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Responsible investment basics: What is responsible investment?

Responsible investment (RI) is the integration of environmental, social and governance factors (ESG) into the selection and management of investments. There is growing evidence that RI reduces risk and leads to superior long-term financial returns. Click on the image to the right to download a two-page brochure about responsible investment.

In recent years, responsible investment has come to encompass:

  • ethical investing,
  • socially responsible investing,
  • sustainable investing,
  • green investing,
  • community investing,
  • mission-based investing,
  • and more recently, impact investing.

Evolution of RI Investment 

Responsible investing has changed. It isn’t just about my values or your values anymore. It’s about managing risk to long-term shareholder and stakeholder value. In a world where climate change, water scarcity and global supply chain issues dominate the business pages, that job has become a lot more challenging.

Responsible investors have long known that the integration of ESG factors into the selection and management of investments can provide superior risk-adjusted returns and positive societal impact. What’s changed in the past decade is that it’s becoming a mainstream function of good investment practice, resulting in better, more informed investment decisions.

Why? Because our world is very complex, and the tools that investment managers have traditionally used to manage risk simply aren’t up to the task any more. Interpreting quarterly results just isn’t enough.

We need to know how the companies we invest in are managing the future: ESG analysis gives us a bigger and clearer window into their operations and the quality of their management. It’s just common sense.

Global Initiatives

There’s a growing consensus among investors that accurate valuations and proper risk management require greater disclosure and consideration of ESG issues (e.g., climate change, human rights, labour relations, consumer protection, health and safety and aboriginal relations).

  • The UN Sustainable Stock Exchanges Initiative has brought together sixteen stock exchanges to explore how they can work with investors, regulators and companies to increase transparency on ESG issues. The world’s largest stock exchange, the NYSE Euronext is a part of this initiative. 

The goal is to encourage responsible, long-term approaches to investment. Even stock exchanges are beginning to understand the link between profitability and responsibility. And recent research has shown that analysts are giving more positive recommendations to companies that address ESG risk.

  • With a growing body of evidence that ESG considerations have an impact on the financial performance of securities, the UK, Australia, France and Germany now require that investment decision makers disclose the extent to which they take these factors into account. The Ontario government has proposed similar legislation.

As a result, RI has evolved from just screening out companies that we don’t like to integrating environmental, social and governance or ESG criteria into the selection and management of investments.

Environmental, Social and Governance (ESG) Issues

ESG Issues

In the 1990s, the corporate social responsibility (CSR) movement emerged and leading companies around the world began measuring their performance on a wide range of sustainability and socially responsible policies and practices. By the beginning of the 21st century, many corporate leaders had acknowledged that companies that measured and managed ESG as well as financial factors were more profitable. That growing consensus became a driver of sustainability or corporate social responsibility reporting in many companies.

In 2003, UNEP FI commissioned reports from nine mainstream research institutions to study the financial materiality of ESG issues.

  • They wanted to know if managing issues like climate change or supply chain would have an impact on the share price of a company. A key finding was that there was “agreement that ESG issues affect long-term shareholder value… and in some cases those effects may be profound.” 

In 2006, the Principles of Responsible Investment were launched by the UN and responsible investment moved into the mainstream.

  • More than 1,200 pension funds and other institutional investors representing more than $45 trillion have become signatories to the principles. Of these, 94 percent have responsible investment policies in place. 

A 2012 study by DB Climate Change Advisors reported that they:

  • “believe that ESG analysis should be built into the investment processes of every serious investor, and into the corporate strategy of every company that cares about shareholder value.”

Their conclusion was that:

  • “Firms with strong ESG performance may now be enjoying both financial outperformance (particularly market-based) and lower risk as measured by the cost of equity and/or debt (both loans and bonds) capital in the short run.” In other words, they are achieving higher rates of return at lower levels of risk.

There are a number of ESG issues that can affect company valuations:

Climate Change

Climate change poses a severe threat to our planet and the global economy. Climate-related events disrupt investment markets and erode the long-term profitability of companies. As extreme weather events wreak havoc on business operations and supply chains, financial risks to investors will be amplified.

Organizations such as  Carbon Tracker warn that current estimates of fossil fuel reserves being accounted for by global energy companies are five times the allowable carbon budget necessary to limit our exposure to catastrophic climate risk. Regulatory and market responses to climate change and the transition to a low-carbon economy make it imperative that investors assess the financial impact of energy companies reducing their reserves to 20 percent of current levels.

Investors and companies that assess climate risks will be better prepared to reduce the impact and provide competitive financial returns.

 Read the Global Investor Statement on Climate Change for more information.

Water Scarcity

The Earth’s supply of fresh water is limited and the demands upon it are increasing. According to the Pembina Institute, it is predicted that climate change and industrial water use in Canada’s oil sands development will decrease the flow of the Athabasca River downstream of Fort McMurray by 30 percent by 2050.

