Sustainable Investing

A Path to a New Horizon

Herman Bril, Georg Kell, Andreas Rasche, Herman Bril, Georg Kell, Andreas Rasche

• Publisher: Routledge
• Year: 2020
• ISBN:
  9781000097993
• Edition: 1
• Topic: Business
• Subtopic: Etica aziendale
• Index: Business

This book tells the story of how the convergence between corporate sustainability and sustainable investing is now becoming a major force driving systemic market changes. The idea and practice of corporate sustainability is no longer a niche movement. Investors are increasingly paying attention to sustainability factors in their analysis and decision-making, thus reinforcing market transformation.

In this book, high-level practitioners and academic thought leaders, including contributions from John Ruggie, Fiona Reynolds, Johan Rockström, and Paul Polman, explain the forces behind these developments. The contributors highlight (a) that systemic market change is influenced by various contextual factors that impact how sustainable investing is perceived and practiced; (b) that the integration of ESG factors in investment decisions is impacting markets on a large scale and hence changes practices of major market players (e.g. pension funds); and (c) that technology and the increasing datafication of sustainability act as further accelerators of such change.

The book goes beyond standard economic theory approaches to sustainable investing and emphasizes that capitalism founded on more real-world (complex) economics and cooperation can strengthen ESG integration. Aimed at both investment professionals and academics, this book gives the reader access to more practitioner-relevant information and it also discusses implementation issues. The reader will gain insights into how "mainstream" financial actors relate to sustainable investing.

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Sustainable investing

A path to a new horizon

Herman Bril, Georg Kell, and Andreas Rasche

A changing context for sustainable investing

This book tells the story of how the convergence between corporate sustainability and sustainable investing is now becoming a major force driving systemic market changes. The idea and practice of corporate sustainability is no longer a niche movement. It is now on the agenda of the boardrooms of leading corporations on all continents. At the same time, investors are increasingly paying attention to sustainability factors in their analysis and decision-making, thus reinforcing market transformation. This book discusses the link between sustainability and investment practices—a link which is increasingly discussed under the Environment, Social, Governance (ESG) label. Although a number of terms and definitions populate the broader field of sustainable investing (see the overview by the Institute of International Finance, 2019), we follow the Principles of Responsible Investment (PRI) and see such investing as an approach “to incorporate ESG factors in investment decisions and active ownership” (PRI, 2019). Some of the chapters in this volume even move beyond sustainable investment in the narrow sense, for instance by highlighting the role of banking (Chapter 8 by Eric Usher).

Sustainable investing is not about philanthropy or giving up returns. The value of investments is not only determined by short-term profits but influenced by many long-term global drivers, including technology, natural resources and the environment, geopolitics, the inter-dependencies of globalization, shifts in social norms, inequality, and demographics (see e.g., McAfee, 2019). One important implication of considering these drivers is that we need to rethink how externalities impact systemic risks and the long-term financial implications they may have. Considering these drivers is also essential to ensure the long-term viability of investments, because investors should strive to avoid risks that may compromise long-term economic value. Colin Mayer (2018, p. 132) recently summarized this as follows: “The survival of firms depends as much as we do on the maintenance not only of physical and financial capital but also of natural, human, and social capital.”

Sustainable investing not only needs to cope with these drivers; it also needs to do so in an increasingly volatile, uncertain, complex, and ambiguous (VUCA) business context. Managing in such a VUCA business context has profound consequences for how to approach sustainable investing. Consider these two examples: (1) In a complex world, the volume and nature of information can be overwhelming, making predictions and assessments more difficult. However, assessments of firms’ ESG performance are necessary even when our knowledge about what exactly drives relevant ESG attributes is still rather limited. It is therefore not surprising that research shows divergence of companies’ ESG ratings (Berg, Koelbel, and Rigobon, 2019). (2) In an ambiguous world, causal relationships are often unclear, for instance because no precedent cases or reliable information exist (Bennet and Lemoine, 2014). For the world of finance—which is to a large degree based on understandings of cause and effect relationships—this is surprising, maybe even upsetting.

