The Routledge Handbook of Responsible Investment

Tessa Hebb, James Hawley, Andreas Hoepner, Agnes Neher, David Wood

• Publisher: Routledge
• Year: 2015
• ISBN:
  9781136249730
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The UN-supported Principles for Responsible Investment initiative has led to around a third of the world's financial assets being managed with a commitment to invest in a way that considers environmental, social or governance (ESG) criteria. The responsible investment trend has increased dramatically since the global financial crisis, yet understanding of this field remains at an early stage.

This handbook provides an atlas of current practice in the field of responsible investment. With a large global team of expert contributors, the book explores the impact of responsible investment on key financial actors ranging from mainstream asset managers to religious organizations.

Offering students and researchers a comprehensive introduction to current scholarship and international structures in the expanding discipline of responsible investment, this handbook is vital reading across the fields of finance, economics and accounting.

Part I

1
Introduction to The Routledge Handbook of Responsible Investment

Tessa Hebb, James P. Hawley, Andreas G. F. Hoepner, Agnes L. Neher and David Wood

Understanding responsible investment

We hear a lot about responsible investment these days. But what is it and how is it being implemented around the world? What are the impacts of responsible investment for investors, for the financial industry and for society as a whole? The Routledge Handbook of Responsible Investment provides a deep examination of responsible investment. It brings together over 60 authors to explore responsible investment practices around the globe. You can think of this volume as an atlas of current practice, one that spans six continents and profiles over 25 countries.

This Routledge Handbook also draws on top experts in the field to explore the impact of responsible investment on key financial actors ranging from mainstream asset managers to religious organizations. These authors examine current strategies used to implement responsible investment and the challenges they face going forward. The volume concludes with a series of chapters from top academics in the field as they reflect on the implications of responsible investment now and for the future.

What is responsible investment? Put simply, responsible investment (RI) takes environmental, social and governance (ESG) factors into consideration in investment decision-making. It is an investment approached increasingly adopted by institutional investors. In fact the UN-backed Principles for Responsible Investing (detailed below) now has over 1,300 signatories representing $45 trillion of assets under management. These signatories have pledged to bring ESG considerations into their investment decision-making. Add to this the fact that Bloomberg and MSCI now provide ESG data to the financial industry as a major component of their company reporting, and it is clear that responsible investing is increasingly moving to the mainstream of investment practices.

In the past, these three factors were considered to be non-financial (sometimes termed extra-financial) concerns. It was assumed that all known information about the firm was embedded in its stock price, and therefore additional attention to ESG information was not required. But over time the risks (and possible rewards) for taking ESG into account have become more evident. Regulatory bodies such as the U.S. Securities and Exchange Commission (SEC) suggest that ESG factors have ‘material’ impact on companies’ future earnings and as a result require mandatory reporting on these issues in annual reports to shareholders.

Events such as the Global Financial Crisis of 2008 reinforced the understanding that these factors play a critical role, particularly for long-term institutional investors, as these factors can pose risks to company performance over time. Post the Global Financial Crisis, and with a growing awareness of sustainability issues, mainstream investors are increasingly taking on responsible investing practices (UNPRI, 2014).

RI’s theoretical underpinning

The old mindset of RI as divergent and to some extent adversarial to company and shareholder goals (Friedman, 1970) is eroding (Donaldson & Preston, 1995; Jones & Wood, 1995; Freeman & Phillips, 2002). Instead responsible investing is being seen as a means of driving shareholder profit rather than a performance laggard (Porter & Kramer, 2006). This fundamental change in mindset is the result of the RI business case that seeks to develop and bind the notions of financial performance with ESG indicators. The business case contends that it is not simply a matter of ethics but rather that financial gains, management of risk and corporate responsibility converge in the long run (Louche & Lydenberg, 2006). The RI advantage is one of anticipating and mitigating long-term risks through raised ESG standards, not simply moral and ethical considerations (Scholtens, 2010; UNEP, 2008).

The theoretical underpinnings of responsible investment address problems associated with the efficient markets hypothesis (Fama, 1970; Samuelson, 1965) and modern portfolio theory (Markowitz, 1952) with their assumptions of a rational market. There is increased criticism of this theory in light of the Global Financial Crisis of 2008 (Bogle, 2005; Fox, 2009; Taleb, 2008, 2010), with behavioral finance (Lo, 2005; Schleifer, 2000; Shiller, 2000) coming to the fore. Rather than an efficient market, information asymmetries in financial markets are the norm (Akerlof, 1970; Stiglitz, 1976). Responsible investing builds on this theoretical framework, recognizing that ESG factors are a source of information asymmetry in financial markets.

Traditionally, ESG factors have been viewed as externalities of the firm and therefore not considered in its value (Hebb, 2008; Kiernan, 2009; Krosinsky & Robins, 2009; UNEP, 2008). Yet taking ESG into consideration can reduce risk for investors and add value over time (Gompers et al., 2003; Porter & van der Linde, 1995). This understanding is known as ‘the business case’ for responsible investing. Building on the critique of efficient markets, the ‘universal ownership hypothesis’ (Hawley & Williams, 2000) suggests that because large institutional owners own the whole market, what may be negative externalities for one company in the portfolio are direct and often costly impacts on another holding. As a result, today’s institutional investors must be concerned about the ESG standards of the firms they hold in their investment portfolios.

Additionally, the principal–agent problem (Jensen & Meckling, 1976; Fama & Jensen, 1983; Schleifer & Vishny, 1997) plays a part in the market failures that drive the need for responsible investment. The struggle for corporate control between owners and managers has a long history in legal, financial and economic literature (Berle & Means, 1933; Roe 1994). Responsible investing represents a shift away from firm managers and toward owners of corporations. It suggests that share owners provide active and engaged oversight of today’s corporations (Monks, 2001; Davis et al., 2006). Responsible investment encourages active share ownership, and increasingly such oversight is seen as critical to the health of our financial markets.

