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Joseph Mariathasan: Time to take ESG seriously

Responsible ownership requires taking a proactive approach to many areas of a company’s activities, writes Joseph Mariathasan

The United Nations Climate Change Conference in Paris has brought the issue of climate change to the fore in investors’ minds. Environmental, social and governance (ESG) issues such as climate change are certainly becoming more and more mainstream, but ESG as a concept investors should take seriously still has its detractors.

Luke Johnson, private equity entrepreneur and Sunday Times columnist, was scathing about corporate social responsibility in his 15 September column this year, declaring: “Corporate social responsibility is an indulgence of affluent societies and rich companies.” He concluded his diatribe by declaring: “The field feels rank with hypocrisy, unrealistic expectations and questionable motives.”

Ironically, within a few days, the Volkswagen scandal broke out when the US Environmental Protection Agency (EPA) issued a Notice of Violation of the Clean Air Act to the German automaker. The BBC reported that this was not the first time Volkswagen had attempted to sidestep regulation, having been fined $120,000 (€110,230) in 1973 for dodging similar tests.

For pension funds holding Volkswagen shares, the damage has been twofold. They have seen not only a significant loss arising from the share-price fall but they also have the knowledge that one of their investee companies has caused environmental damage and contributed to the ill health of society at large, including their own beneficiaries.

ESG factors clearly can be components of investment analysis. There is some academic evidence, and many would argue companies that adhere to high standards when it comes to ESG outperform over the long term. But establishing conclusive proof, as with any other theory in investment, is always elusive, and results are debatable. 

Irrespective of which side of the debate you are on, 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. 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.

Investor lobby group Preventable Surprises issued a report recently entitled “Investors, Climate Risk and Forceful Stewardship: An Agenda for Action”. It advocates pension funds taking a more activist stance based on two key investment observations. First, climate change poses a significant and increasing systemic risk to the global economy and thus to the portfolios of diversified investors, in turn threatening the security and financial well-being of their beneficiaries. Second, institutional investors have a fiduciary obligation to control this risk and prevent it from increasing as much as they reasonably can.

The issue for the industry as a whole is that of which entity has the resources and motivation to 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.

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 ESG movement fades away, not because it has been a failure but because it has been such a success in that no distinction can be made between mainstream investment and ESG.

Joseph Mariathasan is a contributing editor at IPE

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