This book is about managing sustainable investing in a such a VUCA world. We have invited high-level academics and practitioners to reflect on four key themes, which constitute the four main part of this book. First, we have asked a group of contributors to reflect on the changing context of sustainable investing (Part I). These discussions clearly touch upon the relevance of a VUCA business context for ESG, but they also reach beyond it, for instance by challenging deeply embedded theoretical assumptions (e.g., the efficient market hypothesis) that may impede further progress. Second, we have asked a group of contributors to reflect on how to rethink sustainable finance (including both investing and lending) against this changing business context (Part II). These contributions also explore the role that corporate leadership has to play when it comes to ESG investing. Third, we also asked a group of scholars and practitioners to discuss the emerging link between sustainable investing, technology, and (big) data (Part III). These contributions show how alternative data sources, algorithms, and artificial intelligence can reshape the practices attached to sustainable investing (e.g., risk assessments) and drive transparency. Finally, we also asked some contributors to reflect on the future of ESG and sustainable investing (Part IV). What can drive future change in the field? How can relevant debates be mainstreamed, also when looking at organizational requirements for asset owners and investment managers?

We do not claim that this book contains all the answers to the multiple questions which are thrown up in the four parts. But we are positive that the contributions contain vital lessons on future debates in the field of sustainable investing, including the contextual conditions shaping future ESG practices and the role of technology and data. The remainder of this opening chapter discusses two key aspects that were critical while developing this book. The first aspect relates to the need to challenge traditional assumptions, both in theory and in practice (see “Challenging traditional assumptions”). We debate the role of some theoretical assumptions that underlie traditional management theory and investment thinking. Our main aim is to show that future progress in the ESG field will depend on challenging and critically debating some of these assumptions. The second aspect relates to the need to consider more closely what drives and impedes progress in sustainable investing (“Drivers of and challenges for sustainable investing”). We identify a number of drivers that support the further uptake of sustainable investing (e.g., the perceived importance of planetary boundaries and the increasing availability of ESG data). However, we also show that these drivers can possibly impede further progress in the field, if businesses and policymakers do not manage them correctly.

Challenging traditional assumptions

Efficient financial markets

Traditional management and investment thinking has been rather linear and is mostly based on the neoclassical economic ideology, which itself is grounded in unrealistic rational homo-economicus assumptions (see, e.g., Ghoshal, 2005). The financial crisis of 2008 showed the fallibility of this traditional school of thinking. This led to renewed interest in behavioral economics, complexity economics, evolutionary economics, and ecological economics. A number of well-known scholars denounced the efficient markets hypothesis, which is one of the most influential ideas underpinning finance and economics. At the heart of this hypothesis is the idea that market prices include all relevant information in a rational manner (Fama, 1970). Behavioral economics criticized this hypothesis for its lack of empirical support (Kahneman and Tversky, 1979). Are financial markets rational and efficient, as traditional economists would claim, or irrational and inefficient, as some behavioral economists would argue? This debate goes to the heart of debates around ESG and sustainable investing, as it influences our very understanding of how investors and markets behave.

Andrew Lo’s work integrated both theories in the so-called Adaptive Markets Hypothesis (Lo, 2004, 2017), which is influenced substantially by ideas from evolutionary psychology. This new hypothesis claims that markets can indeed be efficient when the environment is stable. But, in times of instability investors resort to instinctive reactions, which have been shaped over the course of human evolution. In other words: “Markets do look efficient under certain circumstances, namely, when investors have had a chance to adapt to existing business conditions, and those conditions remain relatively stable over a long enough period of time” (Lo, 2017, p. 3). The VUCA business context, which was mentioned above, influences the possibility of these adaptation processes and thereby affects how long investors need to adapt.

The Adaptive Market Hypothesis also influences our thinking about sustainable investing. It shows that investors have to reach beyond traditional economic data when analyzing their business environment, for instance to calculate market volatility and risk premia. Simon Levin, Martin Reeves, and Ania Levina (Chapter 2) follow this line of thinking and propose a number of principles that can shape the future of business and sustainable investing. Their arguments, which are based on nested complex adaptive systems theory as well as considerations around systems robustness and longevity, highlight the need to consider the broader, planetary context when evaluating risks and opportunities. Detecting risks that are not local in character, but rather stem from the instability of the planetary system in which businesses are embedded (e.g., related to climate change and biodiversity), creates significant future challenges for managing ESG.

