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Sustaining sustainability: What institutional investors should do next on ESG

Tue, 28 Jun 2016 00:03:43 +0000

Mainstream institutions have made progress integrating environmental, social, and governance factors into their investing, but they still have far to go. Six ideas can take them to the next level.

Institutional investors face a moment of truth about their commitment to environmental, social, and governance (ESG) factors. Many have long realized that these issues—including climate change, workplace diversity, and long-standing corporate concerns such as executive compensation—can drive risks and returns. In fact, many large institutional investors have publicly committed themselves to integrate ESG factors into their investing. The UN-backed Principles for Responsible Investment (PRI) have been signed by more than 1,500 investors and managers, representing nearly $60 trillion in assets under management.

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Yet look a little deeper, and it’s clear that many investors have struggled to convert their commitment into practice. For example, less than 1 percent of the total capital of the 15 largest US public pension funds is allocated to ESG-specific strategies, such as ESG-screened passive indexes, active management using ESG insights, or private-market management with a fully integrated ESG strategy. Moreover, many institutional investors continue to treat ESG as a sideshow rather than an integral part of their investing. While ESG and corporate-governance teams are commonplace, they are often held at arm’s length from core investment activities. Even the most successful funds have integrated ESG unevenly. While sustainable-equities strategies (such as low-carbon indexes) are no longer oddities, most funds haven’t expanded ESG integration to other asset classes. Members of the PRI agree that more is required. Its board is considering a change that would allow it to remove signatories that haven’t made sufficient practical progress.

This is not to say that the industry has been standing still. In fact, three big problems have recently been cracked, setting the stage for continued growth. First, investors have struggled for some time to determine which ESG concerns are relevant to particular investments. In response, some leading institutions have embraced the idea of “materiality,” derived from the concept of material information in accounting. Much as knowledge that could influence investors’ decisions is deemed material, so too are ESG factors that will have a measurable effect on an investment’s financial performance. According to a recent study using the materiality framework of the Sustainability Accounting Standards Board (SASB), companies that address material ESG issues and ignore immaterial ones outperform those that address both material and immaterial issues by 4 percent and outperform companies that address neither by nearly 9 percent (exhibit). Generation Investment Management, a sustainable-investing specialist founded by David Blood and Al Gore, put ESG materiality at the heart of its global equity strategy and has reportedly exceeded its benchmark by an annualized 500 basis points for over a decade.

Exhibit

Second, many institutions have found it hard to measure external managers’ regard for ESG issues; they need a kind of “greenwashing” detector to see through the obfuscation that plagues some managers’ activities. A number of institutions are now successfully deploying new mechanisms to increase accountability. The New York Common Retirement Fund, for example, recently developed a comprehensive scoring system based on the best available benchmarks. Managers that don’t disclose information receive poor marks, hammering home the idea that transparency is paramount when someone else’s capital is on the line.

Third, some board members and trustees of institutional investors have worried about whether, as part of meeting their fiduciary duties, they are considering ESG factors. Recently, the US Department of Labor revised its ERISA1guidance to say explicitly that consideration of ESG concerns is a part of the pension plans’ fiduciary duty. The department also specified that when a fiduciary considers two investments that are similar from a financial perspective, it should select the one that’s better from the standpoint of ESG. Such cases come up frequently. In France, the Ministry of Finance recently announced new rules that require investors to measure their portfolios’ exposure to carbon, among other ESG considerations. With the regulatory drumbeat picking up tempo, investors will probably soon adopt sound practices to determine materiality and evaluate managers.

Accelerating progress

Materiality, scorecards, and clearer definitions of fiduciary duty are only a launchpad. A commitment to ESG integration will remain merely symbolic unless institutions change their investment and capital-allocation processes in the ways required for this kind of investing to lift off. Investors should consider six steps to broaden and enhance their ESG impact.

Require uniform corporate ESG-reporting standards based on the principle of materiality

Considerations of materiality ought to be a two-way street: publicly traded companies as well as investment managers should disclose material ESG information. Some institutional investors have already been working with groups such as the Carbon Disclosure Project to push companies to report their ESG metrics (for instance, their carbon footprint or water usage), but more must be done.

Requiring companies to share all material information in a standardized, comparable way is necessary if institutional investors and their external managers are to assess the meaningful ESG-related risks and opportunities companies face. Institutional investors can work with the groups that have sprung up to advance the cause. The Sustainability Accounting Standards Board, for example, has rigorously defined materiality factors at sector and industry levels and is pushing for disclosure of material ESG factors in IPO and 10-K filings. Institutional investors should also collaborate with the Financial Stability Board’s task force on climate-related financial disclosures (led by Bank of England governor Mark Carney and Michael Bloomberg) and support the efforts of the International Integrated Reporting Council to encourage more comprehensive corporate reporting, including reporting on material ESG factors. They may also wish to comment on the US Securities and Exchange Commission’s recent consultation about whether investors would like to see more formal disclosure requirements for companies’ sustainability measures.

Build a shared ESG-rating system for external managers

Institutional investors usually have a rigorous due-diligence process for evaluating their external managers, yet too many treat their assessment of the managers’ approach to ESG as merely an exercise in box ticking. Farsighted institutions are already building systems to rate external managers more thoroughly, but a shared system would multiply the benefits considerably. Rather than duplicating one another’s work, funds could both cut the effort needed to make informed decisions and hold managers to a high standard for their ESG performance across the board.

A shared rating system should consider the sources of a manager’s ESG insights and the ways it seeks to engage with the companies in which it invests. The system will need to reflect the nuances of different asset classes and investment styles; ESG factors will be less material for many hedge-fund strategies than for managers investing in real assets or global equities, for example. Over time, a shared rating system should help prime the market for ESG-informed investment strategies. Many of them have historically struggled to gain allocations because of their short investment histories or skepticism about whether the alpha they generate will endure. That’s why institutional investors should invest in building a shared, open standard that their investment professionals will understand rather than simply outsourcing this task to investment consultants.

