It is 25 years since the Exxon-Valdez oil tanker struck a reef in Alaska’s Prince William Sound, resulting in nearly 11m gallons of oil spilled in one of the biggest environmental disasters – and large amounts of clean-up, penalty and litigation costs. In response to the disaster, a North American investor coalition called Ceres was set up, applying pressure to companies and capital markets to incorporate environmental, social and governance (ESG) factors into their decision-making.
On the eve of this anniversary, IPE looks at a selection of the biggest events, scandals and initiatives that have shaped the ESG movement.
• Asset managers dumping their ESG teams. In the wake of the financial crisis, the short-term fling with a long-term matter like ESG came to an abrupt end. Various asset managers – such as Henderson Global investors – fired their ESG or SRI teams for one reason or another. Clearly, the belief was that ESG factor analysis did not add enough value for them to hold on to those teams, confirming that the perception of ESG as a fluffy, nice-to-have but non-essential item on the agenda persists. However, while some quit, others discovered their new long-term love for ESG by hiring individuals or teams and undertaking more research in this area – ironically because, to them, the global financial crisis proved that non-financial matters mattered.
• BP Deepwater Horizon Spill. BP’s Deepwater Horizon Spill, also known as the Macondo blowout, in the Gulf of Mexico is considered the largest accidental marine oil spill in the history of petroleum, with around 4.9m barrels, or 210m gallons, of oil gushing out over several months in 2010. The disaster also claimed 11 lives. Naturally, BP’s share price took a nosedive, wiping billions from its market value.
While BP’s previous track record of accidents may have been ignored, investors certainly took note of this incident. The disaster is now widely being credited with demonstrating that ESG factors do indeed affect the share price of companies. It also spurred engagement with companies, particularly those in the oil and gas sector, not only over health and safety and deepwater drilling but also over issues such as tar sands, shale gas and Arctic exploration. One of the most recent campaigns related to the sector is the fossil fuel divestment campaign that was started by US colleges and endowments but has since reached European shores and its institutions too.
• Climate change and its inclusion in investor portfolios. Climate change has been talked about as potentially one of the biggest threats to human kind. However, little work on climate change-proofing investor portfolios was done until consultancy Mercer published its Climate Change Scenarios – Implications for Strategic Asset Allocation report in 2011.
The report urged institutional investors to take a three-stage approach to integrating climate change in their asset allocation:
1. Enhance their approach to asset allocation by discussing climate change both at the investment and the specialist level so that trustees and investment committees are fully aware of all dimensions of the risk.
2. Change their strategic asset allocation and increase their exposure to climate-sensitive assets to 40% to help capture the upside and protect against the downside risk of climate change at the total portfolio level.
3. Engage with policymakers because policy developments at the country level will produce new investment opportunities and risks that need to be constantly monitored.
Mercer recommended investments in asset classes such as infrastructure, private equity, real estate, timberland, agricultural land, carbon, green bonds, broad and sector-focused sustainable equities and efficient or renewable listed and unlisted assets. Helped by the low-yield environment, some of these have certainly taken off. Pension funds have been keen on all infrastructure-related investments, while the World Bank has been championing green bonds.
• The ESG evolution to integration. What started out decades ago as an ethical approach by faith-led institutions and their exclusions from certain controversial stocks has since moved via positive, best-in-class approaches to the integration of ESG factors. ESG integration means that investors consider material ESG factors in all asset classes, not only in listed equities as was traditionally the case. Various investor guidelines offer best practice advice on how pension funds can adopt material ESG factors in real estate, sovereign bonds and private equity. While integration seems the way forward, it must also be noted that exclusions, when limited, are no longer frowned upon and not automatically equated with a reduction in returns. Many pension funds now exclude controversial weapons such as landmines and cluster munitions. In the Netherlands, investments in cluster munitions have been prohibited from January 2013. Six years earlier, Dutch pension funds were exposed on the country’s TV programme Zembla for investing nearly €230m in US producers of cluster bombs and landmines.
The evolution has also resulted in the coinage of several new terms, including ESG, socially responsible investment (SRI), sustainability, the triple bottom line, non-financials and others – which are more or less used according to individual preference. One of the latest approaches to appear is impact investing – investing not only for financial returns but also for a social impact.
• Fiduciary duty. For a long time, institutional investors were able to say that fiduciary duty came first, and that this prevented them from taking into account any non-financial issues. However, in 2005 the UN Environment Programme Finance Initiative (UNEP FI) commissioned international law firm Freshfields Bruckhaus Deringer to clarify the interpretation of fiduciary duties by investors. It concluded that because of the link between ESG factors and financial performance, the integration of ESG factors in financial analysis was permissible and actually part of fiduciary duty to do so.
