majority of equity in OECD countries is now owned by these institutions (e.g. pension funds and various forms of retirement investment plans, sovereign wealth and pension funds, banks). Large institutional owners that have broadly diversified and globalized portfolios which reflect ownership of the whole economy and market are known as “universal owners”. Institutional investors also tend to have an increased investment time horizon, which is partially determined by their mission – managing intergenerational assets, inherently a long-term project. The combination of these two features implies several things: Fund managers need to consider a broad range of long-term risks, events and trends, and they need to account for the interactive dynamic of holdings within the portfolio. An example of the latter would be having in the portfolio both heavy contributors to the global carbon emissions and companies that are most expected to suffer from climate change (for example, coal in the first instance, and low lying resorts and real estate in the second), thus internalizing in the latter the negative externalities generated by the former. E and S issues contain both long-term and negative externality foci, yet these foci have not traditionally been taken into account by financial analysis and models. This is beginning to change in a number of jurisdictions, e.g. the E.U in particular with a form of mandatory ESG reporting beginning in 2017.
The second factor driving RI’s growth is the failure in general of most (inter-)governmental bodies to mitigate negative externalities of “normal” business operations through regulatory and tax policies. Corporations exist under a social ‘license to operate’, meaning there is an implicit and explicit contract between them on one side and the government and society on the other in regards to legitimate parameters of action. The corporate form is a creature of the state and can have no existence apart from it. Thus firms that create social costs or negative externalities, also create long and short-term risks potentially undermining their license to operate. This is of central concern for institutional investors as the dominant shareowners of publicly traded corporations, together with the fact that it is quite probable that these externalities will entail direct costs due to their broadly diversified portfolios as they internalize to one degree or another externalities generated by their portfolio firms.
The third RI driver is the evolving view of the materiality of ESG issues. Investment professionals are increasing realizing that traditional financial analysis is too narrow to capture the actual but too often unaccounted for costs and benefits of a firm’s total activities. In addition, some financial analysis considers investment time horizons that are too short-term, incentivized by short-term compensation arrangements of financial and other top managers. ESG-based criticism of traditional financial analysis suggests that its narrowness unintentionally results in inaccurate and therefore imprudent results. As ESG issues typically (though not always) concern mid- and long-term risks and opportunities, they are able to provide a more realistic view on how value can be created, unlocked or destroyed over time. As such, a major implication is that fiduciary duty impels an RI perspective on value drivers, one that goes beyond what are currently a too narrow set of financial lenses – lacking such a perspective is an implicit breach of fiduciary obligations.
ESG issues that are material serve as the foundation of RI. But what does material mean? In the US, according to SEC´s accounting standards (based on a U.S. Supreme Court decision) an event or factor becomes ‘material’ when the “reasonable investor” believes it can impact a firm´s valuation in the long or short term. What is material may move markets, and in this sense what market participants think is material may well become material. Therefore, material is not only linked to risk assessment based on probabilities and impact, but also to the “wisdom-of-crowd” or what a critical mass of “reasonable investors” accepts as material in the light of changing social, political and economic trends and/or norms. Material ESG issues in this sense are a moving target. Efforts to map and delineate what is material for a specific industry or sector of the economy are being undertaken by a number of organizations, for example SASB (the Sustainability Accounting Standards Board) in the U.S., which is developing materiality KPIs across sectors.
One critical implication of the growth and widespread adoption of RI is that the value of the firm will increasing be conceived of not only in financial and (narrow) accounting terms, but rather based on what is often called “full cost accounting”. This more accurate and complete accounting can yield its true economic (and social) value.