Blog

Not just a moral choice or an ethical calling

It is hard to resist an idea whose time has come. The history of the Principles for Responsible Investment (PRI) over the last 10 years of its existence has been one of an idea – responsible investment – that has been embraced with extraordinary enthusiasm by the investment community. Since 2006 the PRI has grown from 20 pension funds, foundations and other institutions that drafted the original Principles to the 1,500 signatories who’ve signed up to them today – from US$2 trillion of assets to US$59 trillion.

And it has been embraced to the extent that it has is because it has been framed not as an ethical choice, or as a moral calling, but, at its core, as an investment issue.

As UN Secretary General Kofi Annan heralded in 2006,

“the Principles provide a framework for achieving better long-term investment returns and more sustainable markets.”

At the heart of the Principles is the view that taking appropriate account of environmental, social and governance factors helps investors manage risk and generate higher returns over the long-term. It is a proposition that is backed up by extensive academic research.

And that, in turn, makes responsible investment a fiduciary responsibility. When you manage other peoples’ money, you have an obligation to consider factors that are likely to have a material impact on the risk and returns over the longer term.

Responsible investment – the inevitable norm

How we organise society, run our companies, and manage our investments changes over time. Take attitudes to health and safety standards in industry. Today, strong health and safety standards, with the policies and procedures to deliver them, are considered fundamental to how a modern company does business.  High performance in health and safety is a good indicator of the quality of management in general and leads to fewer disruptions in production, higher efficiency, lower legal risk and higher employee satisfaction. Health and safety has moved from being regarded as an extra cost to being regarded as simply a better way of doing business.

High standards in the integration of environmental, social and governance factors in decision making will, likewise, one day become a way of doing business for successful businesses in the financial sector – not a “nice to have” add-on activity. Eventually, we will simply lose the ‘r’ from RI – responsible investing will just be investing.

But this happy day will not deliver ‘responsible investment nirvana’. There are fundamental problems in the structure of modern capitalist societies that require investors to take a broader view of their role, and work to address some of the systemic challenges that we face.

Micromanaging vs out of control 

Let’s consider the relationship between owners and managers. The creation of the Dutch East India Company, in 1602, is an important milestone in economic history. For the first time, we had a company with a separate legal personality, limited liability and shares that were freely tradable on a stock exchange.

Finance textbooks teach that diversification offers investors a free lunch; in theory, it allows them to increase risk-adjusted returns. But practice shows that it does come at a cost: namely a loss of control over their investment to company managers, and a pooling of ownership with other providers of capital.

This raises profound questions over how investors, holding small fractions of hundreds and thousands of companies, might best monitor, incentivise and control the managers of the companies that they own without resorting to counterproductive micro-management.

Investors have struggled with this issue for over four hundred years now. Recent history is littered with examples of managers criminally seeking to enrich themselves at the expense of their shareholders: WorldCom and Enron are only the most high-profile examples.

Even where managers may not have behaved criminally, there are serious questions to be asked of how their incentives have become misaligned with the interests of investors. Do we risk incentivising company management to neglect the long-term health of the companies they run in the pursuit of quarterly earnings targets or, worse, simply in their own interests?

The global financial crisis was also – among many other things – a manifestation of these principal-agent problems. Across the entire financial system, traders were incentivised to deliver short-term returns with little regard to the long-term management of the risks that accumulated.

Corporations – like the Dutch East India Company – come with a range of inherent issues related to asymmetric information, incomplete contracts and principal-agent issues that are hard-wired into our economic systems.

These issues will never go away, but they can – and should – be managed through high standards of corporate governance as well as better dialogue among investors, to ensure they are speaking as much as possible with a common voice on issues relating to effective stewardship of the companies in which they invest.

The financial system and SDGs – new frontiers?

The global financial crisis has raised profound questions about the role of investors in ensuring the health of the financial system. It is no longer sufficient that it is able to deliver short-term returns, with little regard for the accumulation of longer-term risks.  How the responsible investment community might rise to this challenge will be an important topic for the PRI in the months and years ahead.

What’s more, responsible investors should seek to deliver measurable outcomes that are in line with wider societal objectives on economic growth, social progress and environmental stewardship, perhaps as set out last year in the Sustainable Development Goals. Is it time for responsible investors to demonstrate ‘real world’ impacts? What should those impacts be? How should they be measured?

The responsible investment community has come a long way in the ten years since the PRI was launched. In another 10 years, I think many of the arguments we are making now about the relevance of ESG issues and responsible investment approaches to good investment practice will have been won. How we get from here to there will involve a lot of hard work, and a lot of debate.