Socially Responsible Investment in a Global Environment

Socially Responsible Investment in a Global Environment To our loved ones To Linda Zou (wife), Anna Fung (daughter),...

Author: Hung-Gay Fung | Sheryl A. Law | Jot Yau

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Socially Responsible Investment in a Global Environment

To our loved ones

To Linda Zou (wife), Anna Fung (daughter), my brothers and sister Hung-Gay Fung

To my parents, and my sister. A special thank you to all my teachers over the years. Sheryl A. Law

To Marie Jot Yau

Socially Responsible Investment in a Global Environment Hung-Gay Fung University of Missouri–St Louis, USA

Sheryl A. Law Peregreen Group LLC, USA and

Jot Yau Seattle University, USA

Edward Elgar Cheltenham, UK • Northampton, MA, USA

© Hung-Gay Fung, Sheryl A. Law and Jot Yau 2010 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library Library of Congress Control Number: 2009938396

Disclaimer Investment products and organizations mentioned in this book are for illustrative purposes only, and should not be construed as investment advice. Investors should in every case perform their own due diligence on potential investments or consult their financial advisors. The opinions expressed in this book are those of the authors and do not necessarily reflect those of their affiliations.

ISBN 978 1 84844 213 9

02

Printed and bound by MPG Books Group, UK

Contents List of tables About the authors List of abbreviations

vi vii viii

1. Socially responsible investment: opportunities, challenges, and practices 2. SRI approaches and criteria 3. Incentives, alternatives, and financial performance of SRI 4. Environmental issues 5. Social, ethical, and religious issues 6. Corporate governance issues, corporate policy, and corporate social responsibility practices 7. Practice of SRI by institutional investors, non-governmental organizations, and supranational agencies 8. Socially responsible investment and global banking 9. Outlook and conclusion Index

1 25 44 73 90 107 131 149 170 177

v

Tables 1.1 1.2 1.3 1.4 2.1 3.1 6.1 6.2 7.1 8.1

8.2 8.3

World SRI (2007) Growth of SRI in the US Socially screened funds (1999–2007) Socially screened separate accounts SRI strategies in different regions and countries Performance of selected SRI indices as of 31 March 2009 Performance of economies against the five disclosure criteria Total number of Fortune 500 companies in KLD Broad Market Social Index as of 31 December 2007 Selected public pension fund case studies Twenty-nine out of top 50 commercial banks and savings institutions in the US by total domestic deposits, as of 30 June 2007 Thirty-six out of top 50 bank holding companies by total assets Thirty-five out of top 50 insured US-chartered commercial banks by consolidated assets as of 31 December 2007

vi

8 9 9 10 32 55 123 124 142

164 165 167

About the authors Hung-Gay Fung is Department Chair (Finance and Legal Studies) and Dr Y.S. Tsiang Chair Professor at the College of Business Administration and Center for International Studies, University of Missouri–St Louis. Fung’s research covers a wide range of international finance, international banking, and Chinese financial markets. He has published over 100 scholarly papers, including those in leading academic and professional journals. He has also published six books. He is a recipient of many grants and academic awards. As a senior expert of Chinese finance studies and international finance, Fung has organized many international conferences and symposiums. He received his PhD in finance from Georgia State University in 1984 and BBA in finance from the Chinese University of Hong Kong in 1978. Sheryl A. Law is the Founder of Peregreen Group, a research and analytics firm specializing in socially responsible investing. She has worked in environmental research at universities and government institutions, and spent many years as an environmental science consultant. Law has published several papers in scientific journals and written chapters for books. She received an MS in environmental chemistry from the University of Toronto and an MBA from Seattle University. Jot Yau is Robert D. O’Brien Endowed Chair of Business Administration and Professor of Finance at Seattle University. Since joining Seattle University in 2001, he has served as the Chair of the Department of Economics and Finance, Department of Finance, and MSF program director. Yau has published numerous scholarly papers in finance journals and chapters in professional books. He is a co-editor of Advances in International Investments: Traditional and Alternative Approaches (World Scientific, 2008). He is Special Editor (Risk Management) of The Journal of Alternative Investments. He has served on the curriculum and exam committees for the CFA Institute and the CAIA Association. He has cofounded Strategic Options Investment Advisors Ltd, a Hong Kong-based investment advisory firm. He has also served as treasurer of the Northwest Hedge Fund Society and on the Board of Directors of Group Health Credit Union in Seattle. He holds a PhD in finance from the University of Massachusetts at Amherst, and is a CFA charterholder. vii

Abbreviations AMWG AUM BMSI CalPERS CalSTRS CDO CDP CEO CERES CMO CPRT CFP CSP CSR CV400 DC DJIM DJSI World DS400 ECGI ECX ERISA ESG EPFI ETF FDIC FOF GCC GDP GFP GPFG GRI GSEES GSI ICBC

Asset Management Working Group (of UNEP FI) assets under management KLD Broad Market Social Index California Public Employees’ Retirement System California State Teachers’ Retirement System collateralized debt obligation Carbon Disclosure Project chief executive officer Coalition for Environmentally Responsible Economies collateralized mortgage obligation Connecticut Retirement Plans and Trust Fund corporate financial performance corporate social performance corporate social responsibility KLD Catholic Values 400 Index defined contribution Dow Jones Islamic Market Index Dow Jones Sustainability Index World Domini 400 Social Index European Corporate Governance Institute European Climate Exchange Employee Retirement and Income Security Act environmental, social, and (corporate) governance Equator Principles for Financial Institutions exchange traded fund Federal Deposit Insurance Corporation fund of funds Gulf Cooperation Council gross domestic product Government Pension Fund (of Thailand) Government Pension Fund Global (of Norway) Global Reporting Initiative Goldman Sachs Energy, Environment and Social Index KLD Global Sustainability Index Industrial and Commercial Bank of China viii

Abbreviations

ICCR ICGN IIGCC IFC INCR ISO LCM LPFA MFI MSCI NBIM NGO NPV OECD p.a. PCCW PREVI PRI QIB RGGI ROA ROE S&P500 S&P/IFCI SAIC SEC SEE SEPA SFC SIF SIV SMR SO SRF SRI TIAA-CREF UNCDF UNEP FI

ix

Interfaith Center on Corporate Responsibility International Corporate Governance Network Institutional Investors Group on Climate Change International Finance Corporation Investor Network on Climate Risk International Organization for Standardization life cycle management London Pensions Fund Authority microfinance institution Morgan Stanley Capital International Norges Bank Investment Management (Norway) non-governmental organization net present value Organisation for Economic Co-operation and Development per annum Pacific Century CyberWorks Limited Caixa de Previdência dos Funcionários do Banco do Brasil (Brazil) Principles for Responsible Investment Qatar Islamic Bank Regional Greenhouse Gas Initiative return on assets return on equity Standard and Poor’s 500 index Standard and Poor’s emerging market index Shanghai Automotive Securities and Exchange Commission social, environmental and ethical State Environmental Protection Administration (China) Securities and Futures Commission (Hong Kong) Social Investment Forum structured investment vehicle sustainability management and reporting strategic option sustainability reporting framework socially responsible investing or investment Teachers Insurance and Annuity Association of America – College Retirement Equities Fund United Nations Capital Development Fund United Nations Environment Program Finance Initiative

x

UNPRI WBCSD WHO

Socially responsible investment in a global environment

United Nations Principle for Responsible Investment World Business Council on Sustainable Development World Health Organization

1.

Socially responsible investment: opportunities, challenges, and practices

INTRODUCTION Socially responsible investment or investing (SRI) is an umbrella term for investments and investment strategies that have taken into consideration the attempt to create positive social change, minimize environmental damage, and incorporate religious or ethical beliefs. SRI is not a new phenomenon but has taken over 80 years to reach its present-day popularity.1 Due to globalization, financial market participants are now cognizant that their investment decisions have ramifications around the world. Historically, concerned stakeholders used to be activists, non-governmental organizations (NGOs), and consumers. They clearly demonstrated their dissent over issues such as environmental problems, human rights issues, and other social concerns. However, our increasingly intertwined world makes it almost impossible for investors to make decisions without having some effect on the environment and social development. Thus, it is inevitable that investors for public and private corporations have garnered some concerns about their investment choices and are balancing positive financial returns with minimization of environmental and social damages. Investors now have choices in creating portfolios with profit and positive social and environmental impacts by incorporating social, environmental, and ethical considerations. Investors have taken actions so that boards of directors and corporate management consider their demands and create change in their firms. SRI has become a practical vehicle for investors who are concerned about the moral implications of their portfolio and the investment returns resulting from their investing decisions. SRI is also a practical way for fiduciaries to act in the best interest of their beneficiaries. Despite the increasing pressures to consider environmental, social and (corporate) governance (ESG) in the investment process, there is no legal guidance available as to how analysts and fund managers can practically and 1

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quantitatively incorporate these criteria into valuation of equities. Fund managers are left to their discretion on developing an institutional framework to address ESG criteria in their investments. SRI has become the fastest growing segment in the financial market in recent years. In step with corporate leaders, institutional investors have instituted some ESG metrics as a means of documenting and monitoring non-financial data to achieve risk reduction, sustainability and subsequently, long-term financial returns. Public pension funds in various countries have integrated SRI initiatives, expectations, and criteria. Government agencies that manage funds, securities regulators, and retail investors are all increasingly gravitating towards scrutiny of nonfinancial data and evaluating the adequacy of investment research and analysis that are required for investment decisions. Investment in a firm with a poor environmental record or less-than-reputable social practices represents a big risk in the portfolio. SRI has increasingly become an important consideration in the global financial industry as both retail and institutional investors demand proactive integration of ESG issues into investment considerations. So, whether SRI is an ethical decision or an act of prudence, investors and fiduciaries should give it serious consideration in their decision processes. The corporate response to SRI is corporate social responsibility (CSR). The term is often used synonymously with ‘corporate social performance’, ‘sustainability’ or ‘triple bottom line’.2 CSR is the company response to the ESG issues raised by shareholder advocacy and activism. CSR and SRI can be considered as the two sides of the same coin. SRI investors value social responsibility as much as financial reward and company management view CSR as a way to align these same values with its owners or shareholders. As corporations act in a socially responsible manner, their behavior and activities are closely related to that of sustainable development consisting of social, environmental and economic dimensions (see Henderson 2001). In this book, we aim to provide readers with perspectives of SRI from various players – investors, corporations, investment fiduciaries, nongovernmental organizations, and supranational agencies – and discuss the opportunities, challenges, and practices of SRI in a global environment. We discuss the environmental, social, and corporate governance issues within the framework of regulatory, reputational, legal, and operational risk management. We also provide a conceptual framework to evaluate SRI from a firm’s perspective in decision-making using a real option approach. This framework enables us to integrate traditional theories with SRI considerations and to examine the SRI decisions using a consistent approach, based on tradeoffs and merits of each SRI proposal.

Opportunities, challenges, and practices

3

Throughout the book, we describe and analyse the SRI landscape facing various participants (for example, investors, corporations, and fiduciaries). Investors have differing reasons for participating in SRI. The most identifiable SRI participants are those that are driven to values-based investing because of their profound beliefs and the need to integrate their values in all aspects of their lifestyle, including their investments. Valuesbased investors fall into three categories – Some feel that the trade-off of ‘doing good’ is sufficient reward and they can accept possible shortfalls from the expected returns on their SRI portfolio. The second group of values-based investors do not believe that there has to be a direct trade-off between positive returns and adhering to values. Some SRI proponents are ‘sustainable’ investors, who use ESG criteria as a means of minimizing the universe of risk, such that over the long term, risk-adjusted returns would be greater than conventional portfolios that are not adjusted for ESG risks. The last group of SRI investors feel that since only a few companies would be excluded from their SRI portfolios, the material impact of a slightly smaller investment universe is too small to affect returns. In light of all the different goals, values and views, SRI has become an investment process in which non-financial criteria are evaluated with conventional financial considerations. Thus, we do not necessarily endorse any particular type of SRI without subjecting the investment to an economic and conventional analysis. This book is aimed at readers with all levels of interests and beliefs in SRI. We merely present an overview of ESG factors to consider, the impacts they may have on the investment community, and their incorporation into investment practices as a risk management tool. For investors with long-time horizons, evaluating ESG factors and their associated risks make economic sense if they are concerned about the long-term survival of the firm. ESG factors are dynamic risk considerations, constantly evolving over time. However, notwithstanding these risks, SRI is gaining more popularity and traction over time. The book is organized as follows. In this chapter, we first define SRI, and then discuss the growth of SRI as well as the opportunities in terms of financial returns and non-financial rewards (the corporate social performance or CSP). We provide an overview of how corporations, institutional investors, non-governmental organizations, and supranational agencies embrace the environmental, social, regulatory, ethical, and corporate governance opportunities and challenges presented to them. In Chapter 2, we explain the screening criteria used to include or exclude investments in a SRI portfolio. We review the common screening strategies used in portfolio construction in various SRI investments and indices. In Chapter 3, we explain the financial and non-financial incentives of socially responsible investing. We present the common approaches to SRI and the various

4


asset alternatives under each approach, including stocks, mutual funds, hedge funds, private equity, social venture capital, community banks, and microfinance organizations. We review the evidence of historical performance of SRIs versus conventional investments. In addition, we explain reasons why investors would consider SRI when the financial performance is comparable or even below the returns of conventional strategies. In Chapters 4–8, we present and discuss the various challenges facing SRI with respect to environmental, social, ethical, religious, and corporate governance issues. We demonstrate how different investors manage these issues and how they align their SRI strategies with their interests, while remaining in compliance with various regulatory requirements. We explore theoretical rationales behind the activities toward SRI by corporations and global banks in an attempt to reconcile and rationalize SRI activities within the traditional theoretical framework. In addition, we look at the practices advocated by institutional investors, non-governmental organizations, and supranational agencies. We also discuss global developments in Islamic investments and microfinance. In Chapter 9, we present an outlook and some conclusions.

DEFINING SRI Socially responsible investment or investing has been broadly identified as the investment decisions that are based on environmental, social and governance standards. For example, the Social Investment Forum (SIF) defines SRI as ‘an investment process that considers the social and environmental consequences of investments, both positive and negative, within the context of rigorous financial analysis.’3 This definition attempts to be all-encompassing without specifically alluding to ‘ethical investing.’4 However, some SRIs are based on ethical standards which are originally derived from religious institutional beliefs and/or personal core values and morals. SRI criteria are more objective and standardized than ethical standards which are harder to define. Thus, ‘SRI’ tends to be a more popular term which may sometimes be used to embrace ‘ethical investing.’ While some authors, for example, Beal et al. (2005), and Valor and de la Cuesta (2007) use the terms ‘socially responsible investment’, ‘ethical investment’ and ‘ethical funds’ interchangeably, others prefer to use the term ‘ethical investment’ in lieu of SRI for they believe that ethical investment better describes the process in which values-based organizations apply internal ethical principles to an investment strategy (see Schaefer 2004; Sparkes and Cowton 2004). For European markets, ethical investment or ethical funds is a generic


5

term for SRI funds (see Kreander et al. 2005). For example, in Spain, ‘ethical funds’ refer to three types of SRI funds – ethical funds, green funds and sharing funds (see Valor and de la Cuesta 2007). Ethical funds, in other countries, use positive or negative criteria to choose certain companies from the portfolio. Green funds are environmental funds that specifically exclude companies which are not environmentally friendly or include pro-environmental companies like alternative energy. Sharing funds donate part of their management fees to various social organizations (for example, charities, NGOs, and communities), and are more closely related to community investing than to screening, since no criteria (positive or negative) are used to guide their investment.5 SRI may refer to portfolios resulting from a deliberate exclusion of specific investments. For example, ‘green investing’ usually refers to the exclusion of firms with poor operations (for example, strip mining), or products (for example, hazardous chemicals) that lead to environmental pollution, or the inclusion of firms with business strategies that help the environment (for example, alternative energy). ‘White investing’ subscribes to the concept of making investment choices based on religious grounds such as excluding companies that produce weapons, tobacco, and alcohol (the ‘sin’ stocks). Additional white screens can exclude the entertainment industry (for example, casinos and pornography), and other adherences to specific religious rules. Finally, ‘red investing’ defines the strategies that consider labor and human rights in the decision. Red-screened investments scrutinize the working conditions and employee treatments in both the actual firm in question and its supply chain. Companies that turn a blind eye to deplorable work environments or child labor in other countries are omitted from portfolios. Screening criteria and strategies are discussed in detail in Chapter 2. As SRI evolves, the SRI approach embraces a broader concept. The latest trend in SRI is to screen in (positive screen) companies with strong environmental and management records (that is, looking for sustainable businesses), instead of screening out (negative screen) investments connected to alcohol, tobacco, and weapons. The rationale behind this ‘sustainable’ investing approach is that socially and environmentally responsible companies will be more profitable in the long term. Desmadryl (2007) refers to SRI as ‘sustainable and responsible investing’, which is defined as an investment strategy that takes into account a company’s performance in the three pillars (people, planet, and profit or social, environmental, and financial) of sustainable development, when selecting and managing investment portfolios.6 This definition is focused on the concept of sustainable development, a term used to describe economic viability in the long-term horizon that ‘enables present generations to satisfy their

6


needs without threatening the ability of future generations to satisfy theirs,’ a concept originally described in Our Common Future.7 Thus, the sustainability case for SRI is emphasized for those investing over the long term, and accounting for the risks imposed by ESG issues. Sustainable and responsible investing moves away from the values-based approaches of ethical investing to a sustainable, value-enhancing portfolio. It is notable that both SIF and Desmadryl describe SRI as a means of linking corporate social performance to corporate financial performance. The underlying belief is the ‘moral’ argument for corporate social responsibility that businesses, just like individuals, have a duty to society, and that they must help protect the interests of future generations. As such, it is closely linked to green investing, renewable energy and sustainable business models. The business case for sustainability provides the ‘economic’ argument for CSR. For example, reducing a company’s carbon footprint reduces environmental damage, but it also cuts waste, reduces costs, and makes the business more efficient. Likewise, renewable energy is not just better for the planet than fossil fuels, but it is often cheaper, according to Senge et al. (2008). In other words, it makes economic sense to corporations to be sustainably responsible. The concept of CSR is heavily geared towards global environmental and social aspects, or some kind of solution for the world’s problems (such as ending poverty), but since the economic downturn in the past few years, there has been more emphasis on economic sustainability as well. As socially responsible investors try to impose their demands on the boards of directors of corporations and influence corporate practices on economic, environmental, and social issues, corporate governance has become an important criterion for investor consideration. Socially responsible investors are more inclined to invest in companies where shareholders can effectively engage the company through the normal corporate governance channel without resorting to some hostile activist approaches in regard to its corporate social responsibility. In sum, SRI is a broad-based approach to investing that recognizes corporate responsibility and societal concerns as valid parts of investment decisions. We would consider SRI and CSR as two sides of the same coin. While on the one side it addresses the ESG issues from the investor’s vantage point of view, it also deals with how managements of companies and investment fiduciaries try to fulfill the hopes and dreams of the investors as well as their own. Thus, the objectives of SRI are to enhance the bottom lines of the companies and thus the wealth of shareholders in the long run, while hopefully helping to build a better world. In short, SRI investors hope to put their money to work to build a more sustainable world while earning competitive returns both today and over the long run.


7

Socially responsible investors include individuals and institutions, such as corporations, foundations and endowments, insurance companies, public and private pension funds, supranational agencies, and non-profit organizations, including universities, hospitals, and religious groups. Institutional investors represent the largest and fastest growing segment of the SRI world. With so many definitions and nuanced terms used for socially responsible investing, we use ‘SRI’ or ‘SRI funds’ to refer to the collection of investments resulting from a decision-making process that has taken into account environmental, social, ethical, corporate governance, faith, and values-based criteria in the deliberation. More specifically, ‘SRI funds’ are portfolios formed using these criteria and under professional management (SRI mutual funds, unit trusts, hedge funds or separately managed accounts).

OPPORTUNITIES: THE GROWTH OF SRI IN THE GLOBAL FINANCIAL MARKETS The SRI strategies being implemented and integrated with traditional investment decisions have seen an admirable growth in both acceptability by investors and assets under management with a SRI mandate. The growing pre-eminence of SRI in the global financial industry is consistent with the movement of economic prosperity from the US to other nations, as suggested by Cohen (2006), and evidenced by the proliferation of various SRI indices and products as well as initiatives taken by international companies and investment practitioners. In addition, there are initiatives with the United Nations Environment Program Finance Initiative (UNEP FI), and within the UN Global Compact activities, to demonstrate the value of sustainability analysis to the financial services sector. The increasing amount of assets allocated to SRI investment products by both individual and institutional investors is prima facie evidence of the growing popularity of SRI. In Table 1.1, Eurosif (2008) reports that the global SRI market in 2007 was estimated to be US$7.2 trillion or approximately €5 trillion, with about 53 percent of assets under management (AUM) in Europe, 39 percent in the US, and 8 percent in the rest of the world (primarily Canada, Australia/New Zealand and Japan).8 It is noted that this growth represents a change in trend since it was estimated that about 64 percent of AUM was in the US and 34 percent was in Europe in 2006.9 The growth in the global total assets in SRI also corroborates the observation that countries with a developed financial market have all seen increases in SRI retail products as a result of the surging demand by

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Table 1.1

World SRI (2007)a

(In billions)

US ($)

All SRI Core SRI Broad SRI

2710.00

Total in local currency

Canada Australia/ (C$) NZ (A$)

Japan (¥)

Europe (€)

World total

840.00 57.40 446.00

19.40 52.80

511.70 2153.70

2710.00

503.60

72.20

840.00

2665.40

Total in US$b

2710.00

509.67

82.27

7.52

3892.28

7201.74

Total in Eurob

1855.78

349.02

56.34

5.15

2665.40

4931.69

Notes: a. Canada (as of 2006) and Japan (as 30 September 2007) b. Exchange rate as of 31 December 2007 (http://www.newyorkfed.org) Source:

Eurosif (2008)

environmentally and socially concerned investors. Countries that are on the fringe of SRI (for example, South Africa) are following the lead of the European countries that have provided the impetus of the movement.10 Growth in the US Table 1.2 shows that SRI assets in the US rose more than 25 percent from $2.16 trillion in 1999 to $2.71 trillion in 2007. Social screening, which accounts for about 72 percent of the money in SRI mutual funds, is the most prevalent form of SRI followed by shareholder advocacy (22 percent) and community investing (1 percent).11 The remaining 5 percent was accounted for by a combination of screening and advocacy. Of the total $2.7 trillion in SRI, $2.1 trillion used social screening. During 2005–7, SRI assets increased more than 18 percent to $2.71 trillion, compared to a less than 3 percent rise for the broader universe of professionally managed assets. About 11 percent of assets under professional management in the US are now involved in SRI (see SIF 2008). The number of socially responsible mutual funds in the US increased from 168 in 1999 to 260 in 2007, while the total net assets in mutual funds increased from $154 billion to $202 billion during the same period (Table 1.3). Among the $2.7 trillion in SRI, more than $1.9 trillion in assets were


Table 1.2

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Growth of SRI in the US

(In billions)

1999

2001

2003

2005

2007

Social screening Shareholder advocacy Screening and shareholder advocacy Community investing

$1497 $922

$2010 $897

$2143 $448

$1685 $703

$2098 $739

($265)

($592)

($441)

($117)

($151)

$5

$8

$14

$20

$26

Total

$2159

$2323

$2164

$2290

$2711

Notes: Social screening includes socially and environmentally screened funds and separate account assets. Overlapping assets involved in screening and shareholder advocacy are subtracted to avoid potential double-counting. The total amount of socially screened funds (mutual funds, closed-end funds, and exchange traded funds), $174.8 billion, is included in the $2.7 trillion total for SRI. Source:

Social Investment Forum 2007 Report

Table 1.3

Socially screened funds (1999–2007)

(Assets in billions)

1999

2001

2003

2005

2007

Number of funds Total net assets

168 $154

181 $136

200 $151

201 $179

260 $202

Notes: The $202 billion in assets reported in this table includes all funds, including alternative investments and other pooled products. Assets in socially screened funds (mutual funds, closed-end funds, and exchange traded funds) account for $174.8 billion. Source:

Social Investment Forum 2007 Report

socially screened separate accounts managed for institutional and highnet-worth individual clients in 2007 compared to $1.5 trillion in 2005. This sector has grown over 27 percent over two years (Table 1.4). Growth in Europe European SRI is categorized as either ‘core’ or ‘broad’ SRI by Eurosif. Core SRI includes more elaborate strategies that include both negative screening (ethical exclusions) and positive screening (for example, best-in-class and

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Table 1.4


Socially screened separate accounts

(Assets in billions)

2005

2007

Institutional investors High-net-worth clients

1490 17.3

1880 39.5

$1507.3

$1919.5

Total net assets

Source: Social Investment Forum 2007 Report

thematic screening).12 Broad SRI is defined as strategies that include the core SRI, as well as simple exclusions, norms-based screening, engagement practices, and explicit integration of ESG into the analysis (see Eurosif 2008). As was shown in Table 1.1, assets under management in core SRI in Europe reached €511.7 billion and broad SRI was €2.15 trillion, a total of €2.67 trillion in 2007. In contrast, in 2005, AUM in core SRI in Europe was €105 billion and broad SRI AUM was €1.033 trillion (see Eurosif 2006). Core SRI has grown 387 percent, while broad SRI, 108 percent, within two years. This phenomenal growth seems to echo the highly inflated asset values in the global financial markets but due credit should also be given to the leadership that the European countries initiated earlier on. Law and Yau (2008) discuss some initiatives taken by countries, NGOs, and institutional investors that help drive the growth of the European SRI. For example, the fiduciary and pension regulations in Austria, Belgium, Germany, Italy, and the UK, the mandatory SRI policy disclosure in Germany, the consideration of SRI alternatives in the pension plans in Sweden, and the engagement of large investors such as the Fond de Réserve pour les Retraites in France were all attributed to the growth of SRI funds. Global Growth There are several factors that contribute to the worldwide growth of SRI. First, more and more investment professionals consider SRI as part of their practice in response to the increasing demand from socially responsible investors. This, however, does not necessarily mean that everyone who helps their clients to invest in SRI is fully convinced that SRI is among the best investment options from the risk–return trade-off perspective. But many of them are getting more and more amenable to considering SRI as a complement to their portfolios as long as it is no worse than other alternatives. Although there are pundits among investment fiduciaries who are


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still skeptical about the potential cost in SRI, they now are more willing to look into the opportunity on behalf of their clients. The gradual shift in acceptance among investment professionals seems to take root, notwithstanding a dearth of conclusive evidence on the economic benefits of SRI. As such, the investment industry has started to respond with a proliferation of new products and fund styles in socially and environmentally screened funds, especially exchange traded funds (ETFs) and alternative investments such as social venture capital and double- and triple-bottom line private equity. The choice of many more SRI alternatives, from shelfproducts like mutual funds to tailor-made separately managed accounts, helps to convince both investors and their financial advisors that they would be able to find an option that fits in well with their portfolios. These industry developments parallel the megatrends in the environmental and socio-economic-political arenas such as global warming and Islamic investing. A growing concern about climate change and its risk for portfolios is intensifying the interest in SRI among money managers. Investor demand is growing for portfolio opportunities in clean and green technology, alternative and renewable energy, green building and responsible property development, and other environmentally-driven businesses. The growing importance of the Islamic countries as major investors in the world economy has also added impetus to SRI and is to some degree changing the investment landscape. With many Islamic countries also major oil-producers, they have amassed a huge amount of financial resources to invest. Their investments have to abide by Islamic laws or Shariah. In the past, investment industry has not paid much attention to this sector but recently it has grown phenomenally around the world. The Islamic products include Islamic funds and bonds (sukuk), and products offered by Islamic banks. The market for Islamic products is growing at about 15–20 percent a year and the equity fund assets alone are forecast to jump from $15 billion to $53 billion (€45 billion) by 2010 (see Sullivan 2008). Islamic indices and products have sprung up to meet the investor demand. For example, the Dow Jones Islamic Market Index (DJIM) family covering 50 countries has 99 Shariah-compliant indices, including the Shariah-compliant sustainability index, DJIMSI.13 The FTSE Shariah Global Equity Index series has 96 indices, including the All-World Index series and the FTSE Shariah Multinationals 150 Index. The MSCI Global Islamic Indices have more than 400 Islamic indices covering about 50 developed and emerging countries and more than 50 regions, whereas Standard & Poor’s has more than 27 major Shariah indices covering 55 countries as well as niche sectors such as global healthcare, property and infrastructure (Sullivan 2008). Some proponents of SRI suggest that ‘competitive returns’ earned

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by SRI strategies will create broader acceptance of the funds and large pools of capital. This in turns leads to economies of scale and lower costs (which helps keep returns competitive) and continues the access to larger pools of capital (see Budde 2008). Arguably, this has not been a major growth factor for SRI as we shall see in the review of the existing empirical evidence in Chapter 3. Moreover, as corporations begin to enjoy the economy of scale from their investments in ESG-compliant efforts, additional investments in harnessing new ESG issues and standards might keep the costs up before the full benefits of the economy of scale from previous investments can be harvested. This might be one of the reasons for the hidden financial cost of SRI as we shall discuss in Chapter 3. Last but not least, the policy stance and philosophy of regulators towards SRI would affect its future growth. The stricter the policy and the more stringent the regulations, the greater is the impetus to provide growth of SRI. In contrast, countries with less regulation will see less significant SRI growth. This type of regulatory impact has been observed in Australia, where disclosure regulations for occupational funds and mandates over mutual funds in 2002, increased SRI (see George et al. 2006). Likewise, in France, institutional investors are required to abide by the Employee Savings Plan, which has helped the growth of SRI. Sometimes regulations may not be needed if institutional investors are aware of their social and fiduciary responsibilities to their beneficiaries. For instance, the Netherlands does not have SRI regulations, but the majority of their pension funds consider SRI in their decisions and have been expected to provide a greater push for SRI than statutory regulations (see Whitten 2004). Another case in point is Germany. In 2004, Germany mandated regulations for all pension funds to report their SRI policies to their members. However, funds that had contractual agreements with members that stated they were not considering SRI in their investments were exempt. Unfortunately, many of the funds decided to utilize this exemption (see Statman 2005). Compared to other EU countries, Germany has very little regulation for SRI activities and there is limited information on whether ESG transparency is broadly accepted yet.14 Likewise, SRI has gained little acceptance by Spanish institutional investors who have not advanced in adopting engagement activities. In general, European regulations have provided momentum in SRI, especially when competition is used as the incentive. For example, Swedish investors use SRI regulations in the Swedish National Pension Funds as a vehicle for a competitive marketplace by requiring the funds to consider SRI without decreasing the overarching goal of high investment returns. Unlike Germany, this approach gives each fund the flexibility to choose


13

how to implement SRI in their investments, and use only exclusionary screening as a final resort (see Statman 2005). The driving forces behind the phenomenal growth of SRI in Australia are regulations mandated by the Australian Securities and Investment Commission,15 industry groups (such as Investment and Financial Services Association and Australian Council of Superannuation Investors), Australia’s Superannuation funds, and the formation of the Ethical Investment Association. In the US, the SEC mutual fund proxy disclosure requirement of 2003 has compelled US institutional investors to develop proxy-voting policies. Active endowments (for example, universities) have also had to develop policies for voting on ESG issues. The Federal Employees Responsible Investment Act has also helped boost the growth of SRI when government pension funds are required to offer an SRI option under the Thrift Savings Plan. While there are favorable drivers for the growth of SRI, daunting challenges face it with many and varied social, ethical, environmental and governance issues. In the following sections, we provide an overview of the issues (Chapters 4–6) and practices (Chapters 7–8) we shall cover in this book.

ISSUES AND CHALLENGES TO THE GROWTH OF SRI An emerging investment landscape that incorporates non-financial ESG factors into traditional valuation analysis poses a number of challenges to investment professionals. With each challenge, however, comes potential opportunity. A company that incorporates ESG risk exposures in its long-term strategic planning and adequately communicates these risks to investors will provide a more complete picture of the company’s prospects. A company that factors ESG issues into its strategic thinking may position itself to address future costs or burdens more competitively. However, before a company can successfully meet the challenges, it must identify, confront, and embrace the issues underlying the challenges. We enumerate those issues that we shall discuss in detail in subsequent chapters. Financial Benefits of SRI Previous studies have examined whether there are financial benefits or economic costs to SRI. A review of prior work indicates that in most studies the financial performance of funds that used SRI strategies was comparable to those of traditional portfolios (see Hamilton et al. 1993;

14


Statman 2000; Bello 2005; Hudson 2006; Renneboog et al. 2006). A few studies, however, show that SRI may have been disadvantaged because profitable options are screened out, implying a ‘cost’ to SRI (see Rudd 1981; Grossman and Sharpe 1986; Minor 2007; Fabozzi et al. 2008). In addition, discussions on whether fund managers using SRI strategies are meeting their fiduciary duties and acting in the best interest of the beneficiaries seem to be prevalent in recent literature.16 Kinder (2005) has noted that the revised SEC standards will require fiduciaries to factor into their judgments, social and corporate responsibilities issues. The CFA Institute has published a manual on ESG factors to help investors and practitioners to incorporate them in their investment decisions, indicating the growing importance of the ESG consideration in the investment profession (see CFA Institute 2008). Despite the absence of definitive evidence of financial benefits or legal resolution of fiduciary duties, SRI has transcended from a niche concept into a mainstream practicality being performed by institutional investors. We shall review and discuss the evidence of the financial performance of SRI in Chapter 3. Screening Strategies and SRI Criteria There are numerous ways to create SRI portfolios. In Chapter 2, we describe five common strategies used in SRI investments and indices: positive and negative screens, best-in-class, engagement, shareholder advocacy, and integrated. The commonly employed screening strategies are categorized into two groups – exclusionary (negative screening) and inclusive (positive screening). Historically, SRI leaders in the US and UK have predominately used negative screens. They have used negative screens to select out ‘sin’ companies which deal in alcohol, tobacco, and weapons. More recently, they have used positive screens to sort out companies with strong environmental and corporate governance records. These companies are believed to be profitable and sustainable in the long run (see Mincer 2008). The challenge to investors is to determine which approach is better. Moreover, one screen may screen in a company known for its progressive social justice policies while another may screen it out for its poor environment records. More recent advances in positive screening have included the ‘best-inclass’ methodology as part of the screening process (see Eurosif 2004). The fund manager first rates companies from a universe of equities (such as a large-cap index) on ESG issues. Then, depending on the agreed-upon threshold, the top percentage of performers based on the ESG ratings will be retained. The third and final step is to apply a traditional financial analysis to these companies and balance the portfolio by adjusting sector


15

weightings so that they reflect the original index weightings. The challenge in this approach is to determine the appropriate threshold so that the good companies would be screened in and the bad ones screened out. Moreover, the scheme for adjusting sector weighting requires subjective judgment, which is susceptible to error. Another approach in inclusive screening is the use of engagement. Engagement is essentially the use of an investor’s shareholder rights to influence the operations and business strategies of a firm. Institutional investors can leverage ESG issues by virtue of their large portion of holdings (and votes) in the equity market (see Smith 2005). Many fund managers already focus on corporate governance in traditional investing strategies, but are increasingly adding SRI dimensions. Engagement is all about persuading companies that dealing with ESG issues is in their best interest. Fund managers have many engagement options open to them, such as questioning company management, writing to other shareholders to express concerns, creating a dialogue with the company in question, proposing shareholder resolutions, exercising voting rights, calling on extraordinary general meetings, and possibly even issuing press briefings. Many companies would prefer engagement practices to divestment if a win–win situation is created, since it is in the best interest of both parties and a business case for this practice. The challenge is to find issues that are in the best interests of all investors to address and vote on. Often, investors take an integrated approach to developing SRI portfolios. Investors employ some combination of all the above approaches. The integrated approach can even be used in conjunction with conventional investing criteria, for example, adding ESG metrics as an additional set of input data into quantitative financial models. Some define integration as the inclusion of ESG analysis with conventional financial analysis. Instead of a separate analysis by the financial analysts and SRI analysts, the integrated approach aims to combine material ESG information throughout the decision process. Environmental Issues Environmental issues have been the focus of many SRI funds, which employ exclusionary screening to screen out companies with poor environmental management practices. Factors that are scrutinized include the production of hazardous waste (for example, nuclear energy), operations with negative impact on the environment (for example, natural resource extraction), non-renewable energy (for example, oil and gas), and greenhouse gas emissions (for example, automobiles and utilities). Excluding these types of companies will prevent additional risk to the

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portfolio if they are held accountable to their actions through litigation and regulatory compliance. The challenge to investors and fund managers is that environmental risks are hard to measure, in addition to challenges arising from lack of data and ‘green washing.’ While earlier studies seem to suggest that negative environmental issues have no impact on stock price performance, more recent studies seem to find that some importance is attached to environmental issues. The trend of increasing regulations and compliance costs poses a challenge to companies embracing environmental issues in their operations. We shall discuss environmental issues in more detail in Chapter 4. Social, Ethical, and Religious (Faith) Issues Social factors used in exclusionary screens fall into two categories – labor and human rights. SRI fund managers will use labor criteria such as supply chain monitoring, codes of conduct, use of child labor, sweatshop conditions, employment diversity, women and minority rights, and fair wages. Human rights criteria include affiliations to warring countries, treatment of workers, and access to health care and education. While human rights screens are common among SRIs, they have also been used in conventional investment decisions.17 Ethical issues are many and varied. Putting a value on good social or ethical performance is a challenge to investors. Also, incorporating these non-quantifiable risks into investment consideration imposes constraints to the investment set, reducing the risk– return trade-off. We shall discuss social, ethical, and religious (faith) issues in more detail in Chapter 5. Corporate Governance Issues Similar to environmental, social, and ethical issues, corporate governance is important to socially responsible investors in their analyses and valuations of companies, in light of their particular investment perspectives, objectives, and risk-tolerance levels. Additionally, socially responsible investors should understand and analyse how corporate governance may affect the value of their investments and thus help them in making informed investment decisions. Corporate governance refers to the rules prescribing how boards of directors and corporate managers operate. In general, it refers to the control mechanism used to reconcile company managers’ interests and shareholders’ interests. Corporate governance issues arise as there are conflicts of interests between the shareholders and the fiduciaries (the board of directors and managers). For example, corporations need to reconcile the rational economic operating framework (in


17

which profit maximization is the presumed ultimate objective of the firm) with good social behavior, as corporate citizens. Corporate governance issues include the conflicts between the board of directors, corporate management, and shareowners. Issues relating to shareholder rights include: (1) the voting system; (2) rights to nominate individuals to the board, submit proposals to the annual general meeting, and implement the shareholder approved proposals without the board and management; (3) equality in shareholder structure; (4) corporate restructuring; and (5) the opportunity to take legal or seek regulatory action to protect and enforce their ownership rights. Issues relating to the board of directors include: (1) the number of independent board members; (2) the qualifications of the board members and their business relationship with the company; (3) the ability to hire independent third-party consultants; (4) election of board members; (5) independent committees for financial reporting, executive compensation, nomination of independent board members, as well as committees for overseeing the management’s activities in areas such as corporate governance, mergers and acquisitions, legal matters, and risk management. Issues relating to corporate management include: (1) the adoption of a code of ethics; (2) use of company’s assets for personal use; (3) determination of executive compensation; and (4) management of share-repurchase programs and price stabilization efforts.

CURRENT PRACTICES OF CORPORATIONS, INSTITUTIONAL INVESTORS, NON-GOVERNMENT ORGANIZATIONS AND SUPRANATIONAL AGENCIES Corporate Policy and Practice Towards SRI We discuss corporate policy and practice in two areas: corporate social responsibility (CSR) reporting and the incorporation of SRI issues into the corporate policy. The increasing popularity of CSR reports produced for shareholders and stakeholders is indicative of the growing importance of the concept of sustainable growth in SRI. Increasingly, public companies are providing additional non-financial disclosure about their environmental practices and social performances. Although it is not mandatory in all countries, companies are catching up with the practice voluntarily. According to a report by the Social Investment Research Analyst Network done in early 2008, 87 percent of companies in emerging markets offer some kind of sustainability

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disclosure, with South Africa leading the way and Chinese companies lagging behind (Financial Times, 8 September 2008, p. 11). Companies have the freedom to report any of their environmental and social sustainability information in any format, using any metrics and criteria they feel would help the transparency of their activities. The increase in CSR reporting demonstrates that corporations and their stakeholders are in agreement that non-financial reporting is essential to fully characterize all risks and wealth creating potential of a firm. Knowledge of environmental and social issues that are being dealt with at the corporate level, along with financial data, encourages a more efficient market and subsequently more accurate pricings of equities and firm values. Examples of some of the forerunners of CSR reporting frameworks, for example, the Global Reporting Initiative (GRI), and the UN Global Compact, are discussed in Chapter 6. Practices of SRI by Supranational Agencies and Institutional Investors Aside from many multinational corporations, (such as the members of the World Business Council for Sustainable Development (WBCSD) who recognize the need to integrate ESG concerns into business operations for long-term sustainability in business), many institutional investors (financial institutions and pension funds which are members of the United Nations Environment Program Finance Initiative (UNEP FI)), participated voluntarily in the early efforts. As the practices of their corporate counterparts discussed above, the practices of institutional investors, NGOs, and supranational agencies are discussed in the same two areas in Chapter 7. In step with corporate leaders, institutional investors have instituted some ESG metrics as a means of documenting and monitoring nonfinancial data to achieve risk reduction, sustainability, and subsequent long-term financial returns. Public pension funds in various countries have integrated SRI initiatives, expectations, and criteria (see UNEP FI 2007). Government agencies that manage funds, securities regulators, and retail investors are all increasingly gravitating towards scrutiny of non-financial data and evaluating the adequacy of investment research and analysis that go into investment decisions. In addition to incorporating the ESG factors into their investment decision-making process, many institutional investors have also taken an active role as leaders of shareholder activists, for example, TIAA-CREF and CalPERS in the US. They have started to either engage the corporations through the more friendly direct engagement activities or through proxy voting as we shall discuss in Chapters 2 and 3. CalPERS has committed to a broad and flexible scope in choosing opportunities with


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environmental benefits, while diversifying the funds by sector, geography, stage and structure. It assigned a separate risk benchmark to these investments to measure the portfolio performance over the long-term horizon by specifically stating that they would expect negative returns in the short-term but would expect an increase to ‘attractive’ returns in the long run as the environmental market evolves (see CalPERS 2004). By 2005, CalPERS initiated the development of a greenhouse gas reporting project that would improve data transparency in the electric power and utilities industry. In that same year, CalPERS signed on to the Carbon Disclosure Project18 and joined the other 154 institutional investors with a combined AUM of US$41 trillion.18 With regard to incorporating ESG into their valuation and investment decision-making process, institutional investors have had help from many supranational agencies and non-governmental organizations such as the UNEP FI, CERES, and the WBCSD.19 A special UNEP FI Asset Management Working Group (AMWG) comprised of fund managers was established to study the materiality of ESG issues in institutional portfolio management since beneficiaries are requesting approaches in asset management that would include any non-financial information as they become relevant in investment decisions. The AMWG concluded that because ESG issues can contribute to shareholder value, non-financial information should be integrated as an important part of fundamental financial analysis (see UNEP FI AMWG 2004). Likewise, financial institutions that provide funding for projects, especially in emerging markets, have adopted the Equator Principles as a guidance framework to evaluate a corporation’s social and environmental management practices, as well as provide a benchmark for use in the analysis and decision process of funding global projects with capital costs greater than US$10 million.20 With regard to reporting, parallel to the CSR framework initiatives spearheaded by corporations, institutional investors (public pension funds) have adopted the United Nations Principles for Responsible Investment (PRI), a guidance framework for institutional investors to consider ESG issues that have impacts on investment decisions.21 Institutional investors who commit to PRI principles believe that they are meeting their fiduciary duty of acting in the best interests of their beneficiaries by taking into account the ESG factors that affect companies, industry sectors, and geographic regions, and over time, their portfolio performance. SRI in Global Banking Practice and Policy Global banks have embraced sustainability and ESG considerations in their operations as global corporations. As global banks feel the pressure from

20


rising social risks, they embrace SRI voluntarily like responsible global citizens rather than being mandated to act on it. This has been taking place at even a faster pace in the emerging markets as global banking goes worldwide. In Chapter 8, we provide a conceptual perspective on how global banks look at SRI efforts as part of their corporate strategy to increase the value of the firm. We discuss several predominant trends in SRI in global banking businesses. One area of global banking practices that receives our attention is the financing of sustainable projects (projects pertaining to environment and climate change). Another area of practice closely related to sustainability is the development of microfinance and microlending in the developing countries. As we shall discuss in Chapter 3, there is a close relationship between environmental protection development and alleviation of poverty. Microfinance, if used strategically, can help alleviate world poverty while protecting the environment and promoting economic development in developing countries. The third area of global banking practice is ‘extended’ private banking, which focuses on meeting the philanthropic goals of the high-net-worth clients of international banks. Typically, the focus is more on world humanity, a further outreach beyond good citizenship for the local community. Finally, the phenomenal growth in Islamic banking and investment inevitably changes the banking practices in many parts of the world. The growth in Islamic banking and investment as an offshoot of the SRI adds much impetus as well as swirls to the entire SRI movement. While the demand for Islamic investment products and banking services is great and increasing rapidly, practices of institutional investors serving in this segment are being significantly affected, and adaptation is inevitable. In spite of many similarities between the principles of Islamic and SRI investments, institutional investors have to pay special attention to the different needs of Islamic investors.

