Responsible Investment and Environment Society Governance
Hello and welcome to the next edition of ‘a view from the desk’. My name is Chris Redman and am the Head of Responsible Investment.
In this edition I will be discussing Responsible Investment and its many different facets, including ESG (Environment Society Governance). Whilst there is nothing new about Responsible Investment, in the last few years the subject has gained unprecedented levels of publicity. In growing from being a rather specialist backwater of the investment world, ESG is now big business. The investment scene is rapidly evolving as asset managers try to work out how to embed ESG into their processes. So, if we are going to navigate this fast-moving space successfully, we need to understand what people are talking about when they discuss ESG, Responsible Investment, and its other variations. In some cases, the differences are subtle, and in others they are very large.
To my way of thinking, ESG is a form of analysis; Responsible Investment is a course of action.
Let us look at ESG first, then compare with Responsible Investment.
From an investment analysis perspective, the term Responsible is not really very helpful. It is simply too subjective. Analysts need to be able to quantify factors and put them in spreadsheets so that they can put a value on a security and compare it with other securities. This requires breaking down ‘Responsibility’ into simple, quantifiable factors. So, the financial community conveniently disaggregates Responsibility into Environmental, Social and Governance factors (ESG). These factors can then be broken down into 100 or more subfactors, each of which can be assigned a value (often subjectively!). Well, that seems methodical, and on the face of it, quite sensible. But these factors are necessarily an incomplete list and many times will be estimates or even guesses. So, there is much criticism of the real value of this process.
Furthermore, ESG is poor at capturing a company’s positive contribution to society. For most institutional users, ESG scores are primarily used to highlight areas of risk in a business that traditional financial analysis might not pick up. For example, is a diverse board of directors (by ethnicity, wealth, age, and gender) more likely to make educated decisions than a board comprised of elderly white middle class men? ESG analysis is adding to fund managers’ pool of knowledge and their ability to make sensible decisions. In that sense ESG is an important advance on traditional investment methods. Arguably, ESG should be as important as financial analysis.
A further step in the ESG process is the extent asset managers talk with management of investee businesses about the practices they can improve on. Many asset managers claim to do this. The transition to a Sustainable world is a journey and investors and management need to recognise the need for change and work together. With the companies we speak with, discussions about sustainability are generally valued. Good company directors welcome shareholders views. If our comments are clearly not welcome, then that might be a signal to not invest.
Unfortunately, many people who invest through funds may not be getting what they expect. When people are buying into an ESG focused fund, for the most part they are being told that their money is putting the world to rights – it is solving the climate crisis, it is ending child labour and a whole host of other ills. When a fund management company says it is integrating ESG into its processes, investors are expecting big things. But they are in danger of being badly misled. As I mentioned earlier, ESG is big business and no asset management firm wants to be left behind, so everybody says they are doing ESG. What we work out is how much importance is attached to the ESG analysis. In the worst case, ESG is little more than a marketing tool. You need to be able to tell the difference between managers that talk the talk for Responsibility and those that walk the walk.
Let’s turn to what we mean by Responsible Investment.
A Responsible Investor acknowledges their involvement in the consequences of that companies’ actions and in its interactions with the world. They are saying ‘this is my money and I care what is done with it’. Investors may exclude certain investments, try to change a company’s behaviour (engagement) and prioritise favoured companies where activities have clear benefits to society. What this process entails is analysing not just the financial returns but also the company’s impact on customers, employees, its locality, the environment, and the companies it does business with. At the same time, we look to create superior financial returns. We believe that companies operate with social licence. That means that companies need the tacit approval of their society to operate successfully. Companies that treat their stakeholders with respect are more likely to prove to be better run companies, and consequently, better investments than those that don’t. I can take this further and suggest that if everybody behaves with this positivity, the world would be a much better place, which is a long-term goal of Responsible Investment.
For those of us that want our money to make a difference, within that catch all word of ‘Responsibility’, we can help investors refine how they would like that money managed. Peregrine & Black Investment Management have a structured process for engaging with clients and helping them to select the issues that matter most to them, so that we can emphasis these wishes in their portfolio.
Let us look at some of the subsets of Responsible Investing. Understanding these can help in the conversation between client and adviser.
· Ethical investing (as it sounds) tends to reflect matters of personal belief and tends to be associated with religious belief. Most religions have well developed frameworks detailing which activities are acceptable and which are not.
· Socially Responsible Investment (SRI) might arguably be similar, but in a more secular context.
· Impact and Thematic. There are undoubtedly investment themes at work which Graham (Withers) alluded to in his last newsletter. Some of these might be described as Impact (investing in companies whose activities are considered to directly provide solutions to some problem) and some may be described as Thematic (where a particular type of business activity is thought to have a strong economic justification). A crucial difference between Impact and Thematic is that Impact investors are trying to effect change, whilst Thematic investment seeks to profit from a narrowly defined investment strategy. These can of course be found together. What these do have in common is identifying a subject such as new energy, or perhaps any of the United Nations Sustainable Development Goals, and enabling an investor to gain diversified but focused exposure to that trend. This is a useful way of being able to execute your positive investment preferences.