Globally, climate change is already affecting water patterns, leading to droughts in some areas and floods in others.  Water is an important issue to investors because companies, especially companies in water-intensive industries, face significant financial risks. These risks include business interruption (directly through local infrastructure or indirectly through suppliers) and the potential market impact of negative media attention if the company is affecting a local community’s water supply or quality.

Supply Chain

The 2013 collapse of Rana Plaza in Savar, Bangladesh attracted worldwide attention. The deaths of more than 1,100 garment workers show how a company’s business decisions have serious consequences for workers. They also underscore the reputational, operational and legal risks associated with human and labour rights in the supply chain.

Investors recognize the risk inherent in owning companies that are not addressing these issues. In addition to the devastating human cost, the Rana Plaza incident had a significant impact on the reputations of the companies involved. In Canada, thousands of consumers checked their labels. Without remediation, the next step would have been consumer boycotts.

Responsible investors are actively trying to prevent similar tragedies from happening.

Aboriginal and Community Relations

The International Labour Organization (ILO) and the United Nations Declaration on the Rights of Indigenous Peoples have advanced the principle of obtaining the free, prior and informed consent (FPIC) of indigenous people before the approval of any project affecting their lands or territories and other resources.

It is especially important for the extractive sector to obtain and maintain support from local communities, Aboriginal or otherwise. Even if a project has received the necessary regulatory approval, community opposition has the potential to prevent a company’s project from coming to fruition – at great cost to the company.

Say on Pay

Over the past two decades compensation awarded to top Canadian executives has grown at a much faster rate than wages paid to the average Canadian worker. The growth in executive compensation can lead to social inequality, negative media attention and increased regulations.

In the US, the Dodd-Frank Act has mandated shareholder votes on executive compensation or “say on pay” (SOP). According to Mercer, over the past few years, many Canadian companies have adopted SOP policies. Canadian institutional shareholders represented by the Shareholder Association for Research and Education (SHARE) and Meritas Mutual Funds have pressured the companies in their portfolios to adopt SOP policies. 

Read the Canadian Mutual Fund Proxy Voting Survey for more information.

Board Diversity

Boards should reflect the diversity of their workforce and society. There is compelling evidence showing a positive correlation between the presence of women on boards and financial performance. A 2012 global study of 2,360 companies by Credit Suisse showed that companies with one or more women on their board delivered higher than average returns on equity, better average growth and higher price/book value multiples over a six-year period. Studies by Catalyst and McKinsey have shown similar results. Yet the 2013 Catalyst Census reports that women make up just 15.9 percent of directors on corporate boards in Canada.

Canadian securities regulators are proposing amendments to corporate governance disclosure regulations that would require all TSX-listed issuers to disclose the level of representation of women on their boards and in senior management. This transparency is intended to assist investors in their investment and proxy voting decisions.

Asset Classes

Responsible investments are found in all major asset classes: equities, fixed income (corporate bonds, green bonds, etc.), money market and alternatives such as impact investments.

 

RI Investment Vehicles

  • Mutual funds
  • Private equity funds
  • ETFs
  • Pooled funds
  • Real estate funds
  • Hedge funds

RI Trends

 

RI Strategies

There are a number of strategies employed by responsible investors:

Positive and Negative Screening

Negative screening

Exclusion (from a fund or portfolio) of sectors, companies, projects or countries based on ethical, moral or religious beliefs. For example, a fund or pension manager may decide to exclude specific sectors such as military weapons, tobacco or fossil fuels in the portfolio, or not to invest in a country involved in human rights abuses, such as Burma.

Exclusion of companies because they do not perform as well as their industry peers such as best-of-class funds.

Positive screening

Inclusion of companies based on positive ESG performance relative to their industry peers. Best-0f-class and impact investing are investment strategies that employ positive screening.

ESG Integration

ESG is the term that has emerged globally to describe the environmental, social and corporate governance factors that concern investors and other stakeholders. The issues are ones that were traditionally considered non-financial or not material. Recent studies, however, have shown a correlation between strong ESG performance and financial outperformance.

Integration is different from screening in that integration combines ESG data, research and analysis together with traditional financial analytics in making investment decisions. Research has shown that ESG integration combined with a best-in-class approach is more likely to generate superior portfolio returns than negative screening or traditional socially responsible investing which has typically incorporated both negative and positive screening. The evolution of responsible investment has produced many funds that are hybrids of the various strategies. And SRI and RI are often interchangeable terms.

  • Unlike screening, companies are not ‘screened in’ or ‘screened out’ of an investable universe.
  • Integration must be verifiable by a transparent and systematic process informed by ESG research & analysis.
Engagement/Shareholder Action

Engagement is using the power of shareholders and stakeholders to influence corporate behaviour. SHARE, an Associate Member of the RIA, discusses the four C’s of shareholder engagement as a response to the real environmental, social and governance challenges we face:

  • Comprehensive, focusing on the range of challenges and risks to value and the whole range of stakeholders affected by a company’s actions;
  • Collaborative, building collective action with other shareholders and other relevant stakeholders;
  • Committed to real outcomes, not endless discussion; and
  • Creative, focused on problem solving and using the right means to achieve the right ends. 

