Taking stock

Until recently, sustainable development and the City of London’s financial institutions did not mix. Even 10 years ago, it would have been hard to find many who had even heard of sustainable development.

But over the past five years there has been a revolution. New markets trading in environmental commodities such as carbon dioxide emission allowances, have been launched, project finance banks such as Citigroup have introduced sustainability requirements on their major projects in emerging markets, and investors have realised that socially responsible investment (SRI) is not just for tree-huggers.

Investment funds that either select stocks or engage with companies on the basis of environmental and social performance have grown exponentially since 1997.

Recent estimates suggest that SRI funds under management in the UK have grown ten-fold to almost £225bn. In the US, assets under SRI management now total over £1.6 trillion. There are substantial assets under SRI management in Canada, while growth in European funds is also accelerating.

There has also been steady growth in SRI unit trust investment by individuals. These funds are often screened to exclude companies that perform badly on environmental, social or ethical grounds. However the only way that they are going to influence companies is by affecting their cost of capital.

Institutional investment

Although the recent publication of SRI equity indices such as FTSE4Good may well have an influence on the companies that have poor ratings, unit trust funds are still relatively small and have limited impact on companies’ behaviour. Of more concern to business is the change in investment behaviour by institutional investors such as charities, pension funds and insurance companies. These investors are much more influential than unit trusts, particularly in UK markets where shareholder ownership is more concentrated than in other countries such as the US.

In July 2000, new disclosure requirements on pension funds required them to state whether or not they took social, environmental and ethical matters into consideration in their investment process. And since pension funds and insurance companies have a fiduciary responsibility to seek the best investment returns, this meant that they now look much more closely at companies’ environmental and social performance.

As a result, direct action by institutional investors on corporate environmental and social performance now represents a very real issue for many companies. Not only do they have to have the relevant information to hand, they may also have to change performance to fit with the investors’ new investment profile.

Changing company performance

The Carbon Disclosure Project (CDP) is just one example of a group of investors collectively taking action where they are concerned that a sustainable development issue threatens their investments.

On 31 May 2002, 35 institutional investors representing assets in excess of US$4.5 trillion, wrote to the chairmen of the FT500 Global Index companies. They asked the companies for investment-relevant information relating to greenhouse gas mitigation.

The analysis of the responses found that the financial impacts of climate change extend well beyond the obvious, emission-intensive sectors. Companies, including those in the financial services, transportation, semi-conductor, telecoms, electronic equipment, food, agriculture and tourism sectors are also affected.

The Institutional Investors Group on Climate Change is a group of mostly UK institutional investors and fund managers. They intend to use the influence of their assets, and the analysis of the CDP and other studies, to engage with polluting companies to get them to improve their emissions performance.

Shifting trends

This is an important change in attitudes. Investors now see sustainable development issues such as climate change, as a material investment risk.

The point was forcefully made in a recent report by the investment bank Dresdner Kleinwort Wasserstein (DKW) on climate change. It has told its institutional investor and fund management clients that when the European emissions trading scheme begins in 18 months, energy prices could rise by 8-20% in the long term and 10-15% could be added to earnings and valuations

This has alerted mainstream investors and asset managers to the fact that sustainable development issues can have a material impact on shareholder value. Moreover, the report shows investors that sustainable issues can create as well as destroy value. Instead of investors seeing improved environmental performance as a cost, it is now perceived as adding value and creating competitive advantage.

Recent corporate scandals in the US and elsewhere have also brought corporate governance and responsibility to the forefront of investor thinking. Previously, the principal concern of investors has been for the rights of financial stakeholders — the issues over which good corporate governance practice is now sought includes environmental and social performance.

Investment principles

Take the example of Hermes, one of the UK’s largest fund managers with around £37bn of assets managed on behalf of over 100 pension funds, insurance companies, the government and other clients.

Although it has been one of the main investor activists on corporate governance and has been very successful in improving shareholder returns, it has not previously been considered an SRI investor in the ethical investing mould.

However, last year, it published The Hermes Principles: What shareholders expect of Public Companies — and what Companies should expect of their Investors.

While most of it concerns financial and strategic objectives, and processes, it also includes the following principles: “Companies should manage effectively relationships with their employees, suppliers and customers and with others who have a legitimate interest in the company’s activities”; and “Companies should behave ethically and have regard for the environment and society as a whole, and should support voluntary and statutory measures that minimise the externalisation of costs to the detriment of society at large”. It goes on to say that companies should not externalise costs and should welcome frameworks and regulations that prevent them from doing so.

If an investor with the clout of Hermes is including social and environmental criteria in its business decisions, it means that these issues are gradually becoming mainstream. Companies cannot afford to bypass sustainable development and carry on doing business as usual.

Not only will non-performers fall foul of regulators, damage reputation, and remain inefficient, they will also find it increasingly hard to attract the investment needed to sustain long-term growth. As investors become more familiar with the concept of sustainable development and its financial impacts and benefits, so companies will come under increasing pressure to remain attractive low-risk investment propositions.