Most recently, the UK Law Commission’s consultation paper on fiduciary duties of investment intermediaries – which was a result of the 2012 Kay Review – was published. It concluded that the consideration of ESG factors by investment intermediaries is ‘clearly permissible’ and that trustees can take macroeconomic and systemic factors into account in their decision-making. The paper seems to have stepped out of the shadow of the Cowan v Scargill High Court case in the UK in 1985, which had, until now, made sure that the focus remained purely on financial returns.
The consultation closed on 22 January. A report with recommendations to the UK government is due to be published by June 2014.
• Integrated reporting. Getting companies to report on relevant non-financial, ESG issues was difficult enough to start with. However, since more and more companies have cottoned on to the fact that appearing green and responsible can also be used as marketing material – or that they were obliged to report on corporate social responsibility (CSR), like in Denmark – a great deal of company sustainability reports have been produced.
But this form of silo reporting – keeping the sustainability report separate from the financial statement in the annual report – means there is a disconnect between the two, which is why the Integrated Reporting Initiative (IIGC) has called for integrated reports. Those should disclose any ESG information that is material and relevant for the performance of the business.
The IIGC launched a new corporate reporting model to that effect in 2013. Stock exchanges were asked by investors to crack down on inadequate reporting. This is also part of the Sustainable Stock Exchanges (SSE) initiative, which was launched in 2009, and aims to promote ESG issues.
• Shareholder Spring. The infamous voting season of 2012 became known as the Shareholder Spring. Although overall voting statistics at year-end did not show a large rise in votes against remuneration, the number of investors voting against company proposals and the CEOs that were let go in that year attracted headlines. It also raised investor expectations.
And the momentum does not seem to have faded, with more movements, initiatives and regulations springing to life despite more discussions taking place behind closed doors.
The Kay Review of UK equity markets
and long-term decision-making, for example, certainly caused a stir. As a result of that review, an Investor Forum was launched that intends to promote shared commitment to long-term strategies and sustainable wealth-creation among asset owners, asset managers and companies. Crucially, it will also be open to non-UK investors and is expected to be in operation by June 2014.
• Stewardship Code. The introduction of the UK Stewardship Code in 2010 can be regarded as groundbreaking. The UK already had a corporate governance code in place but the Stewardship Code is specifically aimed at institutional investors. It is based on a comply-or-explain system and aims to enhance the quality of engagement between asset managers and companies to help improve long-term risk-adjusted returns to shareholders.
It set an example to many other countries. The Code for Responsible Investing by Institutional Investors in South Africa (CRISA), which also works on an apply-or-explain basis, was welcomed by institutional investors, as was the Dutch Code – known as Eumedion’s Best Practices for Engaged Share-Ownership. Investors generally prefer voluntary codes to legislation which, they warn, tends to be based on the lowest common denominator and encourages a box-ticking approach.
The European Fund and Asset Management Association (EFAMA) Code for External Governance from 2011, meanwhile, provides a best practice framework for asset managers to engage with investee companies.
Even the European Commission (EC) waded into the corporate governance debate with green papers and an action plan on European company law and corporate governance.
• Swiss mandatory shareholder voting. Switzerland introduced a mandatory say-on-pay ruling in 2014, with the legislation taking full effect from 2015.
It means Swiss pension funds will have to vote annually on the compensation of the board of directors, executive board and advisory committee on all their domestic shareholdings. The vote must be in the interest of their members. This means they cannot systematically say yes on board proposals. They also have to disclose their votes at least once a year.
The new rules are a result of the Minder-Initiative – named after its founder, the businessman and later politician Thomas – that the Swiss public backed with a 68% yes vote in March 2013, probably spurred by recent corporate excesses.
The initiative aims to reduce executive compensation and abolish golden hellos and parachutes through the increase in shareholder rights.
The echoes of this legislation were heard across the world, as executive remuneration remains a hotly contested issue in many countries. It may be a sign of more regulation to come.
In the UK, for example, a binding forward-looking remuneration policy vote was introduced in October 2013.
• UN PRI growth and exodus. The UN-backed Principles for Responsible Investment (PRI) were launched in April 2006 at the New York Stock Exchange after then UN secretary-general Kofi Annan had invited a group of the world’s largest institutional investors to participate in their development a year earlier. The initiative’s goal is to understand the implications of sustainability for investors and support signatories to incorporate these issues into their investment decision-making and ownership practices via six principles. The global initiative grew swiftly from its launch with 65 investor signatories to more than 1,200 signatories in 2013, despite its introduction of fees in 2011 and a tougher reporting framework in 2013.
However, despite all this success, in December 2013 a revolt took place when six Danish pension funds – ATP, Industriens Pension, PensionDanmark, PKA, Sampension and PFA Pension – left the initiative over governance issues and a lack of transparency and democracy. They were swiftly followed by another two compatriots.
The PRI responded by saying it would appoint an external, independent adviser to help review the PRI’s governance – a process it announced before the exodus in the autumn of last year.