Many of our fund managers employ the following strategies as active shareholders:

  • Engaging in dialogue with company management and boards of directors.
  • Filing or co-filing shareholder resolutions
  • Voting proxies based on ESG criteria

Canadian RI funds have been leaders in bringing forward proposals to press companies to consider the environmental, social and financial risks associated with issues like oil sands production or supply chain management.

Thematic Investing

RI addresses the ESG risks faced by today’s investors but there are many opportunities as well. Thematic funds invest in sustainable businesses that are involved in energy efficiency, green infrastructure, clean fuels, low-carbon transportation infrastructure and those that provide adaptive solutions to some of the most challenging issues of our time. These are investments that present solutions to our problems and are great opportunities for investors.

A recent Ceres report says that in order to avoid the worst impacts of climate change, we will need to invest an additional $36 trillion in sustainable businesses by 2050. That’s $1 trillion dollars a year in green business development opportunities for investors.

In some cases, thematic funds are fossil fuel free and provide a good alternative for investors who choose to exclude resource extraction companies from their portfolios.

Common themes:

      • energy efficiency
      • green infrastructure
      • clean fuels
      • low-carbon transportation infrastructure
      • adaptive solutions
Impact Investing

The Global Impact Investing Network (GIIN) defines impact investments as:

“investments made into companies, organizations, and funds with the intention to generate a measurable, beneficial social and environmental impact alongside a financial return. Impact investments can be made in both emerging and developed markets, and target a range of returns from below-market to above-market rates, depending upon the circumstances.”
Norms-based screening

Norms-based screening is the screening of investments based on compliance with international norms and standards such as those issued by the Organization for Economic Cooperation and Development (OECD), the International Labour Organization (ILO), the United Nations, etc. Norms-based screening may include exclusions of investments that are not in compliance with globally recognized norms or standards. As at December 31st, 2013, there were $569 billion Canadian AUM using a norms based screening strategy. The top three norms identified in our survey were the UN Global Compact, the UN Guiding Principles on Business and Human Rights, and the OECD Guidelines for Multinational Enterprises. 

 

RI Performance Myth

Despite evidence to the contrary, a 2014 NEI investor survey confirms that most investors and their advisors believe that responsible investments will underperform their traditional investments.

Critics of responsible investment argue that considering ESG performance will reduce the size of the investment universe and, according to modern portfolio theory (introduced in 1952), reduce portfolio efficiency and generate lower risk-adjusted returns.

Responsible investors agree that integrating ESG factors will eliminate companies from their investment universe, but argue that the remaining companies will be better long-term investments.

Historically, ethical investing and socially responsible investing (SRI) have been based, at least in part, on values-based exclusionary screening. There have been many studies on the performance of those funds relative to traditional investments.

The results have shown that they have achieved results similar to or slightly better than their non-SRI counterparts. There has been no penalty for investing according to one’s values.

A 2012 RBC Global Asset Management study concurred.

They looked at four distinct bodies of evidence:

  • SRI indices relative to traditional indiceses
  • Performance of SRI funds relative to traditional funds
  • Relative financial performance of hypothetical stock portfolios compared to conventional portfolios and indices
  • The linkage between corporate social responsibility (CSR) and improved financial performance

The chief finding in their research was that SRI did not hurt investment returns.

In the past decade, the focus of many of those funds has gradually changed. Responsible investment (RI), defined as the integration of ESG factors into the selection and management of investments, has become widespread in both retail and institutional funds.

ESG criteria are used to help managers identify risks that are not adequately measured by traditional investment analysis. In doing so they are better able to accurately predict financial performance. This does not diminish a values-based or ethical approach but merely enhances it by identifying the material risks and opportunities associated with ESG factors. It provides the information needed for investors to capture the financial benefits of environmental, social and governance leadership.

In the 2012 report Sustainable Investing, DB Climate Change Advisors looked at:

  • 100 academic studies,
  • 56 research papers,
  • two literature reviews
  • and four meta studies on responsible investing from around the world.

Their analysis showed that ESG factors are consistently correlated with superior risk-adjusted returns at the securities or stock level. The market rewarded companies with the best ESG performance with higher share prices. Those findings were supported by 89 percent of the studies they examined; 85 percent of the studies showed a correlation between ESG performance and accounting-based outperformance or earnings per share.

If price performance and earnings per share aren’t enough, their findings also showed that companies with good ESG ratings have a lower cost of capital in terms of both debt and equity.

Almost every comparison of RI versus traditional investment returns points to better long-term risk adjusted returns when ESG issues are taken into account.

In the RIA’s quarterly mutual fund reports there are top-performing RI mutual funds in every major category.

Social indices offer further evidence of positive performance by responsible investments. The Jantzi Social Index (JSI®) and the MSCI KLD 400 Social Index have demonstrated outperformance since inception.

Jantzi Social Index

MSCI World SRI Index



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