CONCLUDING REMARKS SRI is becoming an increasingly important consideration in the global financial industry as both retail and institutional investors demand proactive integration of ESG issues into investment considerations. In the following chapters, we shall look at the issues that are confronting both the investors, corporations, institutional investors and regulators with regard to the ESG issues that are relevant to investment decision-making. We review the extant literature and empirical evidence as well as providing our own perspectives on how to incorporate these ESG considerations in the thought process. We discuss the social, environmental and governance issues and discuss how participants in the SRI segment evaluate, embrace


21

and act on these challenges. To us, opportunities arise when these challenges are clearly understood and due diligence is given to the analysis and decision-making process. We shall be amiss, however, if we do not provide the following caveat. The concept of SRI is being expanded to a broader concept of sustainability. Uncertainties are bound to arise and errors in valuation and pricing are inevitable. Prospective investors in SRI should proceed with care as there are now more risk dimensions to consider in addition to the traditional ones. Ignoring these new dimensions or misjudging their impact on one’s portfolio financial performance could be as harmful as other traditional risks.

NOTES 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15.

16. 17.

See Law and Yau (2008) for an account of the historical development of SRI. These terms are explained later in this chapter. The Social Investment Forum is a US nonprofit organization promoting the concept, practice, and growth of socially responsible investing (www.socialinvest.org). In addition to ethical investing, other SRI equivalent approaches to investing include mission investing, responsible investing, double or triple bottom line investing, or sustainable investing. In Spain, most of the ethical funds are also sharing funds. Although sharing funds in community investing accounts for a small percentage of SRI in the US, it is growing rapidly (SIF 2008). Desmadryl (2007) presented this broader definition of SRI to a Roundtable at the United Nations Environment Program Finance Initiative (UNEP FI). Also popularly known as ‘The Brundtland Report to the United Nations’ (1987). Although the estimate of the total amount invested in SRI is now significantly lower due to the global financial crisis of 2009, the trend in SRI has been upward. See Desmadryl (2007). Also, the appreciation of the euro vis-à-vis US dollar affects the euro amount in SRI, but not the percentage of funds under management in their each country. One has to be careful about these statistics since the definition of SRI differs in each country. For a summary of the size and growth of SRI, and types of investors and investments in selected countries and geographic regions, see Law and Yau (2008). The European Social Investment Forum found that community investing was more frequently observed in Latin countries such as Italy, France or Spain (Eurosif 2003). Detailed explanations of screening criteria are presented in Chapter 2. http://www.djindexes.com/islamic assessed on 18 April 2009. It provides incentive rather than regulation in supporting SRI, for example, ‘green investing’ ever since the 1991 Renewable Energy Act that allowed tax-advantaged closed-end funds to create wind farms (White 2005). The Financial Services Reform Act (2002) requires all investment firms to disclose the extent to which their socially responsible investment issues are taken into account. Since March 2005, every Australian ethical investment fund is required by law to have a product disclosure statement that describes the way they select, retain, and sell their investments. See UNEP FI AMWG (2005) for an excellent comparison of the legal perspectives from different countries. Examples of traditional investment decisions that have applied human rights screens include the divestments in companies and financial institutions that do business in countries with human rights violations, such as South Africa during the apartheid

22

18.

19. 20. 21.

Socially responsible investment in a global environment movement, Myanmar during the military regime repression, and most recently, Sudan with the crisis in the Darfur region (Law and Yau 2008). The Carbon Disclosure Project (www.cdproject.net) is a NGO that provides information about business risks and opportunities to institutional investors regarding the implications for shareholder value and commercial operations presented by climate change and works to create open dialogue between policymakers, corporations and shareholders. The figures are as of August 2007 (www.cdproject.net). The WBCSD is made up of CEOs from 200-plus companies working towards sustainability. CERES is a network of investors and public interest groups. Source: www.equator-principles.com. The PRI was developed in partnership with the UNEP FI and UN Global Compact and launched in 2006.

REFERENCES Anderlini, J. (2008), ‘China wealth fund promises to shun tobacco, guns and gambling’, Financial Times, June 14–15. Beal, D.J., M. Goyen and P. Phillips (2005), ‘Why do we invest ethically?’, Journal of Investing, 14 (3), 66–77. Bello, Z.Y. (2005), ‘Socially responsible investing and portfolio diversification’, Journal of Financial Research, 28 (1) (Spring), 41–57. Brundtland Report (1987), Report of the World Commission on Environment and Development: Our Common Future, accessed 20 August 2009 at www. un-documents.net/ocf-cf.htm. Budde, S.J. (2008), Compelling Returns: A Practical Guide to Socially Responsible Investing, Hoboken, NJ: John Wiley. California Public Employees’ Retirement System (CalPERS) (2004), ‘Alternative investment management (AIM) program presentation the members of the Investment Committee’, 15 March 2004, accessed 20 August 2009 at www.calpers.ca.gov. CFA Institute (2008), Environmental, Social, and Governance Factors at Listed Companies: A Manual for Investors, Charlottesville, VA: CFA Institute Centre for Financial Market Integrity. Cohen, A.J. (2006), ‘Challenges for the next generation of investors’, in Rodney N. Sullivan (ed.), Global Perspective on Investment Management: Learning from the Leaders, Charlottesville, VA: CFA Institute. Desmadryl, X. and HSBC (2007), ‘SRI & ESG inclusion: Does it pay after all?’, presentation made at ANBID/UNEP FI Roundtable in São Paolo, March. European Sustainable Investment Forum (Eurosif) (2003), ‘Socially responsible investment among European institutional investors’, accessed 20 August 2009 at www.eurosif.org. Eurosif (2004), ‘Pension programme SRI toolkit’, accessed 20 August 2009 at www.eurosif.org. Eurosif (2006), ‘European SRI study 2006’, accessed 20 August 2009 at www. eurosif.org. Eurosif (2008), ‘European SRI study (2008)’, accessed 20 August 2009 at www. eurosif.org. Fabozzi, F.J., K.C. Ma and B.J. Oliphant (2008), ‘Sin stock returns’, Journal of Portfolio Management, 35 (1) (Fall) 82–94. George, A., N. Edgerton and T. Berry (2006), ‘Mainstreaming socially responsible


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investment (SRI): a role for government?’, University of Technology Institute for Sustainable Future, working paper, Sydney. Grossman, B.R. and W.F. Sharpe (1986), ‘Financial implications of South African divestment’ Financial Analysts Journal, 42, (4) (July/August), 15–29. Hamilton, S., H. Jo and M. Statman (1993), ‘Doing well while doing good? The investment performance of socially responsible mutual funds’, Financial Analysts Journal, 49 (6) (November/December), 62–66. Henderson, D. (2001), Misguided Virtue. False Notions of Corporate Social Responsibility, London: Institute of Economic Affairs. Hudson, J. (2006), The Social Responsibility of the Investment Profession, Charlottesville, VA: Research Foundation of the CFA Institute. Kinder, P.D. (2005), ‘New fiduciary duties in a changing social environment’, Journal of Investing, 14 (3), 24–37. Kreander, N., R.H. Gray, D.M. Power and C.D. Sinclair (2005), ‘Evaluating the performance of ethical and non-ethical funds: a matched pair analysis’, Journal of Business Finance & Accounting, 32 (7 and 8), 1465–93. Law, S.A. and J. Yau (2008), ‘Socially responsible investing: growth and development in international financial markets’, in Hung-Gay Fung, Xiaoqing Eleanor Xu, and J. Yau (eds), Advances in International Investments: Traditional and Alternative Approaches, Singapore: World Scientific. Mincer, J. (2008), ‘Principles and principal’, Wall Street Journal, 21 April. Minor, D.B. (2007), ‘Finding the [financial] cost of socially responsible investing’, Journal of Investing, 16 (3) (Fall), 54–70. Renneboog, L., J.R. ter Horst and C. Zhang (2006), ‘Is ethical money financially smart?’, European Corporate Governance Institute (ECGI) – finance working paper no. 117, accessed at SSRN: http://ssrn.com/abstract=887162 Rudd, A. (1981), ‘Social responsibility and portfolio performance’, California Management Review, 23 (4), 55–61. Schaefer, H. (2004), ‘Ethical investment of German non-profit organizations – conceptual outline and empirical results’, Business Ethics: A European Review, 13 (4), 269–87. Senge, P., B. Smith, N. Kruschwitz, J. Laur and S. Schley (2008), The Necessary Revolution: How Individuals and Corporations Are Working Together to Create a Sustainable World, New York: Doubleday. Smith, T. (2005), ‘Institutional and social investors find common ground’, Journal of Investing, 14 (3), 57–65. Social Investment Forum (SIF) (2006), ‘2005 Report on socially responsible investing trends in the United States, 10-year review’, 24 January, accessed 20 August 2009 at www.socialinvest.org. SIF (2008), ‘2007 report on socially responsible investing trends in the United States’, accessed 20 August 2009 at www.socialinvest.org. Sparkes, R., and C.J. Cowton (2004), ‘The maturing of socially responsible investment: a review of the developing link with corporate social responsibility’, Journal of Business Ethics, 52 (1), 45–57. Statman, M. (2000), ‘Socially responsible mutual funds’, Financial Analysts Journal, 56 (3) May/June, 30–50. Statman, M. (2005), ‘The religions of social responsibility’, Journal of Investing, 14 (3), 14–22. Sullivan, R. (2008), ‘Islamic investment products offer boost to global exposure’, Financial Times, 3 November, p. 8.

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United Nations Environment Programme Finance Initiative (UNEP FI) (2007), Responsible Investment in Focus: How Leading Public Pension Funds are Meeting the Challenges, 2007 Report, April, Geneva: UNEP Finance Initiative. United Nations Environment Programme Finance Initiative Asset Management Working Group (UNEP FI AMWG) (2004), The Materiality of Social and Corporate Governance Issues to Equity Pricing, June, Geneva: UNEP Finance Initiative. UNEP FI AMWG (2005), A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment, October, Geneva: UNEP Finance Initiative. UNEP FI AMWG (2007), Responsible Investment in Focus: How leading public pension funds are meeting the challenge, 2007 Report, Sustainable Pensions Project, Geneva: UNEP FI AMWG and the United Kingdom Social Investment Forum. Valor, C. and M. de la Cuesta (2007) ‘An empirical analysis of the demand of Spanish religious groups and charities for socially responsible investments’, Business Ethics: A European Review, 16 (2), 175–90. White, C.F. (2005), ‘SRI best practices: learning from the Europeans’, Journal of Investing, 14 (3), 88–93. Whitten, D. (2004), ‘Socially responsible investment pays in Japan: the latest investment boom elsewhere finally gains traction in Japan – upfront’, February, accessed 20 August 2009 at www.japaninc.com/mw56.

2.

SRI approaches and criteria

INTRODUCTION This chapter outlines the general criteria used to include or exclude investments in a SRI portfolio and reviews the common screening strategies used in index construction as well as SRI portfolios. Construction of SRI portfolios is based on several premises. Portfolios can address specific concerns or be generic exclusions of the common ‘sin’ stocks. Sin stocks conventionally refers to the common stock of companies with core business in alcohol, arms and weapons, and tobacco products. Other SRI portfolios are inclusive of companies with stellar corporate governance, environmental management and social considerations, companies that adhere to international or industry standards, and companies with awards and recognition from third parties, such as NGOs. Specific concerns addressed in SRI portfolios are dependent on the investor. They range from investing with religious requirements (for example, Islamic investing), moral convictions, or other interests such as clean fuels and green technology. Similarly to developing a conventional portfolio, SRI investors must specify their investment objectives, ascertain their risk tolerance, and determine their investment horizon. However, SRI fund managers must take the additional step that makes SRI different from conventional investing. The fund manager must identify the values and beliefs held by the investor, and work towards aligning the portfolio to these additional goals. As discussed in Chapter 1, some of these goals are seen by SRI detractors as being additional constraints to all the possibilities in the investment universe. However, investing with an SRI mandate incorporates the belief that doing good with investments will ultimately translate into positive returns. Although integrating a long-term approach to assessing risk is difficult with a short-term mindset, anticipating ESG issues should be positively reflected in financial risk mitigation, and thus, help determine short-term decisions.

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TYPES OF SRI PORTFOLIOS There are four general categories of SRI portfolios: environmental, religious or ethical, social, and corporate governance. Portfolios can incorporate one, all or a combination of these categories. SRIs dedicated to environmental issues has been termed ‘green investments’ and sometimes ‘clean tech investments’. These portfolios actively screen out companies with operations that impair the environment. Other environmental SRI portfolios can be inclusive of companies that have no net environmental effects (for example, carbon neutral) or even enhance the environment with new technology, such as wind and solar energy producers. Mercer (2007) found that most brokers conducted thematic research, instead of quantitative ESG analyses. These thematic studies focus on industries that have potential future growth, such as carbon sequestration and nanotechnology. Like conventional industry analysis, thematic investing requires market analysis to determine if these entrants are viable in the future. However, environmental performance is included as an additional consideration to complement traditional analysis. Religious or ethical portfolios are based on moral beliefs or religious teachings, and historically have excluded the typical ‘sin’ stocks of companies that produce weapons, tobacco products, alcohol, and parts of the entertainment industry (for example, pornography and casinos). Despite the commonality of the sin stock exclusion, SRI portfolios based on religious beliefs can vary widely on composition of investments. Social SRI portfolios often take into account labor and human rights. These portfolios typically do not invest in companies with questionable labor practices, either within the firm or along its supply chain, or those that choose to work in countries with poor human rights records. Social investment portfolios can also be inclusive of investments in developing communities, international development, or those that are focused on specific issues such as health care. The last type of SRI portfolios based on the concerns related to corporate governance focuses on those companies that are open towards shareholder resolutions and active engagement by investors with the board of directors. SRI investing is not limited to mutual funds (such as focused funds that identify themselves as a ‘health care’ or ‘alternative energy’), but can take on several different forms of investing, such as fixed income, microfinance to the world’s poor, private equity, venture capital funds, and private portfolios that are offered exclusively to clients in private asset management firms or private pension funds (discussed in Chapter 3). Throughout this book, SRI is discussed within the context of


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investments made with selective decision criteria that have a direct impact on the risk and return of the portfolio, and not funds that consider themselves SRI because they give charitable contributions as part of their operational strategy or provide direct investment (foreign or domestic) to community projects. Historically, some investors believed that SRI is a form of philanthropy. However, we see SRI as an investment style that falls into the conventional framework of financial analysis subject to scrutiny by investors in efficient markets based on the traditional financial theories of risk and return. SRI as a theme speaks to the increasing trend of investors who seek non-financial information as additional sources to assess risk and help make informed decisions.

STRATEGIES FOR CONSTRUCTING A SRI PORTFOLIO Constructing SRI vehicles require the same standards of practice as any other conventional investment portfolio, including the development of an investment policy, defining short-term and long-term goals, assessing risk tolerance, and having a solid understanding of the objectives of the portfolio. In conventional portfolios, the objectives are an integrated balance of risk, return, and the time horizon. For a SRI portfolio, the objectives also encompass environmental, religious, social and corporate governance considerations. SRI investors focus on how their investments are ‘doing good’ in the world, while considering the long-term horizon of the risks associated with these ESG factors. SRI portfolio construction requires a more stringent set of standards and a more detailed analysis of companies’ operations and practices than conventional portfolios. Some believe that ESG performance is a proxy for management quality, and is a reflection on management’s operations in the long term (see Mercer 2007). Contrary to critics of SRI who mistakenly believe that SRI advocates investments in portfolios that have returns below the market, we believe that only companies that have passed conventional financial criteria should be considered for additional ESG scrutiny. When developing SRI portfolios, investors assess the company’s financial performance, their industry positioning, and management quality, using all the tools available for conventional stock picking and portfolio creation. Once that assessment is completed, SRI investors identify the ESG criteria which they use to construct the portfolio and measure performance. Criteria considerations will be discussed later in the chapter. There are five common strategies used to create SRI portfolios:

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Socially responsible investment in a global environment ● ● ● ● ●

Screens Best-in-class Engagement Shareholder advocacy Integrated.

Screens Screening options for a SRI portfolio can be divided into negative and positive. Negative screening is exclusionary and is the most basic form of choosing investments. A simple negative screening strategy omits companies based on certain criteria. The decision is usually a yes/no decision. Some investors simply exclude entire sectors from the portfolio, such as the tobacco industry, or, depending on the portfolio objectives, some investors will screen out individual companies. Investors using a simple negative screening strategy can run into difficulties with companies with several different business lines. For example, a company that produces both food and tobacco only partially meets the negative screen for tobacco. In cases such as this, the investor must decide on a threshold percentage to adhere to so that a restrictive screen is placed on the portion of the business that meets the tobacco screen. Another example of restrictive screens is Islamic funds that aim to omit companies that receive payment of interest. To meet this objective, Islamic investors avoid conventional financial service firms with a debtto-equity ratio greater than 33 percent (see Hussein and Omran 2005). (Additional discussion of Islamic banking and finance can be found in Chapters 3 and 8.) Positive screening is an inclusionary portfolio construction strategy. This strategy is based on actively choosing investments that meet the criteria of the portfolio objectives, and involves making conscious choices that can deviate from conventional choices. Using a positive screen to include investments is more difficult than the passive, simple negative screening strategy. As discussed later in this chapter, some social criteria may not be quantifiable and/or difficult to measure, and therefore positive screens are highly dependent on the investor’s thresholds and professional judgment. In cases where metrics for criteria exist, positive screening is used to create thematic funds that focus on specific criteria, such as alternative energy funds that seek renewable and carbon neutral energy sources or healthcare funds. Combinations of negative and positive screening strategies may provide a practical way to integrate ESG issues into SRI portfolios, minimize risks, and increase financial returns. Portfolios based on the FTSE4Good


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and DJSI indices (discussed below) are examples of portfolios using mixed screening strategies. Renneboog et al. (2006) found that SRI mutual funds employing a higher number of screens to model their investment universe received larger money inflows and performed better in the future than focused funds. Best-In-Class The best-in-class strategy aims to have a side-by-side comparison of investments categorized in a pre-determined group and ranked. This strategy allows investors to make decisions about a company, based on their relative ratings to others in the same pre-selected group. The groups can be based on industry sectors or from a benchmark index. The use of a best-in-class strategy is more sophisticated than the simple screening strategies, and is useful for companies that do not fall into black and white categories of being ‘good’ investments, especially for companies with multiple business lines. Best-in-class strategy includes the use of preference weighted criteria. Using a weighting scheme allows for a gradation of environmental and social performance, and has reportedly been used to make incremental changes in valuation metrics, such as discount rates (see Rubino 2008). The best-in-class strategy is prevalent in Europe and has been used by several institutional investors. The UK Environment Agency used this strategy as part of their overall strategy to include environmental considerations in their pension fund (Environment Agency and Robeco 2007). The Pension Committee decided to consider only private equity funds of funds (FOF), and developed a ranking scheme to further understand the FOFs’ relative risks, products, costs, and benefits. Criteria included: performance (that is, the ability to deliver on the mandate); risk; process (organization and team stability, integration of environmental issues, and client reporting); price and value for money (the fees and associated with each FOF); people and investment process quality; integration of sustainable environmentally responsible investment and corporate governance; and client service and reporting. The Committee weighted the criteria by importance (10 to 30 percent) and came up with an overall score and ranking for each FOF. Using this best-in-class strategy, they reduced their initial 25 FOFs to one. Their final decision was assessed to be the bestin-class that fitted all of the Pension Committee’s criteria. Not only did this best-in-class strategy provide a transparent and consensus approach amongst members of the committee, but it was also a more objective way of making the decision.

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Engagement Engagement, the third strategy for conducting a SRI portfolio, involves the investor working with the company they are considering or have already invested in, and consists of dialogue, direction, and guidance. This strategy is often used in private equity investments, bank lenders, or any situation in which there is a critical amount of capital invested and shareholders can engage with management to promote environmental and social progress. Unlike shareholder activism, engagement is usually done in private with company managers and can include a coalition of investors. The Principles for Responsible Investment Engagement Clearinghouse allows its signatories to post ideas and proposals with others to seek changes in company behaviors, policies or systemic conditions. Other collaborations include the Carbon Disclosure Project, the Enhanced Analytics Initiative and Institutional Investors Group on Climate Change. Shareholder Advocacy and Activism Unlike the engagement strategy, the advocacy and activism strategy is used to support specific ESG causes, and can often be confrontational. Using this strategy often involves the promotion of shareholder resolutions and voting at annual meetings, and it is employed when engagement with the company is no longer a viable option. Advocacy can involve multiple investors. Investors who band together to advocate specific issues initiate multi-stakeholder dialogues, such as bringing in other members of the industry or companies that face the same issues, and advocate fostering better industry practices. Advocacy investors make public statements and engage with others to formulate public policy, as well as publish reports, business white papers and refereed journal articles. There is a general belief that monitoring these companies will reduce risks (see Hudson 2006). Advocacy has been used by New York City’s pension funds and SRIs, in which they filed resolutions at several large corporations, with the request to provide equal rights to gay, lesbian, bisexual and transgendered workers and protect them from discrimination in the workplace. The resolutions were specific to having the companies publicly declare the prohibition of discrimination based on sexual orientation (see Gunther 2006). In 2007, the average support votes for climate change-related proposals initiated by the Investor Network on Climate Risk (INCR) increased to 22 percent. The INCR is composed of 60 institutional investors with $5 trillion in AUM. In some cases, shareholder resolutions may not win majority votes but the support for causes has been manifested in


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negotiated settlement agreements with the company (and thus, have turned into engagement strategy). For example, shareholders withdrew a climate proposal at Ford Motor Company after the company presented its plans to reduce greenhouse gas emissions by 30 percent in new vehicles by the year 2020 (see Melican and Westcott 2008). In 2008, investors with $300 billion AUM filed 57 climate change related resolutions and almost half were withdrawn after companies agreed to provide climate change commitments. Of the 26 resolutions requesting sustainability reports, 80 percent were withdrawn after the companies agreed to produce them (see Fleming 2009). By far the most popular SRI subject for shareholder activists is corporate governance and executive pay, as discussed in Chapter 6. Shareholder activists go beyond advocacy by launching public campaigns that can resort to shaming the company. Activists can work in cooperation with other investors, often directing their campaign to other shareholders. Shareholder activism has resulted in smear campaigns, public denouncements, government lobbying, and protests. The last resort of activists is to divest. Some of the biggest divestments in recent history includes divestiture in South Africa in the late 1980s and early 1990s and Sudan in the mid- to late 2000s. Integrated Approach Commonly, investors take an integrated approach to developing SRI portfolios. Investors perform some combination of all the above strategies, matching the technique to the type of portfolio, asset class, and portfolio mandate. The integrated approach can even be used in conjunction with conventional investing criteria, for example, adding ESG metrics as an additional set of input data into quantitative financial models. Some define integration as the inclusion of ESG analysis with conventional financial analysis, such as Eurosif (2008). Instead of separate analyses by the financial analysts and SRI analysts, the integrated approach aims to combine material ESG information throughout the decision process. Table 2.1 provides a summary of the SRI strategies used in several countries.

SRI CRITERIA Each type of ESG category has a unique set of criteria on which the portfolio is based. Some of these criteria are publically stated and apply to all

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Table 2.1


SRI strategies in different regions and countries

Region

Country

Screening approacha Positive/ Negative/ inclusiveb exclusionaryc

Major criteria applieda,d

Europe Austria Belgium Denmark France Germany Italy Netherlands Norway Spain Switzerland Sweden United Kingdom

1 1 3 2 1, 2, 3, 5 1, 5 1, 2, 3 3 1, 5 3 2, 3

6 6 6 6 6 6 6 6 6 6 6 6

c c a1, a2 a1, c c

2,3 3, 4

6 6

a1, b, e1, e2, e3, e4 a2, b, e2, e3, e4

6 6

a2, b a2, b, e2, e3, f

a, b, c

North America United States Canada Asia and Pacific Rim Japan Australia

Notes a The predominant screen approach used and major criteria applied in each country are in bold. b Positive screening approaches: 1) Best-in-class; 2) Integration; 3) Engagement; 4) Proxy voting; 5) Pioneer/thematic screening c Negative Screening Approaches: 6) Simple d Criteria: a) social (human+labor) a1) Labor, a2) Human rights, b) environmental, c) ethical, d) religious, e1) alcohol, e2) tobacco, e3) gambling, e4) non-weaponry, f) sustainable development Sources: Ali 2006; Baue 2004; Carpenter 2004; Desmadryl 2007; EIA 2007; Eurosif 2008; Law and Yau 2008; SIO 2007; White 2005; Whitten 2004; Stewart 2006.

inclusions in the portfolio, such as mutual funds, but in some cases, such as private equity investments, the criteria can be very specific to the nature of the investment itself. Environmental criteria can be categorized into three groups: ecoefficiency, environmental impact, and environmental management. Eco-


33

efficiency is a term widely used for the production of more valuable goods and services, while using less natural resources, and producing less waste and pollution. Criteria within this category include, but are not limited to: ● ● ● ● ● ● ● ● ● ●

Minimum use of water Minimum use of energy Minimum waste disposal in landfills Minimum greenhouse gas emissions Minimum transportation during production and distribution (for example, firms that process materials close to the source location) Maximum use of sustainable materials Maximum use of recycled materials (for example, rubber) and recovered materials (for example, metals) Maximum use of alternative or renewable energy Producing products that are durable with long life spans Producing products with enhanced recyclability or reuse at the end of life.

These eco-efficiency criteria can be quantified by normalizing to a financial factor such as sales or production. For example, the amount of energy used to create a quantity of product, divided by the sales of the product, gives a ratio that can be used by the investor to compare energy usage between companies. Environmental impacts are a category that describes the effect the firm has on the environment during its operations. Examples of these criteria include: ● ● ● ●

Water, soil, air, and groundwater pollution (for example, release of greenhouse gas emissions) Loss of biodiversity, decrease of animal and plant populations, and loss of important habitats Impacts on economically-important natural resources such as forests and fisheries License to operate in communities that have a lot of natural resources.

Criteria categorized within the environmental management framework are focused on a company’s commitment and management of their environmental impacts and liabilities. These criteria include: ●

Implementation of robust environmental management systems that document protocols, record results and monitor environmental impacts

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Socially responsible investment in a global environment ● ● ● ● ●

●

●

●

Current and historical environmental liabilities Commitment to performing routine internal and independent environmental audits Policy statements from corporate officers about their stand on environmental issues Involvement with environmental NGOs or funding environmentallyfocused projects Certifications from industry groups (for example, the Sustainable Forestry Initiative sets standards, tracks tree products, labels and certifies wood and paper products are from well-managed, sustainable forests in North America) Awards and commendations from independent groups (for example, Corporate Knights and Innovest Strategic Value Advisors announces the ‘Global 100 Most Sustainable Corporations in the World’ each year at the World Economic Forum in Davos.) Instituting environmental systems throughout the entire life cycle of their products or services (for example, implementing ‘take back’ recycling programs for their products after their useful life) Providing employee training and fostering a culture of environmental awareness.

Social Criteria Social criteria are varied in the types of considerations that investors make. Criteria can be categorized into three groupings: labor, social development, and corporate governance. Labor criteria revolve around the basic violations of good company treatment their workers, including: ● ● ● ● ● ●

Adherence to national and international labor laws (for example, child labor) Good health and safety records and protocols Fair treatment and non-discrimination (for example, promoting women to executive levels, diversity goals within the company) Fair wages and/or living wages and fair trade with suppliers Level of employment benefits (for example, flexible schedules, on-site daycare, promotion of healthy lifestyles such as gym memberships) License to operate in communities, or positive community relations.

Several SRI portfolios are based on the social development aspects of the investments. These criteria are based on the concepts of sustainable development and human rights. Criteria include:

SRI approaches and criteria ● ●

●

●

● ●

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Violations of human rights Social programs and investment in developing areas (for example, building schools and water treatment facilities, tuition and training for local workers, and other proactive investment in local communities) Foreign operations (for example, companies that uphold high standards in other countries in which they operate, divestments in companies that work in countries with oppressive regimes) Companies with foundations or mandates that help poor communities or developing nations (for example, pharmaceuticals companies that manufacture affordable drugs and make them accessible to poor people in countries that suffer from diseases uncommon in developed countries) Political contributions Involvement in areas with political upheaval, social disruption, or failure to adhere to international laws/rights.

SRI portfolios that focus on corporate governance can include the following criteria: ● ● ● ● ●

Level of shareholder rights, shareholder advocacy or activism, and stakeholder engagement Board structure and composition (including education and knowledge of directors) Charters and bylaw provisions Executive and director compensation (including stock ownership) Independent audits, transparency, disclosures, and board performance reviews.

Religious and ethical criteria are much harder to discern for SRI fund managers. Not only does each religious institution have its own set of beliefs,1 each individual also has their own level of moral beliefs and standards. Traditional SRIs that avoid the ‘sin’ stocks are often considered to be adherents to religious criteria, covering areas such as: ● ● ● ●

Weapons, nuclear weapons or nuclear power Entertainment industry, gambling or gaming (casinos, racetracks) Cigarettes and other products harmful to human health (for example, alcohol, fatty foods, etc.) Other criteria that are morally and ethically opposed by individual investors (for example, animal rights, biotechnology, same-sex rights, politics, etc.)

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SRI INDICES The use of ESG criteria is a critical step in constructing a SRI portfolio because it provides a checklist of values-based decisions and forms a basis of comparison between investments. SRI investors use benchmarks, to which they can compare their fund results. Several SRI indices are available from different investment and financial research firms that track corporate governance, corporate responsibility and sustainability, and exclude the traditional sin stocks. Some benchmark indices are focused by geography, such as the EURO STOXX® Sustainability Index and the Dow Jones Sustainability World Index. Other indices are specific to environmental values, such as the FTSE4Good Environmental Leaders Europe 40 Index. There are also benchmarks for portfolios that follow religious frameworks such as the Dow Jones Islamic Market Index, the S&P Shariah Indices, and the KLD Catholic Values 400 Index. There are a vast array of indices with special focus on ESG issues such as the Ethibel Sustainability Index, the S&P ESG India Index, and the Calvert Social Index. Among the first indices that were specific to ESG, sustainability, and other SRI factors were the Dow Jones Sustainability Indexes (DJSI), launched in 1999. The DJSI family includes the Dow Jones Sustainability World Index, North American Index, United States Index, STOXX® Sustainability Index, EURO STOXX® Sustainability Index, STOXX® Sustainability 40 Index, and EURO STOXX® Sustainability 40 Index. The DJSI was a response to the growth of corporate sustainability and the need for a benchmark that investors could use for analysis in portfolio management. All DJSI are comprised of the leading companies based on ESG criteria, such as codes of conduct, corporate governance, ecoefficiency, philanthropy, and human capital development. Closely related to DJSI is the Dow Jones Islamic Market Index that seeks to provide a benchmark that complies with shariah, or Islamic law. There are 99 indices covering 50 countries and various regions and sectors. The key attribute of these indices is the exclusion of ‘sin’ stocks as well as companies involved in pork-related products and providing certain types of financial services. The FTSE Group has created three types of indices that can be used for SRI analysis and research. The FTSE Corporate Governance Index Series tracks corporate performances such as compensation systems, stock ownership, equity structure, board independence and the audit process. The FTSE4Good Index, launched in 2001, was created specifically for SRI. It uses criteria such as corporate responsibility, social, environmental, and ethical (SEE) issues, and excludes the traditional ‘sin’ stocks. Eligible companies that are included in this index must meet five criteria: (1) working


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towards environmental sustainability; (2) develop positive relationships with stakeholders; (3) uphold universal human rights; (4) ensure good supply chain labor standards; and (5) counter bribery. The FTSE4Good Environmental Leaders Europe 40 Index was created specifically to track the top 40 European companies with leading, best, environmental practices. In light of the growing concerns of climate change, the FTSE indices have recently included five new climate change criteria based on a company’s policy on addressing climate change impacts, management of the impact, disclosure of greenhouse gas emissions, performance measures for assessing their response actions, and the scope in which they reduce their climate change impacts. In addition, FTSE has set up the Shariah Global Equity Index series made up of 96 indices, including some for developed and emerging markets, the All-World Index series and the FTSE Shariah Multinationals 150 Index. It also has thematic indices. KLD Research and Analytics, a focused social research company for institutional investors, created a family of indices to address SEE factors in 1990. Among the indices are the Domini 400 Social Index (DS400), KLD Broad Market Social Index (BMSI), KLD Catholic Values 400 Index (CV400) and KLD Global Sustainability Index (GSI).2 The DS400 is based on the S&P 500 index (comprising mainly of US equities), excludes the ‘sin’ stocks, and includes companies with positive ESG records based mainly on community relations, diversity, employee relations, human rights, and product quality and safety. The BMSI is based on the Russell 3000 index (which represents 98 percent of the US capitalization in equities), screens out companies involved in the ‘sin’ industries and chooses the top 65–75 percent performers based on ESG criteria. The CV400, which represents the large-cap US equities segment,3 meets the eligibility requirements of the United States Conference of Catholic Bishops Socially Responsible Investment Guidelines.4 Specifically, the index does not include companies that produce tobacco, anti-personnel landmines, firms that derive more than 5 percent of their revenue from weapons and companies involved with nuclear power generation (although companies with notable involvement in alternative energy are given consideration). It also excludes companies that are counter to the Catholic Church’s views on abortion, embryonic stem cell/fetal tissue research, human cloning, and contraception. It seeks to include companies that are instrumental in promoting human dignity such as health care and pharmaceuticals and opportunities for women and minorities, and exclude companies with a history of discrimination. It includes firms that pursue economic justice without sweatshop manufacturing, predatory lending, and poor labor conditions. In addition, it includes companies that provide affordable housing, protect the common environment, promote environmentally

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beneficial technologies, reduce greenhouse gas emissions, and develop alternative energies (see www.kld.com). MSCI Global Islamic Indices has more than 400 Islamic indices covering about 50 developed and emerging countries and more than 50 regions such as Gulf Cooperation Council (GCC) countries and Arabian markets. They include MSCI EAFE Islamic Indices, MSCI Emerging Markets Islamic Indices, MSCI The World (Developed Markets) Islamic Index, MSCI GCC Countries Islamic Index, and MSCI Europe Islamic Index as well as MSCI US Islamic Index. In addition, there are numerous investment and finance research firms which provide their own benchmarks that account for social and environmental factors, such as the Morningstar Responsible Investment Index, Goldman Sachs Energy Environment and Social Index (GSEES), the Ethibel Sustainability Index in Europe, the Jantzi Social Index in Canada, the Calvert Social Index in the US, and the OWW Responsibility SRI Asia Index.

ESG INFORMATION AND REPORTING Investors building a SRI portfolio can find pertinent environmental and social information in a number of ways. Although there are no regulatory requirements for extra financial reporting on ESG facts, there are some guidelines and encouragement from several countries’ securities regulators. Germany has issued standards on key performance indicators and even indicators for specific sectors (see Bassen and Kovács 2008). There is an increasing trend of companies producing corporate sustainability reports or corporate social responsibility (CSR) reports, which provide non-financial disclosure about their environmental and social practices and performances, including emerging countries (discussed in Chapter 6). Investors can use this information as a supplement to analysing financial data. However, unlike financial reporting, in some countries CSR reports are not mandatory or regulated. There is currently no standard report format and companies are free to report any environmental and social information using any metric and criteria to provide information about their activities. The Global Reporting Initiative currently provides the de facto standards for sustainability reporting, but adherences to these standards are voluntary for each reporting entity. Investors seeking SRI information in CSR need to exhibit some caution, as some SRI metrics can be emphasized in the report, and others not reported at all. A study found that approximately 41 percent of the US firms they studied across several different


39

industries provided some form of CSR disclosure, with the majority of the information being related to community relations, employee health and safety, and employee diversity (see Holder-Webb et al. 2009). The researchers found that environmental disclosures were not as widespread and that political contributions were the least mentioned in CSR reports. The authors point out that the majority of the companies wrote their CSR reports with a mostly positive tone and were self-laudatory and only 13 percent of their sample were considered to be written with a neutral tone. The authors suggest that the CSR reports were treated as marketing pieces, and that enhanced reporting would be necessary if investors try to use CSR report for material information. Thus, although CSR reports are useful in discerning some of the self-publicity, SRI investors should consider other sources of information such as company management surveys and independent assessments. Independent research is crucial for assessing the ESG factors for each investment. NGOs such as CERES and the World Business Council for Sustainable Development provide research, analysis and consulting to SRI investors. There are also numerous private firms that provide similar information on individual firms and guide investors towards investments that can follow through with the SRI mandates. SRI investors use ESG criteria to assess how environmental, social, and corporate governance affect the industry, the company, and ultimately their investments. ESG risks are dependent on several issues, some of which include the location of operations, the regulatory environment, and stakeholder perspectives. Although ESG criteria may not be quantitative and precise measures, they are useful indicators of environmental and social risk, help define how firms rank in relation to each other, and provide an idea of the long-term risk.

CRITICISMS There are several criticisms of portfolio creation that go beyond the initial critique that SRI-focused funds limit the universe of investments and therefore the potential for higher returns. The Hawken and Natural Capital Institute (2004) discuss several of these issues. They found that there is a lack of transparency and accountability in screening and in portfolio selection. They found this problem when firms used proprietary screening methodology such as in-house questionnaires, management interviews, and other tools that assess the company’s overall rating. Moreover, any fund manager can call their portfolio an SRI if they used just any one of the SRI factors on which to base some of their selections.

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And without an overarching regulatory authority, there are no standard financial regulations for SRI funds and similarly, no ratings specific to SRI (for example, similar to Morningstar ratings). All this leads to a vast array of SRI vehicles that make it difficult for investors to do a comparison amongst different SRI funds. Hawken and Natural Capital Institute (2004) found that over 90 percent of the Fortune 500 companies are included in SRI portfolios because many screening methodologies allow the majority of publically-held companies to be included. This could be related to the general problem that fund managers assume and choose the important criteria for their investors, even though investors’ values are highly variable and divergent. Some funds will target one issue, but include other companies that are likely to offend other social/environmental criteria. Using SRI screening strategies requires fund managers to decide on subjective grouping of preferences for their investors (see Farmen and van der Wijst 2005). Decisions to include firms in a portfolio can also be swayed by publicity, as some firms heavily market some of their SRI values and underplay others. Fund managers who look at the company as a whole sometimes subjectively ignore gray areas within their operations. There have been reports of SRI fund managers debating strategic approaches towards SRI funds. The majority of SRI funds are long-only funds (that is, managers purchase securities with the expectation that the value will increase). Some fund managers have questioned whether a short-selling strategy would be an appropriate investment strategy (see Cui 2007). In this case, a stock from a company with poor ESG performance would be borrowed and sold by the fund manager, with the expectation that the stock would decrease in value. In this case, managers who use both long and short strategies can benefit from both the good and bad ESG performers. SRI funds with long-only strategies would be constrained within their investment universe. Criticisms of SRIs are not only focused on their construction but also the value that they have in creating environmental and social progress. Hawken and Natural Capital Institute (2004) found environmental screens are loose and do little to help the environment. The researchers also state that although shareholder activism is an important aspect of SRIs, they have found very few SRI mutual funds that engage with firm management or sponsor shareholder resolutions. Other researchers have claimed that SRI fails to produce social change (see Munnell 2007; Teoh et al. 1999; Wright and Ferris 1997). However, despite these negative assessments, firms are aware of the importance of their reputation and materiality to their bottom line and have made some progress in addressing ESG issues as part of their management and operational


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strategy. This in effect, is a step towards global environmental and social changes.

CONCLUSIONS In this chapter, we described the different strategies for creating a SRI portfolio. Investors have graduated from simple negative screens of sin stocks, to inclusionary screens. Inclusionary screens include bestin-class, engagement, advocacy, activism, and integration strategies. Environmental, social and corporate governance are important considerations when constructing a SRI portfolio. Environmental criteria can be categorized into eco-efficiency, environmental impact, and environmental management criteria. Social criteria include labor, human rights, corporate governance, and religious/ethical criteria. Investors creating SRI portfolios should define the ESG considerations that they value and choose appropriate criteria which they can use to choose investments, benchmark against, and use to measure non-financial performance.

NOTES 1. For a comprehensive discussion on religious criteria, see Lane (2005). 2. Other indices in the KLD family include the KLD Dividend Achievers Social Index; KLD Global Climate 100 Index, KLD Large Cap Social Index, KLD Large Cap Sudan Free Social Index, and the KLD Select Social Index – see www.kld.com. 3. ‘Large cap’ generally refers to companies with a market capitalization value of more than $10 billion. 4. The United States Conference of Catholic Bishops Socially Responsible Investment Guidelines in general endorse investments which give consideration in: (1) respecting human life; (2) promoting human dignity; (3) reducing arms production; (4) pursuing economic justice; (5) protecting the environment; and (6) encouraging corporate responsibility.

REFERENCES Ali, P. (2006), ‘Investing in the environment: some thoughts on the new breed of green hedge funds’, Derivatives Use, Trading & Regulation, 12 (4), 351–7. Bassen, A. and A.M. Kovács (2008), ‘Environmental, social, and corporate governance key performance indicators from a capital market perspective’, Zeitschrift fuer Wirtschafts- und Unternehmensethik, 9 (2), 182–92. Baue, W. (2004), ‘Daiwa launches Japan’s newest socially responsible investment fund’, assessed 23 August 2009 at www.socialfunds.com. Carpenter, J. (2004), ‘Advising SRI- presentation to EIA Australia’, accessed 23 August 2009 at www.ea.org.au.

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Cui, C. (2007), ‘How social conscience hooks hedge funds’, Wall Street Journal, 27 November. Desmadryl, X. (2007), ‘SRI & ESG inclusion: does it pay after all?’, presentation made at ANBID/UNEP FI Roundtable in São Paolo, Brazil, for HSBC, March 2007. Ethical Investment Association (EIA) (2007), ‘2006 benchmarking study’, accessed 23 August 2009 at www.eia.org.au. Environment Agency and Robeco (2007), ‘Responsible investment in private equity. A case study’, the Environment Agency pension fund mandate with Robeco Private Equity, accessed 23 August 2009 at http://www.environmentagency.gov.uk/aboutus/organisation/35603.aspx. European Sustainable Investment Forum (Eurosif) (2006), ‘European SRI study 2006’, accessed 23 August 2009 at www.eurosif.org. Eurosif (2008), ‘European SRI study 2008’, accessed at www.eurosif.org Farmen, T.E.S. and N. van der Wijst (2005), ‘A cautionary note on the pricing of ethics’, Journal of Investing, 14 (3), 53–6. Fleming, P. (2009), ‘Investors achieve major company climate change commitments’, Business and the Environment, February, p. 5. Gunther, M. (2006), ‘Corporate America backs gay rights’, Fortune, April 26. Hawken, P. and Natural Capital Institute (2004), ‘Socially responsible investing’, October, accessed at www.responsibleinvesting.org, Holder-Webb, L., J.R. Cohen, L. Nath and D. Wood (2009), ‘The supply of corporate social responsibility disclosures among U.S. firms’, Journal of Business Ethics, 84, 497–527. Hudson, J. (2006) The Social Responsibility of the Investment Profession, Charlottesville, VA: Research Foundation of CFA Institute. Hussein, K. and M. Omran, (2005) ‘Ethical investment revisited: evidence from Dow Jones Islamic Indexes’, Journal of Investing, 14 (3), 105–24. Lane, M.J. (2005), Profitable Socially Responsible Investing: An Institutional Investor’s Guide, London: Institutional Investor Books. Law, S.A. and J. Yau (2008), ‘Socially responsible investing: growth and development in international financial markets’, in Hung-gay Fung, Xiaoquing Eleanor Xur and Jot Yau (eds), Advances in International Investments: Traditional and Alternative Approaches, Singapore: World Scientific. Melican, J. and S. Westcott (2008), ‘What the proxies tally: a rising tide of activism’, Director and Boards, 8, (Annual Report, Special Issue), 30–53. Mercer (2007), ‘Demystifying responsible investment performance. A review of key academic and broker research on ESG factors’, Boston College for Retirement Research working paper, October. Munnell, A.H. (2007), ‘Should public plans engage in social investing?’ Boston College Center for Retirement Research, working paper 7–12, August. Rennebog, L., J.R. ter Horst and C. Zhang (2006), ‘Is ethical money financially smart?’, European Corporate Governance Institute finance working paper no. 117, Accessed 23 August 2009 at SSRN: http://ssrn.com/abstract=887162. Rubino, J. (2008), ‘Green alpha’, CFA Magazine, (Sept–Oct). Social Investment Organization (SIO) (2007), ‘Canadian socially responsible investment review’, March 2007, accessed 23 August 2009 at www.socialinvestment.ca. Stewart, G. (2006), ‘Socially responsible investing: transforming to the mainstream’, Mercer Investment Consulting Insights Newsletter, September 27, accessed 26 August 2009 at www.mercer.com/referencecontent.htm?idContent=1196625.


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Teoh, S.H., I.Welch and C.P. Wazzan (1999), ‘The effect of socially activist investment policies on the financial markets: evidence from the South African boycott’, Journal of Business, 72 (1), 35–89. White, C.F. (2005), ‘SRI best practices: learning from the Europeans’, Journal of Investing, 14 (3), 88–93. Whitten, D. (2004), ‘Socially responsible investment pays in Japan: the latest investment boom elsewhere finally gains traction in Japan’, Upfront, February 2004, accessed 23 August 2009 at http://findarticles.com/p/articles/mi_m0NTN/ is_52/ai_113526684. Wright, P. and S.P. Ferris (1997), ‘Agency conflict and corporate strategy: the effect of divestment on corporate value’, Strategic Management Journal, 18, 77–83.