Implementing responsible investment

Large institutional investors have become the dominant players in our financial system, representing over 70 per cent of today’s shareholders. Many of these institutional investors hold retirement savings, and as a result have liabilities to beneficiaries that can last over 30 years. These long-term obligations have given rise to an increased awareness of risk over time in their investment portfolios. Increasingly, institutional investors are recognizing the danger of short-termism in our financial markets (Kay, 2012; Barton & Wiseman, 2014). The Global Financial Crisis served to heighten those concerns. Such a recognition is critical to understanding the risks posed from ESG factors, as these often play out over time. While in the short-term it may cost more to put safety mechanisms in place, over time these investments pay off. The challenge for the investor is to move away from an obsession with short-term quarterly returns and begin to view an investment in the firm over the long-term. However, one of the challenges for responsible investors is that the incentive structure deeply embedded in the financial system remains linked to short-term rather than long-term financial results.

Responsible investment requires a shift in temporal understanding. Large institutional investors either implicitly or explicitly¹ have a set of investment beliefs that underpin their investment decision-making. Increasingly these beliefs include a shift to long-term investment and a valuing of ESG factors embedded in that shift (see CalPERS Investment Beliefs for more on this point). Additionally, our understanding of fiduciary duty, which so often restricted these funds’ actions in the past, has become more sophisticated with regard to the important role ESG considerations can and should take (Freshfields Bruckhaus Deringer, 2005; Hawley et al., 2013).

Responsible investment can be implemented in a variety of ways. Most common is through integration in the investment portfolio (UNPRI, 2014). Often the asset owner requests ESG integration from the internal and external asset managers. Such integration in investment portfolios is handled through stock selection often referred to as ‘best of class’ or ‘best of sector’. Here, the investor selects a portfolio based on companies (and even countries in the case of sovereign bonds) that have the highest ESG standards. The asset owners believe that high ESG standards can reduce risk over time and may lead to outperformance.² Third-party rating agencies (such as Bloomberg, MSCI, and Sustainalytics) provide readily available ESG information to the market that assists in such investment decision-making.

Conversely, the investor can stay away from companies that have poor ESG ratings. Most responsible investors do not exclude whole sectors from their investment portfolios, but rather look for the highest ESG standards across the whole economy. While some investors bring ethical considerations to bare (particularly socially responsible and religious investors), most do not, preferring instead to focus on ‘the business case’ for RI rather than broad-based exclusions.

However, responsible investors often adopt codes and norms within their investment policies that help them to identify the standards they will apply when integrating ESG into their investment portfolio. These are usually globally-based sets of principles such as the UN Declaration of Human Rights, the Global Compact, the Global Sullivan Principles of Corporate Social Responsibility, the environmental CERES Principles, the Carbon Disclosure Project, or the Extractive Industries Transparency Initiative (EITI). These codes provide a generally accepted framework of corporate behavior that informs the institutional investor and are often monitored by third-party non-governmental organizations (NGOs) that bring the increased corporate (or country) transparency that responsible investors require. Violation of these codes of conduct can lead to divestment from companies and even sectors. One prominent example is divestment from companies that produce cluster bombs in violation of the Convention on Cluster Munitions. Many responsible investors have adopted this policy.

The second primary strategy used by responsible investors is shareholder engagement. This is a positive strategy that uses shareholder rights and active ownership to exert pressure on companies to raise their ESG standards. It can be an active or a passive strategy. Proxy voting is an example of a passive RI engagement strategy. Shareholder engagement can also be private or public. Private active engagement usually consists of some form of dialogue with the company, such as personal communication, letter writing and face-to-face meetings, in order to raise issues of concern away from public scrutiny. In contrast, public active engagement includes publishing focus lists of underperforming companies and putting minority shareholder resolutions forward at company annual meetings. These actions often bring public and media attention and can damage a company’s reputation.

Engagement requires the responsible investor to maintain an ownership position in the company rather than to divest. It is the preferred strategy of most responsible investors and is seen as being more effective than divestment campaigns, as it has a direct impact on company management. The process of divestment means that when the investor sells his/her position someone else buys the stock, and the seller then often loses any way to influence and raise company ESG standards. That said, responsible investors find themselves under increased pressure to respond to divestment requests by stakeholders and beneficiaries. The recent fossil fuels divestment campaign is one such example (see Cary Krosinsky, Chapter 47, on this issue). With the growing size and influence of institutional investors in our economy, we can expect more pressure in these areas going forward, creating a second challenge for RI in the future.

While this collection adopts the business case that focuses on engagement rather than divestment, especially for fiduciary investors, we clearly recognize that the actions of others (e.g. NGOs, campaigns, legislative actions, the media) impact directly and indirectly the perspectives of institutional investors, as well as the larger socioeconomic environment in which they operate. For example, the growing movement among universities for fossil fuel divestment (e.g. Stanford University’s divestment from coal) and some philanthropic endowments divestment from oil may in fact create enhanced opportunities for engagement. It is not difficult to imagine that major oil companies may in the future feel compelled to engage with their institutional RI owners to seriously consider scenarios for stranded assets in a way they have not so far done. There is a complex ‘dance of disinvestment’ that takes place on an expanded political, social and economic stage involving a variety of stakeholders taking different roles, and indeed, to follow the dance metaphor, even dancing to different beats.

One of the results of the shift to shareholder engagement is the willingness of large institutional investors to work toge...

Table of contents

• Cover
• Title
• Copyright
• Contents
• List of figures
• List of tables
• About the editors
• Notes on Contributors
• Acknowledgements
• PART I
• PART II
• PART III
• PART IV
• Index