Executive Summary
In early February 2001, the Commonwealth
Group made a submission to the New Zealand Parliament's Finance
and Expenditure Select Committee, which is considering the Bill
creating the New Zealand Superannuation Fund (NZSF). The Commonwealth
Group submission considers how certain forms of socially responsible
investment (SRI) practices might be appropriately incorporated
into the Bill, and so form part of the investment management activities
and practices of the NZSF.
The purpose of this discussion paper is, in part, to summarise the key issues raised in the submission and to place these issues in a broader context for interested parties other than the Select Committee. Interested parties would include the New Zealand investment community and the investing public.
More specifically, the paper advocates and builds a case for the inclusion of SRI practices in managing the NZSF's funds and highlights one particular approach to SRI, responsible engagement overlay (REO) , as an approach quite likely to meet many of the needs and interests of NZSF stakeholders.
Introduction
In recent years, there has been an escalating debate as to whether
public funds should have an 'ethical' bias, an 'environmental'
bias, or whether matters of social policy should be addressed.
The Commonwealth Group's investment management companies have provided our assessment of the current state of industry best practice regarding what has been historically termed 'ethical investing' and which has more recently evolved into the much broader concepts of 'socially responsible' or 'sustainable' investment practices.
We believe that the industry best practice is very close to formally and transparently incorporating SRI or sustainable investment practices as a core part of the philosophy and practice of funds management.
The debate surrounding socially responsible investing (SRI), ranging from definitional issues to the inclusion of SRI-based analysis in the investment decision-making process, continues to evolve in New Zealand, Australia and globally.
The Commonwealth Group intends to be part of the developing public and policy debate surrounding SRI, and more generally sustainable corporate practices. This intention is based on our growing belief that the debate is a meaningful one and will have profound implications for the global funds management industry. In turn, the way in which the various stakeholders contribute to, and influence, the debate surrounding SRI and more broadly, the sustainability of corporate practices, will clearly influence the pace at which contentious issues are identified and resolved.
The wider investment management industry, of which the Commonwealth Group is a key participant, is an important stakeholder in the debate on SRI.
The Commonwealth Group shares the view reflected in the recent Allen Consulting Group Report on SRI in Australia that SRI is in a transition phase, both domestically and internationally. There are signs that SRI is moving from a niche concept somewhat on the fringe of the investment management industry landscape to a more accepted and legitimate place in mainstream investment management circles.
A leading indicator of this change is the increasing interest of retail investors in, and the shift in broader community attitudes to, the sustainability of company practices and behaviour that has been reflected in a number of recent surveys published in Australia. Indeed, we are seeing an increasing number of SRI-type funds launched in both New Zealand and Australia in recent weeks. We expect, partly because of retail demand, the pace at which the SRI debate evolves, and associated investment management practices move into mainstream industry best practice, to intensify in the short to medium term.
SRI in Overview
SRI: An historical
perspective
Since the onset of the environmental movement of the 1970s, we
have seen a gradual maturing of the debate about the sustainability
of corporate practices and the degree to which the analysis of
non-financial factors can and should be incorporated into the
investment decision-making process.
What was once seen as extreme and perhaps the exclusive domain of fringe groups, is now seen as more mainstream manifestations of community values and socially responsible corporate behaviour.
|
|
|||
|
1970s Denial, then Regulatory Overlay |
1980s Regulatory Compliance |
1990s Development of "Ethical" Funds |
2000+ Sustainability
|
Many clients of the Commonwealth Group's investment management businesses, for example large public and industry superannuation funds, are becoming increasingly interested in the environmental and social issues associated with their investments. In Australia, with growing levels of wealth directed towards superannuation, personal share ownership and managed fund investments, this interest is also manifesting itself in an increasing trend towards various forms of shareholder activism and targeted investment.
These trends are consistent with what we perceive to be a broader community view that business should not remain aloof and apart from society, and it should contribute not only to sustainable economic development, but also to social and community development. Together with developing standards of corporate governance, improved transparency and corporate disclosure, new non-financial benchmarks are emerging against which responsible corporate behaviour can be measured.
What is socially
responsible investment (SRI)?
Although as yet there is no clear universal definition of what
SRI is, there are principal themes common to most definitions
of SRI. The concept clearly contemplates an investment management-based
activity that involves consideration of non-financial factors
in investment decision-making and related investment processes.