3.

Incentives, alternatives, and financial performance of SRI

INTRODUCTION There are different incentives for investors to engage in SRI. They do so not only for financial rewards but also non-financial returns that fulfill their own aspirations, moral obligations and values. The non-financial incentives have been described as the ‘feel good’ or ‘do well while doing good’ motivation of SRI. Although it sounds ideal to garner profits while doing some good in the world, is there a cost to SRI? It seems easier to convince investors who are socially concerned that there is no cost to SRI. Many of them are willing to accept a lower return on investment for ‘feeling good.’ Fiduciaries (for example, financial advisors and pension fund managers) who work for socially responsible investors, however, are not as easily convinced. They are confronted with the dilemma of trying to achieve the best risk–return trade-off and at the same time to honor clients’ requests for incorporating ESG factors. Should they incorporate ESG if there is a cost to SRI? However, from the fiduciaries’ vantage point, they have not necessarily been convinced that it is good for everybody. As part of the fiduciary duty, they look for hard evidence to support a rational economic decision. However, they have found no overwhelming and compelling evidence to invest in SRI. Financial performance results of SRI at best have been mixed. The literature suggests that SRI best-in-class strategies may at times outperform the market but this has not been consistent. Other SRI strategies may not even fare as well as the broad market performance. These results imply that there may be some costs of SRI which are not priced by the market or that the costs are ‘social’, rather than financial costs. Since SRI returns are typically measured by the financial metrics, and there has not been any definitive conclusion about the financial benefits of SRI, many financial advisors are unconvinced of the benefits or advantages of investing in SRI. Empirical evidence seems to support both sides of the argument that SRI is good for investors, presenting a conundrum to financial advisors who, on the one hand are trying to help clients to achieve their investment goals, and on the other, trying to ensure that the clients make sound investment 44


45

decisions under their guidance. They need to provide unbiased and sound financial advice to their clients who prefer to invest in a socially responsible manner. Meeting the expected return and putting their client’s financial interests first, is undeniably a financial advisor’s fiduciary duty. Is it acceptable from a fiduciary standpoint to incorporate ESG criteria into the investment decision-making process and possibly garner lower returns? This dilemma begs the question of whether fiduciary duty is legally waived if the client gives their approval for potentially lower returns. On the other hand, financial advisors can be faced with a conflict of interest in recommending a portfolio with lower expected returns if their fees are dependent on the return and growth of assets under management/ advisory. If the financial market is an effective intermediary between firms and society, then two-way dynamics should exist among the three, that is, investors’ behavior affects the financial markets, financial markets influence firm performance and company performance (overall) has an impact on asset prices. In order to evaluate what the investors and their fiduciaries should do, we need to ascertain both the financial and non-financial historical performance of SRI. To answer the questions ‘How do we measure non-financial performance of firms? If there are no immediate financial rewards or benefits from SRI, how do we measure the long-term benefits?’ we also need to review the relationship between corporate social performance (CSP) and corporate financial performance (CFP). In this chapter, we first discuss the incentives for SRI. We then present various alternatives and then review its historical financial performance. We compare the performance of SRI with conventional portfolios, that is, non-SRI investments. Then, we discuss the non-financial incentives (and the metrics to measure them) and explain several reasons why investors consider SRIs even if the financial performance is at, or below par with conventional strategies.

INCENTIVES Financial Incentives of SRI From an investor’s perspective, motivations for SRI are economic (financial) and non-economic. Investors, in either SRIs or conventional investments, are looking for the maximum, risk-adjusted returns in investments. As such, SRIs are subjected to the same performance measurement standards and compared to the appropriate chosen benchmarks. Thus, if there is a greater financial performance, there is a greater financial

46


incentive, and overall a better situation for investors. This economic argument implies financial incentives for SRI should be the same as incentives for other investments. The economic argument also sends a clear and unambiguous message to fiduciaries that their primary duty is to act in the best interest of shareholders, which had been sounded loud and clear by Milton Friedman in his 1970 essay in the New York Times Magazine. Likewise, agents of investors (for example, managers of corporations, financial advisors, pension plan managers, and portfolio managers), have several motivations to comply with the requests from their principals or shareholders for incorporating ESG considerations: financial, legal, moral, and even personal reasons. Institutional investors invest in SRI for two reasons: to invest in accordance with their own institutional principles and to foster change in companies. This twofold aim is still found today, although SRI appears prominently as a means for changing corporate behavior (see Schueth 2003). Thus, shareholders, fiduciaries, and corporate managers classify the motivations for SRI as economic and moral arguments. It is clear that investors look for financial rewards from their investments. However, it is not clear if this is the top priority that trumps other motivations. Many investors have decided they can ‘do well while doing good’ (see Hamilton et al. 1993) and some investors are willing to make their social goals the first priority even if the returns are below par (see Minor 2007). In contrast, it is controversial whether the moral argument for SRI or CSR ignores the financial incentive. First, not all corporations agree that they have a moral obligation to do good, since corporations are not human individuals, but only legal entities (see Barry 2000). Second, there is no consensus that investors should sacrifice returns in return for doing good, because they want to ‘feel good’. This ‘feel good’ factor is not considered in the rational economic model, which is the basis for the economic argument and thus not factored into the market price. To conclude whether the economic or moral argument makes more sense, one has to first determine whether SRI makes economic sense. If companies cannot make profits in the long run and survive, then discussing SRI is hardly relevant. Thus, the sustainability argument trumps both the economic and moral arguments. In other words, businesses have to do well financially first, before they can do good. This is particularly relevant to institutional investors like pension funds that inherently have a long-term investment horizon. Investors are interested in companies that promote sustainability by proactively working on ESG factors and seek long-term success and not those that overlook long-term risk because of short-term goals (see Sethi 2005). They equate these sustainable companies as being financially viable in the future by having a long-term view. It is believed that firms


47

with internal sustainability directives and long-term business strategies are considered valuable, and are favored by investment analysts because of their good corporate management (see Lydenberg 2005). Some investors would thus argue that in order to be sustainable, businesses have to be socially responsible from now on or otherwise we would not even see the future. This is, to many people, a scare tactic that causes the sustainability argument to lose its credibility. Climate change suffered the same criticism and skepticism not only in the early years but also right now.1 Thus, sustainability seems to be a more important question, especially in the light of the financial crisis of 2008. It begs the question: Do investors really need to sacrifice financial returns to achieve positive social results? The answer depends on the magnitude of the social impact intended. Budde (2008) classifies the corporate actions that would bring some impact on ESG issues and their relationship with financial returns into three categories. In the first category, high-impact social change requires sacrifice of investment returns to achieve positive social impact. The SRIs that aim at these high-impact social changes should generate below market returns. In the second category, social change (in contrast to high-impact social change), which can be affected by investment strategies, could still generate competitive market returns. In the last category, investing based on ESG factors can generate above market returns while affecting positive social change in the process. Budde (2008) asserts that competitive returns can be and have been achieved by investing in low-cost socially screened funds, investing in community development projects through FDIC insured community bank certificate of deposits, and shareholder activism through active proxy voting. It is noteworthy that these are the three main approaches to SRI as practiced in the US. Although Budde himself does not present empirical evidence to support his assertion, it fits well with the extant empirical evidence that SRI investments are no better or no worse than conventional investments, that is, having competitive returns. He further claims that many SRI strategies have delivered positive social impact and competitive returns roughly on par with conventional investments. If this is true, it is a compelling case for the ‘do good while doing well’ argument. Yet, there is a dearth of evidence for competitive returns and positive social impact. It has not been shown that this CFP is accompanied by CSP. Maybe this is what it takes for good managers to identify those worthwhile investments that would produce competitive or above expected returns while doing good. An alignment of the investor’s goals and the strategy of the firms they invest in would produce competitive returns. Budde (2008) suggests three pairs of the goal/strategy alignment:

48

1. 2.

3.


Aligning investments with personal values through social screening (in securities or funds selection); Creating direct social impact through community and proactive investing (for example, insured community bank deposits, or private microfinance investments); Sending signals to change corporate behavior through shareholder activism (for example, active proxy voting on key issues, and engagement with portfolio companies).

Thus, Budde (2008) seems to imply that if investors align their values well with their investment strategies, SRI can provide competitive returns while satisfying the investor’s personal goals and values. The unanswered part of the inference is whether SRI produces ‘competitive returns.’ We discuss this issue later in this chapter. Non-Financial Incentives of SRI If SRI cannot provide ‘competitive’ financial returns, why do investors and the financial market still invest in SRI funds? Many investors are motivated for non-financial reasons in their investments. They are looking for a ‘feel good satisfaction’ that they are doing the ‘right thing.’ Mackenzie and Lewis (1999) found that many investors choose to direct only a small portion of their investment monies into SRI funds and suggested that SRI allows investors to ‘assuage their consciences’ and legitimize their concurrent holdings of more conventional investment vehicles. Researchers have also discovered that people who participate in certain activities or events, will experience pleasure in which they maximize their ‘experience utility’ or ‘net affective experience’ (see Beal et al. 2005). These activities can just as well include investing decisions as participating in their favorite hobbies. In this globalized world where investor actions affect distant communities, some investors want to make a difference and incite global change through their investments. People in this group are willing to pay a premium on their SRI investments, just as they would for fair trade products or organic produce. Haigh and Hazelton (2004) provide a legitimacy perspective which offers a plausible explanation for the motivations of some retail investors in SRI funds. Smith (1990) argues that corporations and by extension, financial markets, legitimize their power by offering SRI funds to show that they can effectively deal with the externalities of capitalist production, thus diffusing the demands of governments and society to regulate financial markets (see also, Bruyn 1987). With increasing deregulation of industries, increasing government


49

transfers of vital services to the private sector, and decreasing of barriers to international trade, some investors believe that corporations are the greatest force for social and environmental changes (see Lydenberg 2005). Global issues such as climate change and water shortages affect everyone, and some shareholders believe that they should have some influence with companies with power and money to make these changes. Other SRI investors have taken a pragmatic approach, and consider ESG criteria as additional risk factors. These investors believe that firms behaving in a manner that is not environmentally sound, have poor management of social issues, and limited corporate governance, will eventually crumble, and succumb to the firms that conduct themselves in a sustainable matter. Still other investors have embraced a new definition of a firm’s ‘wealth creation’, considered to be different from ‘profit maximization.’ These new definitions of wealth creation include items such as increased productivity, product innovation, and having less impact on the environment (see Lydenberg 2005). Investors want to see public companies increase their value with this idea of corporate wealth. In the following, we first present the alternatives from which the incentives of investors can be obtained. Then, we discuss the financial performance of SRI and see whether the financial motivation is satisfied by that performance. We then discuss whether corporate financial and social performance can be achieved simultaneously.

ALTERNATIVE APPROACHES TO SRI Individuals wanting to invest in a socially responsible way have several alternative approaches. Direct Investment in Socially Responsible Companies There are several ways of directly investing in socially responsible companies (investing in companies screened by financial intermediaries) such as private equity, listed public companies, SRI mutual funds and unit trusts, SRI hedge funds, and separately managed accounts. (Screens are discussed in Chapter 2.) Recently, new products are being offered to investors for direct participation, for example, the green bonds issued by the World Bank. Through Shareholder Activism Designed to Change Corporate Behavior Shareholder activism has become a major force in financial markets. Shareholder activists can be institutional investors (for example, pension

50


funds such as CalPERS and TIAA-CREF), individual investors (for example, Carl Icahn), focused collaborations between organizations (for example, Interfaith Center on Corporate Responsibility (ICCR) and Institutional Investors Group on Climate Change (IIGCC)) or hedge funds. Specifically, shareholders who have similar interests would voice their concerns at annual shareholder meetings and through proxy votes to change corporate behavior. The impact of shareholder activism on shareholders’ wealth could be very significant.2 Shareholders who are social activists pressure companies on topics ranging from human rights in Tibet to global warming. For example, Father Michael Crosby, a Catholic priest at the Province of St Joseph of the Capuchin Order, filed a shareholder resolution at Philip Morris International in 2008 to demand that the company dealt with ‘green tobacco sickness’ that makes farm workers ill. He withdrew his resolution after Philip Morris International laid out a plan to address the problem (see Etter 2009). According to the Social Investment Forum, the average level of shareholder support for resolutions on social and environmental issues jumped 57 percent during 2005–07. The total number of resolutions has been around 360 since 2005. The number of investors that were involved in filing shareholder resolutions on social or environmental issues had $739 billion in assets under management in 2007, an increase of more than 5 percent from 2005 (SIF 2008). It appears that investor support for resolutions on social and environmental issues has gained traction. Proxy voting is not the only mechanism open to shareholder activists to get the attention of a company. Hedge funds have been using short sales to get the attention of management of companies that do not stand up to social or environmental standards. Some SRI hedge funds would argue that companies with poor financial, environmental, or social records should be ‘punished’ by having their stocks sold short.3 But, this is not the consensus of all SRI investors and hedge funds. Nevertheless, some SRI investors utilize this approach to sharpen management’s attention to their concerns and may in fact end up engaging that very same management. Through Direct Investment in the Community Community investing consists of procuring capital for investors who want to develop local communities and have had difficulty accessing capital from traditional sources. These investments may be in the form of debt or equity, through banks, the capital markets, and public or private equity. The funds raised can be provided to low-income individuals, small businesses or community services. For instance, investors put money in CDs or bank accounts with community development banks or credit unions


51

that support low-income communities/disadvantaged neighborhoods or environmentally sensitive or damaged areas. Globally, the United Nation has set up a UN Capital Development Fund (UNCDF) in 28 countries to create conditions for sustainable development and poverty reduction. This entails community investing and microfinance. (We will discuss microfinance in Chapter 8.) Investors can also give money directly to charitable or activist organizations within the community in order to show their support (see Merrill Lynch 2008). Community development investing has been expanding rapidly in the last 10 years in the US according to the Social Investment Forum (2008). Between 2005 and 2007, community development investment has increased by about 32 percent, from $19.6 billion to $25.8 billion (see Table 1.1). Community investment continues to expand in the number and diversity of community investing products and services available to US investors. Alternative Investments The last means of SRI involvement is through alternative investments. The Social Investment Forum estimated $5.3 billion in capital was under the management of 46 different socially or environmentally screened alternative investment vehicles, including social venture capital, private equity, and hedge funds in 2007.4 Social venture capital is gaining in popularity. As an alternative option to the three traditional approaches to SRI discussed above, social venture capital investors can invest in socially responsible firms before they go public. Social venture capital funds are direct investments in socially responsible firms or in target companies that produce goods or services that advance or contribute to the solution of a particular social or environmental problem.5 Investors who provide venture capital to socially responsible firms not only enjoy the benefit of transparency, but also gain all the advantages of stock screening. However, investment choices are still limited and firms funded by venture capital inherently carry higher risk. It is noted that each of the first three alternatives presented above requires progressively more commitment and involvement on the part of the individual investor. To make it easier, many money managers offer socially responsible investing in separately managed accounts to individual investors. These portfolios are customized to the environmental, social, and governance preferences of each investor and may invest in some of the securities listed in the next section. Some money managers argue that separately managed accounts may do a better job than a mutual or index fund, because the former can tailor portfolios to meet investors’ particular

52


values (see Lane 2005). However, to date, there have been no studies that examine the performance of separately managed SRI accounts. Financial Instruments SRI has evolved into several types of financial products for retail investors. In the following, we describe some of these financial instruments or assets. Mutual funds or unit trusts The US SIF (2008) reports a total of $171.7 billion invested in 173 different socially and environmentally screened funds, 19 of them with $12.5 billion in variable annuity products.6 Closed-end funds Three socially and environmental screened closed-end funds with assets of $850 million are now tracked separately for the first time by the US SIF (2008). Exchange traded funds Exchange traded funds (ETFs) are similar to closed-end funds but are traded on exchanges like stocks. There are 721 ETFs with about $478 billion in assets, according to the Investment Company Institute (Salisbury 2009). In the US, SIF tracks eight socially and environmentally screened ETFs with $2.25 billion in total net assets (SIF 2008). Other ETFs were launched in 2007 to track indices addressing a variety of social and environmental concerns related to water, clean technology, alternative energy and the crisis in Sudan.7 Despite their recent appearance in the market with varying degrees of success, ETFs promise to be a dynamic catalyst for SRI growth in the future (see SIF 2008). Faith-based ETFs Faith-based ETFs include Baptist, Roman Catholic, Lutheran, Methodist funds, and even a ‘Christian’ option, tailored to nondenominational evangelicals. There are also ETFs designed to reflect Shariah or Islamic law. Islamic funds Funds that are tailored to abide by Islamic law have grown to over 350 funds and have reached $20 billion in assets under management.8 Islamic or Shariah law: (1) forbids speculation; (2) bans interest paid on debts; (3) requires money proffered be backed by collateral, and if financial instruments are traded, they generally have to sell for face value, which deters


53

banks from repackaging debt; (4) prohibits short sale because investors are not allowed to sell what they do not own since it represents an unacceptable form of speculation; and (5) requires risk-sharing. Thus, Islamic funds do not allow interest receipts or interest payments, are usually equity-based and avoid fixed income instruments. Islamic funds also avoid firms associated with the sin products (that is, alcohol, tobacco, gambling, and pornography), pork, hotel and leisure industries, conventional financial services and firms with a debt-to-equity ratio greater than 33 percent (see Hussein and Omran 2005). Depending on the interpretation of Shariah compliance, some funds interpret that firms with interest income not more than 5 percent of the total revenue, and account receivable not greater than 45 percent of total assets can be included in the fund.9 Islamic mutual funds investing in companies that are shariah-compliant will have a lower leverage than non-shariah compliant mutual funds. Islamic (sukuk) bonds Sukuk bonds are secured by property and other assets that produce income or profits to pay investors in compliance with shariah or Islamic law (under which interest is banned). It is estimated that $10 billion worth of sukuk bonds were outstanding in 2005 and $25 billion in 2006.10 SRI equity hedge funds Hedge funds offer SRI investors the opportunity to do well by investing in companies that have positive financials and strong environmental and social performance. Currently there are only a handful of SRI equity hedge funds and FOFs in the market.11 A Catholic FOF has recently been created by Catholic Institutional Investors and several shariah-compliant hedge funds seeded by a Saudi Arabian bank have been launched. The recent announcement by the Dubai government that it will invest $250 million in five new shariah-compliant hedge funds would lend credence to these hedge funds (Mackintosh 2008). Other Pooled Products Nearly 11 percent of the total assets in all socially screened funds – $21.7 billion – were invested through 30 other pooled products, typically commingled portfolios managed primarily for institutional investors and highnet-worth individuals. Green bonds The World Bank issued its first green bonds denominated in Swedish kronor for a total amount of kr 2325 million in 2008 in response to demand from a group of Scandinavian investors. It also issued its first

54


green bonds denominated in US dollars to the state of California for $300 million in 2009.12 The funds raised are to be used to reduce global warming.

FINANCIAL PERFORMANCE OF SRI SRI proponents and fund managers make two claims: SRI can influence companies to change their operations, and financial returns on SRI funds are no different from those of conventional investments in the short term and are likely to be superior in the long term (see Haigh and Hazelton 2004). The logic behind these claims is that the impact of social responsibility on corporate performance are expected to show up through increasing sales growth (or market share), higher efficiency (asset turnover), higher profit margins (through cost savings, or price effects), or higher returns (return on equity (ROE) or return on assets (ROA)). In other words, they assert that being socially responsible, companies will gain in production efficiency, leading to higher ROA and ROE, which will eventually be translated into better financial performance and higher stock prices. Behind this argument is an implied linkage between CSP and CFP. SRI Indices Before the creation of SRI benchmarks, SRI portfolios were simply compared to non-SRI portfolios or to the broad market indices as a measure of financial performance. However, since the advent of SRI benchmarks, the financial performance of SRI can now be measured against SRI indices. In the following sections, we review and discuss the historical performance of SRI by way of the performances of selected indices (presented in Chapter 2) as well as those of the screened portfolios and mutual funds. Table 3.1 shows the performances of several SRI indices. As indicated in Table 3.1, the past SRI performances (one-year, three-year and five-year) are all skewed by the financial crisis of 2008.13 Returns since inception representing the performance of each index for the longest available period indicate that SRI performance is similar to the non-SRI comparable indices. For example, the Domini 400 Social Index (DS400), the earliest launched index, has a total return of 7.74 percent since its inception in May 1990 vs. S&P 500’s 7.01 percent for the same period. KLD’s CV400 has a total return −1.38 percent since its inception in May 1998 vs. S&P 500’s −1.32 percent for the same period. Likewise, DJSI World Index has a total return of −24.15 percent versus MSCI World’s return of −23.55

55 −24.15 −29.05** −25.29** 3.59

1 January 2001 1 May 1998 2005 1 October 2007 31 August 1999 15 October 2001 15 October 2001 1999

KLD Broad Market Social Index (BMSI) KLD CV400 KLD Global Climate 100 Index KLD Global Sustainability Index (GSI)

Dow Jones Sustainability Index World (DJSI World) DJSI STOXX® Sustainability Index DJSI EURO STOXX® Sustainability Index Dow Jones Islamic Market World Index (DJIM)

−4.35 −1.38 −4.12 −35.85

7.74

1 May 1990

Domini 400 Social Index (DS400)

−41.09 −41.03 −38.10

−45.19

−37.29 −36.23 −41.52 −42.16

−35.04

−42.58 −42.93

−23.55c −19.74d

N/A N/A

MSCI World DJ Euro STOXX®

−38.09

7.01a −1.32b

N/A

S&P 500

One-year return

Return since inception

Inception date

Performance of selected SRI indices as of 31 March 2009, returns in percent

Index

Table 3.1

−44.46 −42.01 −10.72

−35.66

−14.25 −13.38 −12.08 N/A

−12.60

−35.87 −42.89

−13.06

Three-year return*

−19.19 −15.86 −2.37

−15.8

−5.29 −5.57 NA N/A

−5.11

−16.33 −12.68

−4.76

Five-year return*

56

N/A N/A N/A N/A

1 June 2007 1 June 2007 1 June 2007 1 June 2007

Sources:

−42.72 −44.05 −49.92 −59.55

−37.71

One-year return

www.kld.com; www.sustainability-indexes.com;www.djindexes.com;www.mscibarra.com

Notes: N/A Not available ** Annualized ** Returns in euros a Matching inception date with DS 400, 5/1/1990 b Matching inception date with KLD CV400, 5/1/1998 c Matching inception date with DJSI World, 8/31/1999 d Matching inception date with DJSI Euro Stoxx SI, 10/15/2001 MSCI Islamic indices returns before 2007 are based on simulated historical data.

N/A

1 June 2007

MSCI The World (Developed Markets) Islamic Index MSCI EAFE Islamic Index MSCI Europe Islamic Index MSCI Emerging Markets Islamic Index MSCI GCC Countries Islamic Index

Return since inception

Inception date

(continued)

Index

Table 3.1

−12.00 −10.67 −9.42 −33.25

−9.91

Three-year return*

−1.48 −0.21 4.34 N/A

−1.49

Five-year return*


57

percent. Given that the overall performance is similar to the earlier years and has not revealed any new pattern, we review the extant literature that has studied the performance of SRI with a longer history and without the impact of the financial crisis of 2008. All Shariah or Islamic indices seem to have outperformed the traditional benchmarks in the three-year and five-year periods, especially in emerging markets, because constituent stocks are often better run companies with good governance, less use of debt financing and are less risk-averse. The MSCI World Islamic Index outperformed the MSCI World Index for all three periods (one-year, three-year and five-year). Similarly the MSCI Emerging Markets Islamic Index also outperformed its standard counterpart and other indices in the three- and five-year horizons as shown in Table 3.1. Collison et al. (2008) examined the financial performance of the FTSE4Good indices for 1996–2005. Their results indicated that these indices outperformed their relevant benchmarks for the study period. They concluded, however, that most of this outperformance was due to risk differences between the FTSE4Good indices and their benchmarks. In addition, much of the outperformance arose in the period before the indices became investable. Nevertheless, the results suggested that those who invest in a portfolio of companies that satisfy FTSE4Good’s corporate social responsibility criteria do no worse than their counterparts who do not follow SRI criteria in picking stocks. From Table 3.1, the returns of SRI indices are comparable to those of other broad market indices. The indices are investable and thus can be considered as passive investments. A question arises: would actively managed SRIs outperform the traditional non-SRI investment in terms of return and risk? SRI advocates believe green-minded and socially conscious investors do not have to sacrifice returns in order to have a portfolio with which they feel good. In contrast, pundits believe that the effect of shrinking the investment universe through constraints (screenings for instance) either causes the portfolio to lose return opportunities or have exposure to increased volatility because of the lack of diversification. In the following sections, we review the historical evidence on the financial performance of SRI from the active investor’s perspective. To answer the question: ‘Do actively managed SRIs create financial values for investors?’ we look at the performance of screened portfolios and mutual funds. Screened Portfolios Studies show that pension portfolios that include the ‘sin’ stocks (for example, alcohol, tobacco, firearms, gaming, and certain entertainment)

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have usually done well and the return on sin stocks have outperformed market indices. Kahn et al. (1997) documented that tobacco stocks averaged 7 percent p.a. more than the S&P500, or a risk-adjusted return averaged 0.59 percent p.a. for a ten-year period. Likewise, companies that were screened out because of involvement with apartheid in South Africa had a premium of 0.77 percent p.a. (see Grossman and Sharpe 1986). Lane (2005) found that portfolios of alcohol, tobacco, and gaming industries all outperformed the S&P500 during the period 1995–2003. Guerard (1997) found that SRI-screened portfolios lagged the non-SRI portfolios by 0.83 percent p.a., although not statistically significant. A comparison of SRI funds to ‘vice’ funds (those that include sin stocks) found no statistically significant difference in excess returns over a three-year period, but found better returns over a five- and ten-year period (see Shank et al. 2005). More recently, Hong and Kacperczyk (2008) found that sin stocks had higher expected returns than otherwise comparable stocks. Fabozzi et al. (2008) examined a ‘sin’ portfolio of companies that involved alcohol, adult services, gaming, tobacco, weapons, and biotech alterations. They found that the sin portfolio unambiguously outperformed common benchmarks in both returns and frequency, that is the number of times that the return of the sin portfolio exceeded those of the common benchmarks. The researchers concluded that the negative screening (screening out these industries from the portfolios), lowered risk-adjusted returns. Lane (2005) documented that portfolios created through a positive ‘best-in-class’ approach, which screens in companies with best practices on social and environmental responsibility, outperformed the benchmark. However, Waddock and Graves (2000) found that screened-in and screened-out companies performed about the same financially and as compared to the market. In summary, some screened portfolios have been positive and some have been negative in their performance. But, the portfolios of screened-out stocks (that is, sin stocks) seem to outperform the common benchmarks in most studies. Mutual Funds Previous studies found no statistically significant relationship between the returns of SRI mutual funds and those of conventional mutual funds (see Hamilton et al. 1993; Goldreyer and Diltz 1999; Bauer et al. 2005; Stone et al. 2001). Statman (2000) found that, on average, both socially responsible and conventional mutual funds trailed the S&P500 Index and the Domini Social 400 Index. The under-performance of the funds, although not statistically significant from the indices, was due mostly to mutual


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fund costs. Statman (2007) suggested controlling the fund costs as tracking errors, and noted that the performance of SRI portfolios, like that of most conventional portfolios will inevitably deviate from conventional benchmarks during many periods. In other words, investors can expect to neither lose nor gain financially, by investing in socially responsible mutual funds. Evidence on international SRI provides similar results. Kreander et al. (2005) found no difference in risk-adjusted returns between 60 European ethical and non-ethical funds, from four countries during 1995–2001. The researchers also documented that the management fee was a significant variable for the Jensen’s measure.14 Le Sourd (2008) examined SRI funds distributed in France and found that SRI stock-picking did not produce excess return. These results are in line with results of previous research in the UK that found weak evidence of UK ethical funds outperforming the market indices (see Luther et al. 1992; Luther and Matatko 1994). Although these studies had adjusted for the ‘small firm’ factor, there was still no evidence of out-performance. Pundits point out that comparing the performance of SRI funds to broad market indices is inappropriate because they have different risks. Mallin et al. (1995) overcame this benchmarking problem by using a matched-pair analysis on 29 ‘ethical’ funds vs. 29 ‘non-ethical’ funds in the UK between 1986 and 1993. They found that a small majority of funds from both groups outperformed the market in terms of higher risk-adjusted measures as compared with the FT All Share index. They concluded that the British ethical funds performed at least as well as their non-ethical counterparts or maybe even better if measured by Jensen’s alpha. Following the study by Mallin et al. (1995), Gregory et al. (1997) used a smaller sample, adjusted for the small firm or size effect, and found no significant difference between the returns of ‘ethical’ and ‘non-ethical’ funds.15 In summary, previous studies suggest that SRI strategies are no more or less likely to perform better than other funds. Although the literature is inconclusive regarding systematic SRI outperformance, it does suggest that actively managed SRI funds do not underperform their conventional counterparts. Indeed, the performance of SRI funds in the US, Canada, and Australia appears to be correlated more with the performance of broad market indices than with SRI market indices (see Bauer et al. 2005). Haigh and Hazelton (2004) believed that if investors can identify companies that produce social benefits (that is, positive externalities not priced by the market), SRI will outperform other investments, and investors will gain financially. The researchers also suggested that SRI funds correlate more with broad market indices rather than with SRI indices because SRI portfolios are not markedly

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different than conventional mutual funds. In other words, benchmarking and proper performance measurement may still be issues. Three issues pertaining to SRI are discussed below. Performance Bias – Style and Size Performance studies from the late 1990s to early 2000s indicate that SRI outperformed both broad market indices and non-SRI funds. SRI prospered during the 1990s, not only because the included companies were well run, but because they were weighted heavily in technology and small capitalization stocks. After the technology bubble burst in the early 2000s, the performances of SRI funds were affected. Moreover, given that US SRI mutual funds tended to lean towards growth (rather than value) companies and had a modest bias towards smaller cap stocks, SRI funds, on average, outperformed their market benchmarks in the late 1990s when growth was in favor. Since then, some of these growth-oriented SRI funds underperformed the market in the value-oriented period since 2000. Likewise, Merrill Lynch (2008) found that style bias may be a cause for SRI non-performance. They demonstrated there was no out-performance (or alpha) to be gained for values-based investments, where large cap stocks were predominant in the portfolio, during periods when small cap stocks outperformed large cap stocks.16 Orlitzky (2001) posits that firm size may have an impact on the relationship between corporate social performance and financial performance. The Costs of SRI Earlier we asked the question of whether there were costs for being socially responsible. Thus far, our review of older studies reveals no evidence of a financial cost (that is, lowered investment return) for SRIs. However, more recently, some evidence is surfacing that there is a financial cost to SRI. For instance, socially responsible investing substantially reduced the returns at two Californian pension funds in 2007. The California State Teachers’ Retirement System (CalSTRS) revealed that banning investments related to cigarettes cost them $1 billion in lost gains. The California Public Employees’ Retirement System (CalPERS) left $400 million on the table by screening out investments in China, Colombia, and other countries; their screened emerging market investments underperformed an index without the same limitations by 2.6 percent a year.17 Adler and Kritzman (2008) estimated the cost of practicing socially responsible investing by designing and executing a Monte Carlo simulation


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to compare the performance of a skilled investor in an unrestricted investment universe with the performance of the same investor in a restricted investment universe. They found that there was a cost for SRIs at several investing skill levels and investment universes. This cost was substantial, even for moderately skilled investors. Thus far, most studies have left out non-financial costs and benefits, which are precisely what SRI investors attempt to integrate with conventional money management. The cost of SRI links to the idea of economic efficiency. That is, apart from substantial administrative cost of implementing SRI through screening and selection, the resultant choice of portfolios may not reflect market returns that provide objective signals to investors for the best allocation of available resources. However, using SRI criteria may deviate from the market information perspective and thus depends largely on personal and subjective preference. Constrained investment opportunity set – Loss of diversification benefits Portfolio theory predicts that a constraint imposed on the portfolio will give a less than optimal solution. If we are forced to choose from fewer uncorrelated assets, the risk-adjusted return (and thus utility) will suffer. That is, if we begin limiting our security choices with ESG constraints, portfolio theory suggests that we ought to suffer from some type of diversification cost, at least on average, over time. SRI portfolios that exclude the sin industries may succumb more to economic downturns because of the decrease in risk and return tradeoff. Thus, to some investors, the concern of participating in SRI is losing this diversification benefit. On the other hand, SRI proponents argue that screening out bad companies should in effect, avoid disaster in the long run and thus SRI portfolios should perform well over the long-term horizon. Fund managers who practice SRI contend that they know how to manage investments within a constrained universe. Minor (2007) argued theoretically that there may be no net total cost or benefit (both financial and social) with SRI. However, according to three fundamental economic principles, (law of supply and demand, the budget constraint, and externalities), Minor (2007) estimated a net financial cost to SRI of as much as 1 percent per year. However, on a total cost basis, Minor (2007) did not expect a cost to SRI when the utility is considered. In other words, the net financial cost of SRI is offset by the increased utility of accomplishing social good. Paradoxically, as Minor (2007) puts it, the financial cost of SRI increases monotonically as more non-SRI investors become SRI investors under the fundamental economic principles. Given the financial cost function of SRI, he theorizes that all the while,

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the remaining non-SRI investors will systematically enjoy higher financial returns for their lack of ESG concerns. Thus, the SRI investors’ total utility remains constant but the non-SRI investors’ total utility increases. In this case, doing good does not pay nor does it cost. However, if there are hidden factors overcoming the fundamental economic law, or if SRI managers achieve superior alpha, or if in the future there is an internalization of externalities, then SRI investors should enjoy abnormally high returns – the same financial returns to non-SRI investors plus the social good utility of SRI investing. In this case, being good will really pay. Linking Corporate Social Performance and Corporate Financial Performance Several management theories suggest that there is a positive relationship between corporate social performance and corporate financial performance. Instrumental stakeholder theory suggests that the satisfaction of various stakeholder groups is instrumental for organizational financial performance. Stakeholder–agency theory suggests that the negotiation and contracting dynamics between the stakeholders and management would ensure that management does not stray away from broad organizational financial goals (see Cornell and Shapiro 1987; Donaldson and Preston 1995). In addition, the stakeholder–agency theory can be seen as a nexus of contracts within the organization (see Jensen and Meckling 1976). Thus, simultaneous coordination and satisfaction of multilateral stakeholder interests may benefit the organization by both increasing efficiency and adapting to external demands (see Freeman and Evan 1990). In other words, firms can consume their limited and valuable resources for addressing the various demands from different stakeholder groups, or they can use their resources to their competitive advantage by addressing demands in a fair and rational manner. The latter strategy, derived from instrumental stakeholder theory, is known as the ‘good management theory’ (see Waddock and Graves 1997). Since CSP investment is seen as a highly discretionary expenditure of limited resources, slack resources theory hypothesizes that CFP needs to be positively related to CSP, in order for CSP investment to be justifiable (see McGuire et al. 1988, 1990). Although CSP can be seen as a consumer of valuable resources, investment in CSP can help firms develop new competencies, resources, and capabilities. CSP can also help firms build a positive reputation and offer goodwill to their external stakeholders. Subsequently, these should in turn enhance the financial performance of the firm (see McGuire et al. 1988). Companies that operate in a socially responsible manner sometimes pay higher operating costs, resulting in lower profits. However, many


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other business costs can actually be lowered as a result of acting in a socially responsible manner, for example, lower exposure to litigation and associated costs, better employee (labor) relations, positive public image, and greater public perception a better product/service. Subaru of Indiana Automotive revised their manufacturing processes and worked with suppliers to reduce waste and conserve energy, resulting in savings of millions of dollars. Moreover, Subaru has positioned themselves with an advantage over their competition when government- or market-imposed environmental regulations are placed on the industry in the near future (see Robinson and Schroeder 2009). Other studies have also tested various hypothesized relationships between CSP and CFP. Roman et al. (1999) reviewed over 50 articles and found a positive correlation between CSP and CFP in the majority of the studies they reviewed. Simpson and Kohers (2002) found a positive link between financial performance and social performance at banks. Ruf et al. (2001) found some support for a tenet in stakeholder theory, which asserts that the dominant stakeholder group (shareholders) benefits financially when management meets the demands of multiple stakeholders. Using various definitions of CSP, Verschoor and Murphy (2002) found mostly positive linkages between financial and other performance measures. Margolis and Walsh (2001) reviewed 13 academic studies and found a relationship between ethical corporate behavior or ‘good corporate citizenship’ and various positive outcomes. Additional studies also demonstrate links between CFP and the firm’s commitment to their code of ethical conduct and diversity. Franko (1989) found no evidence of a systematic tendency across industries towards negative relationships between multinational enterprise acceptance of minority positions and company underperformance. Verschoor’s studies (1998, 1999) showed that there was a statistically significant relationship between management commitment to strong internal controls that emphasize ethical and socially responsible behavior and favorable CFP. Waddock and Graves (2000) found a positive, bilateral relationship between CSP and CFP, with each improving the other. Orlitzky et al. (2003) used a meta-analysis on previous empirical studies on the relationship of CSP and CFP and developed three main conclusions. First, CSP and CFP were positively correlated. Corporate social responsibility (CSR) programs and activities were generally associated with higher or improved financial performance across a variety of industries and time periods. Second, there was a two-way chain of causality between CSP and CFP. CSP and CFP were in a virtuous cycle, in which financially successful companies spent more on CSR outlays in part because they could afford to, but also because the firms found that their CSR programs contributed to even greater success. However,

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the study found little relationship between stock performance and CSP. Third, the effects of CSR on financial performance mainly appear to come from its effects on the firm’s reputation with external stakeholders and not from internal efficiency improvements. The above results have several implications for corporate managers. First, market forces generally do not penalize companies that have high CSP. Second, managers must learn to use CSP as a reputational lever and be attentive to perceptions of third parties, regardless of whether they are market analysts, public interest groups, or the media since it can improve CFP. This seems to be consistent with the strategies suggested by public relations firms to corporate clients. PR firms maintain that ‘mutual social responsibility’ (that is, companies and customers acting together on ‘societal problems’) and ‘private-sector diplomacy’ (corporate activism on global concerns such as climate change) are good PR and could improve the bottom line.18 More recent evidence indicates similar results. For example, Garz and Volk (2007) found strong evidence of a link between ESG factors and financial risk surrogates (such as the cost of capital of a firm) based on a sample of 540 European companies. While they were not able to show the linkage between ESG factors and share price performance, results from other researchers show some promise. Derwall et al. (2005) found that the average return on an equity portfolio with a higher eco-efficiency score was substantially higher than that of a portfolio with lower score for 1995– 2003 (after controlling for differences in market sensitivity, investment style, or industry-specific factors). Barber (2007) estimated that CalPERS would have created shareholders’ wealth valued at $3.1 billion due to shareholder activism between 1992 and 2005. Thus, it appears that previous studies have established a consensus that there is a positive correlation between CSP and CFP,19 although the evidence for a definitive correlation between CSP and stock price has yet to be established. A question remains that if corporate social policies are financially beneficial, why is this not reflected in the stock price? It is possible that while some corporate social policies result in good financial results, others do not. However, can the ESG policies that contribute positively be identified from those that do not? More importantly, are the corporate social policies that are priced by investors differentiated from those that are unvalued in the capital markets? It is possible that both are correctly priced in the market but offsetting each other. It is also possible that neither is being priced in the market. If the financial market does not recognize or value corporate good deeds, investors may not be convinced that SRI makes true economic sense.


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Changing Corporate Behavior Based on the limited empirical evidence that CSP and CFP are related, opportunities seem to exist for SRI investors to pressure corporations to advance their corporate social goals, and subsequently benefit all financially. SRI is considered a powerful means for targeting corporate malpractice and more effective than taking an adversarial approach (see Guay et al. 2004; Feuerherd 2005). Unfortunately, SRI funds have not been successful in influencing the behavior of corporations for better congruence with social preferences (see Schepers and Sethi 2003). The challenge to investors is that they lack sufficient clout and voting powers to influence corporate management behavior. Haigh and Hazelton (2004) argue that SRI funds under management are too small, as compared with the whole market capitalization, to have any impact on corporate behavior. SRI ranges from 0.26 percent (US) to 0.4 percent (Europe) of total market capitalization. Haigh and Hazelton (2004) suggest that since SRI does not affect the cost of capital, it would have no impact on corporate behavior. Statman (2000) argues that the cost of capital argument is unlikely to be borne out, even if SRI is a significant part of the equity market, because there are conventional investors who are ready to provide capital at the same cost. In contrast, Garz and Volk (2007) found evidence of a link between ESG factors and the cost of capital of European firms. Another challenge to SRI investors is that they may have to rely on the proxy vote of the pension funds that they participate in. This requires that the funds become shareholder activists and may create a different type of issue: shareholder activism versus social activism. While portfolio managers can use their position to monitor conflicts that might arise between managers and shareholder activists, they can also abuse their position by pursuing actions that advance their own moral values. The outcome of institutional activism hinges critically on the successful mitigation of two agency costs: (1) the conflicts of interest between corporate managers and shareholders, and (2) the conflicts of interest between portfolio managers and investors (see Barber 2007). The resolve of the first type of agency problem increases the shareholder wealth, which Barber (2007) has shown with CalPERS’ activist strategy in which they propose corporate reforms. The resolve of the second type of agency problem may require, at times, institutions to engage in social activism and take positions on sensitive issues. Barber (2007) believes that portfolio managers should pursue the moral values or political interests of their investors rather than themselves. Lougee and Wallace (2008) found significant positive canonical correlations between community, corporate governance, diversity, employee

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relations, environment, human rights, and product-rating criteria used by KLD Research & Analytics Inc. using S&P 500 firms and Domini 400 firms as samples. The researchers also reported that ROA was associated with more CSR strengths and fewer weaknesses for both samples. Results showed that reducing the number of concerns had greater impact on ROA than increasing strengths, holding all other factors equal. This asymmetric impact seems to lend support for the argument against poor reputations. Lougee and Wallace (2008) concluded that companies appear to be devoting more resources to strengthen existing CSR attributes than to eliminate CSR concerns, which is consistent with the strategy of using CSR as a form of risk management (promoting their strengths to divert attention away from their weaknesses). Corporations spend resources on CSR initiatives primarily to maximize value rather than upholding stakeholder commitments as an end in itself. Based on the results above, the economic argument for CSR wins over the moral argument for it. The moral argument for CSR views corporations as if they were individuals, exhorting them to be ‘good corporate citizens’ by sacrificing investor profits when necessary, to honor equal if not more important commitments to other stakeholders, including society at large. The economic argument for CSR, in contrast, does not view corporations as individuals, but in Jensen’s term, as a nexus of contracts among a variety of stakeholders – some individuals, some institutions – with shareholders as the ‘residual claimants.’ That is, the shareholders only benefit from what’s left over after all other claims, contractual or otherwise are satisfied. Thus, corporate managers are instructed, both by law and as a matter of economic theory, to maximize the long-run value of their claims.

CONCLUSION There are different incentives for investors engaging in SRI. We suggest that individuals consider SRI for the economic, moral, and sustainability arguments. In other words, in addition to financial rewards, investors engage in SRI because of their personal values, morals, and beliefs. SRI proponents and investors believe that there is no cost to SRI considering the utility derived from ‘doing good.’ Some SRI advocates argue that competitive return can be achieved with positive social impact, supporting the ‘doing well while doing good’ hypothesis. We believe the economic argument supersedes the moral argument, while the sustainability argument seems to be a compelling longterm business case for SRI. Sustainability seems to be gaining acceptance among both investors and corporations.


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We describe the different approaches to SRI. They include direct investment in socially responsible companies, through shareholder activism, through direct investment in the community and investing in alternative. Each of these approaches requires a different degree of personal commitment and involvement. We also describe the different financial instruments to which SRI investors have access. We review the historical financial performance of SRI indices, screened portfolios, and mutual funds. Empirical evidence from previous studies has been mixed on the financial performance of SRI. On average, at aggregate, SRI indices seem to have performed at par with other broad market indices. However, results are less favorable on the screened portfolios. Results are mixed when portfolios with positive screens are compared to market benchmarks or non-screened portfolios. On average, the positively screened portfolios are no better or worse than comparable portfolios. However, portfolios or funds comprising of stocks that have been screened out from SRI funds (or ‘sin’ portfolios) have typically outperformed the SRI portfolios and mutual funds. Finally, extant literature seems to suggest that corporate social performance and corporate financial performance are bi-directional linked, that is, they affect and reinforce each other. Yet, previous studies have not been able to establish the relationship between corporate social performance and share price performance. Pundits point out that there may be a cost to SRI and some researchers have found that these costs can be substantial. To sum up, the debate on whether there is a cost or not is not yet settled and awaits more evidence. Fabozzi et al. (2008) provide a caveat that trustees or fiduciaries should fully understand the economic consequences of excluding stocks of companies, that either produce products/services or have a management whose philosophy is inconsistent with the companies’ value systems. In addition, institutional investors should ask themselves if the cost of upholding common social standards is a worthwhile cost, especially if this cost is substantial.

NOTES 1. 2.

3.

Stern (2009)’s article entitled ‘The deadliest greenhouse gas? The hot air of CSR’ in a recent issue of Financial Times reflects the sentiment of this camp of pundits. Barber (2007) estimates the total wealth creation from CalPERS’s involvement in shareholder activism to be approximately $3.1 billion between 1992 and 2005, pursuing reforms at firms on its focus list. Unrelated to the focus list program, CalPERS has also pursued social activism (for example, the divestment of tobacco stocks). See more below. See Van Schyndel, Z. ‘Green Hedge Funds?’ at http://www.institutionalshareowner. com/commentary.html?id=15.

