Principles for Responsible Investment

Equator Principles

Environmental, Social, and Corporate Governance (ESG) data refers to metrics related to intangible assets within an enterprise. Research shows that intangible assets comprise an increasing percentage of future enterprise value.

While there are many ways to think of intangible asset metrics, these three central factors together, ESG, comprise a label that has been adopted throughout the U.S financial industry. They are used for a myriad of specific purposes with the ultimate objective of measuring elements related to sustainability and societal impact of a company or business.

Historical decisions of where financial assets would be placed were based on various criteria, financial return being predominant. However, there have always been plenty of other criteria for deciding where to place money—from political considerations to heavenly reward. In the 1950s and 60s, the vast pension funds managed by the trades unions recognized the opportunity to affect the wider social environment using their capital assets—in the United States the International Brotherhood of Electrical Workers invested their considerable capital in developing affordable housing projects; the United Mine Workers invested in health facilities.

In the 1970s, the worldwide abhorrence of the apartheid regime in South Africa led to one of the most renowned examples of selective disinvestment along ethical lines. As a response to a growing call for sanctions against the regime, the Reverend Leon Sullivan, a board member of General Motors, drew up a Code of Conduct in 1971 for practising business with South Africa. What became known as the ‘Sullivan Principles’ attracted a great deal of attention and several reports were commissioned by the government to examine how many U.S. companies were investing in South African companies that were contravening the Sullivan Code. The conclusions of the reports led to a mass disinvestment by the U.S. from many South African companies. The resulting pressure applied to the South African regime by its business community added great weight to the growing impetus for the system of apartheid to be abandoned.

In the 1960s and 1970s, Milton Friedman, in direct response to the prevailing mood of philanthropy argued that social responsibility adversely affects a firm’s financial performance and that regulation and interference from ‘big government’ will always damage the macro economy. His contention that the valuation of a company or asset should be predicated almost exclusively on the pure bottom line (with the costs incurred by social responsibility being deemed non-essential), underwrote the belief prevalent for most of the 20th century.

Towards the end of the century however a contrary theory began to gain ground. In 1988 James S. Coleman wrote an article in the American Journal of Sociology titled Social Capital in the Creation of Human Capital, the article challenged the dominance of the concept of ‘self-interest’ in economics and introduced the concept of social capital into the measurement of value.

There was a new form of pressure applied, acting in a coalition with environmental groups: it used the leveraging power of its collective investors to encourage companies and capital markets to incorporate environmental and social challenges into their day-to-day decision-making.

Although the concept of selective investment was not a new one, with the demand side of the investment market having a long history of those wishing to control the effects of their investments, what began to develop at the turn of the 21st century was a response from the supply-side of the equation. The investment market began to pick up on the growing need for products geared towards what was becoming known as the Responsible Investor. In 1998, John Elkington, co-founder of the business consultancy SustainAbility, published ‘Cannibals with Forks: the Triple Bottom Line of 21st Century Business in which he identified the newly emerging cluster of non financial considerations which should be included in the factors determining a company or equity’s value.

He coined the phrase the ‘triple bottom line,’ referring to the financial, environmental, and social factors included in the new calculation. At the same time the strict division between the environmental sector and the financial sector began to break down. In the ‘City of London’ in 2002, Chris Yates-Smith, a member of the international panel chosen to oversee the technical construction, accreditation and distribution of the Organic Production Standard and founder of one of the City of London’s leading branding consultancies, established one of the first environmental finance research groups.

The informal group of financial leaders, city lawyers and environmental stewardship NGOs became known as ‘The Virtuous Circle,’ and its brief was to examine the nature of the correlation between environmental and social standards and financial performance. Several of the world’s big banks and investment houses began to respond to the growing interest in the ESG investment market with the provision of sell-side services; among the first were the Brazilian bank Unibanco, and Mike Tyrell’s Jupiter Fund in London, which used ESG based research to provide both HSBC and Citicorp with selective investment services in 2001.

In the early years of the new millennium, the major part of the investment market still accepted the historical assumption that ethically directed investments were by their nature likely to reduce financial return. Philanthropy was not known to be a highly profitable business, and Friedman had provided a widely accepted academic basis for the argument that the costs of behaving in an ethically responsible manner would outweigh the benefits.

However, the assumptions were beginning to be fundamentally challenged. In 1998, two journalists Robert Levering and Milton Moskowitz had brought out the ‘Fortune 100 Best Companies to Work For,’ initially a listing in the magazine ‘Fortune,’ then a book compiling a list of the best-practicing companies in the United States with regard to corporate social responsibility and how their financial performance fared as a result. Of the three areas of concern that ESG represented, the environmental and social had received most of the public and media attention, not least because of the growing fears concerning climate change. Moskowitz brought the spotlight onto the corporate governance aspect of responsible investment.

His analysis concerned how the companies were managed, what the stockholder relationships were and how the employees were treated. He argued that improving corporate governance procedures did not damage financial performance; on the contrary it maximized productivity, ensured corporate efficiency, and led to the sourcing and utilizing of superior management talents.