The range of criteria to which SRI practice relates differs widely amongst commentators. However, there appears to be consensus for the inclusion of environmental and social considerations (e.g. corporate governance, occupational health & safety). Because of the imprecise and subjective nature of the term, it becomes somewhat problematic to include 'ethical' factors under the banner of SRI, although many commentators do so.
At its core, the SRI process requires researching/gathering data on corporate social performance and then benchmarking this data against standards determined by reference to a nominated party. The end objective is to provide a more accurate assessment of the risks associated with the future performance, and hence the value of, a particular corporation with reference to its peers on a global basis.
It is important to point out that SRI does not necessarily incorporate a screening process. This is where investment in the securities of corporations is either excluded (i.e. negatively screened) or included (i.e. positively screened) based on the SRI research and benchmarking processes.
The ethics
of 'ethical investing': Is social responsibility or sustainability
the new benchmark?
As the SRI debate has matured, the language used by the stakeholders
in the debate has also evolved. Use of the term 'ethical investing',
which is perceived by mainstream investment managers to have a
more subjective, imprecise and indeterminate meaning, has gradually
been superseded by the broader term 'socially responsible' as
it relates to investment management practice.
More recently, the terms 'sustainable' and 'sustainability' have been used to both challenge corporate practices and also as an approach to investment management based on these concepts. There is an emerging view amongst major investors that the question of sustainability is relevant to security analysis and stock selection, and that investment managers should take this into account in managing client portfolios.
It has been suggested that focusing on the sustainability of corporate practices offers a perspective that is consistent with the fundamental objective of investment management - that is, optimising the financial return of an investment relative to its risk.
The theoretical argument in support for a shift in the language of the debate, moving away from the use of terms such as 'social' and 'ethical' to using the term 'sustainable' is usefully summarised by author Mark Mansley in a recent article in Sustainable Business Investor :
"Typically, fund managers are expected to perform on a quarter-by-quarter basis. At a political level, there has long been concern that attention on short-term financial returns may not be in the best interests of the economy in the long-term. …. In Continental Europe, this concern has expressed itself in continuing unease over the rise of the Anglo-Saxon economic model, with its emphasis on shareholder value and the power of financial markets.
So how does sustainable development help resolve this dilemma and provide a tool for linking short-term and long-term investment practices? Most investment professionals deal with this dilemma by arguing that long-term returns are best cultivated by maximising the returns in each successive short-term period. …For short-term investment strategies to deliver the best long-term returns, it is necessary that the process of meeting short-term investment objectives does not compromise the ability to generate investment returns in the future.
This [argument] may sound familiar ...and …is essentially the same as the most common and powerful definition of sustainable development, from 1987 the Brundtland Report, which is "a pattern of development or progress that: meets the need of the present without compromising the ability of future generations to meet their needs."
Further, there is empirical evidence to suggest that the financial performance of companies that engage in sustainable corporate behaviour is superior to the performance of companies that do not adequately, correctly and optimally manage their business in a sustainable manner .
In response, investment management firms are beginning to develop sustainability value criteria for analysing firms against a range of benchmarks, and to establish processes for engaging companies in a dialogue over issues that naturally arise.
Sustainability value criteria are not simply confined to the ethical or environmental considerations. It also includes:
Each of these value criteria includes a number of sub-components.
Historically, trustees and investment managers have been confronted with a dilemma that still characterises the debate surrounding ethical and socially responsible investment. This critical question is how is it possible to determine and define what is 'ethical' or 'socially responsible' with reference to heterogeneous groups of investors?
The operational question that arises is how can the view of the trustees or investment manager on these matters be employed in overlaying investment decisions that they might make on behalf of their investors?
Blurring lines
of distinction - the need for standardisation
The issue of unclear definitions of social, ethical and environmental
corporate and investment practices leads to an element of overlap
and confusion as to just what is, or should be, included under
each SRI criteria, and in many cases the actual criteria themselves.
For example, there is little uniformity in the social screening
criteria of the major US SRI investment managers and this has
resulted in many confusing and anomalous classifications for companies
on the basis of the different criteria .
