$4 Trillion of Investment Assets Back Principles for Responsible Investment
Submitted by: Doug Cogan, Deputy Director of Social Issues Services
Is it one small step for a group of progressive fund managers or a giant leap for the global investment community? That is the question raised by a new set of investment principles unveiled at ceremonies at the New York Stock Exchange on Apr. 27 and the Palais Brongniart in Paris on May 2.
At these launch ceremonies, 50 institutional investors with $4 trillion in assets signed on to the Principles for Responsible Investment. These principles contain six pledges and 35 action items that investors can take to integrate environmental, social and governance (ESG) issues into their portfolio management practices. (Download file here to read more about the six pledges.)
The Principles for Responsible Investment were more than a year in the making, with over 20 institutional investors and 70 experts involved in drafting this voluntary code. United Nations Secretary General Kofi Annan convened the process, with coordination by the U.N. Environment Programme Finance Initiative and the U.N. Global Compact. Mercer Investment Consulting was hired by the U.N. to help facilitate the development of the Principles, and the Ceres environmental coalition served as an advisor.
Skeptics may argue that the Principles for Responsible Investment have been launched with two strikes against them, because they are voluntary in nature and have been drafted under the auspices of the U.N. rather than an organization with more clout in the financial community. However, Mercer's role helps to diffuse this. Moreover, charter signatories include some of the world's largest and most influential pension funds. Money managers will have to take notice of these funds' desire for more consideration of ESG issues if they want to secure their business. (Download filehere to read more about charter signatories.)
"There's never been an international group of funds managing this much money coming together and publicly committing to a set of global guidelines" remarked Gavin Power of the U.N. Global Compact at the Apr. 27 launch of the principles. "The global roll-out will encompass many hundreds, perhaps thousands, of public and private pension funds around the world. This is a giant step for financial markets in terms of collective action and a big step for the U.N. system," he said.
Colin Melvin, director of corporate governance for Hermes Equity Ownership Service, and Chair of the PRI Investor Group, added that while there have been similar public-private initiatives in the past, there has been "nothing to this extent. This represents a shift in the mainstream of investment supported by the world's largest corporate owners."
Legal underpinning for the Principles for Responsible Investment came last year from an analysis written by Freshfields Bruckhaus Deringer, one of the world's largest law firms with a highly regarded environmental, planning and regulatory practice. The legal brief evaluated existing fiduciary guidelines for investment managers in seven countries in Europe, North America and Asia. The Freshfields analysis concluded, "the links between ESG factors and financial performance are increasingly being recognized. On that basis, integrating ESG considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions."
In effect, the Principles for Responsible Investment and this legal brief are turning conventional thinking about fiduciary prudence on its head. Rather than making exceptions for analyzing the shareholder value impacts of environmental, social and governance issues, they say, fund managers should make such analysis the rule. Conversely, fund managers that summarily dismiss ESG analysis because it does not conform with their traditional research methods or notions of corporate governance might be failing to conduct proper due diligence.
"The need for these principles is driven by a simple investment reality," observed Tim Gardener, Global Head of Mercer Investment Consulting, as his firm signed on to the principles on May 2. "While environmental, social and corporate governance factors are increasingly perceived as having an impact on corporate financial performance, they are rarely incorporated into investment decision-making. This leaves room for corporate scandal, environmental degradation and human rights abuses---all of which can affect both a company's bottom line and its share price."
In endorsing the principles, Chanchai Supasagee, director of corporate governance for the Thai government pension fund, framed the argument more bluntly. "We believe in the long-term returns to our beneficiaries," he told the Financial Times on Apr 27. "In the long run, if people are selfish or greedy, they are putting a bomb to their own land, and one day it is going to explode."
In the end, the Principles for Responsible Investment may not be a small step or a giant leap for the investment community, but rather the start of a chain reaction. As signatories increasingly look to incorporate ESG issues into their investment processes, the implementation of the principles will ripple through the investment supply chain---affecting investment managers, professional service providers and, ultimately, corporations. The principles will provide an overarching framework that enables investors around the world to address complex ESG issues in a coordinated fashion, and share their learning experiences as their investment management practices evolve.
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OXFORD ANALYTICA DAILY BRIEF
INTERNATIONAL: UN plan could boost ethical investing
EVENT: The European launch of the Principles for Responsible Investment took place in Paris on May 2.
SIGNIFICANCE: This investor led and UN supervised ethical investment charter will join together the world's largest institutional investors, investment managers, and professional service partners in a voluntary framework for so-called environmental, social and governance investment practices. The PRI, which has already attracted about 4 trillion dollars in assets under management, provides a framework for investments driven by ESG criteria that better reflect the tenets of sustainable development.
ANALYSIS: The Lothian Pension Fund (LPF) -- a 2.8 billion pound (5 billion dollar) pension fund in the United Kingdom -- has recently come under heavy criticism for having invested about 19 million pounds in arms manufacturers (3 million of which were in manufacturers of cluster bombs) and nearly 48 million pounds in tobacco companies. In its defence, LPF argued it was committed to engaging with its portfolio companies and bound by its legal obligation to obtain the highest possible return for its beneficiaries. Nevertheless, members are pushing for legislation that would force the managers to divest these holdings. LPF is but one example of institutional investors coming under fire for their perceived unethical investment practices, and part of the rationale for the UN's Principles for Responsible Investment (PRI).
