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The Paris Agreement nudged governments to promise to try to reduce emissions that are causing alarming changes to our climate. Following the disappointment in Madrid last December, there are good reasons to think it did not go far enough – and plenty of governments are dragging their heels -or worse. So what else can be done?  Frances Cowell investigates.

Public policy is important, but private businesses can do a lot too. Some firms are taking the initiative to do their bit for our planet, but most consider their first duty toward their shareholders, abiding by Milton Friedman’s 1970 exhortation that “the business of business is business”. If a firm’s priority is to please shareholders, it follows that, as an investor, you can influence their decisions. If you have any doubts about that, consider how consumers, voting only with their wallets, nudged firms such as Nike to lean on their developing-market suppliers to treat their employees better. Clearly investors, who have much more leverage, for example by selling their holdings, voting directors out and leaning on management to do things differently, have much more. Wealthy investors can do so directly, but ordinary people acting collectively through their pension and trust funds can do even more.

Under increasing pressure from civic groups and investors themselves who, in turn are responding to the demands of their members including, importantly, some very big and influential pension funds, firms are now falling over themselves to be seen to be taking care of their environmental footprint, treating workers fairly, ensuring their suppliers do too, and improving their internal governance. Meanwhile, the managers who pension funds contract to carry out day-to-day investment management, are being asked to select portfolios of investments that meet given ESG investment criteria.

CalPERS, the California Public Employees’ Retirement System, is a prominent example, devoting a chunk of its formidable resources to researching climate change and its impact on investing, integrating that research into its main-stream decision-making, engaging with firms and government advocacy. Its stated aim is to earn attractive investment return while ensuring positive environmental and social outcomes.

Pension, insurance and trust funds collectively are increasing their activities in environmental and social investing by tens and hundreds of percentages each year. Much of that growth is driven by pressure from their members.

Once considered a niche activity and a bit weird (like environmental activism), sustainable or responsible (collectively termed environment, social-responsibility and governance, or ESG) investing, has now entered the mainstream.

But how do you select assets to include in your ESG fund? The most obvious way is to invest only in industries and assets that meet your ESG standards, while avoiding those that don’t. You can do this either by filtering in good stocks, filtering out bad stocks, applying some kind of score or rating for each asset, or some combination of these.

But filtering can have unintended consequences, as the managers of a socially-responsible, “ethical” fund found in 2008, when it emerged that embargoing pornography entailed filtering out the entire telecoms sector.

Looking below the label, you may find a firm that, say, builds and manages wind farms, but sources its components from third country suppliers employing child labour, treats its own employees badly and is itself poorly managed or riddled with conflicts of interest. Equally, an energy firm with coal-fired power plants may be well-governed, treat its employees well, clean up after itself and direct new investment to wind and solar energy. Tesla demonstrated how to tick the E box, while getting the G badly wrong.

Hester Peirce, commissioner at the SEC is not being over-cynical when she says that much “responsible” investing risks being “labelling based on incomplete information, public shaming and shunning wrapped in moral rhetoric.” But looking below the label is difficult and time-consuming on a large scale.

Many investors and managers therefore engage independent research specialists to provide neat ESG scores for each asset or fund they might invest in. The problem is that ratings can be easy to game. Firms still have a strong incentive to maximise their profit and in some cases, this will lead them to make cosmetic adjustments so as to tick the right ESG boxes in the agencies’ check-list evaluations without necessarily changing how they do things. You need to watch out for this if your clout as an investor is not to be misdirected; you need to be sure that the rating is underpinned by sound and comprehensive research that is free of conflicts of interest.

You can avoid these problems altogether by investing in one of a growing range of impact funds, a relatively new avenue for responsible investing, which provides capital to address social and/or environmental issues. Alongside a (often lower) financial return, these funds promise a non-financial, quantitative result, such as increasing the number of girls in education in a particular region, or reducing maternal and infant mortality.

But most investors often have demanding return targets to meet. Pension and mutual funds and trusts, which dominate many share registers, rely on them to fund retirement income and keep schools, research institutions, hospitals and other services operating. Knowing that your retirement fund is not supporting child labour or poisoning pristine waterways is of course reassuring, but it doesn’t help meet your own financial obligations.

Can you have your forest and log it too?

Can ESG investing actually enhance financial performance or is it always going to be, in the long term, a drag on it? In fact both may be true – it depends on how you go about it.

Prices for ESG assets have already risen more than others, yet they are likely to be in demand for some time to come for a couple of reasons. For one, millennials, who are especially keen on things ESG, are only just starting to invest, so the weight of their new money is likely to drive capital appreciation even of assets with unspectacular returns. The other is that young investors are naturally more interested in long-term outcomes than short-term cash-flows. That ESG assets themselves tend to have long pay-off, and therefore investment, horizons compounds this effect.

You can also argue that firms engaged in forward-looking industries are themselves likely to be forward-looking, socially-responsible and well governed, hence less likely to suffer corporate catastrophes like the Union Carbide tragedy at Bhopal, Enron in Rajasthan, Exxon in Alaska, and more recently, scandals at Boeing and Volkswagen. Simply avoiding them can add significantly to returns and reduce perceived riskiness.

As demand for environmentally-responsible and sustainable consumption mounts, some polluting assets may find themselves “stranded”. For example, a shift away from coal may leave some coal mines permanently unprofitable, eventually forcing costly closure and write-downs. The mere risk of this happening can raise the cost of capital for such projects and their parent firms, hurting their investors’ returns, so investors are likely to shun them.

HOW many trees?

ESG may turn out to be a sound investment move, but how do you know it really make the promised difference in sustainability? And if so, how much did this cost – or add to – its financial performance? The difficulty of answering these questions leads to another problem.

Vague measures of sustainability provide an opportunity for less committed and less scrupulous firms and agents to skim off fees for services that serve only to provide a smoke-screen or facilitate ineffectual box-ticking that we mentioned earlier.

Ratings are supposed to help, but ratings can be gamed, and of course, once a firm achieves a high ESG ranking, subsequently re-ranking can only be down, so choosing investment according to their existing ranking can be setting yourself up for a fall.

That sustainable investing has entered the mainstream is undoubtedly good news. Sustained action by private business and their investors can help compensate policy failures at government level and help address pressing environmental and social problems. And the sheer number of genuine sustainable investment opportunities means you have a real opportunity to harness your investment pot to help make the world a better place while earning a decent return.

You may have more power to influence how your pension or investment pot is used than perhaps you realise. To deploy that power effectively, you need to beware the traps and make sure your managers and trustees do too – and hold them to account. With power comes responsibility, and responsible investing can start with you, the investor.

 

Frances Cowell
Australian-born and European by adoption, Frances Cowell writes and speaks at conferences about investment risk and governance, financial market stability and business ethics in financial markets – and the implications for the wider political economy. She believes Europe must urgently assume the lead in protecting and preserving liberal democracy, the rule of law and the multi-lateral institutions and alliances that it depends on.

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