68 4. 5.

6. 7.

8. 9.

10. 11. 12. 13.

14. 15. 16. 17.

18.

19.

Socially responsible investment in a global environment The US SIF started tracking SRI alternative investments for the first time in 2007 (SIF 2008). For example, Kleiner Perkins Caufield & Byers has provided venture capital funding to more than 25 companies applying clean technology, including Bloom Energy that develops solid-oxide fuel cells to enable homes to generate their own electricity with half carbon dioxide pollution of large-scale power plants (Gunther and Lashinsky 2007). As of February 2009, the US SIF website lists 108 mutual funds offered by its members (8 balanced, 8 balanced fixed income, 35 equity large cap, 30 equity mid-small cap, 13 equity specialty and 14 international global foreign). While PowerShares WilderHill Clean Energy Portfolio has been successful in attracting capital since its inception in 2005, Claymore Securities Inc. shut down two of its funds, Claymore/KLD Sudan Free Large-Cap Core ETF and Claymore/LGA Green ETF. Pax World Funds plans to launch two new ETFs that target companies with strong environmental, social and governance records and a third focused on companies that use or develop environmental technologies. Also, Veritas Funds Inc. plans five funds based on the values of various Christian denominations. See Askari et al. (2009) for AUM as of 2007 and Slater (2007) for number of funds as of 2006. Not all Shariah scholars agree on the proper interpretation of Shariah compliance. An association in Bahrain is the informal authority on Shariah compliance for Islamic financial institutions. But its standards are not mandatory and do not govern the offerings of Western firms, which retain their own Shariah boards to advise them and issue their own rulings, or fatwas (Merrill Lynch 2008). The Dow Jones Citigroup Sukuk Index tracks the global performance of investmentgrade, US dollar-denominated, Shariah-compliant fixed-income securities (Karrar 2008). For example, Green Cay Asset Management has four market neutral funds using both social and environmental factors and Winslow Hedge Fund focuses on environmental factors and will go long or short depending upon the value of a particular stock. See http://treasury.worldbank.org/Services/Capital+Markets/News+for+Investors. Comparison across indices is biased by the length of the period since inception. Indices with a shorter history are more adversely affected by the financial crisis of 2008 than those with a longer history. Comparisons should be made with the same period of history. Jensen’s measure is a risk-adjusted performance measure that represents the average return over and above that predicted by the capital asset pricing model. Statman (2000) shows similar results for a US sample using the matched pair method. No significant difference in performance was found between the SRI and non-SRI funds using risk-adjusted performance measures for 1990–98. Their definition of values-based investments is the same as the broader definition of SRI presented in Chapter 1. Californian state pension funds started SRI in 2000 when the then State Treasurer Philip Angelides launched his ‘Double Bottom Line’ initiative, espousing a philosophy of profits and social reform. CalPERS dropped investments in countries that lacked a free press, labor unions, and other hallmarks of democracy. CalPERS and CalSTRS also dumped tobacco stocks and plowed money into businesses and real estate that would benefit the local economy (Palmeri 2008). However, it can also be argued that there may not be a direct connection between the bottom line and the reputation of a company. For example, Primark, the UK discount fashion store, which suffered from bad publicity in 2008 after worrying aspects of its supply chain were uncovered, saw its sales figures up by 18 percent in the following 16 weeks (Stern 2009). McWilliams and Siegel (2000) argued that the documented positive relationship between CSP and CFP in the literature is attributed to confounding factors of research and development and dissimilar industries. They show that when holding R&D levels


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and industry constant, any such CSP and CFP link disappears. Thus, CSP, as a form of externalities, does not appear to be priced in the value of a company’s stock.

REFERENCES Adler, T. and M. Kritzman (2008), ‘The cost of socially responsible investing’, Journal of Portfolio Management, 35 (1), (fall), 52–6. Askari, H., Z. Iqbal and A. Mirakhor (2009), New Issues in Islamic Finance & Economics: Progress & Challenges, Singapore: John Wiley. Barber, B.M. (2007), ‘Monitoring the monitor: evaluating CalPERS activism’, Journal of Investing, winter, 66–80. Barry, N.P. (2000), ‘Controversy: do corporations have any responsibility beyond making a profit? A response to Dennis P. McCann’, Journal of Markets and Morality 3 (1) Spring, 115–19. Bauer, R., K. Koedijk and R. Otten (2005), ‘International evidence on ethical mutual fund performance and investment style’, Journal of Banking and Finance, 29 (7), 1751–67. Beal, D.J., M. Goyen and P. Phillips (2005), ‘Why do we invest ethically?’, Journal of Investing, 14 (3), 66–77. Bruyn, S.T. (1987), The Field of Social Investment, London: Cambridge University Press. Budde, S.J. (2008), Compelling Returns: A Practical Guide to Socially Responsible Investing, Hoboken, NJ: John Wiley & Sons. Collison, D.J., G. Cobb, D.M. Power and L.A. Stevenson (2008), ‘The financial performance of the FTSE4Good indices’, Corporate Social Responsibility and Environmental Management, 15 (1), 14–28. Cornell, B., and A. Shapiro (1987), ‘Corporate stakeholders and corporate finance’, Financial Management 16, 5–14. Derwall, J., N. Guenster, R. Bauer and K. Koedijk (2005), ‘The eco-efficiency premium puzzle’, Financial Analysts Journal, 61 (2), 51–63. Donaldson, T., and L.E. Preston (1995), ‘The stakeholder theory of the corporation: concepts, evidence, and implications’, Academy of Management Review, 20, 51–62. Etter, L. (2009), ‘Tackling green tobacco sickness’, Wall Street Journal, March 24, D3. Fabozzi, F.J., K.C. Ma and B.J. Oliphant (2008), ‘Sin stock returns’, Journal of Portfolio Management, 35 (1) (Fall), 82–94. Franko, L.G. (1989), ‘Use of minority and 50–50 joint ventures by United States multinationals during the 1970s: the interaction of host country policies and corporate strategies’, Journal of International Business Studies, 20 (1), 19–40. Freeman, R.E. and W.M. Evan. (1990), ‘Corporate governance: a stakeholder interpretation’, Journal of Behavioral Economics, 19 (4), 337–59. Friedman, M. (1970), ‘The social responsibility of business is to increase its profts’, New York Times Magazine, 13 September, V32, p. 122. Garz, H., and C. Volk (2007), ‘What really counts – the materiality of extrafinancial factors’, Pan European Equity, Extra-Financial Research, WestLB AG research report, February. Goldreyer, E.F. and J.D. Diltz (1999), ‘The performance of socially responsible

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mutual funds: incorporating sociopolitical information in portfolio selection’, Managerial Finance, 25 (1), 23–36. Grossman, B., and W. Sharpe (1986), ‘Financial implications of South African divestment’, Financial Analysts Journal, (July/August), 15–29. Gregory, A., J. Matatko and R. Luther (1997), ‘Ethical unit trust financial performance: small company effects and fund size effect’, Journal of Business Finance & Accounting, 24 (5), 705–25. Guay, T., P.D. Jonathan and G. Sinclair (2004), ‘Non-governmental organizations, shareholder activitism, and socially responsible investments: ethical, strategic, and governance implications’, Journal of Business Ethics, 52 (1) 125–36. Guerard, J.B. (1997), ‘Additional evidence on the cost of being socially responsible in investing’, Journal of Investing, (Winter), 379–97. Gunther, M. and A. Lashinsky (2007), ‘Cleanup crew’, Fortune, 26 November, 82–92. Haigh, M. and J. Hazelton (2004), ‘Financial markets: a tool for social responsibility?’, Journal of Business Ethics, 52, 59–71. Hamilton, S., H. Jo and M. Statman (1993), ‘Doing well while doing good? The investment performance of socially responsible mutual funds’, Financial Analysts Journal, 49 (6) (November/December), 62–6. Hong, H. and M. Kacperczyk (2008), ‘The price of sin: the effects of social norms on markets’, Princeton University and New York University working paper, October. Hudson, J. (2006), The Social Responsibility of the Investment Profession, Charlottesville, VA: Research Foundation of CFA Institute. Hussein, K. and M. Omran (2005), ‘Ethical investment revisited: evidence from Dow Jones Islamic Indexes’, Journal of Investing, 14 (3), 105–24. Jensen, M. and W. Meckling (1976), ‘Theory of the firm: managerial behavior, agency costs, and ownership structure’, Journal of Financial Economics, 3 (4), 305–60. Kahn, R., C. Lekander and T. Leimkuhler (1997), ‘Just say no? The investment implications of tobacco divesture’, Journal of Investing, (Winter), 62–70. Karrar, T. (2008), ‘In booming Dubai, call it the anti-“credit crunch”’, Wall Street Journal, 16–17 August. Kreander, N., R.H. Gray, D.M. Power and C.D. Sinclair, (2005), ‘Evaluating the performance of ethical and non-ethical funds: a matched pair analysis’, Journal of Business Finance & Accounting, 32 (7) and (8), 1465–93. Lane, M.J. (2005), Profitable Socially Responsible Investing: An Institutional Investor’s Guide, London: Institutional Investor Books. Le Sourd, V. (2008), ‘The performance of socially responsible investment: a study of the French market’, EDHEC Risk and Asset Management Research Centre working paper, Nice, France, February 2008. Lougee, B. and J. Wallace (2008), ‘The corporate social responsibility (CSR) trend’, Journal of Applied Corporate Finance, 20 (1), 96–108. Luther, R., and J. Matatko (1994), ‘The performance of ethical unit trusts: choosing an appropriate benchmark’, British Accounting Review, 26, 77–89. Luther, R., J. Matatkoa and D. Corner (1992), ‘The investment performance of UK “ethical” unit trusts’, Accounting, Auditing & Accountability Journal, 5, 57–70. Lydenberg, S. (2005), ‘Social and environmental data as new tools’, Journal of Investing, 14 (3), 40–46.


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Mackenzie, C. and A. Lewis (1999), ‘Morals and markets: the case of ethical investing’, Business Ethics Quarterly, 9 (3), 439–52. Mackintosh, J. (2008), ‘Dubai invests $250m in five new funds’, Financial Times, 19 June, p. 27. Mallin, C., B. Saadouni and R. Briston (1995), ‘The financial performance of ethical investment trusts’, Journal of Business Finance & Accounting, 22, 483–96. Margolis, J.D. and J.P. Walsh (2001), People and Profits, Mahwah, NJ: Lawrence Erlbaum. McGuire, J.B., A. Sundgren and T. Schneeweis (1988), ‘Corporate social responsibility and firm financial performance’, Academy of Management Journal, 21, 854–72. McGuire, J.B., T. Schneeweis and B. Branch (1990), ‘Perceptions of firm quality: a cause or result of firm performance’, Journal of Management, 16, 167–80. McWilliams, A. and D. Siegel (2000), ‘Corporate social responsibility and financial performance: correlation or misspecification?’, Strategic Management Journal, (May), 603–9. Merrill Lynch (2008), ‘Values based investing’, Merrill Lynch Global Investment Strategy report, May. Minor, D.B. (2007), ‘Finding the (financial) cost of socially responsible investing’, Journal of Investing, 16 (3) (fall), 54–70. Orlitzky, M. (2001), ‘Does firm size confound the relationship between corporate social performance and firm financial performance?’, Journal of Business Ethics, 33 (2), 167–80. Orlitzky, M., F.L. Schmidt and S.L. Rynes (2003), ‘Corporate social and financial performance: a meta-analysis’, Organization Studies, 14 (3), 401–11. Palmeri, C. (2008), ‘CalPERS: the price of good intentions’, Business Week, 11 August, p. 54. Robinson, A.G. and D.M. Schroeder (2009), ‘Greener and cheaper’, Wall Street Journal, Business Insight, 23 March. Roman, R.M., S. Hayibor and B.R. Agle (1999), ‘The relationship between social and financial performance’, Business and Society, 38 (1), 109–25. Ruf, B.M., M. Krishnamurty, R.M. Brown, J.J. Janney and K. Paul (2001), ‘An empirical investigation of the relationship between change in corporate social performance and financial performance: a stakeholder theory perspective’, Journal of Business Ethics, 32 (2), 143–56. Salisbury, I. (2009), ‘New ETFs bank on social themes’, Wall Street Journal, 8 January, C11. Schepers, D.H. and S.P. Sethi (2003), ‘Do socially responsible funds actually deliver what they promise? Bridging the gap between the promise and performance of socially responsible funds’, Business and Society Review, 108 (1), 11–32. Schueth, S. (2003), ‘Socially responsible investing in the United States’, Journal of Business Ethics, 43 (3), 189–94. Sethi, S.P. (2005), ‘Investing in socially responsible companies is a must for public pension funds – because there is no better alternative’, Journal of Business Ethics, 56, 99–129. Shank, T.M., D.K. Manullang and R.P. Hill (2005), ‘Is it better to be naughty or nice?’, Journal of Investing, 14 (3), 82–7. Social Investment Forum (SIF) (2008), ‘2007 Report on socially responsible investing trends in the United States’, accessed at www.socialinvest.org. Simpson, W.G. and T. Kohers (2002), ‘The link between corporate social and

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financial performance: evidence from the banking industry’, Journal of Business Ethics, 35 (2), 97–109. Slater, J. (2007), ‘A trading platform for Muslims’, Wall Street Journal, 27 March. Smith, N.C. (1990), Morality and the Market Consumer Pressure for Corporate Accountability, London: Routledge. Statman, M. (2000), ‘Socially responsible mutual funds’, Financial Analysts Journal, 56 (3) (May/June), 30–39, 2001, correction on AIMR website. Statman, M. (2007), ‘Socially responsible investments’, Journal of Investment Consulting, 8 (2), Summer, 17–37. Stern, S. (2009), ‘The deadliest greenhouse gas? The hot air of CSR’, Financial Times, 3 February. Stone, B.K., J.B. Guerard Jr., M.N. Gultekin and G. Adams (2001), ‘Socially responsible investment screening: strong evidence of no significant cost for actively managed portfolios’, 21 June, accessed at wwww.socialinvest.org/areas/ research/Moskowitz/2001_HM_full.pdf. Van Schyndel, Z. (2008), ‘Green hedge funds?’, accessed 6 April 2009 at http:// www.institutionalshareowner.com/commentary.html?id=15. Verschoor, C.C. (1998), ‘A study of the link between a corporation’s financial performance and its commitment to ethics’, Journal of Business Ethics, 17, 1509–16. Verschoor, C.C. (1999), ‘Corporate performance is closely linked to a strong ethical commitment’, Business and Society Review, 104 (4), 407–16. Verschoor, C.C. and E.A. Murphy (2002), ‘The financial performance of large U.S. firms and those with global prominence: how do the best corporate citizens rate?’, Business and Society Review, 107 (3), 371–80. Waddock, S.A. and S.B. Graves (1997), ‘The corporate social performance – financial performance link’, Strategic Management Journal, 18 (4) (April), 303– 19.

4.

Environmental issues

INTRODUCTION In Chapter 2 we outlined the three major considerations in a SRI portfolio – environmental, social, and corporate governance. In this chapter, we focus on environmental issues that impact corporate performance and increase risk for investors. Specifically, eco-efficiency, environmental impacts and environmental management are discussed. We then present water scarcity and climate change as two important case examples of environmental risks. Environmental issues are no longer just a problem for select industry groups, such as a natural resources extraction company like lumber and mining. Media attention is no longer solely focused on conservation groups protesting about environmental destruction in old-growth forests. These days, environmental groups use mass marketing campaigns targeting all companies, from producers who use raw materials, to the distributors, retailers, and even end-users. Such scrutiny has compelled companies like Wal-Mart Stores to publically state their goals for sustainability, energy efficiency and carbon emissions, and include NGOs, academia, and government in their framework. Even more important, they have implemented a program in which their suppliers are held to the same goals and standards (see Wal-Mart Stores 2009). It is not surprising to see an increasing trend of companies producing sustainability reports and working in collaboration with environmental groups. Once in contentiously opposite camps, NGOs and corporations have formed working relationships to tackle environmental issues. As we will see throughout this chapter, pressures and drivers on companies to look at their environmental footprints means that investors now have some additional extra-financial information on which to base their estimates of risk due to environmental issues. The California Public Employees’ Retirement System (CalPERS), one of the largest pension funds in the US, was instrumental in demonstrating how SRIs can be incorporated into pension fund strategies. In 2004, the Treasurer of the State of California proposed that pension funds adopt an environmentally-focused investing strategy such as environmental technologies that are either more efficient (such as recyclable products or products made with less natural resource damage) or less polluting (such 73

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as clean energy) (see Kurtz 2005). They committed to a broad and flexible scope in choosing opportunities with environmental benefits, while diversifying the funds by sector, geography, stage and structure. CalPERS assigned a separate risk benchmark to these investments to measure the portfolio performance over the long-term horizon, by specifically stating that they would expect negative returns in the short-term but would increase to ‘attractive’ returns in the long run as the environmental market evolves (see CalPERS 2004). By 2005, CalPERS initiated the development of a greenhouse gas reporting project that would improve data transparency in the electric power and utilities industry (see CalPERS 2006). In that same year, they signed on to the Carbon Disclosure Project (CDP),1 and joined the other 154 institutional investors with a combined AUM of US$41 trillion.2

ENVIRONMENTAL ISSUES AS RISKS Investors looking at environmental issues for their SRI portfolio need to consider the risks on a short-term and long-term basis. Environmental risks in the short term can include such things as a company’s liability payments for fines incurred for pollution or non-compliance to regulation. Such risks can be a one-off incident that affects the quarterly financial performance. In the short term, companies that mitigate their environmental risks have increased savings from environmental liabilities and save themselves from public scrutiny and being targeted by NGOs. Companies that have learned to internalize their effects on the environment, reduce their risks of paying for liabilities imposed on them by government regulations. However, environmental short-term risks such as these are often a symptom of long-term risks that were not abated, and consequently, a sign that the investor needs greater scrutiny of the company’s environmental practices. For socially responsible investors, the only real value of an investment is based on its long-term value within the framework of sustainability. Long-term environmental risks are a large factor in whether the company will have a sustainable future. Companies that cannot account for the cost of their environmental impacts are risks for their investors. Companies must often pay upfront costs that add no value to the company (that is, regulatory requirements, such as reporting, environmental studies and monitoring, financial assurance for environmental liabilities, pollution and waste management and mandatory inspections). Hidden upfront environmental costs to companies before building new facilities or operations include environmental site studies, site preparation and permits. These costs go beyond regulatory


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compliance, but are often necessary for community outreach and reputational protection. Companies maintain monitoring studies for impacts on the local ecosystem, implement feasibility studies, protect important habitats and wetlands, and even provide financial support to local NGOs for collaborative projects. For example, several utility companies in the US have worked with local conservation groups to prevent electrocution of birds that fly into or land on electricity transmission wires. In the end, when a property is divested from the firm’s portfolio or a facility is shut down, environment-related costs include closure and decommissioning costs and post-closure monitoring. The environmental risks to the firm can occur at any time during pre-operation, during, and post-operation phases. Contingent costs can include additional regulatory compliance costs that may occur in the future, environmental fines and penalties for non-compliance, clean-up responses to pollution, remediation of contaminated resources and costs of property damage, and legal expenses associated with natural resource damages, personal injury damages, and economic loss damages. However, over the long-term horizon, companies that manage their environmental risk are at a competitive advantage. The companies that incorporate environmental factors in their strategic objectives can differentiate themselves from their industry peers as being the chosen company with license to operate in a community. This includes having access to scarce raw materials, access to markets, and attracting talent. Access to natural resources and materials such as timber, water, oil and minerals are key to ensuring a sustainable enterprise, especially for those with a strategy to expand in global operations. An unblemished environmental record or having a history of good environmental management can provide negotiating clout with governmental agencies and prevent backlash from concerned stakeholders. Environmental responsibility is also important for retaining and attracting employees. A company’s values, including environmental, that are in line with their overall value system, helps retain and attract conscientious employees. Thus, acceptances by the customer, the community, governmental agencies, and their own employees are critical for shareholder value. When most people think of environmental impacts, pollution is usually the first thing that comes to mind. These impacts can be contamination on the land, spills in the world’s oceans, and toxic gases spewing into the air. Other environmental impacts include habitat degradation, loss of biodiversity, threats to endangered species, over-extraction of natural resources, waste in landfills, garbage dumping in the oceans, and greenhouse gas emissions. No matter how cautious, everyone has an environmental impact or ‘footprint.’ Firms that have released toxic pollutants into

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the ecosystem have borne that cost with regulatory fines, public denouncements, and severe reputational and brand damages. Investors have long known that pollution and other environmental impacts are direct costs to the company. These liabilities are reported in financial statements as contingent liabilities, and can appear in property, plant and equipment, impairment of assets, and intangible assets (see IFAC 2009). Companies that have experienced extreme reputational scarring from their environmental mistakes have turned the tables and now use their ugly past as a way to show the public (and investors) how far they have come in embracing sustainable practices. In 2000, oil company, Petrobras, was fined over $25 million and suffered embarrassing publicity when environmental groups chained themselves to their headquarters. A leak in Petrobras’s pipeline near Guanabara Bay in Rio de Janeiro state, had caused 350 000 gallons of crude oil to contaminate a nearby tourist destination, local fishing industry, and important wildlife habitat. Then, only six months later, they had an oil spill near Curitiba in Paraná state, and were fined another $115 million. The BBC said that Petrobras showed ‘an embarrassing level of incompetence’ (see Azevedo 2009). Since then, the company has instituted environmental and social aspects in their operations and strategy, promoted a cultural change within their workforce, and has garnered kudos from several independent groups for their sustainability practices. Petrobras is a good example of a company that has used their poor reputation in the past as a benchmark of their progress, and now has a reputation as a progressive company, distinct from their peers in the industry. Unfortunately, even if a single company is diligent and mitigates their environmental risks, reputational risk can still affect the whole industry, especially if other companies have been less environmentally progressive.

ECO-EFFICIENCY Companies that have assessed their environmental considerations and taken appropriate management steps have obtained cost savings in both the short and long term. Eco-efficiency, a term used to describe activities to increase production and enhance services while decreasing the use of resources and waste, ultimately leads to savings. The concept of eco-efficiency also include initiatives that increase or enhance the recyclability of materials, maximize the use of sustainable materials, extend the durability of the end product, and increase value to consumers with no additional environmental costs (for example, shared uses, multi-functionality, and design for upgrading). Wal-Mart set a goal to reduce its packaging by 5 percent by


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2013 and estimated that this effort would result in a savings of $3.4 billion. To accomplish this goal, they developed a simple scorecard in which several metrics such as greenhouse gas emissions, product-to-package ratio, and recycled-content usage was measured. By 2007, there were 6300 vendors who were using this scorecard to rate 100 000 products. This exercise not only provided transparency for their environmental improvements, but these improvements were measurable (The Economist 2008). There are several tools currently available to measure eco-efficiency, ranging from guidelines and standards (for example, cleaner production guides,3 ISO 14000), environmental accounting and auditing (for example, environmental management systems, environmental financial statements), thought frameworks (for example, Natural Step,4 life cycle management) and business management concepts such as supply chain management. Bristol-Myers Squibb, a biopharmaceutical company, implements a life cycle management (LCM) program for all of its products, beginning at research and ending at product disposal. LCM attempts to account for the environmental impacts, risks, and costs associated with the life cycle of a product (or service), from production, during use, and its end-of-life. Reviewing each product costs Bristol-Myers Squibb about $25 000 per review in employee time and resources for implementing improvements. Employees review several environmental, safety, and cost factors relevant to their phase of the product’s life cycle. Criteria include materials, energy usage, pollution avoidance, and costs for substitute materials or changes to operations. To determine if anticipated improvements are viable, they analyse one-time capital costs, annual operating costs, and costs associated with changes to operations such as production efficiency, changes in raw material requirements, and releases of chemicals to the environment. Improvements are evaluated by monetizing them. The product life cycle review results in an average cost savings of $340 000 per product, or net savings of $315 000 per review and total savings of $7 million (see NCDPPEA 2009; Brady et al. 1999). Baxter International, a producer of healthcare products, began reporting its ‘Environmental Financial Statement’ in 1993. The company demonstrated that spending $15.2 million in programs to minimize their environmental costs (such as waste disposal, remediation, environmental attorney fees, and packaging reductions), resulted in $87.4 million in savings in 1995 alone (see DeSimone and Popoff 2000). The results were not just one-time paybacks, but were cumulative over the years after their efforts were initiated. The cumulative cost avoidance from environmental initiatives six years prior to the reporting date was $302.9 million between 2004 and 2007 (see Baxter 2009). Companies that reduce or recycle their wastes, or even sell them as

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source materials to a downstream user, can create more product with less wastage and save money on costs of disposal. The Peter Paul Philippines Corporation, a candy maker, creates 100 000 liters of waste coconut liquid per year, and was dumping it into the local river. The coconut liquid waste was too acidic to be used as irrigation water for rice paddies. Unfortunately, the high organic content of the coconut liquid resulted in decreased oxygen content in the water, so much so that all aquatic organisms, including fish, literally died of suffocation. In a partnership with Chia Meei, a drink company, Peter Paul was able to funnel 40 000 liters of the coconut water to the joint venture processing plant. Here the coconut water was frozen and used in Chia Meei’s drink products. Peter Paul had found a way that maximized the use of sustainable materials (coconuts), decreased waste, and developed shared uses. The new process created $370 000 in savings, generated revenue from a waste stream, and most importantly, decreased the impact the coconut waste water was having on the local river (see DeSimone and Popoff 2000). Savings are not limited to raw materials and energy during the manufacture of the product, but also savings for the end-user. Companies that can innovate products or services that have little environmental footprint for customers provide even more customer satisfaction, leading to greater value for the investors. For example, Procter and Gamble marketed coldwater laundry detergent to consumers, with the intent of saving household energy usage by forgoing hot water. If every household in the US used cold water for washing clothes, domestic energy usage would decrease by 3 percent (see The Economist 2008). Not only did Procter and Gamble provide a vehicle for which consumers could feel good towards helping the environment while doing mundane household tasks, but they also made a hefty profit in doing so. Innovative environmentally-friendly products, even those that are as stodgy as laundry detergent, can be a contender in a SRI portfolio.

ENVIRONMENTAL IMPACTS Some environmental risks and impacts on society can be hard to measure because of lack of transparent data and ‘green washing.’5 However, investors can assess operations and past management decisions for clues. Has the company had transaction failures in the past, such as problems divesting lands that have known contamination? Does the company have high insurance rates due to past environmental problems? Has the company set aside a ‘sinking fund’ or have financial assurance mechanisms in place that it plans to use to offset environmental problems or liabilities such as


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pollution cleanup? Other considerations include lenders and the cost of capital. Have the providers of capital already considered the environmental risks and are they providing an interest rate that is commensurate with level of risk? Investors also assess adherence to industry standards. One approach to assessing environmental impact is to analyse the effects on upstream and downstream stakeholders. Companies that have signed on to third-party certifications can benefit from marketing and publicity and garner favor with downstream companies and end-users. Home Depot, a home improvement retailer, implements a corporate strategy throughout its supply chain where only independently certified wood is purchased. Certifications such as the Forest Stewardship Council ensure that the wood was sustainably managed and harvested from ‘stump to shelf’ (see Home Depot 2009). Scrutinizing companies both upstream and downstream in the value chain, helps ensure that most environmental risks are accounted for.

ENVIRONMENTAL MANAGEMENT Investors analysing environmental risks should look beyond current and future financial obligations, and focus on the company’s business strategy and management’s ability to handle environmental issues. Management that has shown an inability to handle short-term environmental risk can signal to investors that they do not have a plan in place to deal with longterm environmental risk. Corporate management that chooses to incorporate environmental risk in strategic planning is prepared for complex environmental challenges, and this helps them foresee the effect of environmental risk on their overall business strategy. This foresight can help them anticipate future legal or regulatory changes (for example, greenhouse gas emission regulations) and public pressure that may cause them to cease current operations or products. These risks can greatly affect a firm’s core business and add risk to SRI portfolios. Investors looking at environmental risks can find information from sustainability reports or corporate social responsibility reports issued by the company. Communications and engagement with the corporate managers can also provide more insight. Does the firm have a set of corporate values and missions that incorporate environmental factors? Companies that have an environmental policy embedded throughout the company culture have clearly accounted for their effects on the environment, including appropriate training for employees and internal communications. Companies that encourage employee ‘grassroots’ participation in environmental initiatives can be seen as being more progressive. Some

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companies have an environmental policy within their corporate strategy, and have a vision or voice that describes their environmental goals. Other companies incorporate environmental management systems as part of their regular business processes. Environmental management systems help the firm reduce their environmental impacts by defining goals, picking benchmarks, identifying measurable metrics, and indicating the roles and responsibilities of key employees. Often there is a feedback mechanism by which corporate managers can assess progress and review the company’s performance against their goals. As discussed earlier in this chapter, there are several tools available that enable firms to assess their environmental impacts and identify opportunities to redesign their products or redevelop operational processes. Companies that have identified their environmental risk and changed their operations, technology and source material to sustainable products, can gain a competitive advantage by being seen by the public as innovators. For example, wood companies that can source their fibers from other vegetation (for example, bamboo) or replace their non-old-growth trees with faster-growing tree species have advantages over those that continue to source from old-growth forests. In the same vein, pharmaceutical and cosmetic companies are internalizing biodiversity issues because having sources for new drugs and cosmetic products are vital to the long-term health of the company. Thus, investors focusing on environmental risks not only assess the regulatory framework, stakeholder perceptions, and business processes, but also environmental factors in management’s key business decisions and overall corporate strategy. Being innovative with an environmental focus not only helps companies remain sustainable, but can even increase a company’s market share or build new business opportunities. For example, Toyota’s Prius hybrid electric car became the darling choice of eco-conscious consumers when it was released for sale in 2000. Within a short time, the Prius transcended from being a niche product and became a mass-produced hit amongst the general population. The Prius was so influential and popular, that other car manufacturers scrambled to produce their own hybrid models. By 2007, hybrid cars made up 2.2 percent of the car market and accounted for 38 percent of the new car registrations in the US. Sales of hybrid cars grew steadily, even as general car sales declined by 3.3 percent (see Associated Press 2009). Environmentally-friendly products are not limited to retail consumers, but include large-scale products like infrastructure. General Electric’s wind turbines, as part of their ‘ecomagination’ line of products, have resulted in $12 billion in sales since 2007 (see The Economist 2008). Thus, environmental products are not just a niche concept, but are profitable and provide enormous value to their investors.


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ENVIRONMENTAL RISK AND RETURN Environmental considerations are material to investments, although earlier studies seem to suggest that there is no impact of negative environmental issues on stock price performance. Jones and Rubin (2001) found no evidence of impact on stock prices from negative environmental events during 1970–92. They concluded that firms did not even suffer reputational loss. However, recent studies seem to find some importance of environmental issues. Several studies have linked eco-efficiency, reduced pollution emissions, adoption of environmental management systems, reductions in waste, decreased environmental litigation and reduction in environmental liabilities to increased financial performance, decreased cost of capital, decreased company beta, and higher market valuations (see Konar and Cohen 1998; Derwall et al. 2005; Hart and Ahuja 1996; Feldman et al. 1997; Stanwick and Stanwick 1998; Russo and Fouts 1997; King and Lenox 2001). A survey by Innovest and the UK Environment Agency (2004) found a positive relationship between environmental governance and financial performance in 51 out of the 60 studies they reviewed. The studies included companies in several different industries as well as mutual funds. Thus, investors need to be keenly aware that externalizing environmental effects will have a substantial effect on companies’ value, and ultimately, on investment value. However, extra-financial information like environmental performance is difficult for analysts and investors to find, and even if it is readily available (such as liabilities for pollution) it is difficult to directly correlate environmental factors to company performance. There are too many confounding factors to consider. An alternative way of assessing environmental factors is to relate the environmental issues to risk, and incorporate environmental risk into company valuation.

CASE EXAMPLES Environmental risks to companies, and ultimately to investors, fall into three main categories: reputational, regulatory/legal, and operational. Company and brand reputation is critical, especially with the rise of NGO involvement in mass media. Environmental criticisms and calls for being ‘green’ have sometimes forced companies to respond with environmental programs and collaboration with NGOs themselves. Investors evaluating regulatory and/or legal risk to companies focus on upcoming, future regulations that can damage their investments or lead to new opportunities. This is especially true in industries that show a current lack of

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environmental regulatory oversight. Changes in the regulatory framework can result in additional costs for compliance, fines, penalties and litigation, which ultimately impact on market capitalization. Regulations prompted by public concerns can also ultimately result in market rejection. A well-known example is the public outcry against ozone-depleting CFC chemicals and their eventual ban in aerosol products. Below, using water scarcity and climate change as examples of environmental considerations, we discuss how these reputational, regulatory/legal, and operational risks are considered by SRI investors. Water Scarcity Water scarcity has long been an issue facing countries in arid regions. However, access to clean and abundant water is now a consideration for many industries that are faced with competition from other users and increased global stresses, such as climate change, reductions in rain, snow cover and glaciers that threaten to decrease the amount of existing water. By 2025, freshwater withdrawals are expected to increase by 18 percent in developed countries, and by a whopping 50 percent in developing countries (see WBCSD 2009). Major industries such as manufacturing, agriculture, electricity generation and transportation recognize that water scarcity, water availability, and competition will significantly impact on their operations. Large-scale operations that require water are affected if their distribution systems are inadequate to handle changes in water level and extreme weather events due to climate change. Changes in water availability do not just affect companies that consume water in their operations (for example, food and beverage companies, and silicon chip manufacturers), but affect non-consumptive uses such as transportation. For example, transportation in the Mississippi and Rhine Rivers has been disrupted because of drought or flood events (see Pacific Institute 2009). Water scarcity has material impacts on investments. Hydroelectric generation at AES Tiete was disrupted in 2001 when water levels in reservoirs decreased, resulting in low electricity production and increases in production costs. As a result, the company was unable to pay interest on their 15-year bonds and, in 2003, had to negotiate a new payment schedule (see UNEP FI 2004). Some companies have recognized early that availability to clean water is essential to the long-term viability of their company and have come up with innovative ways to ensure a sustainable water supply. For example, Nestlé mitigated the risk of contamination to their groundwater supply in north-eastern France by working with local farmers in the watershed to change their agricultural practices and finance new technology to keep


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the aquifer free of nitrates from fertilizers. Nestlé provided a subsidy of €200 per hectare per year to farmers over five-year periods (with long-term 30-year contracts), up to €150 000 per farm for new equipment and to modernize buildings, free labor to apply compost to farms, and free technical education and assistance with farm planning and networks. In the first seven years of the program, Nestlé spent over €24 million to ensure that nitrates did not pollute their Vittel-brand bottled water supply. Their actions eliminated an environmental risk that affects a business that produces 1 billion Vittel bottles of water a year (see Perrot-Maître 2006). There is an increasing trend recognizing that access to water is a basic human right. This right has been recognized in non-binding UN declarations (for example, 2002 General Comment #15 by the UN Committee on Economic, Social and Cultural Rights, which defines the human right to water as ‘entitl[ing] everyone to sufficient, safe, acceptable, physically accessible and affordable water for personal and domestic uses’ (UN 2002)). Additionally, South Africa, Uruguay and Ecuador have added similar water rights to their constitution (see Pacific Institute 2009). Rights to water have led companies to compete against local farmers, municipalities, and other industrial users. There have been several instances in which local villages, faced with drought conditions, have placed blame and demanded compensation from companies operating in the area for over-exploitation of water. Several companies have garnered negative publicity in cases such as this. Pepsi and Coke bottling plants faced intense competition for groundwater in Kerala, India and tensions with the local community started with public protests and ended in the loss of groundwater extraction rights (see Pacific Institute 2009). Not only was this damaging because they lost their license to operate and thus stunted future growth, but incidents like these have an effect on the brands’ reputations, which should also concern investors. To prevent conflicts, some governments have allowed privatization of water supplies and companies have built their own water distribution infrastructure. However, mitigating water scarcity risks can also mitigate reputation risk, if the technology is shared with locals or by providing a supply of potable water to disadvantaged communities. In 2001, opponents to Nestlé extracting groundwater from Michigan, US, mounted a legal challenge that the groundwater was a public good and should be managed for the community. Opponents also argued that Nestlé provided no financial returns to citizens in the area, aside from nominal permit payments and leasing rights to the state government. Moreover, the government was accused of giving Nestlé tax abatements, while over 8000 low income households in the Detroit area were unable to pay their water bills

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or inhabited buildings with outstanding back payments (see Lyderson 2003). Even though Nestlé won the lawsuit and had legal rights to withdraw groundwater, it was at a great cost in negative publicity and local customer backlash. Governmental agencies with the authority to charge higher prices for clean water can greatly affect the cost structure of companies that consume large quantities of water as an input to their operations. On the flipside, companies that discharge polluted water during their operations can face increasing stringency of waste water contamination regulations, resulting in increased costs for compliance (such as purchasing new technology to decrease contaminants in water or changing operations and processes) as well as face increasing risks of potential environmental fines and litigation. The state of South Carolina brought legal action against North Carolina because the regulators there allowed two growing cities (Concord and Kannapolis) to withdraw up to 10 million gallons of water from the Catawba River. Residents and companies on the South Carolina side of the river cited fears of drought conditions and that claimed this excessive water withdrawal compromised their ability to continue operations (see U.S. Water News 2007). Similarly, the states of Florida, Georgia and Alabama and the United States Army Corps of Engineers have engaged in litigation over the flow of water from the Apalachicola River into Apalachicola Bay. Reductions of the nutrient-rich waters to the Bay affect the $134 million commercial fishing industry in the area (see Florida Department of Environmental Protection 2009). Water scarcity is an important environmental factor to consider when assessing a firm’s reputation, operations, and regulatory impacts. Water is no longer a commodity to be taken for granted, but a precious resource vital to communities and thriving companies. Investors looking at all nodes along the value chain and assessing water footprints can mitigate water risks in their SRI portfolio. Climate Change Climate change, like water scarcity, is an environmental risk to companies on a global scale. Several organizations (for example, Institutional Investors Group on Climate Change, Investor Network on Climate Risk, Carbon Principles) have been formed to understand how climate change risks to companies affect investments. Some of the effects of climate change include changes in air temperature, increasing incidences of drought and heat waves, increasing glacier and snow melt, increasing sea levels, and stronger hurricanes. All of these effects can be devastating to communities and companies. Climate change can also affect people’s


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health by increasing the cases of allergies and asthma. Climate change has already had an effect on the EU financial industry, when the European Climate Exchange (ECX) opened in 2005. At the ECX, carbon credits can be traded and members can participate in futures and options. Similar cap-and-trade programs have already sprung up in some states in the US (for example, Regional Greenhouse Gas Initiative (RGGI) for the power industry). Environmental risk can result in a real cost to business operations. A good example was illustrated by Eurosif and Truecost (2009) who examined climate change risk exposure on the shipping industry. The study showed that the 11 companies that produced 11 percent of all the greenhouse gas emissions in the shipping industry were exposed to €2.9 billion in damage costs. They also predicted that ships that can adapt to using shore-side electricity while in port can reduce their greenhouse gas emissions by 50 percent and benefit from tax breaks. Thus, companies that can change their operations use cleaner fuel sources and strive for other adaptations, will have a competitive advantage in a low-carbon world. Actual savings can be realized from decreasing greenhouse gases. Green Mountain Coffee Roasters’ commitment to greenhouse gas emission reduction has resulted in a decrease of energy consumption during operations and transportation. They used a scorecard system and therms (energy use) per $1000 of net sales as their metric for measuring their ecoefficiency. Green Mountain Coffee Roasters’ therms per $1000 net sales decreased from 8.15 in 2003 to 6.76 in 2006. This is a direct cost savings to the company (see Green Mountain Coffee Roasters 2008). Thus, mitigating climate change risks are not just for marketing and publicity, but can add real value to investments. Investors scrutinizing climate change risk on business operations also assess the effects on employees. Scientists have reported that climate change has effects on people, such as increased diseases and allergies (IPCF 2007). Business operations can be greatly affected if climate change causes an increase in the number of sick days and absenteeism, and adds strains on human resources and the productive capacity of employees. Climate change issues have changed consumer attitudes and how local community stakeholders behave. Companies can take measures to raise their environmental reputation, even if their products do not reflect their environmental efforts. For example, energy companies whose electricity ends up in a ‘brand agnostic’ commodity distribution system can still promote their environmental efforts, leading to good public relations, increases in customer loyalty, and subsequently translating to higher market share and market price. However, investors are also aware that too much ‘green wash’ marketing can confuse the issues and

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risks. When biofuels were initially produced, they were touted to be the environmentally-friendly replacement for petroleum products. However, there was little consideration for the fact that these first generation biofuels required 20 times more water per mile travelled during production, than conventional gasoline (see Pacific Institute 2009). A potential solution to climate change clouded the problems associated with water scarcity. EU companies have been forerunners in internalizing climate change regulatory risks into their business strategy by participating in cap and trade schemes. In the US, the EPA was given the responsibility to regulate greenhouse gas emissions under the Clean Air Act of 2007 and since then, several bills have been proposed for Congress to address climate change. Some industries have already encountered regulatory impacts on their operations. Government agencies have denied air permits to coal-fired facilities (see Webber 2008) and are requiring mandatory greenhouse gas reporting. Despite upcoming federal regulations on climate change, some states have already taken steps to regulate greenhouse gas emissions by establishing targets, considering legislation in which public utilities are required to have a portion of their total generation from a renewable energy portfolio and moving towards a carbon credit market scheme. Companies that have mitigated their climate change risk by shifting to less carbon-intensive operations or have incorporated renewable energy, may have easier access to capital and avoid incurring liability payments for excessive greenhouse gas emissions when a carbon credit market eventually forms. Regulatory risks associated with climate change should not only be thought of as direct effects on industries that have carbon-intensive operations because the indirect effects can be equally material to other investments. Government subsidies or tax incentives can be drivers for new industries (thus, new investment options) and also significantly alter other industries. Government subsidies for biofuel production have been blamed for increasing commodity prices, including food. Although increasing food prices are also affected by inflation, drought conditions and increasing animal disease, the IMF (2007) also points to the increasing demand of biofuel in the EU and US. Biofuel demand led to higher corn and soybean prices, increased substitution crops, and subsequently higher costs of livestock feed. Regulatory risk from climate change has a material impact on investments and prudent investors focus on distilling the uncertainty of new climate change laws and potential litigation across their entire portfolio. Investors who seek the upside from climate change risks can find opportunities investing in companies that are producing clean technologies, such as solar energy or companies that implement energy efficiency programs,


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such as ‘green’ certified buildings in real estate portfolios. Companies that have strategically accounted for their carbon footprint and low-carbon economy risks to their operations publicize themselves through sustainability reports or databases such as the Carbon Disclosure Project.

CONCLUSIONS Companies are greatly exposed to environmental risks. Firms with responsible practices and stellar histories send signals to the investing community that they value their stakeholders (customers, community, and suppliers). They incorporate environmental risk in their operations and strategy by purchasing new technology, retraining employees, and creating products that exceed regulatory compliance and garner public acceptance. These actions save money, reduce volatility, keep their costs of capital low, ensure low liabilities on their balance sheets, and minimize impacts on the environment. Ultimately, these actions produce long-term value to shareholders.

NOTES 1. The CDP is a NGO that provides information about business risks and opportunities to institutional investors regarding the implications for shareholder value and commercial operations presented by climate change and works to create open dialogue between policymakers, corporations, and shareholders. 2. As of August 2007 (www.cdproject.net). 3. See the UN Industrial Development Organization program on cleaner production at http://www.unido.org/index.php?id=o5151 4. See the Natural Step Framework at www.naturalstep.org 5. ‘Green washing’ refers to companies disingenuously promoting their environmental performance or their products for the sake of publicity.

REFERENCES Associated Press (2009), ‘Hybrid sales, led by Prius, up 38 percent in ’07’, accessed 28 March at www.msnbc.msn.com/id/24230209/. Azevedo, J.S.G. (2009), ‘The greening of Petrobras’, Harvard Business Review, March, 43–7. Baxter International Inc. (2009), 2007 Environmental Financial Statement, accessed 2 May at http://sustainability.baxter.com/EHS/2007_environmental_financial_ statement.html. Brady, K., P. Henson and J.A. Fava (1999), ‘Sustainability, eco-efficiency, lifecycle management, and business strategy’, Environmental Quality Management, Spring, 22–41.