PRI background. In 2005, UN Secretary-General Kofi Annan convened leaders from the international investment community to develop a set of 'best practice' principles for responsible and ethical investing. The PRI was developed over the course of a year by the 'Investor Group' -- including 20 of the globe's largest institutional investors from twelve countries -- with the support of the UN Environment Programme's Finance Initiative, the UN Global Compact and 70 experts from around the world. The stated purpose was to encourage long-term investment objectives over short-term considerations -- the short-term outlook of investors is often cited as a significant obstacle to incorporating environmental, social and governance (ESG) principles into investment analysis and decisions.
Asset owners, investment managers and professional service partners signing up to the PRI will be called upon voluntarily to make a number of commitments:
Investments. Signatories will incorporate ESG issues into their investment analysis and decision-making. This can be achieved by including ESG issues in all aspects of the investment process as well as encouraging external investment managers to do the same.
Ownership. Signatories will develop an active ownership policy that engages with their portfolio companies on key ESG issues.
Disclosure. They will standardise and integrate ESG reporting with annual financial reporting. In addition, signatories will report on their progress towards implementing the PRI.
Promotion. They will promote the widespread acceptance and effective implementation of the Principles. This also implies that signatories will communicate transparently about ESG expectations and emerging issues requiring attention.
Remaining obstacles. The above principles represent a positive step towards ethical and engaged investment policies. However, for the PRI to be viewed a success, certain obstacles will need to be overcome:
Voluntary initiative. As with other voluntary initiatives, the PRI is simply intended to be "voluntary and aspirational" (see INTERNATIONAL: Vigilance needed to ensure good CSR - April 18, 2006). Consequently, implementation of PRI may be seen as a greater achievement than adoption, since there are no punitive damages associated with non-compliance for signatories. According to the PRI prospectus, signatories can hope to benefit from a boost to reputation thanks to their public demonstration of a commitment to ESG investment practices. This could create a free rider problem for those that faithfully adhere to the principles vis-a-vis those that simply want the reputation boost.
The Equator Principles (EP) is a similar voluntary initiative for the world's largest banks involved in project finance (see LATIN AMERICA: CSR gains ground, albeit gradually - October 21, 2005). It attempts to guide corporate actions in a manner supportive of sustainable development. However, some signatories have come under fire for withholding information regarding implementation or even engaging in practices that directly contravene the EP. Such practices have, in part, led to a revision of EP standards in order to improve implementation -- the new standards are expected to take effect in July -- and avoid critics labelling the EP 'spin'. PRI will need to avoid similar problems of adoption without faithful implementation.
Investment performance. Adhering to the PRI may actually raise ethical considerations for pension trustees who have a fiduciary duty to invest in a manner that ensures pensioners retirement security. While implementing PRI would align investors' objectives with the broader objectives of society, it is conceivable that pension funds committing to PRI may be breaking their fiduciary duty if ESG investing is associated with lower returns (see AFRICA: Pension funds hold promise for infrastructure - April 25, 2006):
Traditional financial theorists -- those ascribing to Markowitz' optimal portfolio selection -- argue that ethical investing would result in under-performance over a long-term time horizon because an 'ethical portfolio' would only be a subset of the 'market portfolio', resulting in a lack of risk-reducing diversification and a lower return.
Proponents of PRI -- and socially responsible investing more generally -- claim ethical screening can result in higher returns, due to the fact that ESG risks are tantamount to business risks, and thus should be considered as a potential future claim on the business in valuation models. The PRI prospectus indicates that ascribing to ESG in investment analysis and decisions can affect investment performance positively. Both claims are controversial and, according to the majority of academic empirical evidence, false:
The large majority of studies finds no significant difference between the financial performance of ethical and conventional funds and investments. The few studies that do find a relationship between ESG and investment returns have trouble demonstrating causality due to a selection effect -- those that are profitable (unprofitable) may also be the ones able to afford (unable to afford) ESG initiates.
Nevertheless, finding no evidence of a boost to returns may still be a positive result for those championing PRI, since no impact on returns suggests that giving credence to societal goals can still be combined with fiduciary responsibilities -- so long as proper diversification is still achieved in an environment devoid of political pressure.
Outlook. Many of the pension funds that signed up to the initiative -- PGGM, ABP, CalPERS, etc -- were already pioneering ethical and engaged investment practices. They probably view the PRI as a way to reinforce their commitments and maintain focus. As such, large societal benefits from this initiative will stem from firms adopting and implementing the PRI in a reorientation of corporate strategy towards the principles of the voluntary code. Given the high profile nature of the accord, such an outcome is possible, as it becomes difficult for large institutional investors, such as LPF, to ignore the ethics of their investment policies.
CONCLUSION: The PRI is a positive step towards bringing ethical investing into the mainstream. Nevertheless, further empirical research demonstrating the impacts and outcomes of ethical investing -- both on the adopters of the PRI and on the portfolio companies -- is required. Finally, for the PRI to be viewed as a success it will need to succeed where other voluntary initiatives have struggled -- adoption will need to be followed by widespread and transparent implementation.
Oxford Analytica Daily Brief
Monday, May 8 2006
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For information, please contact Mr. Eric Noel, enoel@oxford-analytica.com
Posted by: Eric Noel | May 8, 2006 5:15 PM