In the early 2000s, the success of Moskowitz’s list and its impact on companies’ ease of recruitment and brand reputation began to challenge the historical assumptions regarding the financial effect of ESG factors. In 2011, Alex Edmans, a finance professor at Wharton, published a paper in the ‘Journal of Financial Economics’ showing that the 100 Best Companies to Work For outperformed their peers in terms of stock returns by 2–3% a year over 1984–2009, and delivered earnings that systematically exceeded analyst expectations.

In 2005, the United Nations Environment Programme Finance Initiative commissioned a report from the international law firm Freshfields Bruckhaus Deringer on the interpretation of the law with respect to investors and ESG issues. The Freshfields report concluded that not only was it permissible for investment companies to integrate ESG issues into investment analysis, it was arguably part of their fiduciary duty to do so.

Where Friedman had provided the academic support for the argument that the integration of ESG type factors into financial practice would reduce financial performance, numerous reports began to appear in the early years of the century which provided research that supported arguments to the contrary.

There has been uncertainty and debate as to what to call the inclusion of intangible factors relating to the sustainability and ethical impact of investments. Names have ranged from the early use of buzz words such as ‘green’ and ‘eco,’ to the wide array of possible descriptions for the types of investment analysis—’responsible investment,’ ‘socially responsible investment’ (SRI), ‘ethical,’ ‘extra-financial,’ ‘long horizon investment’ (LHI), ‘enhanced business,’ ‘corporate health,’ ‘non-traditional,’ and others.

Threat of climate change and the depletion of resources has grown, so investors may choose to factor sustainability issues into their investment choices. The issues often represent externalities, such as influences on the functioning and revenues of the company that are not exclusively affected by market mechanisms. As with all areas of ESG, the breadth of possible concerns is vast (e.g. greenhouse gas emissions, biodiversity, waste management, water management).

The body of research providing evidence of global trends in climate change has led investors—pension funds, holders of insurance reserves—to begin to screen investments in terms of their impact on the perceived factors of climate change. Fossil fuel reliant industries are less attractive.

Sustainability issues touch on the depletion of resources and the future of industries dependent upon diminishing raw materials. The question of the obsolescence of a company’s product or service is becoming central to the value ascribed to that company. The long-term view is becoming prevalent amongst investors. There is a growing belief that the broader the pool of talent open to an employer the greater the chance of finding the optimum person for the job. Innovation and agility are seen as the great benefits of diversity, and there is an increasing awareness of what has come to be known as ‘the power of difference.’

Regarding human rights, in 2006, the U.S. Courts of Appeals ruled that there was a case to answer bringing the area of a company’s social responsibilities squarely into the financial arena. This area of concern is widening to include such considerations as the impact on local communities, the health and welfare of employees, and a more thorough examination of a company’s supply chain.

Until fairly recently, caveat emptor (‘buyer beware’) was the governing principle of commerce and trading. In recent times however there has been an increased assumption that the consumer has a right to a degree of protection and the vast growth in damages litigation has meant that consumer protection is a central consideration for those seeking to limit a company’s risk and those examining a company’s credentials with an eye to investing. The collapse of the U.S. subprime mortgage market initiated a growing movement against predatory lending heightened this mood.

Animal welfare is also a growing concern in ESG. From the testing of products on animals to the welfare of animals bred for the food market, concern about the welfare of animals is a large consideration for those investors seeking a thorough understanding of the company or industry being analyzed.

Corporate governance covers the area of investigation into the rights and responsibilities of the management of a company—its board, shareholders and the various stakeholders in that company. Regarding issues of compensation, companies are now being asked to list the percentage levels of bonus payments and the levels of remuneration of the highest paid executives are coming under close scrutiny from stock holders and equity investors alike.

Besides executive compensation, equitable pay of other employees is a consideration in the governance of an organization. This includes pay equity for employees of all genders. Pay equity audits and the results of those audits may be required by various regulations and, in some cases, made available to the public for review.

The ‘Equator Principles’ is a risk management framework, adopted by financial institutions, for determining, assessing and managing environmental and social risk in project finance. It is primarily intended to provide a minimum standard for due diligence to support responsible risk decision-making.

Asset managers and other financial institutions increasingly rely on ESG ratings agencies to assess, measure and compare companies’ ESG performance. More recently, data providers have applied artificial intelligence to rate companies and their commitment to ESG. Each rating agency uses its own set of metrics to measure the level of ESG compliance and there is, at present, no industry-wide set of common standards.

A strong ESG movement exists in Brazil and all of Latin America. More and more companies are aware of the importance of the best practices in environmental, social and governance issues. In Latin America, it is the Latin American Quality Institute with headquarters in Panama and operations in 19 countries that leads the movement with more than 10,000 certifications issued.

One of the major issues in the ESG area is disclosure. Environmental risks created by business activities have actual or potential negative impact on air, land, water, ecosystems, and human health. The information on which an investor makes their decisions on a financial level is fairly simply gathered. The company’s accounts can be examined, and although the accounting practices of corporate business are coming increasingly into disrepute after a spate of financial scandals, the figures are for the most part externally verifiable. With ESG considerations, the practice has been for the company under examination to provide its own figures and disclosures.

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