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California Public Employees Retirement System (CalPERS) (2004), ‘Alternative Investment Management (AIM) program presentation to the members of the Investment Committee’, 15 March, accessed 29 August 2009 at www.calpers. ca.gov. CalPERS (2006), ‘Corporate governance environmental strategic plan update presented by the Global Equity program to the Members of the Investment Committee’, 13 March, accessed at www.calpers.ca.gov. Derwall, J., N. Guenster, R. Bauer and K. Koedijk (2005), ‘The eco-efficiency premium puzzle’, Financial Analysts Journal, 61 (2), 51–63. DeSimone, L.D. and F. Popoff, with the World Business Council for Sustainable Development (2000), Eco-Efficiency: The Business Link to Sustainable Development, London: MIT Press. The Economist (2008), ‘Corporate citizenship: profiting from a sustainable business’, report by the Economist Intelligence Unit, November. European Sustainable Investment Forum (Eurosif) and Trucost (2009), ‘Eurosif shipping sector report’, February 2009, accessed at www.eurosif.org. Feldman, S.J., P.A. Soyka and P.G. Ameer (1997), ‘Does improving a firm’s environmental management system and environmental performance result in a higher stock price?’, Journal of Investing, 6 (Winter) 87–97. Florida Department of Environmental Protection (2009), ‘ApalachicolaChattahoochee-Flint River System (ACF) Timeline of Action’, accessed 29 March at www.dep.state.fl.us/mainpage/acf/timeline.htm. Green Mountain Coffee Roasters (2008), accessed at www.greenmountaincoffee. com Hart, S. and G. Ahuja (1996), ‘Does it pay to be green? An empirical examination of the relationship between emission reduction and firm performance’, Business Strategy and the Environment, 5, 30–7. The Home Depot, Inc. (2009), ‘Wood purchasing’, accessed 28 March at http:// corporate.homedepot.com/wps/portal/Wood_Purchasing. Innovest and the UK Environment Agency (2004), ‘Corporate environmental governance: a study into the influence of environmental governance and financial performance’, report to the Environment Agency, September. International Federation of Accountants (IFAC) (2009), ‘Sustainability framework: impact on financial statements’, accessed 2 May at http://web.ifac.org/ sustainability-framework/ip-impact-on-financial-statements. International Monetary Fund (IMF) (2007), ‘Biofuel demand pushes up food prices’, research report, IMF Survey Magazine, 17, October accessed at http:// www.imf.org/external/pubs/ft/survey/so/2007/RES1017A.htm. International Panel on Climate Change (IPCC) (2007), Climate Change 2007: Impacts, Adaptation, and Vulnerability, contribution of Working Group II, M.L. Parry, O.F. Canziani, J.P. Palutikof, P.J. van der Linden and C.E. Hanson (eds) to the Third Assessment Report of the Intergovernmental Panel on Climate Change Cambridge: Cambridge University Press. Jones, K. and P.M. Rubin (2001), ‘Effects of harmful environmental events on reputations of firms’, Advances in Financial Economics, 6, 161–82. King, A. and M. Lenox (2001), ‘Does it really pay to be green? An empirical study of firm environmental and financial performance’, Journal of Industrial Ecology, 40, 534–59. Konar, S. and M.A. Cohen (1998), ‘Does the market value environmental performance?’, Review of Economics and Statistics, 83 (2), 281–9.


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Kurtz, L. (2005), ‘Answers to four questions’, Journal of Investing, 14 (3), 125–38. Lyderson, K. (2003), ‘Bottled water blues’, accessed 29 August 2009 at www.alternet.org/story/16044. North Carolina Division of Pollution Prevention and Environmental Assistance (NCDEPPEA), (2009), accessed 29 August 2009 at http://www.p2pays.org/ias/ P2resources.asp. Pacific Institute (2009), ‘Water scarcity and climate change: growing risks for businesses and investors’, February, Boston, MA: Ceres, accessed 29 August 2009 at www.ceres.org Perrot-Maître, D. (2006), ‘The Vittel payments for ecosystem services: a “perfect” PES case?’ International Institute for Environment and Development report G00388, London, UK. Russo, M.V. and P.A. Fouts (1997), ‘A resource-based perspective on corporate social performance and profitability’, Academy of Management Journal, 40, 534–59. Stanwick, P.A. and S.D. Stanwick (1998), ‘The relationship between corporate and social performance, and organizational size, financial performance, and environmental performance: an empirical examination’, Journal of Business Ethics, 17, 195–204. United Nations (2002), General Comment no. 15 by the UN Committee on Economic, Social and Cultural Rights, accessed from http://www2.ohchr.org/ english/ United Nations Environment Programme Financial Initiative (UNEP FI) (2004), ‘Risks of water scarcity. A business case for financial institutions. Preliminary findings’, accessed 26 March 2009 at www.aiccafrica.org/PDF%20files/UNEP %20FI%20–%20SIWI%20Final%20Project%20Summary.pdf. UNEP FI (2004), ‘Risks of water scarcity: a business case for financial institutions’, accessed from http://www.unepfi.org/work_streams/water/water_ scarcity/index.html. U.S. Water News (2007), ‘S.C. worries over water because N.C. cities can drain river’, April 2007, accessed 25 March 2009 at www.uswaternews.com/archives/ arcrights/7s.c.worr4.html. Wal-Mart Stores (2009), ‘Sustainability’, accessed 22 March at http://walmartstores.com/Sustainability/. Webber, M.E. (2008), ‘Energy versus water: solving both crises together’, Scientific American, October 2008, accessed 29 August 2009 at www.scientificamerican. com/article.cfm?id=the-future-of-fuel. World Business Council on Sustainable Development (WBCSD) (2005), ‘Water, energy and climate change. A contribution from the business community’, accessed 29 August 2009 at www.wbcsd.org

5.

Social, ethical, and religious issues

INTRODUCTION Socially responsible investing with social, ethical and religious issues in mind encompasses an even wider spectrum of considerations than environmental issues. Studies have shown that investing behavior is influenced by morality, and not just economic rationality and profit (see Hofmann et al. 2008). SRI is an attempt to harmonize both, leading to common terms like ‘doing well by doing good.’ Unfortunately, for some people the term ‘socially responsible investing’ is still considered to be the same SRI financial products from the early years, when most SRI portfolios were merely mirroring the values and beliefs of specific religious organizations. However, modern-day social investing strategy has evolved, becoming more than just following religious protocols. It has incorporated individual moral and ethical beliefs. Socially responsible investors are now insisting that their investments be a reflection of how they view the world and how they can advance social progress. This change has translated into unique SRIs such as community investing and microloans. However, social considerations have also become risk factors, as we shall discuss later in this chapter. In this chapter, we first provide a brief history of religious-based SRI and its evolution to modern-day SRIs. Then, we discuss common social criteria of SRI, which include religious and human relations practices. We end the chapter with examples of conflict and community relations as considerations for operational, reputational, and regulatory risk in SRI investments. History of SRI SRI strategies are not a new phenomenon and are rooted as far back as some of the oldest religions (see Lane 2005). Since ancient times, Jewish laws have had investing directives based on their values. The Quakers (members of the Religious Society of Friends), based on their beliefs in human equality, social justice, and non-violence, have practiced SRI since the 17th century. As a result, Quakers divested their money from

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companies that profited from slavery. Many within the SRI movement credit the Quakers for being the first to integrate their religious ideals into their investing style. In the 1920s, the Methodist Church in the United Kingdom began screening out the ‘sin’ stocks, such as tobacco, alcohol and gambling, from their portfolio. Investments in these industries did not adhere to their general belief systems (see White 2005). By the 1940s, labor unions and some government organizations began excluding firms charged with unfair labor practices or firms without proper union/worker representation (see Shank et al. 2005). Twenty years later, SRI was adopted in some European countries and the United States was not far behind in the 1960s when unions began voicing their concerns about the decisions made for their pension funds (see White 2005). In the 1970s, investors began excluding the stocks of any firms that had ties to the Vietnam War. This deliberate resolution gave momentum in the 1980s, to divestment in companies that had even the most ephemeral ties with South Africa during the anti-apartheid movement (see Hussein and Omran 2005). A Ralph Nader-sponsored ‘Campaign GM’ was one of the first to convince churches, university endowments and pension funds to become active in issues such as corporate governance, pollution control and automobile safety (see Lamb et al. 1995). Thus, modern-day SRIs have moved far beyond rigid rules of excluding ‘sin’ stocks, but have become a dynamic and fluid investing strategy where portfolios are tailored to individual beliefs and ethics. Creating a SRI portfolio that is true to investors’ ethics and values is difficult, not only in pinpointing the investors’ values, but choosing the right companies to include. For any kind of moral or ethical issue, there are numerous ways to create a portfolio. Moral issues can range from animal rights to predatory lending practices to healthy work environments for employees. To ease this task, managers should understand the impact of the company on all stakeholders within a framework that includes corporate management decisions and social constraints. Constructing a portfolio of this nature goes beyond simple negative screens. Investors with common social considerations have formed networks for greater impact on social progress through their investments. Several religious organizations have joined together in collaborations such as the Interfaith Center on Corporate Responsibility (ICCR), in which they collectively participate in shareholder actions. ICCR is interested in health care, human rights, and other labor issues relating to supply chain, corporate governance, access to capital, militarism and violence in society, and water and food safety and supply. Another group, the Institutional Shareholder Services (ISS) have strong opinions on several fronts, including equal employment opportunities, greater diversity on

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corporate boards, abuses in executive pay, and curtailment of abusive labor practices at home and abroad, and improvement of consumer health and safety records (see Hudson 2006). Some industries have instituted their own industry-wide practices because they have come to realize that the bad practices of some actors can stigmatize the industry as a whole. For example, manufacturers and apparel retailers are careful to implement sound anti-sweatshop labor practices. Some innovative companies have looked at making ‘social profit’ within their overall strategy when making decisions about business operations. They have taken careful steps to ensure that their projects are developed and implemented in a socially responsible manner. For SRI investors, quantifying social factors in investment decisions is very difficult and more nebulous than environmental factors.

SOCIAL CRITERIA In general, the social criteria for SRI investors can be categorized into religious, human rights, and labor relations practices. Religious Practices Religious criteria are solely based on teachings and indoctrinations of religious organizations. For example, Muslims forgo interest-bearing investments and life insurance and Mennonites shy away from military contractors. Catholics do not invest in companies that make contraceptives or perform abortions and Christian Scientists do not invest in forprofit health care (see Lindorf 2007). Ethical considerations run the gamut of everything anyone believes, and as discussed above, can vary greatly among different investors. Although we cannot cover all possible ethical issues, our discussion for the remainder of this chapter will hopefully touch on many of them. Human Rights Practices Social development criteria based on human rights issues focus on whether the companies’ goods and services are being used to violate human rights and whether the company respects the civil, cultural, economic, and social rights in the area of operation. Companies with involvement in countries with human rights issues or with UN sanctions are generally deemed riskier. We discuss community relations with local communities and aboriginal rights in a risk framework later in this chapter.


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Labor Relations Practices One of the most discussed and studied social issues is labor relations. Companies are scrutinized for their labor practices beyond human rights violations (for example, workers forced into compulsory labor and child labor), such as fair living wages, rights to free association and rights to collective bargaining. Socially responsible investors looking at labor criteria can assess the relations along the supply chain, such as requiring their suppliers to follow similar labor guidelines. Investors looking at employee relations focus on issues such as union labor relations, equal opportunity and non-discriminatory treatment in the workplace, and diversity in upper management and board of directors. Gender diversity in executive positions is not only critical for the firm’s reputation, but it also widens the talent pool during recruiting, gives company management different perspectives, and demonstrates a culture of acceptance to the employees. Studies have found that gender equality in the workplace minimizes the risks associated with sexual discrimination (see Eurosif 2006b). For example, as of February 2009 Wal-Mart faced a class action suit for allegedly underpaying 1.6 million women employees since 1998 (see Baue 2004). Socially responsible investors seeking to minimize labor-related risk also look at the health and safety practices for employees such as safety training, protocols, and safe work environments. Poor safety records not only garner bad publicity, but are direct costs. For example, BP’s violations of security codes resulted in a fine payment of $21.4 million after an accident at a refinery in Texas in 2005 (see Eurosif 2006). Socially responsible investors look at the health and lifestyle benefits provided to employees because they attract talent to the company, and also translate into greater overall employee satisfaction, and ultimately result in cost savings and financial profit for the company. There are several ways companies can provide health and lifestyle benefits to their employees beyond basic health insurance. A few examples include gym memberships, mental health benefits, and health programs such as on-site health screening clinics, physical and lifestyle health assessments, and health education for nutrition, stress management, and smoking cessation programs. Parcelforce Worldwide, implemented a health program that resulted in a 33 percent decrease in sickness absence, saving 55 000 sick days and £5 million. Productivity also rose by 12.5 percent and enhanced customer service by 50 percent (see Hanson 2008). A study of 55 companies that implemented similar health wellness programs found that 80 percent of these companies had reduced sickness absences, 32 percent had lowered staff turnover, and 18 percent had increased productivity (see Hanson 2008).

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Investors looking at companies operating in areas of high risk for disease or health issues should be aware of how employee health will affect the overall risk in their portfolio. For example, companies operating in Africa will need to consider the impacts of HIV and AIDS. Nearly 24 million working age (15–64) people were infected with HIV in 2006, and of them, 67 percent live in Africa. By 2020, the projected loss of this labor force will be 86 million people. For a company, HIV/AIDS will be a direct cost in terms of increased health insurance, employment benefits, funeral and pension costs, recruiting and training, decreases in productivity and profitability, increased employee absenteeism, high rates of employee turnover, low employee morale, and potential losses of skills and experience. As such, health considerations are not limited to ‘extras’ like gym memberships, but the effects of disease on long-term business prospects. Companies that have already made innovative progress towards HIV/AIDS risk have instituted an internal policy of stakeholder engagement, de-stigmatization of the disease, implemented prevention education programs, provided treatment and counseling services, created a non-discrimination policy, and worked in partnership with industry and international charters or organizations (see EIRIS 2008). Companies with a positive culture of work/life balance for employees and employee investment have benefited from employee loyalty and reputation. Work/life balance includes such benefits as on-site childcare, flexible work schedules, innovative work programs such as telecommuting and job-sharing, public transportation assistance, and giving employees time off work during the work day to perform volunteer work. Examples of investing in their workers include tuition reimbursements, sabbaticals, and professional development, such as attending conferences, joining professional groups and obtaining additional training. Some companies have innovative programs where employees are encouraged to spend time on pet projects or collaborate with other departments. Studies have found positive correlations between employee satisfaction and shareholder value. Although financial motivation is a big factor in attracting and retaining star employees, non-monetary benefits are also highly valued, like self-esteem and camaraderie. By feeling valued, employees develop emotional ties and loyalty to their employer. This achieves better retention rates and can be a competitive advantage for company if recruiting/hiring/training expenses are decreased. The financial value of investing in employees may not emerge immediately and thus, should be considered a long-term investment. Despite the qualitative assessments on the benefits of employee happiness, it is still a difficult criterion to isolate, and there are still other factors that can contribute to strong stock returns (see Edmans 2007).


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Other Social Criteria Product safety Other social criteria for SRI investors are the impacts on society by a firm’s products or services. Concerns about risks include product safety and negative health effects, such as food contamination, genetically modified foods, food additives, and chemicals used in household goods or in consumer electronic products. These and other similar issues can become risks to investors if there are product recalls and related litigation. Direct costs to the firm can include regulatory fines, out-of-court settlements, and the actual cost of recalling their products. This can have long-term impacts that damage the company’s reputation and brands. In today’s market there is even public outcry directed at food companies with food containing high fat content or trans fats, and as a result, firms can face regulations associated with obesity. For example, the French Minister of Health, Youth and Sports has considered a proposal that would limit or restrict television commercials for certain food products directed at children, in an effort to curb obesity problems (see Eurosif 2008). Another example is public health concerns of bisphenol A, a chemical used in plastics, which have prompted US lawmakers in 2009, to propose a ban on their use in food and drink containers (see Washington Post 2009). Investors will need to consider how this potential regulation would affect companies that manufacture and use this chemical, and how it will affect their investments in the chemical industry.

SOCIAL PROFIT Putting a value on good social performance is difficult, and depending on the metrics used, can even be misleading if attempted. However, socially responsible investors should focus on how these social criteria are reflections of the corporate strategy and a positive sign of management skills. Some companies have developed products specifically with the rural poor in mind to help them lift themselves from endemic poverty. Such products include improved seeds from plants that are hardy and drought-resistant, increasing the chances of successful crops, and subsequently, improving nutrition and battling hunger in cold or dry areas. Pharmaceutical companies are encouraged by the World Health Organization (WHO) to increase their funding on research and development of drugs to combat diseases in developing countries that are largely ignored (such as malaria) and develop vaccines for children. Drug makers can find profits in helping the world’s poor get access to medicine by decreasing their prices so they

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are affordable, promoting generic drugs that are generally cheaper, and producing drugs in children’s dosages (see WHO 2008; Eurosif 2007). Unilever found that their social impact in Indonesia was not limited to just production activities. They found that they could also increase their distribution and retail channels so that they not only purchased goods from small-scale producers, but also sold products to rural, low-income consumers (see WBCSD 2008). By addressing the needs of the poor, not only did they increase their profitability, but contributed to positive social growth. The above examples are just a few case studies of ‘win–win’ investing. Studies have shown that socially responsible investing behavior is not just for positive social development motives, but is a deliberate financial choice by those who view SRI portfolios as better performers than their conventional peers. Studies (for example, Nilsson 2008) indicate that SRI is not considered to be the same as charitable giving, but is a concrete method for long-term financial return. Some critics argue that social investing is not an effective method of social progress. It is questionable whether investors, who pressure corporations to promote social change, actually have significant impact. Social activists successfully pressured institutional investors to divest from companies with operations in South Africa, convinced firms to cease operations in South Africa, and raised awareness to prompt legislation in the US, Canada and Europe. An event study found no evidence that divesture activities had any effect on the valuation of firms and banks doing business in South Africa (see Teoh et al. 1999). Moreover, they did not find devaluation on the financial markets in South Africa. Others have suggested that divestments in companies with operations in South Africa may have actually harmed black workers who needed jobs (see Wright and Ferris 1997). There are mixed results over the effect of South Africa divestment on the value of the firms involved. The study conducted by Teoh et al. (1999) before and after divestment announcements, indicated that there was no effect on the remaining shareholders who were indifferent to the divestment activity. Posnikoff (1997) found significant increases in returns after divestment announcements. A study by Mukherjee et al. (1995) found significant devaluation of stocks in companies that voluntarily left South Africa up to 20 days before the legislative ban, but no significant effects on firms who divested after the ban. Wright and Ferris (1997) found significant negative excess return only on the day of the announcement. The literature seems to indicate that in the case of South Africa divestment, social investors were highly successful with publicizing discontent with the apartheid regime and were effective in influencing the divestment activities of major institutional investors and firms. Investors who were indifferent


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to the divestment activities may have suffered negative returns shortly after divesture. However, once anti-apartheid regulations were in place, firms and investors were not significantly affected either way. The mixed results further indicate that social issues and activist investors, regardless of their efficacy in promoting social change, are considerations when developing a SRI portfolio.

SOCIAL RISKS Social investing takes on more stakeholder involvement than many other types of investments. Taking into account all stakeholders provides more information about the risks involved, and subsequently, can help SRI investors identify the ways to manage these risks. Considering the social impacts of companies can minimize reputational, operational, and regulatory/legal risks. We discuss these three risks within the context of social issues in areas of conflict and in relation to indigenous rights. Social Issues in Areas of Conflict Left disregarded, some social issues can become extremely damaging to a company’s reputation and operations, and can make it highly susceptible to regulatory challenges and legal action. Divestments often occur in countries that have hostile military regimes, have gross human rights violations, and harbor or sponsor terrorists. In the past, managers have been subjected to protests by investors to divest from companies that have ties with countries or areas of conflict (that is, war, genocide, and terrorism). Divestures have been made during the Vietnam War, apartheid in South Africa, Myanmar during the military regime, and most recently, in Sudan because of the Darfur genocide. A study by the IMF found that conflict was a significant cost to firms, and that terrorism was one of the most important factors preventing investment over the short and medium term. Conflicts in an area can spread financial and economic instability throughout the region and affect the world economy (see UNEP FI and IISD 2004). Conflicts occur in areas of inequity, poverty, and environmental stress. Environmental changes (such as severe drought and scarcity of water around agricultural lands) can trigger conflict, especially in areas where there is weak governmental control and accountability, greater access to small arms, and history of inequities between groups (see UNEP FI and IISD 2004). Investors can become involved in areas of conflict if they previously had investments in the firms operating in these areas during

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peaceful times, or more directly, by financing projects that fuel local injustices. For example, there was controversy in the project financing of mineral and oil extraction projects in Papua New Guinea that allowed the government to profit, while the social and environmental costs were borne by the local communities (see McPhail 2000). Being associated with an area of conflict has severe reputational risks to the firm. Investors need to assess how this vulnerability will affect their assets and overall portfolio risk. Requests for divestments can come from investors themselves, however, managers should be aware of public campaigns that bring awareness over specific areas of conflict. For example, a special interest group has launched a website that calls for several mutual fund companies in the US to divest their investments from PetroChina, which has operations in Sudan.1 The reputational risk to companies that operate in conflicted areas is material. In 1998, several churches and human rights NGOs launched a divesture campaign against Talisman Energy, a Canadian company, for their role in Sudan and pushed for the Canadian government to penalize the firm. The campaign was successful, as institutional investors such as the Ontario Teachers’ Pension Plan threatened to sell their shares if the firm continued their involvement in Sudan. In 1999, Talisman Energy lost approximately US$1.8 billion in market value. In 2003, it completely ended its involvement in Sudan by selling its Sudanese holdings.2 Companies with holdings in areas of conflict should be aware of the risks to their operations. Conflict can cause any number of changes in the marketplace, cause great instability in the government, and have severe impacts on the social and economic development of the area. Although some companies have insurance when operating in areas of conflict and can claim force majeure if a project is delayed or not completed, understanding the risks to operations can reduce defaults and unexpected costs. Projects, operations and infrastructure (buildings, equipment, and information technology) can become vulnerable to acts of terrorism and sabotage. Employee safety is also vital, as violent deaths, kidnappings and hostage situations can occur. Investors will assess not only these operational risks, but also how domestic markets might react to products manufactured by these firms and their general societal acceptability (see UNEP FI and IISD 2004). Regulatory and litigation risks associated with firms operating in areas of conflict are also scrutinized by socially responsible investors. Since the attacks in New York City on 11 September 2001, there have been several regulatory trends around the world for increasing transparency in investments and pressure for better corporate governance on companies to justify their activities in areas of conflict. Several countries have required


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full disclosure of payments between extraction companies (such as mining) to the host government. The financial industry has been pressured by governments to monitor money that may be financing terrorism or organized crime. Several multilateral efforts through the UN, EU, the Council of Europe, the Organization of American States, the OECD, and technical bodies such as the Basel Committee on Banking Supervision have implemented standards to support financial transparency (see Guaqueta 2002). Such regulatory action has resulted in information about money directed to areas of conflict. It has been estimated that diasporic Tamil groups raised US$450 million per year in the 1990s to buy weapons for rebel groups. Since 2001, several countries have blocked an estimated US$70 million that were considered to be used for terrorism (see UNEP FI and IISD 2004; Collier et al. 2003). Regulatory risks can occur when special laws are enacted on specific issues. For example, in 2007 the US passed the Sudan Accountability and Divestment Act, which prohibits American companies from operating in Sudan. Several legal actions against parent companies have raised awareness on the litigation risks of operating in areas of conflict. Parent companies are held liable for their actions in other countries. For example, under the US Alien Tort Claims Act, the Presbyterian Church of Sudan sued Talisman Energy, a Canadian company, in a US court, which was unprecedentedly upheld by an American judge. This suit was later dismissed by the US District Court for the Southern District of New York and appealed in the Second Circuit Court of Appeals. Although there has been no claims filed against leading shareholders or insurance providers, there is a trend of liability for environmental damages against commercial financial institutions who have provided the majority of the project financing. Liability risks incurred by lenders has led to more rigorous compliance monitoring of project financing using guidelines such as the Equator Principles. The Equator Principles provides a framework for examining social and environmental issues in project lending and providing signatory banks with greater leverage in the design and execution of the borrower’s project to meet social and environmental standards. Bank signatories who have pledged the Trade Finance Principles code of conduct through the Wolfsberg Group,3 perform customer due diligence in identifying sources of funds, monitoring, and voluntarily reporting potentially illegitimate transactions to authorities to prevent money laundering.4 Individual industries have created their own guidelines to reduce conflict risks in investments, such as the Kimberley Process to eliminate trade in conflict diamonds. Investors looking to benchmark their portfolios have indices such as the FTSE CSAG Terror-free index available (see Barney 2008). Conflict is a source of great risk for companies that operate in areas with

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social issues and, subsequently, the investors who buy their stocks. Firms that have poor management in areas of conflict can signal to portfolio managers a broader problem of poor corporate governance and risk management, leading to uncertainty about future profitability and depressed value of the company in the long term. SRI investors who foresee these risks are prudent to divest their investments, and meaningfully send a message to the company that their business activities in conflicted areas are unsanctioned and offensive. However, as mentioned earlier in this chapter, investors who are indifferent to such social screens and activism and continue to hold shares, still recognize the potential risks to the shares they own and how these risks will impact their overall portfolio. Social Issues in Local Community Relations and Indigenous Rights Investors who invest in companies with operations in countries other than their own, are faced with social risks associated with local community relations and indigenous rights. The UN reports that there are between 300 and 500 million indigenous people residing in over 70 countries with over 5000 languages and cultures (see EIRIS 2007). The International Labour Organization Convention on Indigenous and Tribal People in Independent Countries 1989, No. 169 (ILO 169)5 defines indigenous people as: (a) tribal peoples in independent countries whose social, cultural and economic conditions distinguish them from other sections of the national community, and whose status is regulated wholly or partially by their own customs or traditions or by special laws or regulations; (b) peoples in independent countries who are regarded as indigenous on account of their descent from the populations which inhabited the country, or a geographical region to which the country belongs, at the time of conquest or colonisation or the establishment of present state boundaries and who, irrespective of their legal status, retain some or all of their own social, economic, cultural and political institutions.

ILO 169 has been ratified by Argentina, Bolivia, Brazil, Colombia, Costa Rica, Denmark, Dominican Republic, Ecuador, Fiji, Guatemala, Honduras, Mexico, Nepal, the Netherlands, Norway, Paraguay, Peru, Spain, and Venezuela. There have been many instances all over the world in which indigenous people have clashed with corporations over natural resources. Indigenous people view the land as a vital part of their culture, spirituality, history, social organization, family, food security, economy and health. As a result, investments in the resource extraction industry are vulnerable to risks posed by the local indigenous community.


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Reputational risk to the company and damage to brands can occur if NGOs publicize an event deemed to be a violation to indigenous rights. Although companies are not required to abide by ILO 169, interest groups can publicly denounce the breaching of ILO 169 in countries that have ratified the convention. NGOs that are able to elevate local concerns into the international spotlight can have profound adverse effects on a company. For example, Woodside Petroleum has faced strong opposition to its expansion of liquefied natural gas facilities in the Burrup Peninsula and the islands of the Dampier Archipelago in Australia. This area is culturally important to the Ngarluma Yindjbarndi, Wong-goott-oo and Yaburara Mardudhunera peoples because of the presence of rock art. These ‘petroglyphs’, estimated at 1 million pieces in the area, are determined to be 30 000 years old, and reportedly contains the first ever representation of the human face in history. The Aboriginal peoples along with local and international conservation groups have waged a publicity campaign to save the area from further destruction. Although Woodside Petroleum is not the only company operating in the Burrup Peninsula, nor was it the first in the area, it has been caught in the international spotlight, as NGOs have petitioned that the area meets the criteria to be listed as a UNESCO World Heritage site. The situation at Burrup Peninsula has caused operational risk to Woodside Petroleum, namely, many delays in the expansion of their facilities. Financial analysts projected that there would be considerable and unpredictable costs due to the project delays and between 2006 and 2007, Woodside Petroleum’s share price decreased by 12.5 percent, while a competitor’s increased by 14.5 percent (see Bennetts 2007). In 2008, under the watchful eye of Aboriginal groups, the company moved 170 pieces of petroglyphs with plans to move another 42 pieces. Although the relocation represented less than 0.02 percent of the petroglyphs in the area, it was enough to damage Woodside’s reputation, interrupt operations, and lose shareholder value. Analysts were keenly aware of upcoming litigation risks related to the environmental damages, and possible Aboriginal claims in a class action lawsuit to the Australian Supreme Court (see Bennetts 2007). Poor community relations can cause costly delays to companies, even if they have legal rights to operate in the area. For example, AbitibiBowater Inc., a forest product company, was given license by the Ontario government to log the Grassy Narrows forests until 2023. This area has sustained the Grassy Narrows First Nations people and is considered to be their traditional territory. However, the longest delay in logging operations in Canadian history occurred when the First Nations people blockaded the area between 2002 and 2007. As a result of the protests, the provincial

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government has promised to negotiate with all stakeholders – the logging company, First Nations, and other local communities. This negotiation process was anticipated to take about four years. In 2008, AbitibiBowater withdrew their plans to log the area, citing that four years of negotiation is too long. As a result, the company reported a net loss of $4.32 per share (see Gorrie 2008). Companies that can obtain consent from indigenous populations to operate in their area are viewed as being respectful of human rights and engaging in positive community relations. There are several examples of companies that have pursued positive economic development in indigenous territories. The Wai Wai people in Guyana, with collaboration from the government and American conservation groups have banned mining and logging in their territory of the Amazon, and instead, have developed a market for ecotourism, research and traditional crafts (see EIRIS 2007). Working with indigenous people can provide valuable information such as environmental aspects of the area. The BH Billiton Naonayaotit Traditional Knowledge Project was developed to integrate traditional Aboriginal knowledge with science and engineering studies at a diamond mine in northern Canada. Traditional knowledge from the Inuit, Yellowknives Dene, Chipewyan of Lutsel K’e and the North Slave Métis Alliance were compiled into an atlas and database, as a reference for future land use planning and collaboration with industry (see BH Billiton 2006). As a start, companies can honor indigenous communities by employing them. By having indigenous people working at the firm, the company can find support from the local community, help build social and economic development in the area, and provide company employees with a greater understanding of the indigenous people. There are several guidelines and conventions related to indigenous rights. ILO 169 gives rights to own and control lands, territories and resources, right to self-determination, and right to recognition and protection of social, cultural, religious and spiritual values and practices. The UN Declaration on Rights of Indigenous Peoples emphasizes the rights of indigenous people to determine and develop priorities and strategies for the development or use of their lands, territories and other resources, including the right to require that States obtain their free and informed consent prior to the approval of any project affecting their lands, territories, and other resources. The World Bank provides guidance called ‘Indigenous peoples – Operational Policy/Bank Procedure 4.10’ which outlines policies and procedures for companies to screen for the presence of indigenous people, perform social assessments, consult with affected communities, and disclose information about affected indigenous people on financed projects. The International Finance Corporation has standards that


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require avoidance of adverse impacts, information disclosure, consultation, informed participation, and protection of places with cultural heritage. Several industry groups have their own guidelines. The International Council on Mining and Metals has a position statement on meaningful participation and engagement with indigenous people. The Equator Principles for the financial sector calls for respect and preservation of knowledge and practices of indigenous people and the Forest Stewardship Council has principles that recognize legal and customary rights of indigenous people to own, use and manage their lands, protect their cultural sites and be compensated for the use of indigenous knowledge. Socially responsible investors seeking to invest in companies that are vulnerable to the risks associated with indigenous rights or local community relations should assess several aspects, such as internal policy commitments to indigenous rights, informed consultation and consent for proposed projects and engagement throughout the life of the project, and public support for indigenous rights laws. Companies that provide infrastructure to the community, such as housing, education, water treatment facilities, and training for jobs are taking an additional step to maintain open communication with the community and reduce operational, reputational, and regulatory risks.

CRITICISMS Detractors of socially screened investments have often pointed out that a ‘one-size-fits-all’ fund is impractical for investors who wish to go beyond this traditional negative screening of sin stocks. As mentioned earlier in the chapter, it is difficult to pin down the values of individual investors and analyse companies against all moral metrics. Statman (2007) points out that a tobacco company can still have a stellar corporate governance culture or an alcohol-producing firm can have an excellent reputation with labor relations and gender diversity. Additionally, the rational-decision theorists charge that since investing is rational and selfish, incorporating moral considerations would be inefficient. By this token, sociallyscreened portfolios would be less efficient than conventional portfolios (see Hofmann et al. 2008). Furthermore, some researchers have pointed out that sin stocks are not ethical choices, because some companies still exhibit stellar ethical and social behavior. New Belgium, a beer maker, has been very progressive with environmental and social issues, by using 100 percent wind power and using only a quarter of the water of other beer manufacturers (see de Colle and York 2009). In addition, some have argued that it is impossible

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to measure the social returns on investments, both in monetary terms and relative to other SRI objectives. For example, it is difficult to compare the social benefits of renewable energy against low income housing. Thus, some critics conclude that it is very difficult for fund managers to create the ideal portfolio that will align their clients’ morals and ethics exactly.

CONCLUSION Despite criticisms, socially-screened investments are an attempt to eliminate from the portfolio some of the operational, reputational, and regulatory risks arising from the impact of social issues. As case examples, we examined how social issues from local community relations and operations in areas of conflict can affect investments. Investors scrutinizing the events in countries or areas where business is carried out and assessing how operations can affect local communities, stakeholders, and participants along the value chain, should reduce some of the risks and provide insight into the long-term profitability of the investment. Major divestment campaigns have generated great publicity to social causes in the past. Whether investors are motivated to use their investments to make social statements, or are indifferent to the cause, the reputational, operational, and regulatory risks brought about by social issues have an impact on investment portfolios. Prudent investors looking to reduce their portfolio risk should assess how material social causes will affect their returns.

NOTES 1. 2. 3. 4. 5.

http://www.sudandivestment.org. http://news.bbc.co.uk/1/hi/business/2835713.stm. See Wolfsberg Principles at http://www.wolfsberg-principles.com/. For a discussion of the Equator Principles for financial institutions, see Chapter 6. http://www.ilo.org/ilolex/cgi-lex/convde.pl?C169.

REFERENCES Barney, L. (2008), ‘FTSE launches “terror-free” index’, Investment Management Weekly, 31 March. Baue, W. (2004), ‘Calvert group launches code for corporations to profit by promoting gender equality’, accessed 30 March at www.socialfunds.com/news/ article.cgi/article1454.html.


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Bennetts, S. (2007), ‘The Burrup gets burked’, accessed at http://newmatilda. com/2007/03/14/burrup-gets-burked. BHP Billiton (2006), ‘EKATI integrates traditional knowledge into environmental management’, accessed 29 August 2009 at http://sustainability.bhpbilliton. com/2006/documents/caseStudiesPDFs. British Broadcasting Corporation (2003), ‘Talisman pulls out of Sudan’, accessed 29 August 2009 at //news.bbc.co.uk/1/hi/business/2835713.stm. Collier, P., V.L. Elliott, H. Hegre, A. Hoeffler, M. Reynal-Querol and S. Sambauis (2003), Breaking the Conflict Trap: Civil War and Development Policy, Washington, DC: World Bank and Oxford University Press, p. 146. de Colle, S. and J.G. York (2009), ‘Why wine is not glue? The unresolved problem of negative screening in socially responsible investing’, Journal of Business Ethics, 85, 83–95. Edmans, A. (2007), ‘Does the stock market fully value intangibles? Employee satisfaction and equity prices’, University of Pennsylvania, Wharton School working paper accessed 29 August 2009 at http://papers.ssrn.com/sol3/papers. cfm?abstract_id=985735. Experts in Responsible Investment Solutions (EIRIS) (2007), ‘Indigenous rights, indigenous wrongs: risks for the resource sectors’, SEE Risk Briefing, October. EIRIS (2008), ‘Positive corporate responses to HIV/AIDS: a snapshot of large cap South African companies’, November. European Sustainable Investment Forum (Eurosif) (2006), ‘Accidents are still the “black box” of health issues on the job’, Le Monde, 7 November. Eurosif (2006b), ‘The “glass ceiling” penalizes women in over 1/3rd of companies’, Le Monde, May 10. Eurosif (2007), ‘Pharmaceutical industry confronts disease in developing countries’, Le Monde, 18 December. Eurosif (2008), ‘Obesity, a major road block for the food industry’, Le Monde, 1 April. Gorrie, P. (2008), ‘Protest prompts Abitibi pullout’, accessed 29 August 2009 at http://www.thestar.com/sciencetech/article/437156. Guaqueta, A. (2002), Economic Agendas in Armed Conflict: Defining and Developing the Role of the UN – A Symposium Report, IPA/Fafo, March Published by International Peace Institute accessed 29 August 2009 at www.ipacademy.or/ publication/meeting-notes/detail/189-economic-agendas-in-civil-wars-definingand-developing-the role-of-the-un.html. Hanson, S. (2008), ‘Fit for work’, Director, December, 52–4. Hofmann, E., E. Hoelzl and E. Kirchler (2008), ‘A comparison of models describing the impact of moral decision making on investment decision’, Journal of Business Ethics, 82, 171–87. Hudson. L. (2006), The Social Responsibility of the Investment Profession, Charlottesville, VA: Research Foundation of CFA Institute. Hussein, K. and M. Omran (2005), ‘Ethical investment revisited: evidence from Dow Jones Islamic Indexes’, Journal of Investing, 14 (3), 105–24. International Labour Organization (1989), ‘C169 Indigenous and Tribal People Convention’, accessed 29 August 2009 at http://www.ilo.org/ilolex/cgi-lex/ convde.pl?C169. Lamb, W.B, R.E. Wokutch and R. Kumar (1995), ‘The financial impact of the end to South African sanctions: an event history analysis’, Academy of Management Journal Research Library, 391.

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Lane, M. (2005), Profitable Socially Responsible Investing? An Institutional Investor’s Guide, London: Institutional Investor Books. Lindorff, D. (2007), ‘Investing for good’, Bank Investment Consultant, December. McPhail, K. (2000), ‘How oil, gas and mining projects can contribute to development’, Finance and Development, 37 (4) (December), accessed 29 August at http. imf.org/external/pubs/ft/fandd/2000/12/mcphil.html. Mukherjee, T.K., V.L. Hingorani and S.H. Lee (1995), ‘Stock price reactions to voluntary versus mandatory social actions: the case of South African divesture’, Journal of Business Finance and Accounting, 22 (2), 301–11. Nilsson, J. (2008), ‘Investment with a conscience: examining the impact of prosocial attitudes and perceived financial performance on socially responsible investment behavior’, Journal of Business Ethics, 83, 307–25. Posnikoff, J.F. (1997), ‘Divestment from South Africa: they did well by doing good’, Contemporary Economic Policy, 15, 76–86. Shank, T.M., D.K. Manullang and R.P. Hill (2005), ‘Is it better to be naughty or nice?’, Journal of Investing, 14 (3), 82–7. Statman, M. (2007), ‘Quiet conversations: the expressive nature of socially responsible investors’, Journal of Financial Planning, February, 40–46. Teoh, S.H., I. Welch and C.P. Wazzan (1999), ‘The effect of socially activist investment policies on the financial markets: evidence from the South African boycott’, Journal of Business, 72 (1), 35–89. United Nation Environmental Programme Financial Institute (UNEP FI) and (IISD) International Institute for Sustainable Development (2004), ‘Investing in stability. Conflict risk, environmental challenges and the bottom-line’, accessed August 2009 at www.unepfi.org. Washington Post (2009), ‘No BPA for baby bottles in U.S’, accessed 29 August at www.washingtonpost.com/wp-dyn/content/article/2009/03/05/AR2009030 503285.html White, C.F. (2005), ‘SRI best practices: learning from the Europeans’, Journal of Investing, 14 (3), 88–93. Wolfsberg Principles (2009), accessed 29 August at from http://www.wolfsbergprinciples.com. World Business Council on Sustainable Development (WBCSD) (2008), ‘Social impact beyond the bottom line. Why measuring social impacts make business sense’, published by the WBCSD and accessed 26 August 2009 at www.wbcsd. org. World Health Organization (WHO) (2008), ‘Essential medicines for children’, accessed 29 August 2009 at www.who.int/childmedicines/en/index.html. Wright, P. and S.P. Ferris (1997), ‘Agency conflict and corporate strategy: the effect of divestment on corporate value’, Strategic Management Journal, 18, 77–83.

6.

Corporate governance issues, corporate policy, and corporate social responsibility practices

INTRODUCTION In the previous two chapters, we discussed environmental, social, ethical, and religious issues, and their associated risks to socially responsible investors and all stakeholders. In this chapter, we examine corporate governance issues and risk, and some of the associated factors considered in the investment decision process. Corporate governance information is of importance to investors for their stock analyses, valuation of companies, and risk assessment. Page (2005) argued that society demands good corporate governance in order to create economic value, leading to contention for the primacy of shareholder interests or supremacy of shareholders. Empirical evidence from other studies have shown that corporate governance can create (or destroy1) value and wealth.2 We also examine the issues surrounding corporate governance among the intertwining dimensions in legal, regulatory, institutional, competitive, and ethical frameworks, and the effects on various the stakeholders of the company. We present a conceptual framework for analysing how the competing forces of profit maximization and corporate social performance determine corporate policy (see Hudson 2006). We end this chapter with a discussion of corporate social responsibility reporting and a case example of Emerson Electric Co.

CORPORATE GOVERNANCE Definition For practitioners and academics, corporate governance refers to the rules prescribing how boards of directors and corporate management operate. In general, it refers to the control mechanisms used to reconcile competing interests between company management and shareholders (see Page 107

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2005). However, other definitions of corporate governance also include the degree of control boards have over the company. Shleifer and Vishny (1997) narrowly define corporate governance as ‘the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.’ In contrast, Page (2005) broadly defines it as ‘the legal, contractual, and implicit frameworks that define the exercise of power within a company, that influence decision making, that allow the stakeholders to assume their responsibilities, and that ensure that their rights and privileges are respected.’ We lean towards the broader definition in our discussions because companies operate in a global environment and require interaction with several stakeholders. However, we are also proponents of the view that shareholder interest should reign supreme, as argued by Page (2005). As such, our definition of corporate governance includes the mechanisms of how shareholders delegate their power and authority to the board and corporate managers and how corporate managers allocate the firm’s finite resources (for example, financial, material, and human) to achieve the goal of maximizing profit, to the extent allowable by governing laws and company mandates. In striving for this goal, other stakeholders’ interests are included in the decision-making process. While the statutory authority of the board is relatively broad, empirical evidence indicates that boards play a significant role in only a few corporate decisions (see Hermalin and Weisbach 2003). The most common are those decisions pertaining to the selection, monitoring, and retention (or dismissal) of the CEO (see Weisbach 1988). Although an important decision, it does not appear to be the main corporate governance issue from a macro perspective.3 In the discussions below, we take a macro and systematic approach in analysing the corporate governance issues. Corporate Governance Issues Several corporate governance issues have arisen in the past and have been resolved by the enactment of new legislation and implementation of new rules and regulations (for example, the US Sarbanes–Oxley Act of 2002). Since well-managed companies are expected to be in compliance with the most updated policies, investors should not have to monitor their routine compliance. Instead, investors should focus on governance practices and analyse whether the corporate governance structure is value enhancing (or destroying), even in well-managed companies. Similarly, this is the same valuation analysis and risk management approach that investors should take on environmental and social issues. Corporate governance issues can be analysed within legal, contractual and implicit frameworks.4 Corporate governance issues can include

Corporate governance, policy, and social responsibility

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management discipline, transparency, independence, accountability, responsibility, fairness and social responsibility (see for example, Gill 2001). A corporate governance manual has been published by the CFA Institute, which categorizes corporate governance considerations into issues related to the shareholder rights, board of directors, and corporate management.5 The interactions between these three groups of stakeholders can be grounds of conflicts of interest, resulting in several corporate governance issues. Shareholder Rights As the residual owners of a firm, shareholders have the ultimate underlying power in and reigning rights in public companies. Thus, a company with good corporate governance protects shareholder rights. According to CFA Institute (2005), shareholder rights include: ● ● ●

● ● ● ● ● ● ●

Voting by proxy – shareholders should be able to vote by proxy whether they attend the meetings in person or not; Casting confidential votes and securing confidential vote tabulation; Cumulative voting – shareholders should be able to cast the cumulative number of votes allotted to their shares for one or a limited number of board nominees; Nominating individuals for election to the board; Submitting proposals for consideration at the company’s annual general meeting; Implementing the proposals that shareholders approve without the board and management; Structure of existing or proposed takeover defense; Voting for changing corporate structure and policies that may change the relationship between the shareholders and the company; Equality in shareholder structure; and Opportunity to take legal or seek regulatory action to protect and enforce their ownership rights in the state where the company was domiciled.

