Environmental, social, and governance (ESG) factors are becoming increasingly important for institutional investors. Once considered the domain of socially responsible investment (SRI), they are moving to the mainstream as both business leaders and investors recognise their wider implications.
The growing importance of environmental issues, for example, was amply demonstrated most recently by the widespread coverage received by former World Bank chief economist Nicholas Stern’s report on the effects of global warming. Sponsored by the British government, the report called climate change “the greatest and widest-ranging market failure ever seen” and warned that the costs of acting now are minimal compared with the future costs of failing to do so. Yet the report’s main findings are already being acted upon by many companies and investors, and were so even before Hurricane Katrina showcased the dangers of climate change.
In addition, a coalition of 225 global institutional investors managing over $31,000bn (€23,820bn) set up the Carbon Disclosure Project to study the business implications of climate change. The project has now produced four annual reports on carbon emissions by 2100 global companies. Fourteen leading institutional investors also recently released the Global Framework for Climate Risk Disclosure to provide guidance to companies on the information they give to investors about the financial risks posed by climate change. The point is that so many businesses are ahead of political leaders on responding to climate change because they recognise the direct relationship between climate change risk and their own bottom lines.
Corporate shareholder activity is also rising. Investors are becoming more engaged in the process of evaluating investments using ESG perspectives. Fiduciaries are beginning to look at investment risk from both long-term and environmental-impact perspectives. Organisations outside traditional socially responsible investing circles are taking notice. A November 2005 report from the law firm Freshfields Bruckhaus Deringer commissioned by the United Nations Environment Program Finance Initiative (UNEP FI) established that fiduciary duty not only allows ESG considerations, it sometimes requires them. The ESG momentum of late continues with the recent release of the Principals of Responsible Investment (PRI). At the request of the United Nations Secretary-General, Kofi Annan, PRI was created in April 2006 by a group of professional investors representing 20 institutional plans with over $2000bn in assets under management.
The PRI provides a framework for incorporating environmental, social and governance issues into the investment philosophies and ownership practices of asset owners. Currently, at least 50 institutional investors with more than $4000bn in assets have signed the PRI. Over 30 investment managers with more than $3000bn in assets under management have signed the principles.
The PRI consists of six statements, each of which contains four to eight suggested actions to comply with the PRI:
1. We will incorporate ESG issues into investment analysis and decision-making processes.
2. We will be active owners and incorporate ESG issues into our ownership policies and practices.
3. We will seek appropriate disclosure on ESG issues by the entities in which we invest.
4. We will promote acceptance and implementation of the principles within the investment industry.
5. We will work together to enhance our effectiveness in implementing the principles.
6. We will each report on our activities and progress towards implementing the principles.
There are three types of signatories who may comply with the PRI: asset owners, investment managers and professional service partners. Asset owners are long-term investors including pension funds, endowments and government funds. These asset owners are the main signatories of the PRI. The PRI must be supported by senior levels of management and applied throughout the entire organisation. Therefore, an organisation cannot sign the PRI and only apply the principles to SRI products or mandates.
The PRI website states that the principles are: “voluntary and aspirational”. They are not prescriptive, but instead provide a menu of possible actions for incorporating ESG issues into mainstream investment decision-making and ownership practices.” Due to the voluntary nature of PRI, there are no penalties associated with failure to follow the guidelines. The PRI is meant to be a potential goal rather than rules to follow. Institutions can choose to focus initially on any of the six drivers, and complete them over time in an incremental fashion.
While PRI shares some of the same concepts as SRI, such as active ownership and the use of ESG criteria, the two differ in important ways. PRI operates across the totality of investment options and discourages negative screening, whereas SRI is often focused on a certain strategy and screens to eliminate potential investments are used. PRI is also designed to work with the fiduciary requirements of all institutional investors, not just those concerned with SRI.
PRI seeks to eventually increase investment returns while lowering risk. This will be accomplished through the signatories’ pooling of resources and research to better understand ESG issues while lowering the costs of active ownership. The principles will also allow members to work together to address various problems, such as managing for the short-term and ignoring environmental costs. Resolution of these issues may lead to more stable and profitable market conditions.
William H. Page, portfolio manager, ESG team, State Street Global Advisors.
