The Engaged Investor: The E and the S in the UK code
Praised for its response to governance issues, the UK Stewardship Code has come in for criticism over its handling of social and environmental risks, as Mike Scott reports
The UK's Stewardship Code, published in July 2010, is rapidly becoming something of an international benchmark for governance for institutional investors, and it has been hailed as a significant advance in ensuring that shareholders become more responsible and active owners of the companies they invest in.
"The code is a positive development that is in the interests of our clients because it is about higher standards of corporate governance that will enhance standards in the longer term," says Will Oulton, European head of responsible investing at the consultancy Mercer.
However, there is concern that there is too much focus on governance in the code and not enough on other non-financial issues. Under its fourth principle, the code says: "Instances when institutional investors may want to intervene include when they have concerns about the company's strategy and performance, its governance or its approach to the risks arising from social and environmental matters." But it does not make any more explicit mention of investors having to deal with social and environmental matters.
Christine Berry, policy officer at campaigning charity FairPensions, says: "We really welcome the code - it is a big step forward in embedding the idea that owners should be acting responsibly. But there is only a vague sense that stewardship and responsible investment are linked - it is not made explicit."
This is reflected in the disclosures that have been made under the code, which are very governance-focused, she adds.
FairPensions has reviewed disclosures under the code and says the standard is highly variable. "A notable feature is the absence of reference to management of environmental and social risks, even in the wake of the Gulf of Mexico oil spill, which should have removed all doubt as to the financial relevance of environmental and social issues," the organisation reports. "This suggests that when the FRC revises the code, it will be necessary to flag up the importance of monitoring and managing ESG considerations to safeguard clients' assets."
UK parliamentarian Jon Cruddas said: "The G in ESG, governance, has received a huge amount of attention, after it became obvious that conflicts of interest, excessive pay and poor risk management contributed to the financial crisis. Yet with typical myopia, many investors still neglect the E and S of ESG - the environmental and social. The Deepwater disaster, which forced BP to cancel its dividend for the first time since the Second World War, should have been a wake-up call for anyone who still doubted that companies that ignore such issues face serious financial risks. It should also have been a wake-up call for pension funds - for which the BP dividend was a significant source of steady income - to pay attention to such issues as a key part of their fiduciary duty."
By contrast, South Africa's draft Stewardship Code asserts that companies have "legal and moral obligations in respect of the economy, society and the natural environment. As a responsible corporate citizen, the company should protect, enhance and invest in the well-being of the economy, society and the natural environment."
Its first principle states: "An institutional investor should incorporate ESG considerations into its investment analysis and activities as part of the delivery of superior risk-adjusted returns to the ultimate beneficiaries."
By contrast, Berry argues that the UK code's focus on governance "contributes to the idea that shareholders are responsible to the companies in which they invest rather than to their beneficiaries. We need to bridge the gap between stewardship and responsible investment."
Environmental and social issues do not get dealt with unless they are given specific prominence in their own right, she adds. "Part of the problem at the moment is that environmental and social issues are seen as optional extras. They need to be in the code because that recognises that they are part of good management, good risk management and responsible ownership."
Consideration of sustainability issues is crucial to investment analysis, says Erik Breen, head of responsible investment at Dutch investment firm Robeco. "The corporate risk oversight guidelines of the International Corporate Governance Network are explicit that boards and investors need to consider all material risks that are within the management's sphere, including environmental, ethical and reputation risks," he points out.
Breen highlights another report, written by Trucost for the United Nations Environment Programme Finance Initiative (UNEP-FI) and Principles for Responsible Investing (PRI), which points out that the annual environmental cost of human activity amounts to 11% of global GDP, or $6.6trn (€5.1trn). "Corporate earnings could be at risk in future," he observes. "There is a materiality to these issues."
A further reason for considering environmental and social risks together with governance issues is globalisation. The World Economic Forum's Global Risk Network has highlighted the fact that we are in a world of unprecedented interconnectivity, so risks in one area can spill over into another. "While it is possible to come to the conclusion that individual risks are well-managed, a number of systemic risks remain and those are much harder to protect yourself against," Breen says. "For Robeco, sustainability issues are critical to better analysis and investment in companies," he adds.
However, Oulton says it may not be fair to require the code deal with this. "The intent was to improve dialogue between investors and boards, which is a corporate governance issue. The code is primarily about the process of engagement, interaction and dialogue. However, it does not exclude them talking about environmental and social issues if they're relevant."
Simon Wong from Governance for Owners agrees. "The UK Stewardship Code is very procedural. It is about being an active and engaged owner. Investors should be considering all forms of material risk, not just environmental and social matters."
While Wong concedes that there may be a gap between stewardship and responsible investment, he says this is not necessarily a problem. "We should not have the Code trying to do too much, particularly as there are other initiatives out there that deal with these issues."
In particular, there is growing momentum for companies to report on ESG issues regardless of pressure from investors. In 2010, the Johannesburg Stock Exchange introduced requirements on listed companies to integrate their sustainability reports with their annual reports (see article in this section). In the US, the SEC requires listed companies to disclose their exposure to climate change risks. ESG disclosure rules have also been introduced in China, Malaysia, Indonesia, India and Brazil. Additionally, the UK government has committed itself to reinstate the Operating and Financial Review (OFR) to ensure that directors' social and environmental duties have to be covered in company reporting.
Meanwhile the EU is also considering plans to introduce mandatory ESG reporting for businesses. "It is important for investors to be able to assess not only a company's value now, but what it will be worth in the future," says Matt Christensen, executive director of EUROSIF, the European Social Investment Forum. "EUROSIF supports mandatory ESG reporting and refocusing disclosure requirements to provide greater clarity on the significance of ESG issues."