The last four issues are related to corporate restructuring and management control, all of which can significantly affect the share price. The following is a case example of corporate structure changes, shareholder structure equality, and subsequently, legal action at Pacific Century CyberWorks Limited. Pacific Century CyberWorks Limited. Pacific Century CyberWorks Limited (PCCW),6 a telecommunications company in Hong Kong, has

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faced significant shareholder rights issues in the last few years. Several attempts have been made by majority shareholders to take PCCW private. In November 2008, minority shareholders again rejected the low offer price for shares in the company, by majority shareholders. When the offer price was increased marginally in February 2009, minority shareholders voted and approved the sale. The result was suspiciously odd. Within one day of the approval, long-time corporate governance activist, David Webb, tipped off a local newspaper and the Securities and Futures Commission (SFC), of evidence that there was an unusual increase in the number of shareholder registrations, just before the privatization vote. The evidence pointed to the possibility that majority shareholders had manipulated the number of voter headcounts by ‘splitting of shares’ to meet the ‘majority of holders’ criteria under the Hong Kong Code for Takeovers and Mergers. Specifically, this Code requires the approval of (1) not less than 75 percent of total minority shares voted in person or proxy (not more than 10 percent of minority shares against it), and (2) by at least 50 percent of shareholders (present in person or proxy) for a privatization offer. By virtue of the latter provision of the Code, all retail investors were given the same weight irrespective of the number of shares they owned. Simply put, by increasing attendees to the required number at the meeting, any vote put forth can be approved. It was subsequently proven in court, that the ‘share splitting’ was instrumental in voting through the privatization offer. The defendants had cleverly executed a plan in which hundreds of people were given a PCCW share with the expectation that they be physically present at the meeting, and vote for privatization. The SFC initiated a fraud investigation that stopped the privatization process going forward. Defendants appealed to the High Court but were denied. The PCCW case reveals how the prevailing loopholes in Hong Kong regulations can be exploited by controlling shareholders, to the detriment of minority shareholders. In this case, a shareholder owning one share was not entitled to one vote. Not only was this the first successful case in Hong Kong where investors sought legal and regulatory action for shareholder rights, but it has also set a precedent for SFC intervention (in its capacity as a market regulator) to safeguard the interest of minority shareholders and strengthen corporate governance in Hong Kong companies. The boards of public companies in Hong Kong are now exposed to the criticisms and pressures of corporate governance activities. The Board of Directors The board of directors (the board) are elected by, and expected to work for, the shareholders. As such, the board should act in the best interest


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of these shareholders. The board selects, monitors, and removes senior management, including the CEO. Board members can be insider directors who are former or current senior management employees, or independent directors with no past relationship with the firm. The recent trend is to elect as many independent directors to the board as possible. Potential corporate issues listed by CFA Institute (2005) involving the board of directors include: ● ●

● ● ●

●

The number of independent board members; The qualifications of the board members and their business relationship with the company – members should have the credentials and skills the board is looking for. The board members should not engage in any business with the company and the company should have a procedure to ensure the transparency of those relationships; Ability to hire independent third-party consultants without budget approval from management; Staggered annual election of board members; Committees for financial reports and executive compensation/ remuneration should comprise of independent board members; preferably the same for the nomination committee, or at least a separate committee for nomination of independent board member; and Separate committees for overseeing management’s activities in areas, such as corporate governance, mergers and acquisitions, legal matters, and risk management.

Corporate Management Corporate management refers to the CEO and other senior corporate officers in the company. Since the board selects the CEO on behalf of the shareholders, the CEO is essentially accountable to the shareholders, not the board. There have been cases when the board mistakenly believes that the CEO is working for them, and correspondingly, the CEO believes he/ she is working for the board. Undoubtedly, in these situations, corporate governance issues arise. Potential corporate management issues discussed in CFA Institute (2005) include: ● ● ●

Adoption of a code of ethics and the company’s commitments to an appropriate ethical framework for their actions; Use of company’s assets for personal use by board members and management; Determination of executive compensation – in the past, executive compensation has been determined by the board (and its committee

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●


on executive compensation). Shareholders seldom voted on it. However, the global financial crisis of 2008 brought this corporate governance issue to the limelight and shareholders demand a ‘say on pay.’7 In good corporate governance, shareholders must approve executive compensation (see Page 2005); and Management of share-repurchase programs and price stabilization efforts.

Executive Compensation and Social Responsibility Executive pay, particularly in the US, has received a great deal of attention and debate in the media and public arena. The two main issues involved are the large compensation paid to the top executives and the corresponding large salary gap between the CEO of a firm and employees. Compensation for corporate leaders The average compensation for chief executives holding the job for at least two years, rose by 5 percent in 2007 to $11.2 million. If new CEOs are included in the sample, that number increases to $11.7 million (see Deutsch 2008). If pay is supposed to be commensurate with performance, it is disturbing to see that not only were top executives overpaid for their work, but also they were paid well even after extremely poor performances. The median value of a CEO severance package was $21 million, with 60 percent in cash.8 An interesting case in point can be illustrated with Northwest Airlines. In the wake of high fuel prices in 2008, over 2500 Northwest Airlines employees lost their jobs (New York Times, 10 July 2008) and the company faced bankruptcy. Delta Airlines proposed an acquisition of Northwest. If the acquisition was completed before the end of the year and if his employment was terminated, the CEO of Northwest was entitled to $18.3 million, including $6.2 million in pension benefits and the value of the restricted stock units outstanding.9 Similarly, an outrageous exit-pay of $23.2 million was awarded to the departing chief executives who had underestimated the effects of the credit crunch, and had driven Fannie Mae and Freddie Mac into failure (Wall Street Journal, 10 September 2008, A5). The last example involves rewards and incentives. In principle, monetary incentives are expected to make intuitive sense. However, extensive disapproval was heard when $4 billion from the Bear Stearns bonus pool was paid to employees for their ‘competent’ risk management in 2006. This was the same competent management that led Bear Stearns to bankruptcy in the following year. Clearly, in executive compensation examples such as this, public outcry and media scrutiny are warranted.


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Internal equity pay A related issue of executive pay is the increasingly wide gap between top executive and employee compensation over time. The disparity can trigger low morale and productivity on some corporate staff, making it more difficult to attract and keep talent within the company. Payouts hit record highs in 2007, despite efforts by corporate directors to stop the overly generous signing bonuses and exit packages. According to the Congressional Research Service, the average pay for CEOs was more than 180 times average worker pay, up from a multiple of 90 in 1994 (see Hymowicz 2008). A study by the Financial Times confirmed the widely-held assumption that, on average and including all compensation, chief executives earn twice as much as their closest lieutenants. That gap has been steadily rising since the 1960s and 1970s, partly due to the recent explosion in options awards for chief executives (Financial Times 2007). Dan Amos, CEO of Aflac, an insurance company, argues that the best way to promote loyalty and teamwork to a company is to link all staff pay to the company’s performance. Aflac has become the first US public company to give investors a vote on top officers’ pay packages. When he took charge many years ago, Amos replaced the company’s traditional Christmas bonus with a profit-sharing plan for all employees, from callcenter personnel to top executives. In 2007, Aflac’s 4500 US employees received an average of 6.7 percent of their annual salaries in bonuses. Amos, who received $4.1 million in salary, bonus and other compensation was granted restricted stock and stock options valued at $8.4 million.10 In November 2006, Jeffrey Immelt, head of General Electric, said that paying chief executives wildly more than their senior managers was bad, opening a fresh debate on a thorny issue of internal pay equity for corporate America. In 2007, Immelt received $3.3 million in basic salary, $5.8 million in bonuses and $396,267 in other compensation, as well as other plan-based awards valued at $4.7 million at their grant date. His compensation was in ‘the two to three times the range’ of GE’s other 25 top executives.11 Smaller, more entrepreneurial companies have pushed internal pay equity further. At Analytical Graphics, a Pennsylvania company that designs software for the aerospace, defense and intelligence industries, employees receive at least 15 percent of compensation in bonuses tied to performance targets. The higher the rank of an executive in the company, the steeper his targets. Analytical Graphics’ top four officers and 12 senior managers receive 100 percent of their bonuses only if the company achieves 110 percent of its growth targets. The company also provides non-financial perks to its 250 employees. Among these include a free gym at headquarters, washers and dryers so employees can do their laundry

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during work hours, and free dinners for anyone who stays late. Such benefits have helped to keep employee turnover at 3 percent to 5 percent annually, compared with the industry average of 21 per cent.

CONCEPTUAL FRAMEWORK FOR CORPORATE SOCIAL PERFORMANCE Theories of Firms In this section we describe how proponents of corporate social performance (or corporate social responsibility) fit within the current conceptual framework of theories of firms. A popular rationale for CSR is the human psychological approach. Human psychology focuses on the ‘feel-good’ aspects of socially responsible investors (stockholders). In addition, this psychological argument has been used to explain reputation building through causal marketing. For example, some companies launch a campaign where they donate a portion of their proceeds to charity. Avon was probably one of the first firms to do this with their breast cancer campaign. The Body Shop and others have also used this tactic to make consumers feel good in that they are helping environmental progress through their buying behavior. This psychological/behavioral approach, based on the utility concept, rationalizes that socially responsible investors are willing to accept a lower return (or forgo a higher return from an alternative investment) because they derive non-financial utility from the investment. However, it is not easy to measure the aggregate utility of a socially responsible investment, as there may be hidden financial costs that are not priced in the market. These hidden costs in SRI pose a challenge to both advocates and critics. SRI advocates are unable to quantify the intangible benefits of doing good. Pundits working in rational economics and efficient market theory believe that ‘doing good’ has a cost in an efficient market and point to evidence that SRI does not outperform the conventional portfolios, or at best, point to the inconclusive evidence (see the discussion in Chapter 3). The behavioral approach involves two different groups of people who interact with each other. The first group are traditional, conventional investors who are indifferent to other people and causes, and are concerned only with making abnormal profits, while the other group are ESG conscious, and pushing for SRI. Costs increase in the long run and corporations playing along as good citizens, attempt to lower their costs. As noted in Chapter 3, Minor (2007) explains theoretically why we should expect a hidden financial cost for SRI. He suggests that the markets may not have fully priced the ESG factors in the valuation. In other words,


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for the time being, companies that invest in CSR activities and socially responsible investors may be paying a price (the cost). Companies and investors, who do not actively incorporate ESG, profit at their expense. As the market evolves and incorporates ESG risks in the valuation, the costs should reflect fully in the price and the discrepancy should disappear. It is being recognized among investment professionals that ESG factors may add a new array of risk factors to the traditional valuation framework. If value maximization as the goal of the firm is subject to debate, maybe the theory of finance needs to be altered in order to explain the increasing popularity of CSR. Under the rational expectation model of traditional finance, stockholders prefer more return than a less and only consider the pecuniary reward in their investments. However, applying the traditional finance model (assuming the mean-variance criterion and rational behavior), does not appear to fully explain the empirical results of CSP. Assuming that firms maximize the market value of their shares, managers should be focusing primarily on the financial performance of their products and services, not on CSP. The current standard model of corporate finance is to use the value maximizing rule, consistent with the free market argument by Friedman (1970). In his 1970 article, Friedman contended that the idea of corporate social responsibility was beyond the interests of the firm and beyond that required by the law. The objective of the firm is well-defined and the firm is to use its resources to increase its profits in light of the rules within the legal system. In this framework, it is difficult for a firm to satisfy stockholders who are strong advocates for CSP. Accordingly, this framework suggests that socially responsible investors can maximize their utility by divesting shares in non-CSP-seeking firms in preference to firms which are more socially responsible. In fact, this is in line with the separation theorem in finance where firms can take the largest net present value (NPV) projects and similarly, investors can trade shares for their greatest utility. The legal theorists, of course, believe corporations are social organizations, which are sanctioned by the state or government to achieve certain social objectives. Thus, the theory of the firm prescribed by the legal theorists is to enforce social norms through corporations, which should behave and act in accordance with the desirable social norms. However, such a view is problematic because a corporation is a private enterprise that is supposed to achieve private gains. If there is a desirable social objective (for example, ending poverty) to be accomplished, the government should set up legislation and laws to achieve these goals and corporations should only concentrate on activities that maximize value for the firm. This division of labor (that is, government sets up the laws and corporations

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comply with the laws) seems to be a more efficient way for firms to comply with the restraints imposed by regulatory agencies. Governments are paying more attention to CSR by corporations because of increasing political pressures from the ‘green movements’ and the ‘Gore effect.’ Thus, if governments believe that CSR is desirable for all society, then it is better for the government to create the laws that will shape corporate activity, rather than asking firms to be more socially responsible. In this way, firms can easily incorporate social policies into their objective function as being a legal-binding, corporate entity. In other words, it might be more efficient for corporations to consider the ESG issues within a specific legal framework and let the market work out the economics. Some companies have undertaken projects to capitalize on the concerns for the environment and social progress. For example, China’s carmakers are embracing next-generation, cleaner-car technology. It is likely that such motives are driven by future profit and pragmatism, suggesting that the future potential market for these products is more important than the current demand. Apparently, SRI concerns are becoming increasingly important. Chery Automobile and Geely are currently developing hybrid, electric, and other alternative-energy vehicles. Shanghai Automotive (SAIC), China’s largest domestic carmaker, plans to produce more than 10 000 hybrid cars a year by 2010, including those made by its joint venture partners. The local industry’s push into greener cars appears to be motivated mostly by China’s preoccupation with energy security and a desire to build a world-class auto industry. Given China’s size and ability to set standards, it is likely that it will dominate the next generation of carmaking, as well as key supplier industries (for example, lithium-ion batteries), even in light of the weak demand in the US and Europe (Financial Times 2008). Thus, companies may take advantage of the opportunities created by the ESG concerns, not necessarily because they believe it is their responsibility to do good, but because there is a business case for doing good. To reconcile the different theories in the literature, we propose a new framework for CSP in the following section that reflects both traditional financial theory and empirical evidence that supports CSP. New Framework of Firms The profit function (P) of a firm can be expressed traditionally as follows: P

= Sales − Cost = PQ − CQ − other expenses

(6.1)


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where P is the price of the product; Q is the output in quantity; and C is the cost per unit. Other expenses include depreciation, financing (interest) expenses, and taxes in the above expression of the profit function. In the traditional economic/financial theory, Q in Equation (6.1) is assumed to be a function of only two parameters, capital (K) and labor (L), which are exogenous. In addition, the traditional finance model provides a framework for analysing firm value, particularly in capital budgeting decisions, by separating the financing expense in Equation (6.1) from the real cash flows of the firm. That is, when evaluating projects, managers do not mix financial variables with real cash flow variables. In this light, the goal of a firm is to maximize profit from real cash flows (excluding financial cash flows or interest expenses). Alternatively the firm maximizes the present value of its future real cash flows, if revenues and costs from production, framed in multi-period terms, are discounted with the firm’s appropriate cost of capital. Thus, managers of the firm should only select project for investment with the highest NPV among mutually exclusive projects. Traditional financial theory imposes two preconditions related to Equation (6.1). First, whatever the quantity the firm produces, say Q, all goods produced can be completely sold in the market.12 Second, under the perfect financial market assumptions of Modigliani and Miller (1958) (no transaction costs, no taxes, atomistic investors, and perfect information), financing decisions are separated from investment decisions. After investments are made by the firm and made fully known to investors, in a perfect market setting, the value of the firm is irrelevant with respect to whether projects are financed through common stocks or bonds. In the above static model, the price of the product is given to us at the certain output, Q at a point in time (in a steady state). However, in reality, firms can constantly shift, upgrade, or change the quality of the product throughout the product life cycle to reflect the changing demand or market conditions. For example, by targeting a higher income group of consumers, the elasticity of the original product may change from its previous elasticity, implying a stronger, and most likely a non-linear relationship between price and output. Alternatively, firms can sell their goods faster in the market by promoting greater consumer awareness through various marketing strategies. Thus, it stands to reason that output Q should be augmented to reflect three variables: capital (K), labor (L) and strategic options (SO). K and L are exogenous variables and SO is an endogenous variable. We can also view SO as an investment by the firm, particularly as real options, to account for flexibility and innovations that add value to the firm. Unfortunately, real options can add negative values to the firm at times if improperly used.

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Suppose that social capital is a strategic option that can be developed between a firm’s managers and the business community. Firms hoping to increase their visibility can either increase or create interlocking board membership or perform socially responsible projects. Studies by Zhang and Fung (2006) and Fung et al. (2007) have shown that developing social capital as a strategic option can increase sales potential and thus higher profits. Whether CSP (as a general strategic option) can translate into higher profits for the firm remains to be confirmed more rigorously in future research. After China’s earthquake on 12 May 2008, the Jiaduobao Group that owns Wang Laoji, a popular herbal tea soft-drink brand, announced that the company would donate 100 million yuan (about US$ 15 million) to the earthquake relief fund, becoming the largest donor to the cause. Chinese consumers were moved by the news and their response to the gesture dramatically increased sales of the Wang Laoji herbal tea drinks, making up the amount they had initially donated, and also garnering valuable brand equity. The inclusion of SO in the production process can better explain the interaction of a firm’s investment and financing decisions, a result different from the finance separation theorem explained earlier. To illustrate this concept – a bank typically acts as broker of funds by setting conduits for corporations to issue commercial papers. The bank also guarantees the credit supply of these short-term financial instruments when they mature. In doing so, banks establish SOs (off-balance sheet commitments), intending to earn a fee (for profit), and at the same time, have already linked their potential funding needed for their investment decisions. In fact, Fung and Mehta (1993) show that diversion of managerial efforts to monitoring debt covenant requirements, can link the investment and financing decisions of a firm. If managers devote their valuable time to financial constraints away from the production process in order to satisfy the constraints of the bond covenants, the results are a violation in the separation of financial and investment decisions. Similarly, costs can also be argued in the same way, as they are closely related to the quality of output controlled by strategic options. For example, when the firm strategically chooses to become an innovation leader by developing new products, or be a cost leader by minimizing costs incurred in the industry, its cost structure will be drastically different from competitors. Thus, this cost is closely linked to the strategic options and consequently, linked to the output. When a firm faces a decision with ESG considerations, it becomes imperative that the firm assess when to invest or when to implement their strategic options. In some instances, it is better for the firm to invoke


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their SOs right away, while other firms may prefer to wait and see, with a delayed response of the real options. With this real options framework, we can explain why some firms invest in corporate social responsibility and others do not. Employees are important inputs (that is, L) to the production function of the products and thus critically important to the firm. The new generation of employees is quite concerned about their firm’s contributions towards society and involvement with social progress. These new entrants to the workforce are well informed and are making an impact on corporate behavior. Managers are faced with the challenge of improving morale in the workplace, and subsequently, increasing productivity in the firm. Investments into the process of winning over this generation of employees are part of the strategic options. This is particularly important when we discuss SRI in a global context, because in effect, we are actually talking about ‘sustainability investing’ which is long-term survival concept that includes proper corporate behaviors.

CORPORATE REPORTING FOR ESG ISSUES Increasing Corporate Non-Financial Reporting The increasing popularity of corporate sustainability or corporate social responsibility reports produced for shareholders and stakeholders by companies is indicative of the importance of good corporate behavior. Increasingly, public companies are providing additional non-financial disclosure about their environmental practices and social performances. Investors use this information to supplement their analysis of financial disclosures. The disclosure of potential risks related to environmental and social practices is not mandatory in most countries. Companies that opt to report their environmental and social sustainability information can do so in any format and can choose any criteria to disclose, compare, and benchmark their activities. The Global Reporting Initiative has provided a ‘Sustainability Reporting Framework’ with ‘Sustainability Reporting Guidelines’ that is the de facto global standard for reporting performances.13 France was the first country to mandate that corporations report their environmental and social performance in their financial reports when they passed the ‘nouvelles régulations économiques’ (new economic regulations) in 2002 (see Lydenberg 2005). These new economic regulations require reporting based on nearly 40 social and environmental indicators,

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including employment diversity, engagement with communities and stakeholders, volunteerism or donations, energy usage, carbon emissions, and responsible procurement policies with suppliers. British corporations are also required to include information about their social and environmental responsibility factors within their operations, along with a financial review in their annual reports to shareholders (see Lydenberg 2005). The London Stock Exchange requires listed companies to adhere to a standardized CSR reporting format, integrated into their financial reporting requirements through the Corporate Responsibility Exchange. This Exchange provides a single point of contact for listed companies to demonstrate compliance with domestic and global codes, and for investors to analyse, benchmark, and compare CSR data. The increase in CSR reporting demonstrates that both corporations and their stakeholders agree that non-financial reporting is essential to fully characterize all risks and wealth creating potential of a firm. Knowledge of environmental and social issues that are being dealt with at the corporate level, along with financial data, encourages a more efficient market and subsequently, more accurate pricings of equities and firm values.14 Emergence of Standards and Guidance Frameworks The emergence of standards and guidance frameworks at both the domestic and international level attests to the growing importance of CSR across the globe. Corporations that subscribe to the rigors of these standards will often voluntarily disclose them in their CSR reports. Pragmatic firms find it advantageous to adhere to a specific code because the guidelines are explicit and often provide explanations of the criteria they can use to measure their performance in ESG arenas. The business case for adopting a standard includes recognition, enhanced reputation, and opportunities to partner with other adhering companies. The International Organization for Standardization (ISO) and the UN Global Compact are two important examples of the many forerunners of CSR reporting frameworks. ISO launched their guidelines for social responsibility, known as the ISO 26000. Although ISO 26000 is not a certification standard, it was developed to encourage voluntary commitment to social responsibility by providing guidance on concepts and methods of evaluation for social factors. The UN Global Compact is a non-regulatory, voluntary, and nonenforceable instrument based on ten principles categorized by human rights, labor standards, environment, and anti-corruption.15 It aims to help companies and organizations find practical solutions for corporate responsibility issues involving multiple stakeholders. Although there is no


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certification, the UN Global Compact Office permits participants to use the Global Compact logo in communications that outline participation in the program. Companies that participate in the Global Compact develop a reputation for demonstrating leadership in their industry by advancing corporate responsibility and by managing risks by taking a proactive stance on critical ESG issues. Financial institutions that provide funding for projects, especially in emerging markets, have adopted the Institutional Equator Principles as a guidance framework to evaluate a corporation’s social and environmental management practices, as well as provide a benchmark for use in the analysis and decision process of funding global projects with capital costs greater than US$10 million. Equator Principles for Financial Institutions (EPFIs)16 adopt the following ten principles to ensure that the projects they finance are developed in a manner that is socially and environmentally responsible. ●

● ●

●

●

● ● ● ● ●

Review and categorize the impacts and risks in accordance with environmental and social screening criteria developed by the International Finance Corporation; Assess the social and environmental impacts and risks; Assess the project with applicable social and environmental standards based on whether or not the project is located in an OECD country; Review the project’s action plan and management system that addresses the impacts, risks, and corrective actions required to comply with the host country’s social and environmental laws and regulations; Determine whether the borrower has consulted and disclosed the project to the local community, government and other stakeholders and adequately addressed their concerns; Determine whether the borrower has a mechanism in place to engage with stakeholder grievances; Check that an independent review was performed to assess compliance to the Equator Principles; Incorporate covenants that are linked to Equator Principles in the financing documentation; Ensure that an independent environmental and social reviewer monitors and reports activities throughout the life of the loan; and Make each EPFI commit to annual disclosures of its Equator Principles implementation processes and experiences.

Projects that do not meet the Equator Principles are not funded by EPFIs. More than 50 major international financial institutions have signed on to the Equator Principles, implying the assurance that many finance projects

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are consistent with the Equator Principles (see Chapter 8 for more details on the financial institutions). Sustainability Reporting in Emerging Markets Global companies realize that a commitment to sustainability reporting can contribute to financial success. Such transparency enables them to reach a broader group of investors and customers, improve brand positioning and develop a leadership position in the marketplace. To measure how firms in developing countries react to the sustainability reporting, the Social Investment Forum17 used five criteria to analyse sustainability disclosure by firms in seven countries. The top four companies by market capitalization from the S&P/IFCI index are selected in three sectors: energy (oil and gas), materials (metals and mining), and telecommunications from Brazil, China, India, Russia, South Africa, South Korea and Taiwan. The following five criteria were used to assess CSR performance: ● ● ● ● ●

Does the company have any public disclosure of sustainability issues? Does the company provide a separate section of its website and/or annual report that addresses sustainability issues? Does the company publish a current and stand-alone sustainability report for the past two years? Does the company refer to the Global Reporting Initial framework for its stand alone report? Does the company provide a report on sustainability goals/ benchmarks?

Table 6.1 shows the summary results of the survey study by the Social Investment Forum. The results indicate that South Africa is the leader among the seven developing economies in satisfying the five criteria used in socially responsible investments. China has the lowest percentage in CSR disclosure, while India garnered low scores for setting goals and benchmarks. Taiwan had the lowest in three areas: Separate CSR section, CSR report, and GRI reference, implying that it has the most room for improvement.

CORPORATE SOCIAL PERFORMANCE POLICY AND PRACTICE Today companies are embracing CSR issues as part of their corporate strategy. There are several examples of this newfound corporate focus.


Table 6.1

Performance of economies against the five disclosure criteria

Criteria

Brazil China India Russia South Africa South Korea Taiwan

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(1)

(2)

(3)

(4)

(5)

%

No.

%

No.

%

No.

%

No.

%

No.

92 75 92 83 100

11/12 9/12 11/12 10/12 8/8

92 75 92 75 100

11/12 9/12 11/12 9/12 8/8

67 42 33 67 100

8/12 5/12 4/12 8/12 8/8

17 17 17 25 88

2/12 2/12 2/12 3/12 7/8

25 33 17 58 88

3/12 3/12 2/12 7/12 7/8

82

9/11

82

9/11

36

4/11

36

4/11

36

4/11

88

7/8

50

4/8

13

1/8

0

0/8

25

2/8

Notes: No. represents the number of positive responses by firms in relation to the total firms in the sample. (1) = CSR disclosure criterion; (2) = Separate CSR Section; (3) = CSR report; (4) = GRI reference; and (5) = Goals and benchmarks. Source:

Social Investment Forum 2008b.

Unveiled in 2006, the United Nations sponsored Principles for Responsible Investment established voluntary ESG guidelines for both retail and institutional PRI investors. The UNPRI has nearly 250 signatories, including CalPERS, CPRT and state pension plans from New York and Illinois. J.P. Morgan Asset Management, ABN AMRO Asset Management and Axa Investment Managers are among the investment managers that have signed up. Total assets of the signatories are about $10 trillion. Meanwhile, the Carbon Disclosure Project, founded in 2000, receives reports from 2400 companies, and the data are passed to institutional investors who have more than $41 trillion in assets. The challenge to disclose carbon emissions will justifiably define SRI as a positive concept that can attract investors rather than simply a vehicle to avoid certain types of investments. The early SRI funds in the 1970s and 1980s were defined by what they would not invest in, such as the standard sin stocks. Today, SRI fund managers are actively seeking and evaluating companies that have corporate policies embracing the ESG principles. SRI funds now screen for companies that have made efforts in the areas of labor rights, human rights, workplace diversity, corporate governance and ethics, environmental, and community efforts. We use the Fortune 500 list and examine how many of them are listed in the KLD Broad Market Social Index, a mutual fund investing only in socially responsible companies. Table 6.2 indicates that only 189 companies out of the Fortune

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Table 6.2

Total number of Fortune 500 companies in KLD Broad Market Social Index (BMSI) as of 31 December 2007

Industry

No. of companies

Air transport Banks Computer technology Drug & grocery store chains Foods Homebuilding Retail Electrical utilities Others

5 11 6 6 6 5 22 9 119

Total

189

500 are listed in the index. The low inclusion rate reflects both industry and individual firm characteristics and attitudes towards ESG. Interestingly, the retail industry appears to be more oriented towards including ESG considerations. Emerson Electric Co. – A Case Study We provide a case study of Emerson Electric Co., a manufacturing and technology company in St Louis, MO, and their current policies and practices related to CSR. Information about the CSR practices was obtained in detail from their corporate website.18 At Emerson, the commitment to social responsibility and environmental protection is integrated into company policies, operations, and strategy. Integrating the protection of the environment within the decision-making process is a requirement for all highranking officials of the company at both the board level and all levels of management. Achieving environmental performance is also linked to managers’ compensation. Emerson’s Corporate Citizenship program is directly linked to its operations and is reflected in its corporate governance policy. The role and responsibility of the Corporate Citizen Program can be summarized in the following categories: ● ● ● ●

Compliance with laws and regulations Identifying the most cost-effective and energy efficient processes Developing new technologies and product solutions Meeting the expectations of shareholders, customers, employees, and the community.


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Emerson’s commitment to the environmental concerns is outlined in 10 basic principles, defining the philosophy and practices that ensure business is conducted in an environmentally responsible manner.19 These principles have been translated into numerous languages and are posted in all of Emerson’s facilities throughout the world. However, the company also actively seeks and implements practices that help eliminate or reduce the use of hazardous materials, minimize waste production, and conserve natural resources, above and beyond compliance with local environmental regulations and laws. Governance and Operating Practices Responsibility for environmental stewardship is instituted at the board level and extends down to every plant. Managers monitor environmental performance and ensure compliance with internal and external standards. In addition, a special committee, the Ethics and Environmental Policy Committee, is set for the policies and proper procedures for employees. The Committee is composed of corporate officers who oversee all of Emerson’s environmental activities. The Audit Committee of the board annually reviews the company’s environmental programs and projects. In addition, the Corporate Environmental Affairs Department is responsible for (1) overseeing the company’s compliance with environmental laws and regulations around the world; (2) conducting employee training; and (3) managing audit programs and environmental projects. The Environmental Affairs Department also serves as a clearinghouse for the divisions, sharing successful environmental case histories from inside and outside the company, relevant materials on environmental issues, and literature on new environmental products and alternative manufacturing processes. Manager Training Programs Annual environmental training programs are conducted for its plant environmental managers, division environmental coordinators and other key personnel worldwide. Each training session takes into account the specific needs of the regions across the global facilities. Each year approximately 400 employees attend the training sessions, held at various locations throughout North America, Europe and Asia. This training program has two primary goals: first, it provides employees with a practical understanding of the requirements of environmental laws and regulations. Second, the program promotes ideas on eco-efficiency such as reducing the generation of waste, enhancing the quality of the

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local environment, and conserving energy. The training conferences cover a broad range of topics such as: ● ● ● ● ●

Emerson’s environmental principles and policies Good environmental management practices Country-specific environmental laws and regulations New developments in global environmental laws Pollution prevention, waste minimization, and energy conservation.

Environmental Audit Program Each year, Emerson requires at least 25 percent of its facilities worldwide to be audited by outside consultants for environmental compliance. Independent audits are required for objectivity and transparency. The purpose of these audits is to evaluate environmental regulatory compliance and the overall environmental management practices of each plant. The audit process also encourages plant environmental managers to look beyond basic compliance and explore new ways and opportunities to implement new programs and productive environmental management practices. Each plant is required to complete a detailed questionnaire provided by the Corporate Environmental Affairs Department and independent audits are also submitted to the Department. The Environmental Affairs Department works with the division president and facility personnel in order to ensure that all audit concerns are satisfactorily addressed. In addition, surprise audits are conducted throughout the year. In any year that a site is not formally audited, the division environmental coordinator visits the plant and completes a checklist to ensure compliance with environmental regulations. Corporate environmental staff oversee this annual process. Emerson and its businesses are actively pursuing a number of initiatives to reduce consumption of energy, minimize pollution including greenhouse gases, and cultivate recycling programs to conserve resources. Some examples of activities during 2006–07 include: (1) a program across the company to evaluate the energy-efficiency practices at different manufacturing facilities and to identify opportunities to improve; (2) testing a number of green or conservation initiatives; (3) upgrading plant systems to reduce energy use; and (4) earning a recycling award for an Emerson plant in Missouri where the parent company is located. The company promotes energy efficiency across the globe. As worldwide use and reliance on telecommunications networks and the Internet grows, data centers are doubling in size every 24 months and servers are becoming more powerful. With the increased size and capacity, more heat


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is generated from servers and requires greater power and cooling needs. One of Emerson’s business units, the Emerson Network Power, provides reliable power and backup power technologies for data centers, is currently partnering with industry leaders such as Intel, Dell, IBM and Sun, to identify solutions to reduce server energy use and increase equipment efficiency.

CONCLUSION In this chapter, we have discussed corporate governance issues that are of importance to socially responsible investors. In particular, we have discussed two cases of corporate governance issues. The first related to the rights of minority shareholders in a market where corporate governance is not scrutinized or enforced. The second case example addresses the pertinent issues of executive compensation. Since corporate governance issues are to be considered among multiple intertwining dimensions involving the legal, regulatory, institutional, competitive, and ethical environments, the external clientele including company’s stakeholders, consumers, creditors, and supplier and internal personnel, such as employees and executives, we present a conceptual framework for analysing how corporate policies and operations are determined in light of the competing forces of profit maximization and corporate social performance. The proposed framework has advantages over the traditional theory which is too simplistic and has left out the strategic option consideration. The new framework for the theory of the firm incorporates real or strategic options in firm decisions, and is able to explain a wide spectrum of firm behavior towards CSR. For example, our real options framework explains how internal structures of firms can be modified and made flexible enough to address corporate governance policy demands from investors. The debate as well as the challenges of corporate social responsibility in firms has become an important and pressing issue. One critical issue for socially responsible investors is identifying the driving force of CSR. Are companies moving towards CSR because there is a business case? Or are they motivated by involved and outspoken investors? The proposed framework is consistent with the concept of value maximization, but is cast within a long-term perspective. Future changes in market expectations and evolution of driving forces may provide an answer. We also review and discuss the reporting of CSR results. Several organizations, such as GRI, UN Global Compact, and PRI provide guidance on incorporating CSR principles into company management and strategy, in project financing and reporting. We discuss trends in current CSR

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practices for firms in the developing world. The results suggest that the standard varies across countries and thus remains a challenge for future growth. Finally, we end this chapter with a case example of Emerson Electric Co., to illustrate how one company faces ESG challenges and implements CSR policies.

NOTES 1. 2. 3.

4. 5. 6. 7.

8. 9. 10. 11. 12. 13.

14. 15. 16. 17. 18.

As in the cases of Enron and Worldcom/MCI. Previous studies that show a strong link between good corporate governance and value creation include Anson et al. (2003) and Anson et al. (2004), Gompers et al. (2003), and Weisbach (1988). This can be considered as a criticism of the boards of directors that delegate too much power and authority to the CEO and shirk their fiduciary duty to shareholders. Finding a CEO who will stay on for quite some time with impressive returns to shareholders does not mean that board members have fulfilled their fiduciary duty. The Enron and Worldcom/MCI corporate scandals are good examples. Other examples include Bear Sterns, Lehman Brothers, Fannie Mae and Freddie Mac, discussed later in this chapter. Page (2005) defines the implicit framework as a complex set of rules, tacit agreements, and vague principles concerning the sharing of various responsibilities among employees or other individuals who interact with the companies. See CFA Institute (2005). Appendix A of The CFA Institute CG Manual lists numerous sources for existing and proposed corporate governance codes and principles in different countries. For full detail of the case, see Fung et al. (2009). CalSTRS, the second largest pension fund in the US, demanded that 300 companies (in which it owns shares) overhaul their executive pay policies and allow shareholders to decide on top management compensation (Brewster 2009). ‘Say-on-pay’ policy is discussed later in this chapter. Based on 2006 proxies of 137 Fortune 200 companies. See Wall Street Journal, 26 September 2008, A4. Northwest common shares were priced at $7.47 on 22 April 2008. See Wall Street Journal, April 30, 2008, p. B2. Wall Street Journal, 28 April, 2008, http://online.wsj.com/article/SB120933662693248 203.html. See Business by S. Manning (2009), http://blog.cleveland.com/business/2009/02/ general_electric_ceo_jeffrey_i.html. This assumes the validity of Say’s Law in economics to the firm, that is, the condition that supply creates its own demand. The Global Reporting Initiative (www.globalreporting.org) is a non-profit organization that brings together multiple stakeholders to facilitate consistent, regular, and comparable sustainability reporting and provides a consensus approach in assessing environmental and social disclosure issues. The GRI reports nearly 1000 organizations in over 60 countries using the Reporting Framework. www.unglobalcompact.org www.equator-principles.com See http://blog.kld.com/category/sustainability-reporting/ www.emerson.com/enUS/about_emerson/company_overview/pages/corporate_citizen ship.aspx

Corporate governance, policy, and social responsibility 19.

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See www.emerson.com/enUS/about_emerson/company_overview/Pages/Emerson per cent27s_Environmental_Principles.aspx

REFERENCES Anson, M., T. White and H. Ho (2003), ‘The shareholder wealth effects of CalPERS’ focus list’, Journal of Applied Corporate Finance, Winter, 102–11. Anson, M., T. White and H. Ho (2004), ‘Good corporate governance works: more evidence from CalPERS’, Journal of Asset Management, 5 (3), February, 149–56. Brewster, D. (2009), ‘CalSTRS calls for “say-on-pay” Policy’, Financial Times, 6 May. CFA Institute (2005), The Corporate Governance of Listed Companies: A Manual for Investors. Charlottesville, VA: Centre for Financial Market Integrity, CFA Institute. Deutsch, C.H. (2008), ‘Executive pay: a special report: a brighter spotlight, yet the pay rises’, Wall Street Journal, 16 April, pp. BU1, accessed at www.nytimes. com/2008/04/06/business/06comp.html. Financial Times (2007), 8 October, accessed at www.ft.com/cs/s/0/9cb/27fe-7538-1/ dc-892d-0000779fdzac.html. Financial Times (2008), 20 April, accessed at www.ft.com/cms/s/0/46a8304a-0efe11dd-9646-0000779fdzac.html. Friedman, M. (1970), ‘The social responsibility of business is to increase its profits’, New York Times Magazine, 13 September, p. 33. Fung, H.G. and D. Mehta (1993), ‘Optimal financial leverage and managerial productivity’, in C.F. Lee (ed.), Advances in Quantitative Analysis of Finance and Accounting, London: JAI Press, 2, pp. 1–18. Fung, H.G., E. Xu and Q.Z. Zhang (2007), ‘On the financial performance of private enterprises in China’, Journal of Developmental Entrepreneurship, 12 (4), 399–414. Fung, H.G., G.Y. Gao and J. Yau (2009), ‘Pacific Century CyberWorks: a road to privatization’, ref. 09/448C, The Asia Case Research Centre, The University of Hong Kong. Gill, A. (2001), ‘Corporate governance in emerging markets – saints and sinners: who’s got religion?’, CLSA Emerging Markets, April accessed at www.clsa.com/ public/services/index.cfm?id=15. Gompers, P.A., J.L. Ishii, and A. Metrick (2003), ‘Corporate governance and equity prices’, Quarterly Journal of Economics, 118 (1), February, 107–55. Hermalin, B.E. (2005), ‘Trends in corporate governance’, Journal of Finance, October, 2351–84. Hermalin, Benjamin E. and M.S. Weisbach (2003), ‘Boards of directors as an endogenously determined institution: a survey of the economic literature’, Economic Policy Review, 9, 7–26. Hudson, J. (2006), The Social Responsibility of the Investment Profession, Charlottesville, VA: Research Foundation of CFA Institute. Hymowitz, C. (2008), ‘Pay gap fuels worker woes’, Wall Street Journal, 28 April, B8.

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Lydenberg, S. (2005), ‘Social and environmental data as new tools’, Journal of Investing, 14 (3), 40–6. Minor, D.B. (2007), ‘Finding the (financial) cost of socially responsible investing’, Journal of Investing, 16 (3), (Fall), 54–70. Modigliani, F. and Miller, M. (1958), ‘The cost of capital, corporation finance and the theory of investment’, American Economic Review, June, 261–97. Page, J.P. (2005), Corporate Governance and Value Creation, Charlottesville, VA: Research Foundation of CFA Institute. Shleifer, A. and R. Vishny (1997), ‘A survey of corporate governance’, Journal of Finance, 52 (2), (June), 737–83. Social Investment Forum (SIF) (2008a), ‘2007 report on socially responsible investing trends in the United States’, accessed at www.socialinvest.org. SIF (2008b), http://blog.kld.com/category/sustainability-reporting. Wall Street Journal (2008), (10 March). Weisbach, M.S. (1988), ‘Outside directors and CEO turnover’, Journal of Financial Economics, 20, 431–460. Zhang, Q.Z. and H.G. Fung (2006), ‘China’s social capital and financial performance of private enterprises’, Journal of Small Business and Enterprise Development, 13 (2), 198–207.

7.

Practice of SRI by institutional investors, non-governmental organizations, and supranational agencies

INTRODUCTION Institutional investors, NGOs, and supranational agencies have been instrumental to the development and promotion of the best practices of SRI. Many of them help corporations comply with CSR objectives and SRI principles in a sustainable way, such that investors may enjoy competitive financial returns in the long run. Institutional investors include many types of organizations that invest for their own account or on behalf of clients and beneficiaries. Institutional investors who invest for their own accounts have slightly different concerns and attitudes towards SRI to individual investors (discussed in previous chapters). Institutional investors, like individual investors, seek competitive investment returns, often with relatively limited interest in sacrificing financial returns for superfluous social benefits. They are motivated more by the financial needs to meet institutional goals (for example, an education endowment to fund operations of an academic institution). Similarly, institutional investors acting as fiduciaries (investing on behalf of others), are required to act in the best interest of their beneficiaries. Determining whether the fiduciary is acting in the best interest of the beneficiaries depends on the purposes and goals of the investment and the legal framework in which the institutional fund operates (see UNEP FI AMWG 2005). Fiduciaries may be subject to legal requirements for seeking competitive returns, as is the case with many US private pension plans governed by the Employee Retirement and Income Security Act (ERISA). Thus, SRI practices by fiduciaries and institutional investors receive a great deal of attention from clients, beneficiaries, regulators, other investors and market participants, because institutional investors, by way of their size and visibility, have enormous clout and impacts on the market. Considerably, this is even truer for institutional investors who are regarded as ‘public,’ such as government employees’ pension funds (for 131

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example, CalPERS in the US), pension funds for employees of particular large industries (for example, Ontario Teachers’ Pension Plan in Canada), and foundations and endowments whose missions and objectives are focused on the welfare of the general public or social progress. Religious organizations, a segment of NGOs, focus their investments based on their missions and values. It is the SRI practices of these institutional investors that will be discussed in this chapter. Despite the relentless efforts by the Asset Management Working Group (AMWG) of UNEP FI in clarifying what pension plan trustees and investment managers can and cannot do with regard to SRI within different legal jurisdictions (see UNEP FI AMWG 2005), there is no consensus that SRI is desirable and that consideration of ESG factors in the investment process is advisable. Haigh and Hazelton (2004) argue that the use of institutional investment as a social policy tool is flawed and that SRI funds serve to legitimize investments in the financial markets. The researchers contend that to genuinely change corporate behavior, shareholder activists and SRI fund managers need to lobby corporations and governments with a unified voice. In contrast, Sethi (2005) argued that the objective of SRI is required for public pension funds because there are no better alternatives. The researcher asserts that the objective of public pension funds is to ensure the long-term survival and growth of the companies in which the funds invest. Thus, companies that do not consider ESG factors pose long-term risk to the firm and ultimately to investors. As such, public pension funds should avoid those companies in the best interest of their beneficiaries. As mentioned in previous chapters and later in this chapter, many companies have embraced or at least started to consider ESG factors in their operations. Likewise, many institutional investors have also incorporated ESG issues in their investment decision-making process, including potential impacts on the financial returns, cost in terms of forgone returns and social progress trade-offs, reliable ESG information reporting by firms, and disclosure compliance. Hence, the practice of SRI by institutional investors pertains to the incorporation of ESG factors in their investment decision, increasing transparency of their SRI policies, compliance reporting and disclosure requirements. These issues will be presented with selected case studies of pension funds from different regions of the world later in this chapter. In this chapter, we discuss the practice of SRI by institutional investors from their viewpoints. Our discussion of NGOs, supranational agencies and research groups focuses on their influence in weaving CSR into the operations at corporations and helping institutional investors incorporate best practices of SRI, particularly in the realm of reporting and disclosure.

