Attempting to apply an ethical approach to trade and investment has been a recurrent theme in the development of capitalist economies. Whilst the more pernicious examples of immoral economic behaviour such as slavery, child labour and outrageous working conditions have long been abolished in the developed nations, many argue strongly that some companies still derive profits from such practices in emerging economies. Not only that, many examples of other unethical business activities persist in developed nations, although the issues are often dependent on particular viewpoints of morality.
The rise of large pools of institutional capital held by organisations that wanted to apply their own ethical ideals to their financial investments has been a driving force behind the growth of what is now termed socially responsible and sustainable investment (SRSI). This began in the 1920s when the Methodist Church in the UK began avoiding so called ‘sin stocks’. This niche is still the backbone of the SRSI movement in Europe, but it is being supplemented and some would argue eclipsed by increasing acceptance by the financial community of many of the underlying themes behind SRSI such as good corporate governance and sustainable development.
Whilst there may be universal agreement on many of the core ideals of SRSI, there is also room for substantial disagreement. The forbidden five ‘Bs’, tobacco, alcohol, arms, pornography and gambling (the reader is left to work out the slang alternatives beginning with ‘b’) that summarise especially the retail end of the SRSI market would leave many with problems. The situation becomes even more complex when, as in many cases, there are trade-offs to be made between wage rates, pollution levels and competitiveness in emerging economies. Industrialised nations are ultimately able to pay higher wages with less pollution than developing nations because they are richer. The imposition of industrialised nation standards can be a weapon for protectionism and discrimination against developing nation exports as well as a force for promoting a higher quality of life for those who are able to find work.
For a pension scheme that has a duty to maximise returns for its members, there can be a legal issue as well as moral issues as to whether it can justifiably exclude companies and thereby potentially reduce returns to members on grounds other than purely financial. Some schemes have broadened the scope of their objectives to incorporate non-financial objectives in investment decision-making. The Dutch PGGM for example, explicitly state that they are increasingly assessing investment opportunities not only in terms of the expected financial return, but also from the social and environmental perspective. The UK’s Hermes has laid out a set of principles for investment that state that companies should generate long term shareholder value “within a framework which is economically, ethically and socially responsible and sustainable”. The UK’s University Superannuation Scheme, USS, has also been at the forefront of thinking in this area and sponsored a competition in 2003 explicitly designed to generate new ideas on how to invest responsibly for the long term.
Given the scope for profound disagreement, it is not surprising that there is no single definition of SRSI. The European Sustainable and Responsible Investment Forum (Eurosif) that undertook a detailed study of SRSI in European in 2003 differentiates three separate layers; the first is made of elaborate screening practices that includes both positive screens such as best in class as well as extensive exclusions; the second is simple negative screening for unacceptable activities such as weapons or tobacco and almost all Dutch pension funds they find use these kinds of screens; the third layer is that of active engagement with company management. Eurosif estimate the size of the core SRSI market as E34bn, adding in simple exclusions gives rise to a size of E218bn whilst adding in active engagement gives a size of E336bn. Depending on which definition one chooses to take therefore determines to what extent SRSI can be regarded as having entered the mainstream of financial markets.
Screening is probably still the most widely used form of SRSI and as more DC schemes are set up, a simple screened SRSI fund is often seen as an essential option. A more proactive approach encourages investment in the ‘best in class’ companies in terms of their approach to socially responsible corporate behaviour. The argument made is that all other things being equal, companies with good policies in this respect will outperform over the longer term. Raj Thamotheram from USS, argues that broker research is not structured to covering long term socially responsible themes so there is an information asymmetry in the marketplace. Good human resource practices for example, “have been shown in study after study to make a company outperform, but analysts are not interested because it does not impact on short-term buy/sell decisions”. This is part of a larger issue of how can managers be encouraged to look at the long-term implications of investment decisions, a theme USS itself took up in their competition.
Whilst screening and thematic funds give rise to investment products that have a socially responsible impact, the largest pension funds are faced with the problem that they are essentially universal funds, with stakes in virtually all the investable stocks in the universe. Indeed most have a large indexed core. Such funds have to face the issue that their sheer size may preclude them from disinvesting from large portions of the market. This has given rise to the phenomenon of active engagement by a number of these funds including PGGM, AP-3 and many local authority funds. Maximising returns by robbing Peter to pay Paul is meaningless if you own both Peter and Paul. An example would be the poor management and handling of chemicals by one company leading to additional costs to companies associated with the treatment of water – a universal owner would hold both in their portfolio. Moreover, they would also argue that their members are worse off if companies increase their share price through activities that degrade the environment or reduce the quality of life for their members in other ways.
Engagement is taking on a much higher profile, driven by the increasing emphasis on corporate governance issues, the Myners report etc. The issue for the industry as a whole is that of which entity has the resources and motivation to usefully develop a constructive dialogue with companies. Fund managers can take the free rider approach and look to benefit from the activities of their competitors in this area without having to contribute resources of their own. Pension schemes themselves have the temptation to become complacent with the strategy of delegating this responsibility to their fund managers. Clearly, universal schemes that have holdings in virtually all stocks would benefit from an activist approach. Apart from a few fund managers who have found a niche product in activist funds, there are still many obstacles to overcome before reality can match the rhetoric behind many of the activist approaches that fund managers are claiming to undertake. The problem lies perhaps, not so much with the fund managers themselves as the rules of the game they play in. The Institutional Shareholders Committee (ISC), whose associations represent virtually all UK institutional investors, have produced guidelines for activism and as Thamotheram argues, if mandates awarded to managers had a requirement to be ISC compliant, it would certainly cause more activity either by the fund managers or by specialist agencies that would spring up to service informed client demand. That of course raises the issue as to whether anyone can really add value to the management of a company that they will not have as detailed knowledge of as the internal management. Thamotheram agrees that it requires a level of expertise that not all possess, but those able to suggest best practice behaviour from examples elsewhere in the marketplace can undertake meaningful engagement effectively provided the interactions are with the board and senior management rather than the investor relations department.
What is certain is that responsible ownership requires taking a proactive approach to many areas of a company’s activities such as corporate governance, social and ethical issues, and the external environment. Ultimately, the objective of many idealists is that the SRSI movement should fade away, not because it has been a failure, but because it has been such a success that no distinction can be made between mainstream investment and SRSI.