Sustainable and Responsible Impact Investing (SRI) & Environmental, Social and Governance Factors (ESG)
Many people think of social investing as only Screening (avoiding tobacco, nuclear, etc.), but screening alone has minimal impact unless combined with the more powerful tools of Community Investment and Shareholder Engagement. This guide explores these two higher-impact strategies.
Without sacrifice to financial return, these strategies allow investors to effectively integrate investment decisions with social concerns and personal or institutional values.
Three Levels of SRI
To best understand the three levels of SRI, an analogy may be drawn to the environmental axiom Reduce–Reuse–Recycle, which describes a progression in which recycling is the point of entry, or lowest-impact activity. While necessary, recycling alone is not sufficient to reach long-term goals. To be most effective, every citizen is called upon to engage in the higher-impact activities of reducing and reusing.
A similar progression occurs in social investing with the three key SRI strategies: (1) Shareholder Advocacy, (2) Community Investment, and (3) Screening. Though most people think of SRI as simply applying avoidance screens to their portfolios (to exclude tobacco, for instance), as with Reduce–Reuse–Recycle there are clearly defined levels of benefit in which screening is an entry-level, least-impact activity, while community investment and shareholder advocacy are the higher level activities that can lead to much greater benefits.
These are the three levels of SRI strategies:
(1) Shareholder Advocacy is the prime catalyst for the social investment movement. First used in 1972 by the Episcopal Church that filed a social resolution on South African divestment, shareholder activism (or engagement) employs the proxy resolution process – dialogue with management and the filing of resolutions to be voted on by all shareholders – both to educate and to advocate for improved corporate practices.
The dialogue and resolution-filing process generates a great deal of pressure on corporate executives, while directing public attention to important social, environmental, and workplace issues. This powerful tool has energized many inspiring turnarounds in companies’ social, environmental, and corporate governance practices. Longer term, it can contribute meaningfully to a company’s bottom line by identifying trends – both sustainability initiatives to embrace, as well as looming liabilities to avoid.
(2) Community Investments directly help those who have traditionally been denied access to capital and other meaningful banking services. These investments bring hope to low-income communities throughout the United States and overseas because they provide affordable housing, create jobs, and help responsible small family businesses get started.
(3) Screening began with the churches, which in the 1920s decided to exclude the so-called “sin stocks” from their portfolios. Today the term screening describes either the inclusion or exclusion of securities based on social or environmental criteria. All investors – social or otherwise – begin the investment process with vigorous financial analysis, but then (in addition) SRI investors evaluate a company’s social and environmental qualifications as well.
Social investors seek profitable companies that also evidence respectable employee relations, strong records of community involvement, excellent environmental policies and practices, respect for human rights, and safe and useful products. Conversely, they avoid (screen out) investments in firms that fall short.
While individual screens have little direct impact on a company’s social performance (for reasons discussed below), it may boost financial performance by avoiding corporations whose sub-standard practices can become liabilities that lower shareholder value.
Engage or Avoid?
Key to understanding shareholder advocacy is the concept of engagement vs. avoidance. Many investors do not realize that selling a company’s stock on the exchange (screening, or avoidance) has virtually no direct impact on the company. Just as buying a used car benefits the car-lot dealer but not the original car manufacturer, screening involves ‘secondary’ transactions that the company is typically unaware of. On the other hand, owning shares opens the door of shareholder rights and creates access to the proxy.
Using these rights, social investors look to solve problems by facing them, using their proxy rights to improve the policies or practices of the companies involved. Over the decades, shareholder engagement has led to an impressive array of win/win successes involving a broad range of detrimental social and environmental issues that otherwise – left unchallenged – would continue today.
Four Measures of SRI’s Success
(1) Dollars Under Management
Social investing becomes increasingly more powerful as it continues to grow. SRI assets now total over $3.07 trillion – up nearly five-fold from $639 billion in 1995. SRI monies constitute more than one out of every ten dollars under professional management in the USA. Community investments rose 197.9% in the past seven years – from $14 billion in 2003 to $41.7 billion in 2010 (the most recent year for which data is available). The rate of investment flows into SRI assets has consistently outstripped the rate of growth in non-social assets. This increase fuels the push to better link companies to sustainable business practices – a trend that benefits all investors.
(2) Growth in Shareholder Engagement
In social terms, the 2003-2012 proxy seasons will come to be viewed as a watershed period.
As never before, the previously distinct worlds of traditional institutional investors and socially concerned shareholders found common cause in efforts to bring control, transparency and accountability to executive suites and boardrooms around the world.