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Institutional Investors There are many types of institutional investors. In this chapter, the discussion is confined to pension plans, endowments, foundations, and NGOs (specifically religious organizations). These institutional investors, particularly religious groups and NGOs have been the catalysts for SRI in the US and Europe (see Guay et al. 2004; Kreander et al. 2004; and Sparkes and Cowton 2004). Pension Plans There are two broad types of pension plans – defined benefit plans and defined contribution plans. A defined benefit plan is a pension scheme that specifies the sponsor’s (the employer) benefit obligations, or the retirement payout to plan participants (employees). In contrast, a defined contribution plan is a scheme that specifies the sponsor’s contribution obligations, and the payout to plan participants is dependent on the contribution and investment performance. Conversely, corporate pension plans generally are less amenable to SRI strategies, often paralleling the attitudes of the corporations themselves. However, there is an increasing shift from defined benefit pension plans to defined contribution pension plans in corporations. This trend leads to the increasing possibility of individual employees seeking out SRI options within their defined contribution plans that their employers would not have otherwise considered within a defined benefit plan. Endowments Endowments are established to support the mission of a specific institution or group of institutions, such as academic or cultural institutions, and professional associations. Endowments tend to have high risk tolerances because they have a perpetual time horizon. As such, they tend to be relatively aggressive and are often the first to invest in alternative investments such as private equity and hedge funds (for example, Yale University Endowments). Despite their aggressive investing practices, endowments tend to be cautious of SRI for several reasons. First, investment committees tend to be dominated by traditional investment professionals, and often include the benefactors who donated the money to the endowment. While many of the traditional investment professionals still believe their fiduciary duty is to maximize the financial return and nothing else, the benefactors may have strong influence on the types of investments. Second, for many institutions it is politically simpler to keep the objectives of the institution separate from the endowment investment policy, especially if there are potentially

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controversial investment decisions. As SRI evolves, investment policies that were previously controversial have become mainstream. Among endowments, common SRI policies have included divestment campaigns regarding highly notorious social issues (for example, South African apartheid, tobacco companies, conflicts in Sudan) and development of close ties to communities, encouraging various forms of local community or proactive investing. Foundations Foundations are often created specifically to support social missions without a specific focus on an institution, unlike the endowments discussed above. Foundations typically manage pools of money (the corpus) to support a given mission or a philanthropic purpose. Fiduciaries of foundations, similarly to endowments, have a relatively cautious approach towards SRI strategies, although perspectives on SRI vary by the size, investment philosophy, asset allocation and mission of the foundation. For instance, if both the relative size and the absolute size of the investment pool are large, the endowment has the capability to allocate funds in higher risk-return alternative investments, similar to the approaches of private equity and hedge funds. Ironically, sometimes foundations with large organizational structure appear to be inhibitors of the adoption of SRI strategies, possibly because larger institutions are simply more reluctant to innovate and prefer to implement formal procedures, preserving the status quo. Non-Governmental Organizations Non-governmental organizations are harder to define because of their vast diversity and significant expansion over the past decade.1 NGOs range from local groups (for example, a home-owners association) to international groups (for example, Amnesty International). Their members work together out of a mutual interest towards a common goal. These interests and goals are driven by similar values, religious beliefs or political persuasions. Some NGOs may have shared a common goal with others, but are motivated by different values. For example, the US-based Human Rights Watch aims to protect and promote human rights, acting as a civic society, while the Interfaith Center on Corporate Responsibility, having the same commitment to human rights, is motivated by religious beliefs. Since NGOs have differing ideologies, their focus and outlooks can also differ significantly. Some NGOs focus on issues such as the environment (for example, Greenpeace), sustainable development (for example, the World Business Council for Sustainable Development (WBCSD)),2 and poverty

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alleviation (for example, Oxfam). Other NGOs serve as research organizations that provide intellectual leadership and standards of practice for an industry (for example, the Coalition for Environmentally Responsible Economies (CERES)3); others act as think tanks, using their research to guide policy (for example, United Nations University4). NGOs have brought significant awareness to ESG issues with publications, education, and publicity. In effect, they have become highly influential in changing corporate structures and financial market activity. There are several NGOs composed of a network of institutional investors or include institutional investor memberships. The European Corporate Governance Institute (ECGI) is an international association of academics, legislators and practitioners, with a focus on corporate governance issues and promoting best practices. They have undertaken the primary role of commissioning and disseminating research on corporate governance. Similarly, the International Corporate Governance Network (ICGN) is committed to raising the standards of corporate governance worldwide. The ICGN includes 450 members (mainly institutional investors) from 45 countries, with an estimated $9.5 trillion in AUM (see UNEP FI AMWG 2007). The Interfaith Center on Corporate Responsibility (ICCR) is composed of 275 faith-based institutional investors, including national denominations, religious communities, pension funds, foundations, hospital corporations, economic development funds, asset management companies, colleges, and unions. ICCR and its members have pressed companies to be socially and environmentally responsible for over 35 years. Each year ICCR-member religious institutional investors sponsor over 200 shareholder resolutions on major social and environmental issues. The Investor Network on Climate Risk (INCR) functions as a network of institutional investors and financial institutions, dedicated to the promotion of understanding the financial risks and investment opportunities posed by climate change. INCR includes 70 institutional members with a collective $7 trillion in AUM (see UNEP FI AMWG 2007). Supranational Agency Initiatives Supranational agencies are international organizations with a common goal or interest, and transcend national boundaries. The emergence and involvement of large international agencies promoting ESG initiatives, is indicative of the growing significance of SRI at the supranational level. The UNEP FI is a global partnership between UNEP and the private financial sector. UNEP works closely with 170 financial institutions (signatories of the UNEP FI Statements), and with partner organizations, to develop and

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promote linkages between the environment, sustainability, and financial performance. The AMWG, under UNEP FI, is composed of fund managers from several countries, and works to establish the materiality of ESG issues in institutional portfolio management. Members collaborate to understand the ways that ESG issues can affect investment value, and the evolving techniques for their inclusion in portfolio investment decisionmaking and ownership practices. AMWG works to provide approaches on the inclusion of non-financial information in investment decisions. A report by AMWG concluded that because ESG issues can contribute to shareholder value, non-financial information should be integrated as an important part of fundamental financial analysis (see UNEP FI AMWG 2004). Similarly, the United Nations Global Compact is an initiative to encourage businesses worldwide to adopt sustainable and socially responsible policies, and to report on them. More than 5100 companies from all regions of the world have signed up to advance ten principles in the areas of human rights, labor, environment, and anti-corruption. The Organization for Economic Corporation and Development (OECD), composed of member governments, provides principles of corporate governance, assisting OECD and non-OECD governments in their efforts to evaluate and improve the legal, institutional and regulatory framework for corporate governance and to provide guidance and suggestions for stock exchanges, investors, corporations, and other parties that have a role in the process of developing good corporate governance. The principles focus on publicly-traded companies on issues such as the promotion of transparent and efficient markets, the protection and equitable treatment of shareholder rights, and the timely and accurate disclosure of all material matters regarding corporations. The OECD (2008) also issued the ‘Guidelines for Multinational Enterprises’, a comprehensive document for corporate responsibility, multilaterally agreed by governments. The Guidelines outline the voluntary principles and standards for responsible business conduct for multinational enterprises on issues such as business ethics on employment, human rights, environment, information disclosure, combating bribery, consumer interests, science and technology, competition, and taxation.

PRACTICES Incorporating ESG into Valuation and Investment Process There is a growing view among investment professionals that ESG issues can affect the performance of investment portfolios.5 Investors fulfilling

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their fiduciary (or equivalent) duty arguably need to give appropriate consideration to these issues. It is also arguable that ESG considerations must be integrated into an investment decision where a consensus, expressly or implied, amongst the beneficiaries mandates a particular investment strategy. Furthermore, it is arguable that ESG considerations may be integrated into an investment decision where a decision-maker is required to choose from a number of value-neutral alternatives (see UNEP FI AMWG 2005). The impetus for institutional investors and fiduciaries in incorporating ESG factors into valuation analysis and investment process probably originated from the milestone research project conducted by AMWG in 2003. AMWG identified several social, environmental, and ethical factors (for example, climate change, occupational and public health issues, human labor and political rights, and corporate trust and governance) that significantly affected a company’s competitiveness and reputation in seven industry sectors, and quantified the impact on stock prices. AMWG found that: (1) ESG issues affect long-term shareholder value and may be significant in some cases; (2) due to non-standardized ESG reporting, comparative analysis between companies is difficult; and (3) it is easier to do an analysis if there is clear government policy on ESG issues. The AMWG concludes that because ESG issues can contribute to shareholder value, non-financial information should be integrated as an important part of fundamental financial analysis (see UNEP FI AMWG 2004). There was no guidance framework available to institutional investors to incorporate ESG factors into their investment process until 2006, when the Principles for Responsible Investment (PRI) were developed under the auspices of the United Nations and coordinated by UNEP FI and the UN Global Compact. The PRI was developed with help from experts in the investment industry, intergovernmental and governmental organizations, civil society, and academia.6 PRI signatories are institutional investors, asset owners (for example, pension funds), investment managers (for example, firms retailing financial instruments), or professional service partners (for example, investment researchers and consultants). The PRI reflects the core values of investors with long time horizons and highly diversified portfolios. In parallel to the CSR framework adopted by corporations (discussed in Chapter 6), many institutional investors embraced the PRI. The six Principles are: 1. 2.

Incorporating ESG issues into investment analysis and decisionmaking processes; Being active owners and incorporating ESG issues into their own policies and practices;

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3. 4. 5. 6.


Seeking appropriate disclosures on ESG issues by the entities in which they invest; Promoting acceptance and implementation of the Principles within the investment community; Working together to enhance effectiveness in implementing the Principles; and Reporting of activities and progress by the company towards the Principles.

As with CSR frameworks for corporations, adoption of the PRI is not mandatory. The act of adoption simply demonstrates that signatories recognize and support ESG factors that can lead to positive financial returns in the long run. By committing to the Principles, institutional investors believe that they are meeting their fiduciary duty by acting in the best interests of their beneficiaries. Signatories believe that ESG factors affect companies, industry sectors, geographic regions, asset classes and through time, ESG ultimately affects their portfolio performance. In 2008, only two years after PRI’s launch, more than 360 signatories with AUM of more than US$14 trillion have embraced the PRI. PRI is seen as a method of aligning investment decisions with the concerns of their beneficiaries and simultaneously contributing to the UN’s goal of a stable global economy with social progress and sustainable development.7 For example, the London Pensions Fund Authority has become a signatory to PRI without the concerns of lower returns in the short term, because they believe that incorporating ESG factors into their investment process will turn out a better financial performance in the long run for their pensioners (Financial Times, 6 August 2007) Despite the phenomenal growth in the number of PRI signatories, not all institutional investors have embraced ESG factors in their valuation analysis. For example, a study of pension funds in Spain by Valor and de la Cuesta (2007) revealed that most social and religious groups did not incorporate SRI principles. The researchers found that a large percentage of the religious groups and NGOs did not invest in SRI or ‘ethically’, and of those that did, the invested amount was minimal, averaging just over 10 percent of their investment. The results of this study are not surprising since Spanish non-profit organizations are urged to consider the financial implications of their investments from an economic perspective. Exceptions included three NGOs with development goals that invested all their funds in SRI products. A caveat of the Valor and de la Cuesta (2007) study is that their sample size was small because of the lack of information disclosure. Religious groups in Spain are exempt from disclosing financial information. And although non-profit organizations are not required to

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disclose their investing strategies or policies, they are obliged to present abridged financial statements. Reporting and Disclosure Sustainability Reporting Non-financial sustainability reporting first appeared in the early 1990s. Since then it has spread quickly worldwide mainly amongst large corporations and especially in Europe, the US and Japan (as discussed in Chapter 6). Under the terms ‘sustainability,’ ‘corporate social responsibility,’ ‘corporate citizenship,’ ‘corporate social performance’ and others, corporations disclose non-financial information that integrates their environmental, social and corporate governance performance. The UNEP FI has provided guidelines on sustainability management and reporting (SMR) for financial institutions in developed and emerging markets. SMR provides guidance on full and transparent disclosure for ESG issues (see UNEP FI 2006). SMR is a key differentiating factor between institutions that are leading CSR initiatives and those who are reactive in this complex area. SMR provides a framework for developing products and services, driving revenue growth through early entry into new socio-environmental business opportunities, enhancing reputational advantage in a new and growing market, and by publicizing the institution’s commitment towards sustainability. Not only can SMR be used for building and maintaining the capacity to understand the risks associated with socio-environmental businesses, it can also be used as a risk management tool. In a world with new regulations and growing expectations of social responsibility from financial institutions, SMR assists in appropriately assessing risks within the institution’s overall credit risk analysis and other financial decision-making factors. SMR can improve a financial institution’s access to private and public capital, especially on developing and emerging economies. It can also help institutions satisfy the requirements for listing on a stock exchange. Finally, SMR provides internal benefits such as cost savings and internal efficiency. It is imperative for the financial institutions, working as intermediaries in the emerging economies, to implement SMR since it affects allocation of capital. The GRI developed the Sustainability Reporting Framework (SRF) and the Sustainability Reporting Guidelines to guide corporations on reporting their economic, environmental, and social performance. The core guidelines of the SRF are now in a third-generation evolution of the framework (known as the G3 Guidelines). The SRF also includes Sector Supplements (unique indicators for industry sectors), Protocols (detailed reporting guidance) and National Annexes (unique country-level

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information). To date, more than 1500 companies worldwide have declared their voluntary adoption of the Guidelines. Consequently, the G3 Guidelines have become the de facto global standard for reporting and disclosing their sustainability performance. Use and wide adoption of the GRI framework for sustainability reporting helps investors by having a common benchmark for organizational performance with respect to laws, norms, codes, performance standards and voluntary initiatives, demonstrating firms that have an organizational commitment to sustainable development. It also allows a comparison of firms’ performance over time, as well as between firms. Disclosure According to UNEP FI AMWG (2005), Australia, France, Germany, the UK and Italy have legislations that require investment decision-makers, particularly pension funds, to disclose the extent to which they take ESG considerations into account. Obviously missing from the list of the developed countries are Canada, the US, Japan, and Spain.

CASE STUDIES We now present a summary of four case studies that are included in the UNEP FI AMWG 2007 Report (see Table 7.1). The purpose is to illustrate how leading public pension funds from different countries adopt different approaches to responsible investment practices, even though all agree to the same common principles. The four pension funds were selected among the 15 studied in the UNEP report due to their unique characteristics. The California Public Employees Retirement System (CalPERS) is the largest public pension plan in the US and was one of the earliest institutional shareholder activists. The Government Pension Fund Global (GPFG) of Norway is the largest pension fund in Europe and in the world. The Government Pension Fund (GFP) of Thailand is the only public pension fund from Asia. The Caixa de Previdência dos Funcionários do Banco do Brasil (PREVI) is the pension plan of the employees at the Bank of Brazil and is only allowed to invest in Brazil. We specifically highlight the two areas of interest that we described earlier in this chapter: incorporation of ESG factors into the investment process, and reporting and disclosure. California Public Employees’ Retirement System (CalPERS, US) CalPERS is the largest state-employee pension plan in the US and has played a leadership role in demonstrating how ESG factors can be

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incorporated into pension fund strategies and its impact on the financial performance of SRI. The effort began in 2004 when then state treasurer of California, Philip Angelides proposed that state pension funds adopt his ‘Double Bottom Line’ initiative, espousing a philosophy of profits and social reform. Hence, CalPERS dropped investments in countries that lacked a free press, labor unions, and other hallmarks of democracy. CalPERS, also dumped tobacco stocks and invested in local businesses and real estate.8 It has been reported that these SRI policies have reduced the impressive returns at CalPERS and CalSTRS.9 Specifically, by screening out investments in China, Colombia, and other countries, CalPERS’ portfolio underperformed the emerging market index by 2.6 percent p.a., losing out on $400 million. CalPERS has since repealed this screening policy. CalPERS was not alone in shunning tobacco stocks since pension funds’ holdings in the stocks of tobacco, alcohol, and gambling companies were proportionally smaller than holdings in other sectors in the overall equity market (see Hong and Kacperczyk 2006). Screening out the sin stocks was not without criticism. Munnell (2007) opposed public pensions’ plans to engage in social investing. In addition to presenting the evidence from previous economic studies that shows a lower, sacrificed return from SRIs, she contends that public funds are particularly ill-suited for social investing for three reasons. First, the decision makers, the fund board or the state legislature, and the stakeholders of a public pension fund are one and the same person. The classical principal–agency problem arises. Moreover, the decision makers are making investment decisions that would affect the welfare of future beneficiaries and or taxpayers whom they may not even know. Any losses on the funds have to be made up by future tax-payers or absorbed by future beneficiaries. Second, there are many small public pension funds which do not have the expertise or resources to implement social screens. Third, both the administrative costs of broad-based divestiture and exclusion of a large numbers of companies will lower the returns. CalPERS has also committed to a broad and flexible scope in choosing opportunities with environmental benefits, while diversifying the funds by sector, geography, stage and structure. Its environmentally-focused investment strategy concentrates on technologies that are either more efficient (such as recyclable products or products made with less natural resource damage) or less polluting (such as clean energy) (see Kurtz 2005). CalPERS assigned a separate risk benchmark to these investments to measure the portfolio performance over the long-term horizon by specifically stating that they would expect negative returns in the short term but would increase to ‘attractive’ returns in the long run as the environmental market evolves (see CalPERS 2004). By 2005, CalPERS initiated the

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Norway

2006

1932

US

California Public Employees Retirement System (CalPERS)

Government Pension Fund Global (GPFG)

Year established

Country State pension plan for the state employees of California; largest public pension plan in the US and the third largest in the world Continuation of the Petroleum Fund; Invests to meet public pension expenditure; Largest pension fund in Europe and in the world

Description

Selected public pension fund case studies

Pension fund

Table 7.1 Mandate

$280 billion All outside of Norway; 60% bonds and 40% equities

$230 billion Global equities, global fixed income, real estate and alternative investments

Assets

N/A

1.5 million

Both internal and external

Majority managed by Norges Bank Investment Management(NBIM), a division of the Central Bank of Norway

Membership

Management

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Source:

PREVI

Brazil

1905

Thailand 1997

UNEP FI AMWG (2007)

Government Pension Fund (GPF)

A supplemental defined contribution (DC) plan to the Government’s defined benefit (DB) plan for government officials Employees pension fund of the State-owned Banco do Brasil; Largest pension plan in Latin America $50 billion

$9 billion

Invests only in Brazil: equities, fixed income and real estate

Thai and global fixed income, public equities, property, Thai private equity

97% managed internally

Both internal and external

162 000

1.1 million

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development of a greenhouse gas reporting project that would improve data transparency in the electric power and utilities industry (see CalPERS 2006). In that same year, they signed on to the Carbon Disclosure Project10 and joined the other 154 institutional investors with US$41 trillion AUM.11 Government Pension Fund Global (GPFG, Norway) The management of GPFG assets follows the ethical guidelines established by royal decree in 2004. The ethical guidelines attempt to ensure that the assets generate a sound financial return, contingent with sustainable development. Norges Bank Investment Management (NBIM), a division of the Central Bank of Norway, manages the GPFG and is responsible for the pension funds’ ownership rights. NBIM uses negative screening and exclusion in delineating the investment universe. It screens out companies that produce weapons, violate human rights, do severe environmental damage, engage in gross corruption, and other serious violations of fundamental ethical norms. The NBIM also votes in all shareholder meetings and actively engages companies in discussions of issues that may potentially damage the long-term financial value of the company, issues that contravene the GPFG’s principles, or issues of key concern in relation to OECD and UN guidelines.12 Thus, it is a keen proponent of good corporate governance practices. NBIM encourages companies to refer to the UN Global Compact principles as well as the OECD Guidelines for Multinational Enterprises and the OECD Guidelines for Corporate Governance for guidance on how they can incorporate ethical and environmental considerations into their business activities. It participates in international networks that promote good corporate governance and is a signatory to the UNPRI and ICGN. NBIM reports annually on how ownership rights are exercised and how the aspirations of good corporate governance and sustainability are advanced on behalf on the Government Pension Fund. Government Pension Fund (GPF, Thailand) GPF is one of the largest institutional investors in Thailand and aspires to promote good investment practices in the country. GPF believes that its investment decisions have an impact, not only on share prices but also on corporate and market practices. They view good corporate governance as initiating from their own governance, in companies in which it invests, and in the financial service providers it hires. Thus, GPF sets transparent CSR guidelines for themselves and those who provide financial services. GPF

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commits themselves to the UNEP PRI and seeks companies with good corporate governance practices. GPF uses a negative screen for firms with pollution and environmental problems, firms that breach intellectual property law, and companies that contravene good morals and customs (for example, alcohol consumption is against the values of most Thai people), aggravate social problems, endanger public security, and have questionable accountability. The GPF has developed a corporate governance rating system based on shareholder rights, board quality, accountability, disclosure and transparency, as a way to analyse Thai companies for investment purposes annually. The GPF also assesses the corporate governance practices of its investment managers and custodian banks. It is a signatory to UNPRI. In addition, the GPF has also followed the OECD Guidelines for Multinational Corporations to set up guidelines for issues like environmental disclosure, bribery, and consumer rights. The GPF votes at the general meetings of Thai companies that are held internally and those that are externally managed portfolios. It also engages the companies when it votes against management recommendations. Vote decisions by the GPF are published through the media.13 PREVI (Brazil) PREVI is the employee’s pension fund of the state-owned Banco do Brasil. PREVI administers and controls three different pension plans making them the largest pension fund in Latin America. Because of its sheer size, positioning and history, the PREVI is conscious of its influence in the market and its leadership role to other pension funds in the country. PREVI is allowed to invest only in Brazilian companies because they view these companies as potential agents of change, through which social and environmental issues can be positively addressed and contributions made to the development and sustainable growth of the country as a whole. PREVI considers corporate governance to be a set of practices which are designed to optimize company performance, and among other things, that would lead the company towards sustainable growth and socially responsible behavior. While PREVI emphasizes the need for corporate financial performance, they also try to balance corporate and public interests, minimizing the divergence between private and social returns, and thus, protecting all those with an interest in companies. PREVI applies both a corporate governance policy and a socio-environmental responsibility policy to all investment activities. PREVI’s goal is for ESG issues to be fully integrated into its stock selection process. PREVI votes on shareholder resolutions in accordance with its corporate governance code and

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sends a designated representative to attend board meetings of companies in which it has significant holdings. PREVI is a member of many initiatives, including the Brazilian Association for Pension Funds, the Brazilian Institute for Corporate Governance, ICGN, CDP, and UNPRI.

CONCLUSION Institutional investors (pension plans, endowments, and foundations) incorporate ESG into their investment decisions. Some also play an active role in shareholder activism (for example, CalPERS). NGOS and supranational agencies help promote the consideration of ESG factors in the investment decisions and facilitate the information flows and disclosure among all players in the SRI space. Fiduciaries investing on behalf of others are required to act in the best interest of their beneficiaries. Whether the fiduciary is doing so however, depends on the purpose of the investment and the legal framework in which the pension fund operates. Since there is no consensus that SRI is desirable or whether the consideration of ESG factors in the investment process is advisable, fund trustees interested in SRI need to be prudent in deciding whether they want to test the legal limits of their fiduciary duty. Many companies have embraced or started to consider ESG factors in their operations. Likewise, many institutional investors have started to incorporate the ESG factors in the investment decision-making process as well. ESG issues have potential impact on the financial return, and have costs associated with forgone returns, information reporting, and disclosure compliance. NGOs and research groups have started many initiatives in the reporting and disclosure of sustainability and corporate social responsibility. The increasing information transparency and disclosures has helped drive institutional investors into incorporating ESG factors in their investment decision. Within a context of changing political structures and market activity, NGOs have become significant leading institutions for educating and publishing the ESG issues and their effect on economic development. The influence of NGOs will only continue to grow. Institutional investors have three guidance frameworks with which to incorporate ESG factors in their investment process: PRI, SMR and GRI. PRI provides a framework to incorporate ESG into their decision process. SMR provides guidance on full disclosure and transparent reporting of ESG issues. GRI helps firms report their ESG performance, allowing investors to have benchmarked and comparable non-financial information. Case studies of four public pension funds from the US, Norway, Thailand and Brazil have been included in this chapter to demonstrate the

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different approaches that have been taken to incorporate ESG factors into the investment process, and their process of reporting the information to their stakeholders.

NOTES 1. 2. 3. 4. 5. 6. 7.

8. 9. 10.

11. 12.

13.

For statistics and reasons of the growth of NGOs, see McIntosh and Thomas (2002). The WBCSD is made up of CEOs from 200-plus companies working towards sustainability. CERES is a network of investors and public interest groups. The United Nations University performs research and initiates capacity building to help resolve global issues for the UN and its member states. Academics are more skeptical since results from previous academic studies tend to be mixed and inconclusive. See Chapter 3 for a review of SRI performance. The website is http://www.unpri.org. For example, large pension funds in different countries have signed up to PRI, including the Canada Pension Plan Investment Board and the Caisse de dépôt et placement du Québec of Canada, and the New Zealand Superannuation Fund. For recent phenomenal growth in PRI, see http://www.unpi.org/report08. In October 2000, the board of the CalPERS voted to divest the fund of tobacco stocks. The decision was preceded by a similar decision at the California State Teachers’ Retirement System (CalSTRS), the largest state teacher pension plan in the US. Moreover, CalSTRS has revealed in the 2007 report that its cigarette ban cost them $1 billion in lost gains and expects to review the policy. The CDP is a NGO that provides information about business risks and opportunities to institutional investors regarding the implications for shareholder value and commercial operations presented by climate change and works to create open dialogue between policymakers, corporations, and shareholders. The AUM as of August 2007 (www.cdproject.net). In 2005, it voted on 20 307 resolutions at 2705 general meetings. Shareholders proposals accounted for more than 3 percent of the resolutions on which NBIM voted. NBIM voted in favor of shareholder proposals on topics such as equal voting rights for all shares, splitting the role of CEO and chairman, policies on human rights, to name a few. Its voting decisions are made public as well (UNEP FI AMWG 2007). In 2005, the GPF voted at 84 company meetings, at five of which it voted against employee stock options plans that the Pension Fund deemed not to align employee interests with those of shareholders (UNEP FI AMWG 2007).

REFERENCES California Public Employees’ Retirement System (CalPERS) (2004), ‘Alternative investment management (AIM) Program presentation to the members of the Investment Committee’, 15 March, accessed at www.calpers.ca.gov. CalPERS (2006), ‘Corporate governance environmental strategic plan update presented by the Global Equity program to the members of the Investment Committee’, 13 March 2006, accessed at www.calpers.ca.gov. Financial Times (2007), ‘London Pensions Fund Authority’, 6 August, accessed 18 August 2009 at www.ft.com/home/us.

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Guay, T., P.D. Jonathan and G. Sinclair (2004), ‘Non-governmental organizations, shareholder activism, and socially responsible investments: ethical, strategic, and governance implications’, Journal of Business Ethics, 52 (1), 125–36. Haigh, M. and J. Hazelton (2004), ‘Financial markets: a tool for social responsibility?’, Journal of Business Ethics, 52, 59–71. Hong, H. and M. Kacperczyk (2006), ‘The price of sin: the effects of social norms on markets’, Princeton University working paper. Kreander, N., K. McPhail and D. Molyneaux (2004) ‘God’s fund managers: a critical study of stock market investment practices of the Church of England and UK Methodists’, Accounting, Auditing and Accountability Journal, 17 (3), 408–41. Kurtz, L. (2005), ‘Answers to four questions’, Journal of Investing, 14 (3) (Fall), 125–39. McIntosh, M. and R. Thomas (2002), ‘Corporate citizenship and the evolving relationship between non-governmental organisations and corporations’, report prepared for the British-North American Committee. Munnell, A.H. (2007), ‘Should public pension plans engage in social investing?’, Center for Retirement Research, Boston College, working paper number 7–12, August. Organisation for Economic Co-operation and Development (OECD) (2008), Guidelines for Multinational Enterprises, Paris: OECD, accessed 18 August 2009 at www.oecd.org/dataoecd/56/36/1922428.pdf. Sethi, S.P. (2005), ‘Investing in socially responsible companies is a must for public pension funds – because there is no better alternative’, Journal of Business Ethics, 56, 99–129. Sparkes, R. and C.J. Cowton (2004), ‘The maturing of socially responsible investment: a review of the developing link with corporate social responsibility’, Journal of Business Ethics, 52 (1), 45–57. United Nations Environment Programme Financial Initiative (UNEP FI) (2006), Sustainability Management and Reporting (SMR): Benefits for Financial Institutions in Developing and Emerging Economies, December, Geneva: UNEP Financial Initiative. United Nations Environment Programme Financial Initiative Asset Management Working Group (UNEP FI AMWG) (2004). The Materiality of Social and Corporate Governance Issues to Equity Pricing, June, Geneva: UNEP Finance Initiative, Asset Management Working Group. UNEP FI AMWG (2005), A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment, October, Geneva: UNEP Financial Initiative, Asset Management Working Group. UNEP FI AMWG (2007), Responsible Investment in Focus: How Leading Public Pension Funds are Meeting the Challenge, April, Geneva: UNEP Financial Initiative, Asset Management Working Group. Valor, C. and M. de la Cuesta (2007), ‘An empirical analysis of the demand of Spanish religious groups and charities for socially responsible investments’, Business Ethics: A European Review, 16 (2), 175–90.

8.

Socially responsible investment and global banking

INTRODUCTION Banks financing project loans have been increasingly paying more attention to the environmental and social risks in the projects and the effects on socially responsible investments. Currently the largest social risks to banks are the consumers that have over-extended their mortgage debts, related to the subprime credit crunch crisis starting in 2007. Banks have created an excessive lending crisis, when consumers failed to maintain payments for mortgage and car debts, particularly in the US. The over-exposure of banks to this risk, especially those involved with subprime mortgage lending, has had a substantially adverse effect on their balance sheets. In terms of cross-border lending, global banks face challenges in lending to governments or state-owned companies. Although sovereign loans can be lucrative (often backed by valuable collaterals such as oil revenues), total bank loans can have enormous effects, potentially stabilizing or destabilizing a country. As a result, some global banks (for example, HSBC) have incorporated sustainability considerations into their operations by offering SRI funds with the intention of improving the welfare of the economy. These SRI vehicles invest in companies that attempt to mitigate social problems, such as by providing low-cost housing, developing educational products, or by including companies with best-practice policies against issues such as corruption and child labor. SRI is an attempt to improve social conditions, as well as the economy. Banks have an inherent interest in the sustainability of businesses for two reasons: (1) they expect a decent return on their investment and consider risks associated with ESG issues; and (2) provide financial support to companies with social progress concerns. Risk is a concern to all stakeholders, not just shareholders alone. If an investment by a bank results in a detrimental effect on local populations, the bank can generally be considered responsible, a belief widely held by the public. Interestingly, banks are not typically rewarded for compliance with corporate responsibility, but are often punished by the marketplace if they lack 149

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such protocols and practices. Thus, banks need to incorporate ESG due diligence into their lending policy and practices. Banks are generally considered to be social organizations which are different from profit-seeking corporations. Thus, banks have to perform social functions that are deemed desirable by the public. This view is not unreasonable because banks are given special privileges by the government to be in charge of the credit granting process in the economy. In the recent banking crisis, the government has also stepped in to help banks, for fear of the dire spillover effects on other sectors. However, this perception by the public at large, contrasts sharply to the academic view that banks are similar to public corporations, stressing value-maximizing behavior on behalf of the stockholders. This chapter first discusses the conceptual framework for banks, illustrating the rationale behind their involvement in socially responsible investments. We document the development of project finance in different countries, particularly to the developing countries, where there are environment and social implications. To this effect, microcredit is gaining more importance in recent years. The future effects and issues of microcredit merit more elaboration. Microcredit loans have become a hot topic because they are perceived to be a viable approach in mitigating poverty in poor countries. The chapter also discusses Islamic banking, which is growing in importance in several countries, and the interesting interaction of private banking and Islamic banking.

SRI CONCEPTUAL FRAMEWORK FOR BANKS Branding Issues Historically, the banking business has been battered with negative publicity, so much so, that negative headlines have become commonplace. Thirty years ago, Barclays faced an intense student campaign in the UK against its operations related to apartheid in South Africa. Banking deregulation in Australia in the 1980s led employees at Westpac to stop wearing their uniforms to work. This was a way for them to avoid public criticism over job cuts and branch closures. As a result, Australian banks appear to have become more responsive to stakeholder concerns because of the reputational damage following deregulation (see Financial Times 2006). Banks around the world face a bewildering array of social and ethical challenges that affect their reputation. These challenges range from their involvement with consumer debts, outsourcing jobs, and financing

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projects in areas where there are possible human rights violations. It is only in the past few years that activist groups and NGOs have realized the pivotal role that banks play in supporting businesses and have begun challenging the entire financial sector to improve consultation, disclosure, and management of environmental and social risks. Only recently have investors of SRIs turned their attention on ESG issues and their potential impact on banks’ shareholder value. In 2004, a survey by the UK National Consumer Council found that the public held banks and credit card companies in lower esteem than telephone cold callers and doorstep sellers (see Maitland 2006). This was an obvious indication that banks had a poor public image. In response to the bad reputation, some global banks (for example, HSBC) have begun microfinance projects. Microfinance provides financial services, by way of small loans, to some of the world’s poorest people. It seems clear that banks are expected to respond to social challenges, in order to have the license to operate. Some banks have taken a different approach and focus on brand building. Barclays had a tarnished reputation from their association with apartheid in South Africa and needed to redeem themselves in the public eye. In order to accomplish this goal, Barclays convened a brand and reputation committee, tasked with facilitating brand marketing and sponsorship of initiatives for social progress. The bank has also promoted itself as a supporter of the human rights programs endorsed by the United Nations. At the same time, the bank instituted safeguards and audit policies to ensure that the bank has accomplished its social objectives. The World Bank and several governments have urged banks to oppose or cease funding projects that can potentially violate human rights. There are an increasing number of banks that have committed to undertaking more socially responsible investments. The following are illustrations of banks incorporating ESG issues and commitment to projects with a social progress focus: ●

●

●

Goldman Sachs, Merrill Lynch and HSBC were asked by environmental groups not to underwrite bonds for China’s Development Bank and Export-Import Bank, to finance infrastructure projects (such as the Three Gorges Dam) with severe environmental ramifications;1 The International Finance Corporation (IFC) of the World Bank’s private sector lending arm actively considers human rights, environmental issues, and local community impacts issue in its practices;2 ABN AMRO (the largest Dutch bank) screens countries for human rights violations and corruption practices for their investments;

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ABN AMRO Asset Management began the Indian Sustainable Development Fund, a new emerging markets product that meets global ESG standards, for socially responsive investors.3 Currently, ABN AMRO Asset Management offers 24 country-specific SRI funds with nearly €2 billion in AUM, with plans for more. 27 ministers in the European bloc decided in December 2008 to raise the capital of investment banks by €67 billion to €232 billion to help them fund ‘green technology’ projects (see Barber 2008)

Valuation Framework In Chapter 6, we discuss the importance of strategic options in the valuation of firms. The validity of strategic options can be similarly applied to banks as other business corporations. Strategic options are real options for long-term investments and the SOs in banks are more transparent because of the wider coverage provided by news media. By employing the SOs correctly, banks are able to enhance the franchise value. We discuss a few examples of the possible use of SOs to gain leverage for banks in the current valuation framework. Reputation as a strategic option In the above section, we have discussed the importance of brand equity and reputation to banks. Banks can leverage brand recognition as a strategic option to enhance reputation. In other words, if a bank uses its brand recognition strategically, it adds value to the bank. In contrast, if the bank does not protect its brand or reputation, it damages the franchise value. Banks cannot avoid negative image problems because they are regarded as social organizations with objectives beyond pure profit-making. Thus, banks have to make SO decisions on ways to improve their standing in the business community. For example, banks can opt to work closely with government agencies to tackle social and environment issues through responsible project financing and microcredit loans. Taking advantage of the moral hazard problem as a strategic option Banks can now take advantage of the situation created through the moral hazard problem by shifting excessive bank risks to the government.4 Historically in the US, there was a separation of commercial banks from the investment banks because of the Glass–Steagall Act of 1933. To overcome restrictions, banks created structured investment vehicles (SIVs) and blurred the distinction between investment and commercial banks. SIVs are created by commercial banks to raise funds at low interest rates. The funds are then used to invest in high interest rate instruments such as


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collateralized debt obligations (CDOs) or collateralized mortgage obligations (CMOs). The goal is to increase revenue for the commercial bank. However, increasing risk makes this activity similar to those of investment banks, and thus, blurring the separation of commercial and investments banks in light of US regulations. During the subprime crisis of 2007–8, defaults on CDOs and CMOs caused banks to face unsustainable liquidity requirements. In the end, by virtue of their size, governments bailed out banks because their failure threatened the stability of the entire economy. The evidence of bailout depicts the moral hazard problem, in which risks incurred from banks are transferred to the government. Thus, banks engaging in these activities, including derivative transactions, decrease transparency of bank assets and transactions and increase bank moral hazards. Under perfect market conditions, banks’ functions of accepting deposits and lending deposits as investments can be replicated by other financial institutions, making banks irrelevant to the financial markets. As the market becomes more organized and moves towards less transaction cost, banks will implement policies through strategic options (such as designing complex financial products) to reduce bank transparency in the market for survival purposes. For example, in light of the subprime mortgage credit problem, the world’s top banks are negotiating with governments to implement the ‘fair value’ (historical cost) method for accounting CDOs and CMOs in financial statements in lieu of the mark-to-market rule that reflects market value of these investments. If the mark-to-market rule is adopted, the value of banks will be substantially reduced and more additional bank capital will be required to support the existing bank assets.

PROJECT FINANCE Project financing is a method used by a syndicate of multinational banks to enable lenders to obtain earnings generated from a single project. In addition, project financing is a common method used to raise substantial amounts of money for a project from a group of banks in the global market. Global banks play an important role in financial development through various projects (such as mining and infrastructure construction) throughout the world. Projects at this scale can face enormous environmental and social pressures. The Three Gorges Dam project in China faced several environment and social issues, including the massive forced migration of people to higher lands as a result of flooding and redirection of the river, the loss of habitat to animals in the area, and the loss of historical treasures.

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Global banks play an important role during every phase of the project they finance (see Mehta and Fung 2004). The bank takes an advisory role at the start of the project. Once the special purpose vehicle is formed,5 the bank devises the structure for required financing. During the construction stage, the bank provides the remittance to different parties for the income earned. Finally, after project completion, the bank helps reduce risk, including foreign exchange risk, interest rate risk, and commodity risk for the project company. Thus, by virtue of their involvement in project financing, banks are unable to separate themselves from environmental and social issues facing the project. The International Finance Corporation (IFC), the private-sector lending arm of the World Bank, developed the Equator Principles, a set of guidelines for financial institutions and banks that have project financing activities. The Equator Principles are intended to ensure sustainable development safeguards against undesirable loan practices and policies, and integrates ESG considerations into project financing decisions. The Equator Principles have had tremendous implications for banks financing projects in developing countries. Signatories who adopt the Equator Principles ensure that their project financing activities are done in a socially responsible manner and the projects reflect sound environmental management practices. As a result, potential negative impacts on projectaffected ecosystems and communities are avoided where possible, and if these impacts are unavoidable, they have guidelines for reducing impacts to a minimum level. In addition, the guidelines promote engagement between borrowers and local communities, and facilitate open communication. The Equator Principles are revised regularly to reflect continuing needs and improved practices. Signatories of the Equator Principles are required to promote accountability in their project financing activities, and in turn, promote accountability and reporting of final project results. Banks incorporate different methods of reporting their Equator performance, mostly because some information is considered confidential for the client. To combat this problem, many banks issue sustainability reports. In September 2004, ABN AMRO released its first sustainability report, and quickly established itself as a leader in the Netherlands for sustainability reporting. Banks that have systematically considered environmental and social issues in project financing activities have also effectively incorporated the issues in their other activities, including corporate finance, retail banking, and their internal operations. Many leading international project finance banks have adopted the Equator Principles and endorse SRIs that include human rights issues and green investments. While the banks are responsible for ensuring borrowers


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adhere to sound environmental and social practices during the project, the IFC (a financial arm of the World Bank) has expanded its role as a consultant on socially responsible investments. China, the fastest growing developing country with an average GDP growth rate of 9 percent for the past three decades, has been the subject of environmental concerns in recent years. Recently, China’s environmental agency, the State Environmental Protection Administration (SEPA), has shown commitment to work with the financial sector to institute environmental standards. In an effort to evaluate firms for green credit, SEPA needed an international standard to use as a benchmark. SEPA, working closely with the IFC, introduced the Equator Principles to China (see Sun 2008). As part of their eco-friendly economic policies, China introduced the green loan concept in July 2007. Some facilities were blacklisted from receiving loans because of their poor pollution record. The Industrial and Commercial Bank of China (ICBC) surveyed its 59 000 corporate clients in 2007 to assess their environmental performance. The results indicated that about 78 percent were cleared for green loans of more than 200 million yuan, or about 80 percent of the total loans (see Liu 2008). The China Banking Regulatory Commission has also indicated that there will be a shift in the banking industry’s focus on environmental and social issues as a business risk in the future and that they are willing to join with SEPA in an effort to meet the nation’s energy conservation and environmental protection targets. Banks have taken the initiative to tackle global issues through investment in projects with the potential to advance environmental and social progress. The Bank of America has recently announced a $20 billion initiative to support the growth of environmentally sustainable business projects.6 Citigroup promised to provide $50 billion to environmental projects during the next decade in light of the challenges from climate change (Financial Times 2007) Citigroup will also commit up to $10 billion in planned investment to reduce its own greenhouse gas emissions and has begun to advise their borrowers on how to make their projects more environmentally sustainable and mitigate their risk from future environmental regulation. Citigroup has also made efforts that focus on capitalizing opportunities in areas such as alternative energy, energy efficiency and carbon emissions trading. The bank expects to invest in and to finance more than $30 billion in clean energy and alternative technology over the next 10 years. Moreover, as a signatory, Citigroup has extended the Equator Principles to provide risk assessment to clients in industries that have intensive greenhouse gas emissions.

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MICROFINANCE This practice of lending very small amounts of money to poor entrepreneurs is called ‘microcredit,’ within an industry called ‘microfinance.’ The intent is to lend small amounts of credit to entrepreneurs so that they can start businesses that would alleviate their poverty. Microfinance has been hailed as an invaluable tool to promoting self-sufficiency, stimulate economic activity in some of the world’s poorest communities, and ultimately achieve sustainable economic development – one entrepreneur at a time. Microfinance at the World Bank began in 1990–3 when they began a project aimed at making funds available to cottage enterprises and developing a guarantee system for lending to microenterprises in the Philippines. At that time very few World Bank-supported microlending projects existed. Although microlending was very much needed in the Philippines, the project was fraught with various difficulties. The commercial banks were not interested in lending to the organizations that guarantee loans to microenterprises, while the procedures for establishing these associations were complicated and expensive. Unfortunately, the project did not make extensive use of the existing network of rural banks, focusing only on working through accredited financial institutions. The project also had problems with disseminating information, as many potential borrowers believed the loans included some form of subsidy and thought repayment conditions would be flexible. Even though the project failed, the World Bank learned valuable lessons for the rapidly growing practice of microlending in developing countries, and the advantages of developing informal relationships to implement the program. However, according to a report on the World Bank website, the World Bank has reached more than 6 million of the poor in Bangladesh through microfinance projects worth over US$260 million. Nearly 90 percent of micro-credit borrowers are women. The World Bank reports that microcredit loans have significantly improved the lives of borrowers in the following areas: ● ● ● ● ● ●

Increases in income, often by more than 15 percent, reported by 99 percent of borrowers; Improved quality of life reported by 96 percent of borrowers; More and better food eaten by 99 percent of borrowers; 99 percent of borrowers are clothed better; 86 percent of borrowers live in better housing; 88 percent of borrowers are now able to send children to school.


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Overall, the microcredit program is deemed to be a success by the World Bank. Microfinance by Banks The World Bank is not the only participant in the microfinance industry. Muhammad Yunus, a Bangladeshi banker, economist, and Nobel Peace Prize winner, founded the Grameen Bank in Bangladesh. Grameen Bank is the first microcredit financial institution in the world and simultaneously revolutionized traditional lending practices. Grameen Bank does not focus on large loans to clients with collateral, but instead, seeks out the country’s poorest people, typically women in Bangladesh, and issues them small loans that give them the means to grow crops, make crafts, or start other businesses. These loans can eventually sustain their economic situation, and even pull them from the desperation of poverty. Grameen Bank, is still the best-known operator in the microcredit industry, and has joined forces with Crédit Agricole, to create a €50 million ($76 million) fund that invests in developing and emerging economies. The two banks plan to lend $176 million to individuals in New York who lack bank facilities, following the subprime-mortgage crisis (Wall Street Journal, 6 March 2008). Microfinance by Individual Investors In light of the recent credit crunch, a growing number of individual investors are discovering the financial and psychological rewards of microfinance. Increasingly, individual investors can make microfinance loans themselves through charitable organizations, facilitated by the Internet. While the goal is a charitable one, helping the poor out of poverty, investors have learned that the default rate is low. Nearly 97 percent of the borrowers repay their loans (Becker 2008). Loans typically have a duration of one to four years and have annual returns between 1 percent to 4 percent. A growing number of private banks offer advice to high-net-worth individuals who endeavor to make microloan investments. Internet companies (for example, Kiva), mutual-fund companies (for example, Calvert), financial services organization (for example, TIAA-CREF) and NGOs (for example, Acción) are also enabling individuals to make small loans to the poor. The Calvert Foundation offers a non-rated, securitized note through several organizations – MicroPlace,7 Oikocredit8 and registered brokerdealers. The fund has about $530 million deployed in 410 credit banks and 220 cooperatives that serve as the direct contact to borrowers in poor

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countries. Investments of $1000 for 1 year have a maximum return of 2 percent. Money invested for up to 10 years receives a maximum return of 3 percent, guaranteed by the Calvert Foundation.9 Acción’s Global Bridge Fund allows individual investors to lend money to the funds and earn interest to support small to midsize microfinance institutions. Acción, like Calvert, guarantees the fund, which is not rated by rating agencies for performance and credibility analysis. The minimum investment is $2000 for at least 18 months and interest rates vary from zero to 3 percent for new investments.10 Kiva, a non-profit organization, allows people to lend money through their website.11 Kiva has attracted substantial attention to microfinance in the past two years through public broadcast television programs and web promotions. On the Kiva website, individuals select a specific borrower, contribute $25, and can receive journal updates and track repayments. Once the debts have been repaid, the money can be lent out again or divested from the account. Rating Framework for Microfinance Although microfinance has become a popular capital market industry for investment banks and investors, it still faces obstacles that prevent it from reaching its full potential. Although proposed, there is an absence of a well-defined global framework, including standards and consistent metrics, for mainstream investors to properly assess and compare risks and performances. A transparent and globally-acceptable method for rating microfinance institutions would create a new asset investment class that can include a wider spectrum of investors, instead of a niche group of social investors. Activity in the microfinance sector has been growing in the last few years and has involved increasingly complex deals. The first publicly rated microfinance collateralized debt obligation12 pooled together packages of bonds to raise more than $100 million. This special microcredit deal was rated by Standard and Poor’s (S&P) Rating Services and completed by Blue Orchard, which specialized in the management of microfinance investment funds (Financial Times, 26 June 2007). Subsequently, S&P has proposed recommendations for a rating methodology that can be used to rate 20 microfinance institutions (Business Week, 9 July 2007). Greater accountability and globally acceptable standards can trigger a surge in microfinance-related securitization deals. S&P’s Rating Services expects to rate an additional two to three microfinance CDO transactions and around 25 MFIs in the near future. CDO activities will be increased and were expected to reach $500 million by the end of 2007.


