Research

THE EVOLUTION OF RESPONSIBLE INVESTMENT

Responsible investment continues to attract attention from different stakeholders in the investment community. The value of assets under management of signatories to the United Nations Principles for Responsible Investment (UNPRI) now stands at US$ 22 trillion, more than 10% of the estimated total value of global capital markets.

Signatories publicly commit themselves to incorporate environmental, social and governance (ESG) issues into their decision-making processes and to seek appropriate disclosure on ESG issues by the entities in which they invest. In a joint UN Global Compact / Accenture study released earlier this year, 96% of CEOs agreed that ESG issues should be fully embedded into the strategy and operations of their companies.

In South Africa, the JSE Socially Responsible Investment Index and the Public Investment Corporation (PIC) Governance Rating Matrix are examples of instruments that are used to measure the ESG performance of companies. The Unit for Corporate Governance in Africa has been integrally involved in both initiatives - it is the co-developer of the PIC Governance Rating Matrix and is the local research partner of EIRIS, the data provider to the JSE. The importance of ESG issues has also been emphasised by the third King Report, which became effective earlier this year.

Whilst early examples of responsible investment focused on negative screening (for example, excluding tobacco or arms manufacturers from investment portfolios), the focus shifted over the years to reward responsible corporate behaviour instead of punishing questionable behaviour, and today is driven almost exclusively from a comprehensive risk management perspective. Since the collapse of Enron almost ten years ago and leading up to the recent BP oil spill in the Gulf of Mexico, investors have learnt the hard way that so-called 'non-financial' matters can have a substantial impact on the financial bottom line.

Attempts to prove the value added by a focus on ESG have often utilised comparative graphs, tracking the difference between the performance of responsible investment indices such as the JSE SRI Index, the FTSE4Good and the Dow Jones Sustainability Indices against relevant all share indices. The results of these comparisons have been encouraging, although inconclusive, but miss the bigger picture. If one looks at the overall performance of global markets over the last 10 years, the more important point to make is that the big swings themselves have been caused by ESG issues. Although one should be careful not to oversimplify cause and effect, the causes of events such as 9/11, the collapse of Enron and the Global Financial Crisis can be traced back to social, ethical and governance components.

It is therefore not surprising at all that UNPRI signatories are formally focusing on these issues and it is fair to assume that many non-signatories are also tracking this very closely from a purely risk-based perspective. According to David Couldridge, an investment analyst at Element Investment Managers, the first South African asset manager to have signed up to the UNPRI, a focus on ESG issues leads to a better understanding of the investee company risks and opportunities, which leads to a better valuation and better investment decision making. In a similar vein, Graham Sinclair, principal at Sinco and member of the steering committee of the Africa Sustainable Investment Forum (AfricaSIF), emphasises that neglecting ESG factors leads to underestimating risk, and/or overestimating expected return.

Once there is agreement on the importance of ESG issues, the next challenge is how companies should be measured. The approach at the Unit for Corporate Governance in Africa is that measurement should focus on performance as opposed to compliance. We also try to encourage disclosure by focusing only on publicly available information. The PIC Governance Rating Matrix was designed according to an ESG structure: the governance section focuses on issues such as board composition, independence, remuneration and shareholder treatment, whilst the environmental and social sections focus on performance disclosure, mostly according to GRI indicators. Within a South African context, we also focus on issues such as transformation, diversity and black economic empowerment. While it is relatively easy to collect the information, the interpretation remains complex and still has to rely on a particular context and judgement calls, for example, with regards to issues such as remuneration and independence. Mechanistic year-on-year data comparison often does not give useful information; BP has an existing measure of "number of oil-spills", but the company will be the first to admit that the actual number of spills will not be a major focus area in their next sustainability report.

From a regulatory perspective, a key question is whether disclosure of ESG information should be mandatory or voluntary. In a recent joint publication by UNEP, KPMG, the GRI and the Unit for Corporate Governance ("Carrots and Sticks - Promoting Transparency and Sustainability") this issue is addressed in detail. The report recommends a more active role for government regulators in sustainability reporting - this approach should acknowledge complementarity, that is, raising the bar in terms of minimum reporting requirements, but at the same time, leave enough space for voluntary disclosure and innovation. It should be emphasised that a more active role does not necessarily imply more regulation - existing requirements could be simplified, incentives could be considered, and so on. The report also acknowledges the strategic role of the developing concept of integrated reporting.

A few months ago, the International Integrated Reporting Committee (IIRC) was established. The remit of the IIRC is to create a framework which integrates a company's financial, environmental, social and governance information in a consistent and comparable format. The framework will attempt to support the information needs of long-term investors, emphasise the link between sustainability and economic value, enable environmental and social factors to be taken into account in reporting and decision-making and to move away from an undue emphasis on short-term financial performance. Ultimately, it wants to close the gap between reporting and the information used by management to run a business.

The current focus on ESG issues should be understood as part of an evolving process that will have an influence on global markets and - perhaps more importantly - be influenced by global markets as part of a far more complex network of issues. Within this context, it is interesting to note how the concept of sustainability has changed over time. Before the definition of sustainable development was introduced by the Brundtland Commission, a sustainable business was seen as a going concern, that is, financially sustainable. With the introduction of the Brundtland definition - "development which meets the needs of the present without compromising the ability of future generations to meet their own needs" - the pendulum swung almost entirely to environmental sustainability and, over time, was expanded to incorporate social issues. Acronyms and abbreviations, too many to mention, reflect these shifts - TBL (triple bottom line), CSI (corporate social investment) and ESG are some of the better-known examples.

The spectacular corporate collapses over the last decade have re-introduced the concept of financial sustainability into the equation, that is, we are not only looking at the needs of future generations, but also the immediate future of employees, pensioners and other stakeholders. In a sense, we have thus come full circle, but with a more sophisticated view of all the different components that will determine whether a company will be a going concern. This explains the current focus on integration and should be encouraged. Finally, integration and integrity both have the same Latin root of integer, meaning "wholeness". Even though the main driver for this process remains risk, sound ethical values like accountability and honesty serve as an additional driver to build a strong - ethical - business case for responsible investment.

This piece is based on a presentation by Daniel Malan at the 2010 Mid-Year Conference of the International Corporate Governance Network, which took place in San Francisco on 6 and 7 October 2010.

Daniel Malan is the head of the Unit for Corporate Governance in Africa at the University of Stellenbosch Business School. The views and opinions of the author do not necessary reflect those of the University of Stellenbosch Business School.