Time for a rethink on responsible investing

At the recent annual Who Cares Wins follow-up event in Zurich, with the imposing title "Communicating ESG value drivers at the company-investor interface", discussions centred on whether and which environmental, social and governance issues were actually "material" for companies’ business models and which were not.

Listening to the debates we began to wonder whether the long struggle to put sustainable development on investors’ agendas had been futile. Here’s why.

Sustainable development is fundamentally about raising the standard of living of the world’s poor, without exhausting or eventually destroying the natural life-support system (ecosystems, natural resources).

Green and socially responsible financial products launched in the aftermath of the 1987 Bruntland report took great pride in basing their guiding principles on the definition formulated in that report: a development that meets the need of the present without compromising the ability of future generations to meet their own needs. Are they delivering on their promises?

Early efforts to analyse companies from an environmental and social viewpoint were met with scepticism or outright hostility. To ask for anything but standard, financially relevant information was considered almost indecent.

To convince mainstream finance to swallow the bitter pill of sustainability, analysts in the field of socially responsible investing began to argue that sustainability had a positive impact on companies’ bottom lines. As time passed the mainstream investment industry was persuaded of the economic case for SRI.

But that conversion has come at a heavy price. The newspeak of the SRI community has led them far astray from their original intentions and an unequal contract is being established. The mainstream is willing to take sustainability issues into account if – but only if – they can be reasonably assumed to influence the bottom line, whereas the sustainable investment community is tacitly abandoning any aspiration to convey the remaining (non-material) sustainability issues to the companies they invest in.

Such a view completely ignores the fact that for most of the "goods" that sustainable development is concerned about – intact natural resources, a greenhouse gas-free atmosphere, a just society, and so on – there is simply no market or, if there is (as in the case of greenhouse gas), it is only emerging.

As a consequence, companies producing such desirable public goods cannot sell their positive efforts on the market.

The same holds true for negative consequences. As long as their pollution or emissions are within legal limits and/or not stirring up any boycott or the like, the company that does more than its competitor will automatically incur a cost disadvantage against its merely compliant peers. To argue that these costs will be compensated later through some miraculous mechanism such as "lower risk exposure" or a better public image remains speculative.

If we take materiality seriously, all that is needed are good financial analysts who are experts at analysing all that is "material" to a company. A good financial analyst will factor in the cost of CO2-compliance or a contingent liability for the clean-up of a contaminated site long before an SRI analyst has told him to do so – but only if the issue is material.

But materiality for the company is unrelated to the sustainability of the action itself. For example, a tonne of CO2 emitted in Germany is a good deal more material to a European utilitycompany than to a Chinese company under no CO2 cap, yet the sustainabilityconsequence is identical.

To equate sustainability with what is material and, even worse, to deduce that what is not material is not sustainable, would be the worst post hoc fallacy.

Again, imagine a company that tolerates massive child labour in a remote developing world mining village. Suppose that, for whatever reason, it is unknown to the rest of the world. Should we really not care, just because it doesn’t happen to impact the bottom line?

We say to the SRI community, go back to your roots. Assess and rank companies according to whether they actually deliver more sustainability than their peers and invest in these companies.

Try to influence the bad ones and keep the good ones on track. Engage in an open and constructive dialogue, through exercising voting rights and so on, so as to align long-term strategy with the principles of sustainable development.

This is especially true for diversified global investors such as pensions funds which are – for technical reasons – forced to replicate the broad market with a substantial part of their assets.

To be sure, any sustainable investment approach may come at a certain cost against a conventional benchmark, but there are quantitative techniques that can be used to control the risk of underperformance and create independent, compensating sources of alpha.

In summary, we believe it is unacceptable to give investors some sort ofmateriality-diluted pseudosustainability for the real thing. To provide true sustainability is to respect clients’ interests and preferences and that, we maintain, is the only thing that in the end is material for us.

Christoph Butz is SRI analyst at Pictet Asset Management; Stephen Barber is group managing director at Pictet & Cie; Jean Laville is head of sustainable research at the Ethos Foundation

Copyright The Financial Times Limited 2006

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