Fueled by a string of unparalleled corporate and Wall Street scandals starting in 2002 and continuing on to present, shareholder engagement has become increasingly effective (and necessary) as a curb to corporate power.
Social resolutions increasingly are initiated by and supported by large institutional investors (such as state pension funds), and frequently prompt companies to undertake substantive changes that are both profitable and beneficial for the public at large.
Issues of particular interest to engaged shareholders include climate change, disclosure of corporate political contributions, and the elimination of persistent environmental toxins in products and packaging. As well: the control of excessive executive pay, requiring that board candidates win majority votes, and a number of other steps to ensure full board accountability.
(3) Rule Changes at the SEC
In 2004 the Securities and Exchange Commission (SEC) began enforcement of a groundbreaking new rule that required mutual funds and large money managers to disclose how they vote proxies – which until then had been voted in secret.
2009, the SEC reversed a Bush-era policy that restricted shareholder ability to address the financial risk of corporate activities in environmental and social areas.
2010, the SEC directed companies to disclose to shareholders business risks and opportunities associated with climate change.
2010, the SEC adopted new rules for “proxy access,” allowing large, long-term shareholders to propose their own candidates for elections to the board of directors.
(4) Competitive Performance
Despite Wall Street’s persistent efforts to discredit SRI, it has been amply demonstrated that social screens and shareholder engagement do not automatically harm financial return, and in many cases improve performance while avoiding liability. A sampling drawn from more than 300 important academic studies demonstrates the benefits of SRI and ESG investment approaches:
- McElhaney (2010) CSR is “not a passing fad or trend – it creates and protects wealth.”
- Verwijmeren and Derwall (2010) firms with highest employee well-being scores have lower debt ratios, which reduces the probability of bankruptcy … the authors find that firms with better employee track records have better credit ratings
- Belu and Manescu (2009) the study provides evidence for a “persistently positive link between strategic CSR and the economic performance of companies.”
- Statman and Glushkov (2008) find that companies with a variety of social positives tend to outperform the market.
- Edmans (2007) found that stocks of firms on Fortune magazine’s ‘100 Best Companies to Work For’ list outperformed market averages, even after accounting for market risk, size, momentum, and style effects.
- Barber (2006 & 2010) found that CalPERS’ corporate governance initiatives created over $3 billion in shareholder wealth from 1992-2004. [Reiterated by Barber in 2010.]
- Guenster, Derwall, Bauer, and Koedijk (2005) find that Innovest environmental ratings have a significant relationship with both firm valuation and operating results.
- Orlitzky, Schmidt, and Rynes (2003) perform a meta-analysis of past studies of corporate social performance, and find a statistically significant positive association with corporate financial performance.
- Bauer, Kees, and Otten (2002) measure the risk-adjusted performance of 103 German, U.S., and U.K. mutual funds for the 1990-2001 time period, and find no significant differences between their returns and those of unscreened funds.
- Stone, Guerard, Gultekin, and Adams (2001) show that the returns of a stock selection model were not harmed by the implementation of social screens for the 1984-1997 time period.
- Gompers, Ishii, and Metrick (2001) demonstrate that firms with corporate governance practices that favor management over other stakeholders tend to have lower price/book ratios, and that firms in the bottom quartile of their corporate governance ratings had significantly below-average risk-adjusted returns over the 1990-1999 time period.
- Dowell, Hart, Yeung (2000) show that between 1994 and 1997, U.S. multinational corporations with high global environmental standards tended to have higher price/book ratios than companies adopting local environmental standards, even after adjusting for factors such as industry membership, R&D intensity, and advertising intensity.
- Repetto and Austin (2000) use discounted cash flow models and scenario analysis to show that the financial impact of future environmental regulation may be quite material (up to 11% of market value) for U.S. pulp and paper companies in coming years.
- Russo and Fouts (1998) find that companies with better environmental records appear to have better-than-average returns on assets.
- Hamilton, Jo, and Statman (1993) analyze the risk-adjusted returns of socially screened mutual funds and find that they are statistically indistinguishable from those of unscreened funds.
(see www.sristudies.org/Bibliography for more)
In Conclusion, individual and institutional investors have the opportunity (and in some instances a fiduciary duty) to link their values with their investments.
Addressing financial goals while also encouraging corporations to improve their social and environmental actions is not just fiscally prudent, it is also strategically advantageous and contributes to a healthy, prosperous, and more just world.
Written by Bruce T. Herbert, AIF