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The Future of Microfinance Although microfinance is socially desirable, there are many issues that are worth noting (see Kota 2007). First, can microfinancing sustain itself financially beyond subsidies? It is likely that banks and other multinational financial institutions will be faced with challenges maintaining financial sustainability for those who are very poor because they entail higher costs and risks. Second, if microfinancing becomes profitable, there will be a shift of focus from the poorest borrowers in most need, to relatively safer customers. In this case, microfinance institutions may evolve into direct competitors to conventional banks. As a result, the social benefits for the poorest may be lost in the search for profitability. At the same time, heavily subsidized MFIs may be crowding out self-sustainable MFIs. Third, the interest rates on microloans can range from 20 percent to 35 percent (inflation-adjusted). MFIs incur significantly higher costs than do commercial banks because of higher lending and administrative costs. For some MFIs, the high interest rates cover the cost of doing business. However, increased competition is the key to driving down interest rates for borrowers over time. Fourth, the challenge of monitoring MFIs is for the industry to establish a good regulatory and legal framework. Some countries, such as Morocco and Kenya, have developed legal frameworks to regulate MFIs. Regulators face two key challenges. They must protect depositors and borrowers, while simultaneously promoting the MFI sector without (1) increasing the costs of MFI supervision and (2) suffocating innovation and competition. Fifth, technology plays an important role in microfinance. ‘Branchless banking’ is very active in the developing countries such as the Philippines, South Africa, and Colombia. MFIs can use point-of-sale devices (for example, the equivalent of an electronic cash register) and mobile phones to connect with the rural poor, licensing local merchants, and shop owners to make cash transactions. To this end, transaction costs will be reduced and MFIs can reach more customers with the technology. Finally, there is potential additional funding for microfinance with the creation of a new financial institution – the ‘social investment bank.’ The UK Treasury is in negotiations with the banking industry, to build a social investment bank using the hundreds of millions of pounds that are unclaimed in British banks (Financial Times, 10 July 2006). Unclaimed funds accounts that have had no activity for over 10 years are considered dormant and possible sources for helping small charities gain access to financing. Hopefully, successful lending to charities would prompt donations from wealthier individuals.

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EXTENDED PRIVATE BANKING SERVICES Today private banking extends beyond advice on tax and legal issues for wealthy individuals, and provides advice on how their donations are being used. Banks function almost as brokers for philanthropic ventures. Donors such as Bill and Melinda Gates, Warren Buffett and other wealthy families and individuals are giving more money away to organizations to achieve more socially desirable outcomes (Financial Times, 10 November 2006). Some high-net-worth individuals do not intend to pass on all their money to their heirs, but intend to maximize the social impact of their donations. At the same time, many wealthy individuals want to establish long-term relationships with their beneficiaries, such as taking a place on the board. These new philanthropists are often former business people, and see the opportunity of utilizing their business skills to develop strategies that will have the same effect as setting up their own companies. As a result, financial institutions are starting to expand their range of services to wealthy people who become more active in philanthropic processes, want to donate their money more efficiently, and provide greater social benefit. There are several examples of these new services. HSBC Private Bank’s Legacy program, teaches the children of high-net-worth clients how to manage their wealth responsibly. The Deutsche Bank’s Wealth With Responsibility program includes a variety of services related to family governance, raising children of wealth, art acquisition, strategic philanthropy, socially responsible investing and grant making. The UBS Philanthropy Services group actively manages donors’ funds and will hold meetings with families and other stakeholders to identify and resolve issues for them. The private banking division of Royal Bank of Scotland in the UK includes philanthropy services to help clients set up appropriate giving vehicles, research causes, selects charities and retrieves feedback on projects. The bank also organizes regular roundtable discussions where clients can meet philanthropy professionals. Pictet & Cie, the Swiss private bank, helps their clients identify appropriate partnerships with NGOs and evaluates these organizations to ensure their proper management. The bank also makes connections between donors, charities and philanthropy professionals. It is apparent that private banking services have been expanding rapidly to satisfy the changing needs of clients. The critical issue for financial institutions is to what extent will they expand their services as brokers, in order to match the need of donors and their potential beneficiaries. Knowing this in advance will help banks shape their services.


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ISLAMIC BANKING Islamic banking is a system of banking or banking activities that are consistent with Islamic law (Sharia) principles. Sharia prohibits usury, the collection and payment of interest, and investing in businesses that are considered unlawful such as selling alcohol, pork, gossip media and pornography (see Lewis and Algaoud 2001). Fueled by oil, Islamic financing has become a global business, flourishing in countries like Dubai, Bahrain and Malaysia, with a total of about $1 trillion invested in Islamic financial assets world-wide – including loans, bonds and other instruments. In recent years, there have been new and expanding developments in Islamic banking across the globe. European Finance House, a unit of Qatar Islamic Bank (QIB), has been awarded a banking license in the UK that enables it to capitalize on the growing demand for Islamic finance for the 14 million Muslims in the European Union (Financial Times, 3 February 2008). Doha-listed QIB has ambitious plans in the UK and Europe and is among the leading shareholders in The Shard (a new commercial property development on the south bank of the Thames near London Bridge). QIB owns 66 percent of European Finance House. Malaysia is the main center for Islamic finance in Asia. Islamic banks or Islamic units of conventional lenders account for 12 percent of total banking assets, and ad campaigns often target other faiths. However, Hong Kong hopes to challenge Malaysia by issuing the first Islamic bonds, (commonly called sukuk) valued at $1 billion 2008 (Financial Times 2008b). Because the profit-sharing mechanism of the bond is subject to tax, the Hong Kong government is working on tax details for bonds buyers. Similarly, Indonesia is also passing legislation bills that enable the government to float sukuk domestically or abroad for infrastructure projects in 2008. Although the market is small in Indonesia, there is potential for massive growth. Indonesia is the world’s most populous Muslim nation, with an estimated 215 million followers of Islam. To tap into this growth, international banks with Islamic franchises like HSBC, Citigroup’s Citibank and Standard Chartered have formed boards of Islamic scholars to ensure their Islamic finance units make investments that follow Koranic precepts. Only 5 percent of total deposits in Indonesia’s banking system are currently held in Islamic accounts. Middle Eastern investors interested in Sharia-compliant products have been allocating more money abroad in recent years. These funds provide an opportunity for mainstream banks with Islamic operations. Islamic products can be highly profitable. They cater to a relatively small niche of clients (because the market is fragmented outside the Middle East)

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allowing better margins than in more traditional areas of investments and finance. Global banks like HSBC have expanded their Islamic finance networks, focusing on the competitiveness of their products compared with conventional bank accounts. The existing market is limited for Muslim investors. There are no conventional savings accounts for Muslim customers because of the constraint with accepting interest. As a result, people with Islamic savings accounts and bonds are paid through a profit-sharing arrangement that bypasses the payment of interest. The development of Islamic banking in South Africa is worth noting. The South African government launched an offshore banking scheme in 1989. There are currently 19 banks on the island of Mauritius (compared to their three domestic banks). Banks in Mauritius include HSBC, Barclays, Deutsche Bank, Standard Bank from South Africa, Investec, and Standard Chartered. Growth of the banking industry is due to a combination of government reforms such as the 2004 Banking Act and removal of the artificial division between domestic and offshore banks. Mauritius’ location enables banks to take advantage of the growing Asian-African business and trade links. South Africa has no capital controls, and their currency is floating and stable. South Africa also has a large number of Double Taxation Avoidance Agreements with several governments. At the end of 2007, loans outside Mauritius were larger than banks lending to the island’s private sector, at MR176 billion ($6.6 billion) against MR134 billion. Foreign assets accounted for almost two-thirds of total assets, a good indication of the extent to which the banks have globalized. Two local banks (Mauritius Commercial Bank and the State Bank of Mauritius) account for 60 percent of the market while the top six have 80 percent of the market share (Financial Times 2008a). The fastest growing sector in Islamic banking is private banking, with the intent to capitalize on the 350 million believers who live in the rapidly expanding economies of India, Indonesia, and Malaysia. The CIMB Private Bank in Malaysia is a pioneer in developing Islamic private banking services, offering high-net-worth individuals with more than 1 million ringgit (about US$ 297 000) a service based on Shariah principles. Surveys by McKinsey suggest that 25 percent of investors in Malaysia, Indonesia, and the Gulf States in the Middle East, are strongly committed to seeking out and using financial services fully compatible with Shariah principles (Financial Times, 22 October 2007). Recent credit problems resulting from the subprime mortgages can potentially affect the Islamic finance in the US. Banks are working on handling foreclosures of real estate properties within a structure that will satisfy Islamic law (Wall Street Journal, 12 December 2007).


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SRI PRACTICE AND REPORTING UNEP Finance Initiative (2006) has proposed a sustainability management and reporting framework that enables financial institutions to identify four ways of implementing the principles of the framework: (1) revenue growth; (2) risk management; (3) access to capital; and (4) cost savings and efficiency. These four ways interact with stakeholders (suppliers, employees, clients and shareholders, advance environmental and social progress, improve relationships amongst stakeholders, and develop new business opportunities. These approaches are intertwined with microfinance and project finance discussed earlier in this chapter. Tables 8.1–8.3, using a different ranking criteria of size (the largest deposits or assets) and types (such as bank holding companies, US insured-chartered commercial banks, or banks and savings institutions), demonstrate that more than half of the banking institutions in the US have committed to SRIs as judged and evaluated by the broad-based SRI selection process in the US. This result also confirms the assertion that US financial institutions are indeed leaders in the practice of SRI, thus serving as a benchmark for other countries. Table 8.1 shows 29 banks out of the top 50 commercial banks and savings institutions in the US that were included in the KLD Broad Market Social Index in 2007.13 These banks represent the most important segment of the banking sector in terms of size and banking business. Similarly, Table 8.2 shows that 36 banks out of the top 50 banks, ranked by asset size, are included in the KLD Broad Market Index, suggesting that larger banks are more likely to engage in ESG issues. Again, the largest 50 banks in size is a proxy for the most important sector of the banking industry. Table 8.3 shows that 35 out of the top 50 insured US-chartered commercial banks are included in the KLD Broad Market Index. The USchartered commercial banks present another, yet different, measure of importance in the banking business.

CONCLUSION We first discussed the conceptual valuation framework for banks, illustrating the importance of the brand name and reputation, particularly as they relate to strategic options. Engagement with ESG issues is a great part of the valuation consideration. We documented and explained the development of project finance and the environmental and social implications of projects. In particular,

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Table 8.1

Twenty-nine out of top 50 commercial banks and savings institutions in the US by total domestic deposits, as of 30 June 2007 (dollars)

Rank Institution name 1 3 4 6 7 8 9 10 11 13 15 16 18 19 20 21

22 23 24 25 26 29

Bank of America, National Association Wachovia Bank, National Association Wells Fargo Bank, National Association Washington Mutual Bank SunTrust Bank US Bank National Association Regions Bank Branch Banking and Trust Company National City Bank World Savings Bank, FSB PNC Bank, National Association Keybank National Association Merrill Lynch Bank US Sovereign Bank Comerica Bank Union Bank of California, National Association Commerce Bank, National Association Capital One Bank Fifth Third Bank LaSalle Bank National Association E*TRADE Bank Manufacturers and Traders Trust Company

State where headquartered

No. of offices

Total deposits

North Carolina

5 728

596 584 899

North Carolina

3 103

314 850 000

South Dakota

3 255

263 664 999

Nevada

2 180

202 706 306

Georgia Ohio

1 747 2 590

114 579 848 113 097 080

Alabama North Carolina

2 087 1 484

88 388 815 83 720 251

Ohio California

1 451 287

82 374 824 73 247 967

Pennsylvania

836

59 188 198

Ohio

965

57 286 597

Utah

3

51 601 084

Pennsylvania Michigan California

745 395 331

49 134 698 41 797 801 40 650 535

Pennsylvania

398

40 126 588

New York Michigan Illinois

356 775 138

38 059 484 37 990 237 34 653 022

Virginia New York

2 673

33 197 825 32 811 138


Table 8.1

165

(continued)

Rank Institution name

State where headquartered

31

New York

9

29 601 000

Wisconsin

321

28 899 307

Ohio Michigan

415 268

27 054 097 23 435 977

Tennessee

259

21 763 800

Louisiana

354

20 567 194

Alabama

321

16 663 063

33 35 40

42 44 48

The Bank of New York M&I Marshall and Ilsley Bank Fifth Third Bank LaSalle Bank Midwest National Association First Tennessee Bank, National Association Capital One, National Association Colonial Bank, National Association

No. of offices

Total deposits

Source: FDIC, Summary of Deposits, Summary Tables, http://www4.fdic.gov/SOD/ sodSumReport.asp?barItem=3&sInfoAsOf=2007

Table 8.2

Thirty-six out of top 50 bank holding companies by total assets

Rank Institution Name 2 4 6 8 9 10 12 13 14 15 16 17 18 19 21

Bank of America Corporation Wachovia Corporation Wells Fargo & Company US Bancorp The Bank of New York Mellon Corporation Sun Trust Banks, Inc. Capital One Financial Corporation National City Corporation State Street Corporation Regions Financial Corporation The PNC Financial Services Group, Inc. BB&T Corporation Fifth Third Bancorp KeyCorp Northern Trust Corporation

Location

Total Assets (12/31/2007)

Charlotte, NC Charlotte, NC San Francisco, CA Minneapolis, MN New York, NY

1 720 688 423 782 896 000 575 442 000 237 615 000 197 839 000

Atlanta, GA Mclean, VA

179 573 933 150 590 369

Cleveland, OH Boston, MA Birmingham, AL Pittsburgh, PA

150 383 641 142 936 851 141 043 932 138 976 249

Winston-Salem, NC Cincinnati, OH Cleveland, OH Chicago, IL

132 617 601 110 961 509 99 567 393 67 611 226

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Table 8.2

(continued)

Rank Institution Name

Location

23 24 26 28 30 31 32

Buffalo, NY Dallas, TX Milwaukee, WI San Francisco, CA Salt Lake City, UT San Juan, PR Memphis, TN

64 875 639 62 756 752 59 857 466 55 727 748 52 947 444 44 411 000 37 017 239

Columbus, GA Westbury, NY

33 018 452 30 599 738

Montgomery, AL Green Bay, WI Tulsa, OK Mayaguez, PR Waterbury, CT San Juan, PR Raleigh, NC Kansas City, MO Wayzata, MN Lancaster, PA Beverly Hills, CA Greenville, SC

25 971 125 21 592 083 20 902 545 18 001 639 17 208 062 17 186 931 16 229 958 16 212 371 16 067 612 15 923 098 15 893 886 13 871 556

33 34 36 37 38 39 40 41 42 43 44 46 47 50

M&T Bank Corporation Comerica Incorporated Marshall & Ilsley Corporation UnionBanCal Corporation Zions Bancorporation Popular, Inc. First Horizon National Corporation Synovus Financial Corp. New York Community Bancorp, Inc. The Colonial BancGroup, Inc. Associated Banc-Corp Bok Financial Corporation W Holding Company, Inc. Webster Financial Corporation First BanCorp First Citizens BancShares, Inc. Commerce Bancshares, Inc. TCF Financial Corporation Fulton Financial Corporation City National corporation The South Financial Group

Total Assets (12/31/2007)

Source: National Information Center http://www.ffiec.gov/nicpubweb/Content/HELP/HelpAboutNIC.htm

guidelines have been proposed by World Bank and other agencies for financial institutions to integrate ESG into their guidance. The banking business of microcredit loans has become important and popular in recent years. Microcredit loans can be an effective way to reduce poverty and promote economic growth in poor countries. We also discussed the growing importance of Islamic banking, particularly in South and South-east Asian countries where Islam is dominant. The interaction of private banking and Islamic banking is an interesting and fascinating phenomenon that deserves closer examination in future research.


Table 8.3

Thirty-five out of top 50 insured US-chartered commercial banks by consolidated assets as of 31 December 2007

National Bank name/holding rank company name 2 4 5 6 8 9 10 11 12 14 15 16 17 18 21 22 23 25 26 27 29 30 32 35 36

167

Bank of America NA/Bank of America Corp Wachovia Bank NA/Wachovia Corp Wells Fargo Bank NA/Wells Fargo & Co US Bank NA/US BC Suntrust Bank/Suntrust Bank Fia Card SVC NA/Bank of America Corp National City Bank/National City Corp Regions Bank/Regions FC State Street B&TC/State Street Corp Branch Bank G&TC/BB&T Corp PNC Bank NA/PNC FNCL SVC Group Bank of NY/Bank of NY Mellon Corp Capital One NA/Capital One FC Keybank NA/Keycorp Lasalle Bank NA/Bank of America Corp Manufacturers & Traders TC/M&T Bank Corp Comerica Bank/Comerica Fifth Third Bank/Fifth Third BC Northern TC/Northern TR Corp Union Bank of CA NA/ Unionbancal Corp M&I Marshall & Ilsley Bank/ Marshall & Ilsley Corp Fifth Third Bank/Fifth Third BC Commerce Bank NA/Commerce BC Mellon Bank NA/Bank of NY Mellon Corp Lasalle Bank Midwest NA/Bank of America Corp

Bank location

Consol assets (million $)

Charlotte, NC

1 312 794

Charlotte, NC

653 269

Sioux Falls, SD

467 861

Cincinnati, OH Atlanta, GA Wilmington, DE

232 760 175 108 161 692

Cleveland, OH

138 755

Birmingham, AL Boston, MA

137 050 134 002

Winston-Salem, NC Pittsburgh, PA

127 698 124 782

New York, NY

115 672

Mclean, VA Cleveland, OH Chicago, IL

97 518 95 862 74 424

Buffalo, NY

64 073

Dallas, TX Cincinnati, OH Chicago, IL San Francisco, CA

62 539 61 463 58 398 55 157

Milwaukee, WI

53 721

Grand Rapids, MI Philadelphia, PA

53 431 45 217

Pittsburgh, PA

39 674

Troy, MI

36 922

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Table 8.3

(continued)

National Bank name/holding rank company name

Bank location

37

Memphis, TN

36 726

Providence, RI

35 705

Glen Allen, VA Faribault, MN

33 884 30 108

Montgomery, AL

25 937

Green Bay, WI

21 336

Salt Lake City, UT San Francisco, CA

18 454 17 964

Waterbury, CT

17 064

Wayzata, MN

16 041

38 40 42 44 45 46 48 49 50

First Tennessee Bank NA Mmphs/ First Horizon Nat Corp Bank of America RI NA/Bank of America Corp Capital One Bank/Capital One FC WF NB South Central/Wells Fargo & Co Colonial Bank NA/Colonial Bancgroup Associated Bank NA/Associated Banc-Corp Zions First NB/Zions BC Bank of America CA NA/Bank of America Corp Webster BANK NA/Webster Fncl Corp TCF NB/TCF FC

Consol assets (million $)

Source: Federal Reserve Statistical Lease, 12/31/2007 http://www.federalreserve.gov/releases/lbr/

NOTES 1. 2. 3. 4.

5. 6. 7. 8. 9. 10. 11.

See Conference Report, ‘Investing for the long-term value,’ 25 August 2005, Zurich, Global Impact Office; http://www.unglobalcompact.org/Issues/financial_markets/ zurich_rep.pdf. See www.ifc.org See www.socialfunds.com The moral hazard problem occurs when a bank, which is supposed to carry on its banking business prudently and not take excessive risk, realizes that the government will not allow it to fail because of its systemic spillover to the banking system (‘too big to fail’), and will behave in exactly the opposite way to how they are not supposed to by taking even greater risks. Special purpose vehicles are formed to separate the risk of the project from the parent company. See Bank of America website, http://newsroom.bankofamerica.com/index.php?s =43&item=7697. MicroPlace is a social business owned by eBay that offers microloans to the poor (www. microplace.com). See www.oikocredit.org See www.calvertfoundation.org/. See www.accion.org. See www.kiva.org.

SRI and global banking 12.

13.

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Collateralized debt obligations (CDOs) are a type of asset-backed security and structured credit product, which are constructed from a portfolio of underlying fixed-income assets (microcredit loans). In general, these assets can be divided into different tranches: senior tranches (with credit rating of AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). The KLD Broad Market Social Index (BMSI) is a diversified and comprehensive representation of the US equity market available to investors seeking to integrate ESG criteria into their investment strategies. The BMSI holds companies with the highest ESG rankings in each sector of the US equity market. To reduce the systemic risk introduced by the selection process, the BMSI is designed to approximate the sector weights of the underlying market based on sector weighting targets. See the website of KLD index at http://www.kld.com/indexes/bmsindex/index.html.

REFERENCES Barber, T. (2008), ‘Extra funds for investment bank,’ Financial Times, 3 December, accessed at www.ft.com/cms/s/0/39f0b4ae-c0dc-11dd-b0a8-000077b07658.html. Becker, H. (2008), ‘Microcredit investments: doing ok while doing good,’ NuWire Investor, 8 September, accessed at www.nuwireinvestor.com/articles/micro credit-investments-doing-ok-while-doing-good-51958.aspx. Financial Times (2006), 9 June, accessed at www.ft.com/cms/s/1/3e8bfafe-f79f11da-9481-0000779e2340.html. Financial Times (2007), 8 May, accessed at www.ft.com/cms/s/0/ac932066-fed211db-9971-00065df10621.html. Financial Times (2008a), 11 March, accessed at www.ft.com/cms/s/0/8dfad3baef2a-11dc-8a17-0000779fd2ac.html. Financial Times (2008b), 6 June, accessed at www.ft.com/cms/s/0/f2c0b366-d29011dc-8636-0000779fd2ac.html. Kota, I. (2007), ‘Microfinance: banking for the poor,’ Finance and Development, 44 (2), accessed at www.imf.org/external/pubs/ft/fandd/2007/06/basics.htm. Lewis, M. and L.M. Algaoud (2001), Islamic Banking, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Liu, Y. (2008), ‘Analysis: China uses green loans to tackle environmental problems’, Worldwatch Institute, accessed 11 February at www.worldwatch.org/ node/5604. Maitland, A. (2006), ‘Social sustainability: critics zero in on banks’ ethics’, Financial Times, June 9, accessed at www.ft.com/cms/s/1/3e8bfafe-f79f-11da9481-0000779e2340.html. Metha, D. and H.G. Fung (2004), International Bank Management, London: Blackwell. Sun, X. (2008), ‘China to bring in green loan benchmark’, China Daily, 25, January, accessed at www.chinadaily.com.cn/bizchina/2008-01/25/content_6420781.htm. United Nations Environment Programme Finance Initiative (UNEP FI) (2006), Sustainability, Management and Reporting, December, assessed at www.unepfi. org/about/index.html. World Bank (2009), ‘10 years of World Bank support for microcredit in Bangladesh’, News and Forecast, accessed at www.karmayog.org.microfinance/ microfinance_3603.htm.

9.

Outlook and conclusion

INTRODUCTION Socially responsible investing has become an important consideration in the global financial industry. Retail and institutional investors are demanding proactive integration of environmental, social, and corporate governance factors into the investment process. Several approaches are used to select stocks for SRI portfolios, including negative screens, positive screens, best-in-class, engagement, advocacy, activism, and integrated methods. In previous chapters, we outlined the variations of ESG objectives for corporations, investors, institutional investors and regulators, and discussed how each group confronted and incorporated these issues into their investment decision-making process. The dynamics between these participants makes balancing the competitive forces difficult, and calls for skill and insight in investment management. There is an increasing amount of literature and empirical evidence guiding us on the incorporation of the ESG considerations in the decisionmaking process. It is apparent that opportunities arise when due diligence is performed and ESG challenges are clearly understood. SRI has expanded to include the broader concept of sustainability, that is, environmental, social, and economic survival over the long term horizon. Prospective SRI investors recognize that in addition to the traditional risks, there are additional risk dimensions to consider that can severely impact portfolio financial performance and profitability over the long-term horizon. In this concluding chapter, we discuss the forces driving the future direction of socially responsible investing. The driving forces include the future role of financial discipline in SRI, SRI development stages, legal jurisdictions and orientation around the world, and the volatility and unpredictability of SRI fund performance. We also present some current developments of executive pay as a social issue. CEO pay has increasingly received media attention and is expected to be in the investors’ minds in the years to come.

170


171

SOCIAL RESPONSIBILITY AND FINANCE Finance has been regarded as the source of several economic crises in the past few years. In 1995, the stock market crash and currency devaluation caused much grief to the Mexican government and put many financial institutions at risk. In 1997, the Asian financial crisis caused a stock market crash, caused several banks to fail, and halted economic growth in several countries. Investors suffered substantial losses in wealth during this disaster. Recently, the subprime credit problem in 2007–8 prompted many home foreclosures in the US and bankrupted many financial institutions. These events have caused people to have a negative perception of the finance industry and its contribution to overall economic and social progressive development. However, an examination of the development of SRI has produced a positive insight into the role of finance. Several banks and financial institutions have played a critical role in developing countries, such as alleviating poverty through microlending programs and promoting sound environmental policies through project financing activities. These initiatives have been remarkably successful in making a difference towards social and environmental progress. Second, the development of SRI funds has grown so rapidly that there are multitudes of investment alternatives available to match personal beliefs and values. The investment industry has exerted pressure on firms to perform in a socially responsible manner. SRI fund managers have served on boards, engaged in dialogue, and advocated for corporate management to embrace sustainability. Most importantly, fund managers have made decisions on whether a firm has passed ESG criteria and can be included in a portfolio. This is the ultimate signal to corporations that the financial industry values ESG performance. Investment professionals have also pressured governments to set ESG directives and facilitate dialogue with other interest groups. Finally, stakeholders such as SRI fund managers, activist shareholders, customers and their own employees have convinced corporations to take an active approach to social responsibility. As a result, firms are moving towards developing greater transparency in their environmental, social and corporate governance policies, and becoming flexible in responding to the needs of all their stakeholders. Only recently have employees and stockholders played an active role in guiding corporate polices and governance structures, and this warrants future research and closer examination.

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DEVELOPMENT ISSUES Regional Difference SRI and CSR exist in several evolutionary stages around the world, depending on the level of economic growth in the region. Europe and US have well developed markets for SRI and are highly proactive in corporate sustainability. Responsible corporate behavior is lagging in the majority of Asian companies, possibly due to the lack of consumer pressure and indifferent corporate management. For instance, the majority of Asian companies ignore the risks posed by climate change to their business models. Asia’s technology, materials, and power and gas industries are the most attuned to climate change issues and can make significant progress and difference to environmental progress (see UNEP FI 2005). Thus, awareness, education, and promotion of ESG considerations at both the corporate level and investing level can be important agents of change. Legal Limit on SRI There are several legal rules that define the decision-makers’ role in making environmental, social, and governance considerations for investment. In the US, UK, Australia, and Canada, common laws are used for decisions in courts, implying that some rules are flexible and can be subject to re-interpretation over time. Civil law in European countries (for example, France, Spain, Italy) and many Asian countries (for example, China, Korea, and Japan) have code or statute-based rules that are not generally interpreted by reference (see UNEP FI 2005). Under the common law regime, SRI managers are required to perform their fiduciary duties, which are to act prudently and to act in accordance with the original intent of investment. Fiduciary duties are the result of case law, in common law countries. However, countries with civil laws have different legal rules for fiduciary duty, depending on the country and jurisdiction. However, common principles dictate that fiduciaries (in accordance to the nature and type of institutional investor) act conscientiously in the best interest of their beneficiaries. In light of both legal jurisdictions, ESG factors affect investment decision-makers in two ways. First, the financial value of the investment needs to be considered in countries with common laws. Second, consideration of ESG factors must be consistent with the objectives of the investment, in countries with civil laws. The future direction of SRI will depend on how policymakers and corporate decision makers view ESG and how they enact reforms. It is


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clear that the increasing awareness and continuing education about ESG will play a critical role in further promoting SRI in the years to come. Volatility of SRI Funds SRI funds that focus on thematic investing can produce highly volatile results. It takes patience and arguably, passion, to invest in the environment. For instance, the Impax ET50, an index of leading environmental technology companies, peaked at 286 at the end of 2007 and then plunged by nearly a quarter in January 2008. In light of a general economic recovery, the index was still down 10 percent as of May 2008. The rise and fall of share prices in the green industry are reminiscent of the technology bubble in 2000–1. Environmental technology companies typically require large amounts of capital. Typical companies include alternative energy technology like wind farms, tidal barrages, ethanol from cellulose, and thin-film solar panels. Share prices are likely to remain volatile, as there is uncertainty over the popularity and market availability of these technologies and profits (if any) can be several years away. Moreover, technological breakthroughs or changes in government policy can have a significant impact on valuations. In 2006, the US government offered generous subsidies for ethanol production. As a result, biofuel companies became favorites with SRI investors because they offered the potential to reduce oil dependence (and associated environmental damage). However, the spillover effects on food prices had negative effects on the initial euphoria brought on by the promises of ‘green’ investments. As with all emerging industries, picking the winners in the environmental industry is not easy. Pioneers and innovators can go bust, replaced by a second wave and possibly a third wave of companies that have figured out a strategy to remain profitable, and yet remain true to their commitment to the environment. Thus, socially responsible investments are not without risk, and picking investments that ‘do good’ can be just as uncertain as any other investment. Future Developments and Trends SRI continues to evolve in terms of the number of investment products available for investors and the increasing involvement of SRI investors with companies. SRI fund managers are moving away from simple negative screening and are engaging in dialogue with the companies they invest in. Fund managers are creating new investment vehicles that not only minimize environmental impacts, but offer promising solutions to global environmental problems. There are several SRI thematic funds that invest in the environmental technology, clean technology, or alternative energy.

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Even more innovative, are investments that capitalize on conservation efforts, like carbon emission offsets, ecosystem services,1 and biological diversity. Several interesting cases of environmental ‘asset classes’ are appearing around the world. For example, Canopy Capital raised capital from the sale of bonds, and purchased the rights to the ecosystem services at the Iwokrama rainforest in Guyana (The Economist 2009). Like carbon emission offset credits, the group plans to sell credits for ecosystem service offsets. Credits for ecosystem services are analogous to contracts for maintaining the rainforest in pristine condition, in perpetuity. Conservation of the rainforest is the only guarantee in maintaining ecosystem services. Profits from the sale of these ecosystem service credits are returned to bond holders. Thus, by virtue of the financial engineering, the investments may not only provide positive returns, but also prevent further degradation of the rainforest and enhance conservation efforts. Spillover effects from the conservation efforts benefit indigenous peoples who rely on the rainforest for subsistence and cultural identity. Environmental and social asset classes such as this example are only in their infancy stage. It remains to be seen how a market-based approach will bring positive environmental and social progress to the world. In addition to the environmental and social issues favored by shareholder activists, corporate governance pertaining to curbing executive pay is also a developing trend. In 2008, activist shareholders in more than 90 US companies submitted ‘say-on-pay’ proposals (that is, proposal for an annual, nonbinding vote on the compensation of top executives by investors). US Congress had proposed bills that would mandate such votes. In the UK, the practice of ‘say-on-pay’ has been mandated since 2003. Many people argue that this practice has helped tie pay with performance and reduce severance payouts. Yet it has not slowed increases in total CEO compensation. ‘Say-on-pay’ proponents maintain that an annual vote would force boards to heed shareholder concerns. The practices are not intended to micromanage pay decisions but to provide a means to monitor corporate behavior. In fact, voting against pay packages is less dramatic than ousting directors. Not all investors have embraced ‘say-on-pay’. In 2007, only eight of 53 proposals that recommended an annual say-on-pay vote in US companies won majority support from voting shareholders.2 However, in 2009, two of the biggest UK backlashes to executive pay occurred. Eighty percent of Royal Bank of Scotland shareholders and 59 percent of Royal Dutch Shell shareholders voted down compensation proposals (Burgess and Steen 2009). Investors objected to the compensation and bonuses for dismal performances in 2006–8 and failures to meet targets. This resounding opposition by investors is bound to affect how corporations align their pay with performance, and possibly initiate


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scrutiny of other corporate governance issues. At the same time, corporate executives may use other avenues to boost their bonuses and pay with indirect methods that can avoid explicit scrutiny. For example, the increasing use of life insurance packages to executives as bonuses in recent years is an interesting case in point (see Schultz 2009). How the corporate executive pay evolves over time deserves a closer examination in future analysis.

CONCLUSION Throughout the book we discussed the overall scope of socially responsible investments. SRI opportunities and challenges presented to investors are discussed with regard to environmental, social, and governance issues in a global context. While opportunities to investors may include both the financial and non-financial (intangible) rewards, challenges to investors include the proper identification and analysis of investments that claimed to be ‘sustainable and socially responsible,’ alignment of their motives with the SRI approaches and instruments, and performance evaluation. This requires due diligence of investors and their fiduciaries. While investors may delegate their fiduciaries to act on their behalf, investors should realize that they are susceptible to agency problems when fiduciaries do not act in the best interest of the beneficiaries. As such, investors with the help of advocate and activist shareholders, need to monitor the behavior of their fiduciaries (particularly financial advisors, pension fund trustees, and managers). In helping investors to make intelligent socially responsible investment decisions, fiduciaries have a legal as well as moral duty to exercise due diligence in the analysis and decision making. We discussed the work and the challenges to public pension plans and other institutional investors. We note that the incorporation of the ESG issues into the investment process is a formidable challenge to investment managers, since their fiduciary duty regarding ESG issues is not well defined in many legal jurisdictions. In our discussion, we have also pointed out the difficulty in reconciling the moral argument and the economic argument for SRI. Based on the existing empirical evidence, we are not able to conclude definitively whether there is financial advantage in SRI. However, as we reviewed and discussed the trend of development of incorporating ESG issues into the investment process, we showed that SRI has made substantial progress in the last few years. Many institutional investors have established procedures for SRI analysis and many NGOs and supranational agencies have encouraged and promoted reporting guidelines and frameworks.

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Last, but not least, throughout the book, we discussed how corporations including banks react to SRI and sustainable development. In particular, we presented the actions that corporations and banks have taken in response to environmental, social, ethical, corporate governance, and economic development issues. We argued that investors and corporations do not necessarily have to consider ESG issues for the sake of intrinsic value, but because they cannot afford to ignore them as risk factors that can affect value of the firm and value of the investment. In conclusion, the evolving opportunities and challenges for SRI will be exciting, demanding, and potentially rewarding to all parties concerned. We believe SRI can be used as a vehicle for advancing sustainable social, environmental, and economic development through financial prowess and prudence.

NOTES 1. Ecosystem services are services offered by the environment, such as generating rain, providing habitat for animals, storing carbon, producing oxygen. These services are almost never monetarily valued by investors. In contrast, ecosystem products are items that the environment produces, and most often, have a monetary value, for example, timber, minerals, tree nuts, etc. 2. See www.blog.riskmetrics.com.

REFERENCES Burgess, K. and M. Steen (2009), ‘Shell’s executive pay plan voted down in shareholder rebellion’, Financial Times, 20 May. Deutsch, C.H. (2008), ‘Executive pay: a special report: a brighter spotlight, yet the pay rises’, Wall Street Journal, 16 April. Dvorak, P. (2008), ‘More holders want more say on executive pay’, Wall Street Journal, 28 April. The Economist (2009), ‘Growing on trees: a profitable rainforest’, The Economist, 18 May. Hemphill, T.A. and W. Lillevik (2009), ‘US “say-on-pay” legislation: is it corporate governance overreach?’, International Journal of Law and Management, 51 (2), 105–122. Hymowitz, C. (2008), ‘Pay gap fuels worker woes’, Wall Street Journal, 28 April. Schultz, E. (2009), ‘Banks use life insurance to fund bonuses’, Wall Street Journal, 20 May 2009, C1. United Nations Environment Programme Finance Initiative Asset Management Working Group (UNEP FI AMWG) (2005), A Legal Framework for the Integration of Environmental, Social and Governance Issues into Institutional Investment, October, Geneva: UNEP Finance Initiative, Asset Management Working Group, accessed at www.unepfi.org/about/index.html.

Index ABN AMRO 123, 151–4 Accion’s Global Bridge Fund 158 AES Tiete 82 All-World Index series 11, 37 alternative investments 9, 11, 51–2, 114, 133–4, 141 Angelides, Philip 143 apartheid 58, 91, 96–8, 134, 150 bank branding 150–52 Bank of America 155, 164–8 Barclays 150–51, 162 Baxter International 77 Benchmarks 36–8, 45, 54, 57–60, 67, 80, 122–3 best-in-class 9, 14–15, 28–9, 32, 41, 44, 58, 170 biofuel 86, 173 board of directors 1, 6, 16–17, 26, 35–6, 92–3, 107–9, 110–11, 125 branding issues 150–52 Brazilian Association for Pension Funds 146 Brazilian Institute for Corporate Governance 146 Burrup Peninsula 101 Caixa de Previdência dos Funcionários do Banco do Brasil (PREVI) 140, 142, 145–6 CalPERS 18–19, 50, 60–61, 64–5, 73–4, 123, 132, 140–44 CalSTRS 60, 143 Calvert Foundation 157–8 carbon 6, 26, 73, 84–7, 120, 123, 155, 174 Carbon Disclosure Project 19, 30, 74, 87, 123, 144 Carbon Principles 84 CERES 19, 39, 135 CFA Institute 14, 109

Chia Meei 78 China’s Development Bank and Export-Import Bank 151 Christian Scientists 92 CIMB Private Bank 162 Citigroup 155, 161 Clean Air Act 86 climate change 11, 20, 30–31, 37, 47, 49–50, 64, 73, 82, 84–7, 123, 135, 137, 155, 172 closed-end funds 52 Coke 83 collateralized debt obligations (CDOs) 153, 158 collateralized mortgage obligations (CMOs) 153 commingled portfolios 53 community banks 4 community development investing 51 community investing 5, 8–9, 50–51, 90 competitive returns 6, 11, 47–8 conflict 97–100 controlling shareholders 110 core SRI 8–10 Corporate Citizen Program 124–5 corporate citizenship 63, 139 corporate financial performance (CFP) 45, 47, 54, 62–4 corporate governance 65, 73, 91, 98–100, 103, 107–9, 110–12 corporate management 17, 47, 65, 79, 91, 107, 109, 111, 171 corporate restructuring 17, 109 corporate social performance (CSP) 2–6, 45, 60, 62–4, 107, 114, 122–7, 139 corporate social responsibility (CSR) 2, 6, 17, 38, 57, 79, 107, 114–15, 119, 127, 139, 146

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corporate social responsibility (CSR) reports 17, 38–40, 79, 119–20, 122, 139–40 corporate structure changes 109 Crédit Agricole 157 Darfur genocide 97 Deutsche Bank 160, 162 disclosure compliance 132, 146 divestment 15, 31, 35, 91, 97–9, 134 DJIMSI 11 DJSI World Index 54 Domini 400 Social Index (DS400) 37, 54–5 double bottom line 143 Dow Jones Islamic Market Index (DJIM) 11, 36 eco-efficiency 76–8 Emerson Electric Co. 107, 124–7 Employee Retirement and Income Security Act (ERISA) 131 engagement 10, 12–15, 18, 26, 30–31, 32, 35, 41, 48, 79, 94, 103, 120, 154, 170 Environmental Financial Statement 77 environmental management systems 33, 77, 80–81 environmental risk and return 81 Equator Principles 19, 99, 103, 121–2, 154–5 ethical funds 4–5, 59 European Climate Exchange 85 European Corporate Governance Institute (ECGI) 135 Eurosif 7, 9, 85 exchange traded funds 9, 11, 52 exclusionary or negative screening 9, 14, 28, 32, 58, 103, 144, 173 fiduciary duty 172 foundations 7, 35, 132–5 Friedman, Milton 46 FTSE CSAG terror-free index 99 FTSE Shariah Global Equity Index 11 FTSE Shariah Multinationals 150 Index 11, 37 FTSE4Good indices 28, 36–7, 57 funds of funds (FOF) 29

G3 Guidelines 139 Glass-Steagall Act of 1933 152 Global Reporting Initiative (GRI) 18, 122, 127, 139, 140, 146 Goldman Sachs 38, 151 Government Pension Fund (GFP) of Thailand 140, 141, 144 Government Pension Fund Global (GPFG) of Norway 140, 141, 144 Grameen Bank 157 green bonds 49, 53 green funds 5 green investing 5–6 Green Mountain Coffee Roasters 85 Guidelines for Multinational Enterprises 136, 144 health program 93 hedge funds 4, 7, 49–50, 53, 133–4 high net-worth individuals 20, 157, 160, 162 HIV/AIDS 94 Home Depot 79 HSBC 149, 151, 160–62 human rights 1, 5, 16, 26, 32, 35, 37, 41, 50, 66, 91–3, 97, 102, 120, 134, 136, 144, 151, 154 hydroelectric generation 82 inclusive (positive screening) 9, 14, 28, 32 Indian Sustainable Development Fund 152 indigenous rights 97, 100–103 Industrial and Commercial Bank of China (ICBC) 155 Institutional Investors Group on Climate Change 30, 50, 84 Institutional Investors Group on Climate Change (IIGCC) 50 Institutional Shareholder Services (ISS) 91 instrumental stakeholder theory 62 Interfaith Center on Corporate Responsibility (ICCR) 50, 91, 135 internal equity pay 113 International Corporate Governance Network (ICGN) 135, 144, 146 International Finance Corporation (IFC) 151, 155

Index International Organization for Standardization (ISO) 77, 120 Investment Company Institute 52 investment decision process 107 Investor Network on Climate Risk (INCR) 30, 135 Islamic (sukuk) bonds 11, 53, 161 Islamic banking and investment 4, 11, 20, 25, 28, 36, 38, 52–7, 150, 161–3 Jensen’s alpha 59 Kimberley Process 99 Kiva 157 KLD Broad Market Social Index 37, 55, 123–4, 163 KLD Research & Analytics Inc. 66 KLD’s CV400 37, 54–6 labor union 91, 143 life cycle management (LCM) 77 London Pensions Fund Authority 138 Merrill Lynch 151, 164 microcredit 150, 152, 156–8, 166 microfinance 156–7 moral hazard 152 –3 MSCI Emerging Markets Islamic Index 38, 56–7 MSCI Global Islamic Indices 11, 38 MSCI World Index 57 MSCI World Islamic Index 57 Myanmar 97 Natural Step 77 Nestlé 82–4 Norges Bank Investment Management (NBIM) 141, 144 Obesity 95 Ontario Teachers Pension Plan (OTPP) 132 operational risk 2, 82, 98, 101 Organisation for Economic Co-operation and Development (OECD) 99, 121, 126, 144–5 Oxfam 136 Parcelforce Worldwide 93 Pepsi 83

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Peter Paul Philippines Corporation 78 Petrobras 76 PetroChina 98 Pictet & Cie 160 pollution 5, 33, 74, 76–9, 81, 91, 126, 145, 155 principal-agency problem 143 Principles for Responsible Investment (PRI) 19, 127, 137–8, 145–6 Prius 80 private banking 20, 150, 160–62, 166 private equity 4, 11, 26, 29, 33, 49, 51, 133–4 project finance 153 proxy voting 13, 18, 32, 47–8, 50 Qatar Islamic Bank (QIB) 161 real options 2 red investing 5 Regional Greenhouse Gas Initiative (RGGI) 85 regulatory risk 86, 90, 99, 103–4 reputational damage 150 return on asset (ROA) 54, 66 return on equity (ROE) 54 Royal Bank of Scotland 160, 174 Royal Dutch Shell 174 Sarbanes-Oxley Act of 2002 108 say-on-pay proposals 174 separately managed accounts 7, 11, 49, 51–2 separation theorem 115, 118 shareholder activism 2, 30–31, 35, 40–41, 47–8, 49–50, 65, 67, 100, 146, 170 shareholder advocacy 2, 8–9, 14, 30, 35 shareholder rights 15, 17, 35, 109–10, 136, 145 shareholder structure equality 109 Shariah 11, 36, 52–3, 57, 162 sharing funds 5 sin stocks 5, 14, 25, 35–7, 41, 53, 57–8, 61, 67, 91, 103, 123, 143 social factors 16, 92, 120 Social Investment Forum (SIF) 4, 50–52, 122 Social Investment Research Analyst Network (SIRAN) 17

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social screening 8, 48, 121 social venture capital funds 51 social, environmental, and ethical (SEE) considerations 36–8, 137, 176 SRI equity hedge funds 53 stakeholder-agency theory 62 State Environmental Protection Administration (SEPA) 155 strategic options 117–19, 152–3, 166 structured investment vehicles (SIVs) 152 subprime-mortgage crisis 157 Sudan 31, 52, 97–9 supranational agencies 2, 3, 4, 7, 17–19, 131, 132, 135, 146, 175 sustainability management and reporting (SMR) 139, 146 Sustainability Reporting Framework (SRF) 139 sustainability reporting guidelines 119, 139, 175 sustainable and responsible investing 5– 6 sustainable development 2, 5, 18–19, 32, 34, 39, 51, 134, 138, 140, 144, 152, 154, 176 Talisman Energy 98–9 thematic screening 10, 32 third-party certification 79 TIAA-CREF 18, 50, 157 Toyota 80 transparency 12, 18, 35, 39, 40, 51, 74, 77, 98–9, 109, 111, 122, 126, 132, 144–6, 153, 171 triple bottom line 2, 11

UBS Philanthropy Services group 160 UK National Consumer Council 151 UN Capital Development Fund (UNCDF) 51 UN Global Compact 7, 18, 120, 127, 136, 144 UNEP FI Asset Management Working Group (AMWG) 19, 131–2, 135, 137, 140 Unilever 96 unit trusts 7, 49, 52 United Nations Environment Program Finance Initiative (UNEP FI) 7, 18–19, 82, 97–9, 131–2, 135–7, 139–40, 172 values-based investing 3 venture capital 4, 11, 26, 51 vice funds 58 Vietnam War 91, 97 Vittel 83 Wal-Mart 73, 76, 93 Wang Laoji 118 water 33, 35, 49, 52, 73, 75, 82–4 Westpac 150 white investing 5 World Bank 49, 53, 102, 151, 154–7, 166 World Business Council for Sustainable Development (WBCSD) 18, 82, 96, 134 World Health Organization (WHO) 95 Yunus, Muhammad 157

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