Thank you for your patience while I spend so much time on definitions but if you are reading this because you are interested in responsible investment, it is important to understand how the fund management industry is approaching the subject: what it thinks ESG is, how ESG is being used to make profits for you, and how it is being used to make profits for the fund management industry.
Now let us return to Responsible Investment and why this matters, and why this is not the same as ESG or for that matter, philanthropy.
I am going to come at this question from two angles: the point of view of Responsibility and separately, from the point of view of financial investment decision making, and why Responsible Investment is fundamentally different to traditional investing.
In all aspects of life, individuals to a greater or lesser degree, have some sort of moral compass and this moral compass guides us in our decision making. We all have some notion of right and wrong, and yet somehow the asset management industry has for decades convinced its customers that money is above morality. Indeed, that acting with principles is to your detriment. This is a lie. The success (so far) of the human race has depended on its ability to act in community which requires consideration for the other members of the community. Sometimes it requires sacrifice. But ultimately those sacrifices have payoffs that exceed the cost. If our goal in investing is to become more prosperous as individuals, it makes sense to enrich society at the same time. If we are to do that, we need to be aware of how we are making money as well as how much money we are making. Do you really want to retire on the proceeds of child labour? Society is enriched by healthcare but impoverished by mis-selling of opioids and the misery that has created for millions. Sometimes there are opportunities for profit that should be left alone. Are you happy to leave the climate change crisis to your grandchildren to solve? Sometimes society needs to deal with long term issues in the present.
So why is Responsible Investment such a difficult thing for the City to grasp?
In investment theory, the assumption that overrides all others is that profit maximisation is the only motive. Much of the economic and investment theory that dominates thinking today arose in the 1950s (when the world was quite different) and defined economic man as being completely greedy, selfish, and lazy. He is greedy because his goal is to maximise profits – ‘life is a race to the end and the one with the most wins’. He is selfish because he is only interested in himself, and he is lazy because he will do this with the minimum of effort. The assumption is that we are all completely so. This belief underlies investment theory, economic theory and is arguably the case in our legal system and our system of government. My point here is this assumption is palpably wrong, and yet it is the primary assumption that sits at the heart of financial decision making, and much of the law-making around that. And what happens if we make decisions based on wrong assumptions? We make wrong decisions. My contention, is that the fundamentals of how investment decisions are made, can all be improved upon with Responsible Investment. My contention is that the hard-wired short termism of asset management, and government are hugely detrimental to the long-term wellbeing of investors, people, and the planet. If people’s motives and long-term concerns are more accurately represented in investment decisions, then it seems more likely that better decisions will be made, and better outcomes achieved – not just for the investor but also for the community. This will not be achieved by governments with a four-year horizon, Cabinet ministers with a one-year job horizon, and an asset management industry with a three-month investment horizon. It might be achieved with an investor horizon that spans a generation or more.
So, there is a long way to go. In our legal system, the primacy of the shareholder still exists. Company directors are required to consider the wider effects of their decisions, but they do not override the profit maximisation goal. Our legal and governance systems are still in essence combative rather than cooperative. In the US, under Trump, trustees were firmly directed that ESG motives had to be secondary to profit motives. Biden’s administration seems to prioritise climate risk but is unclear on social aspects. The EU are trying to bring ESG to centre stage, but the lack of any agreed analysis framework will likely result in confused and weak legislation. Large areas of the world are ruled by despots (who control vast natural resources) and climate change may alter the world political balance. Investing with a social conscience requires effort, patience and intelligence but it is necessary and worthwhile. After all, surely the most intelligent solution to a problem is the one that benefits all.
I would like to touch on why responsible investment is not philanthropy. I sense a misunderstanding of what philanthropy is - which is the provision of a benefit with no thought to ones own financial benefit. Philanthropy has economic benefits - it’s just that the immediate benefits accrue directly to the recipient. You could very reasonably argue that they indirectly accrue back to the giver in time, perhaps even with a profit. It is just difficult to connect the two. Responsible Investment in still Investment.
Lastly, I have been asked a few times what the ESG lessons are from the Covid pandemic. I offer a thought on the power of acting in community. I cannot think of a much better example of the astonishing results that humans can achieve if they cooperate, than the possibility that more than half of the world’s population could be vaccinated against a newly discovered virus within a period of 36 months of its discovery. It is an astonishing feat of science and cooperation. Imagine what could be accomplished in eliminating the really nasty diseases that kill tens of millions around the world every year, or perhaps even avoiding catastrophic climate change.
If you are interested in discovering more about our Responsible Investment Models or our Bespoke Service, please contact either myself or your usual investment manager.
Happy Easter to you all.
Chris Redman - Head of Responsible Investment
30th March 2021