Moving from
the fringe to the mainstream
The debate on SRI has developed and captured the interest and
attention of a much wider audience. This shift has occurred in
parallel with the adoption of a broader and more sophisticated
language on the purpose and value of SRI in the general context
of investment management.
This evolution in the debate surrounding SRI could be characterised as a move away from subjective outcomes, and towards more objective outcomes. In part, this has resulted in the debate itself moving from the fringe to the mainstream of the investment management agenda.
There is widespread evidence that companies are starting to acknowledge the idea that the management of activities including environmental, social and ethical considerations can impact corporate financial performance in a positive manner.
Socially Responsible
Overlay (SRO) - a more balanced approach to SRI
The main question is whether, and if so, how might it be possible
to incorporate the principles of SRI into a fund's investment
decision-making process.
One approach that the Commonwealth Group believes a potential solution to this issue is what has been termed a responsible engagement overlay (REO) process. This was pioneered in the United Kingdom by a leading fund manager, Friends Ivory & Sime.
The objective of REO is to reflect the social or sustainability factors of the trustees in the investment decision-making process by engaging in a dialogue with those companies that fail to meet acceptable standards of sustainable corporate practice.
In conjunction with an Australian research house, a Commonwealth Group member, Commonwealth Investment Management, is currently developing and adapting its own version of REO, or a socially responsible overlay (SRO) process, for implementation by a large public sector institutional client for their Australian equities portfolio.
The Commonwealth Group believes that, where trustees or investors are persuaded by the potential value of having a social or sustainability factor analysis incorporated into their investment decision-making process, there are three distinct advantages in employing a REO or SRO approach.
First, a SRO process does not generally involve, other than in rare and extreme circumstances, disinvestment by a fund in a company that forms part of the fund's investment portfolio. The SRO process is concerned with identifying those companies that are not meeting acceptable behavioural standards as judged by their investors and then engaging in a dialogue with the companies to assist them to understand how investors' concerns might be best addressed, and areas where performance can be improved.
This is an important consideration where trustees have mandated investment managers to follow an index fund style of investment management, where disinvestment from a stock is simply not an option. Further, actual disinvestment from the stock may place the trustees and investment managers at risk of breaching their fiduciary duties in taking non-financial issues into consideration in making their investment decision-making processes.
A second argument in support of SRO is that its impact is indirect. By reducing the extent of unsustainable corporate conduct over time, the objective is to have a positive longer-term influence on the financial returns generated by companies. In many respects this argument is related to, and an extension of, the first suggested benefit of SRO.
Third, the SRO process is non-confrontational. It is approached from the perspective that companies and fund managers are engaged in a dialogue. In contrast to many of the more traditional approaches to ethical and SRI based investment decision-making, which commonly involve negative and positive screening and hence are explicitly or implicitly exclusionist in nature, the SRO process results in no dichotomy of classification. Companies that are engaged with as part of the SRO process are, from an investment perspective, treated no differently than other companies in the investment portfolio.
Evidence from UK and US experience suggests that companies are more responsive to engagement requests to change their corporate behaviour than if they are excluded from an investment portfolio.
In many senses, SRO is a pragmatic approach designed to achieve behavioural change. It is grounded in the belief that change will more commonly result from meaningful dialogue, and such change will produce more durable and significant results for all stakeholders.
Commonwealth
Group & SRI
The Commonwealth Group investment management businesses' approach
to SRI is that the debate surrounding SRI, ranging from issues
of definition to its importance to the investment decision-making
process and market demand, is an evolving one, in New Zealand
and globally.
The developing debate around SRI, and more generally sustainable corporate practices, is a meaningful one. Commonwealth Investment Management is pursuing ways to develop the research capability and systems to facilitate the consistent inclusion of SRI/sustainability factors into our investment decision-making process across all asset classes and clients.
Correspondence
All correspondence in relation to this discussion paper may be
directed to either of the following representatives of the Commonwealth
Group:
|
Mr Bruce Abraham Colonial First State Investment Managers (NZ) Ltd, 117 Customhouse Quay Wellington, New Zealand (04) 470 4500 BAbraham@ColonialFirstState.co.nz |
Mr Michael Hill Commonwealth Investment Management Bank House 309-315 George St Sydney, Australia (612) 9378 4751 michael.hill@cba.com.au |