Short-termism

It is no secret that much of the business world is based on short-term thinking. Business objectives are often short-term and so are the resulting incentives and performance metrics (see Levin et al., Chapter 2). In 2015, Mark Carney, Governor of the Bank of England, gave a famous speech on the need to break the Tragedy of the Horizon when dealing with the impacts of climate change. Carney (2015, p. 4) argued:

We don’t need an army of actuaries to tell us that the catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors—imposing a cost on future generations that the current generation has no direct incentive to fix.

In other words, the time horizon of important actors—such as business leaders, investors, and policymakers—is too short, so that once “climate change becomes a defining issue for financial stability, it may already be too late.”

This book was inspired by Carney’s reflections on the Tragedy of the Horizon. We believe that sustainable investing can only progress once we address this Tragedy. What the contributors of this volume try to do is to chart what Carney (2019) in a later speech called “a path to a New Horizon.” Such a path refers to those steps that we can take to break with those problems that are attached to the Tragedy of the Horizon. Paul Polman and Halla Tómasdóttir (Chapter 10) address the problem of short-termism directly. They discuss what corporations can do to move financial markets to longer-term thinking. They highlight that firms need to first of all focus on the broader stakeholder network in which they are embedded—a network that reaches beyond a sole focus on investors. They also discuss the need to escape from quarterly reporting—a step that was taken successfully by Unilever in 2009.

A recent survey by FCLTGlobal (2019) revealed that global corporations are less long-term-oriented than they were before the 2007/08 financial crisis. One key driver of this lack of long-term orientation is an overdistribution of capital in the form of buybacks and dividends. Firms that tend to return money to shareholders instead of safeguarding the money for other uses (e.g., long-term investments) generated lower returns on invested capital. Interestingly, the study also finds that the existence of many ESG controversies in a company can impede long-term value creation. By contrast, a diversified board (in terms of gender and age) contributed to higher long-term value creation. What these results show is that a path to a new horizon can take many shapes. One key ambition of this book is to explore some of them.

Division of labor among societal actors

Much of traditional research on business and finance still assumes that there is a rather clear division of labor among different societal actors. Governments define the legal rules of the game (e.g., regarding property and contractual rights) and also enforce these rules. Businesses employ people, obey the law, and pay taxes. Civil society acts as a base of values for society. Of course, this picture is simplifying. However, it still underlies some of our thinking about how markets, firms, and civil society actors interact. There is need for a paradigm change so that we create a robust conceptual foundation for understanding corporations’ role in global society. John Ruggie’s call to finally let go of Milton Friedman (Chapter 9) is a case in point. As Ruggie observes: “ESG investing already has been and is likely to become even more of a factor in reinforcing the construction of a broader social conception of the public corporation.”

Sustainable investing not only operates in a VUCA business context; this context is to a large degree the outcome of changes in the division of labor among societal actors. German philosopher Jürgen Habermas (2001) once argued that a traditional division of labor among societal actors reaches its limits under a “postnational constellation”—that is, a situation in which the steering capacity of state authorities remains limited because social and economic activities reach beyond the territorially bound national or regional jurisdiction (see also Rasche, 2015). In other words, we face gaps in governing (global) business activities—gaps which are unlikely to be closed by inter-governmental action alone. Such governance gaps are by no means a recent phenomenon; they have been part of the debate for many years. What is new, however, is that we need to start thinking about how the existence of these gaps enables and constrains sustainable investing.

Sustainable investing is affected by this post-national constellation in a number of ways. First, some of the problems that ESG practices try to address result from governance gaps and failures. On the global level, topics like climate change or water sustainability deal with common pool resources and therefore require truly global coordination. Sustainable investing is one way to work towards such coordination. Financial markets are knowing few borders; they are a global phenomenon operating at an enormous scale and scope. This makes them a strong actor that can acknowledge and address problems that reach beyond the nation state. Financial markets can coordinate and command resources across borders, and it is this flexibility that allows sustainable investing to make a contribution to address some of the problems ESG is concerned with. Second, and relatedly, sustainable investing is based on an institutional infrastructure that relies to a large degree on voluntary initiatives and standards (e.g., the PRI, TCFD, SASB). Such a “soft law” approach not only enhances the f...