Work together to engage with corporations

Most investors recognize that as patient capital, engagement is for them both a social responsibility and a source of long-term returns. Yet most have small corporate-engagement teams that can work with only a few companies each year. Leaders such as the Canada Pension Plan Investment Board, the Ontario Teachers’ Pension Plan, and Calpers have built relationship-investing strategies—they back engagement with dedicated capital and sometimes board seats. Large external asset managers such as BlackRock and Vanguard have strengthened their engagement teams and are working with their investors on this front.2But even these efforts have limits to what they can achieve.

Too many investors fritter away their best chance at engagement by relying blindly on third-party proxy-voting guidance. Investors have a real opportunity to move beyond ad-hoc collaboration; instead, they could agree on a specific and narrow set of principles, back these with capital, and commit their votes. From this platform, they could demand that laggards disclose material ESG factors. For example, they might join Fidelity in calling for the pay of all CEOs to be based on incentive plans that are at least five years long—or go further and call for such plans to be based on a mix of operational, free-cash-flow, and material ESG metrics.

Investors should also request better disclosure and ask companies to lay out long-term strategies showing how ESG factors may affect their ability to generate value. Businesses that depend on a “social license to operate” to maintain their pricing power or that need to invest heavily in training to expand a peer-to-peer sales force should reveal these ESG-related dependencies. Investors might slap proxy motions on companies slow to respond.

Stress-test portfolios for ESG risk factors

Since 2008, many institutional investors have strengthened their risk management—for example, by adding tools and skills needed to run scenario analyses on how their portfolios might behave in times of stress. Yet most focus narrowly on “tail” value-at-risk scenarios driven by broad macroeconomic volatility. They ought to complement this approach with considerations of unpredictable shocks, such as regional water shortages, avian-flu pandemics, and increases in (or the introduction of) externality pricing.

Other institutions are embracing risk-factor investing: they evaluate their exposure to root sources of risk, such as currencies and interest rates, and then set limits for them. In both stress-test and risk-factor investing, material ESG considerations are not always taken into account, but they should be. A risk-informed decision-making process allows institutional investors to fulfill their fiduciary duty as stewards of university and foundation assets or of the retirement savings of public-sector employees.

Public concern over climate change is a particularly acute risk factor and source of value at risk. Many institutional investors are considering whether to reduce the carbon exposure in their portfolios or even to divest out of fossil fuels entirely. We realize that some fiduciaries view this as a moral decision. Nonetheless, it is important for institutional investors to have a nuanced understanding of the actual ESG risks they are exposed to, so that they can choose whether and how to respond. Some institutional investors have decided against divestment in the short term but plan to test their portfolios continually for climate risk. They are setting clear limits that, when triggered, will require them to reduce their exposure, to encourage companies to return cash rather than invest in exploration, or ultimately to divest fully.

Use a long-term ESG outlook to unlock new investment opportunities

All investors ought to consider material ESG factors. But the long time horizons and broad market exposure of institutional investors mean that they are particularly vulnerable to the good or bad ESG decisions of the companies in which they invest. Some institutions have developed innovative investment strategies to deal with this issue. For example, several have created indexes that either screen out worst-in-class ESG companies or weight toward best-in-class companies. Since 2012, the Swedish pension plan AP4 has been running a low-carbon fund that excludes the 150 worst polluters in the S&P 500, thereby producing an index whose carbon footprint is about 50 percent lower than that of the broader index.

While differing liability profiles may make custom indexes the optimal solution for institutions, they should consider the scale benefits of collaborating with others. A good example is the $2 billion committed by six big institutions to the Long-Term Value Creation Global Index, designed for them by S&P. Investors should also think beyond passive equities and consider how they can use ESG factors to reduce risk or identify alpha across a range of asset classes. An obvious possibility is direct investments in companies and real assets where institutional investors have enough influence or control to upgrade the ESG management.

Finally, only a handful of ESG managers have ten-year track records. Institutional investors shouldn’t wait passively for such track records to turn up—they ought to use their emerging-manager programs to seed and support innovative ESG-informed strategies. Several managers are pushing the boundaries of ESG-informed investing (see sidebar, “Innovative approaches to integrating ESG”).

Confront the skepticism and misunderstanding that surround ESG head-on

Successful investment organizations have strong cultures, but strengthening a culture takes time. At many institutions, ESG investing is caught in a cultural trap. For decades, conventional wisdom has held that ESG and its forebears, such as socially responsible investing, are merely a sideline, something to be worked on separately from the true business of investing. Changing this mind-set requires concrete action.

Chief investment officers must direct a cultural change within their investment teams. For a start, they can model the right behavior by leading the integration of ESG into the investment committee’s risk/return discussions. Institutional investors should also consider whether training and certifications may advertise the value they place on ESG fluency. Just as the CFA Institute’s Claritas certificate gives investment professionals a measure of credibility after only 100 hours of study, an industry-wide ESG certification could become a signal of qualification to institutional investors as they hire and invest. Bloomberg, the CFA Institute, the SASB, and many universities already offer ESG courses, and some consolidation around a clear industry qualification would benefit everyone.

Turning a symbolic commitment to ESG into daily practice will not be easy. But faced with rising stakeholder demand for meaningful action, there is little choice. Institutions that get out in front of the growing wave will be the first to reap the benefits of sound ESG investing: better returns, lower risk, and—should these ideas be widely adopted—a more sustainable world.

The quest for a Pan-African Investment Code to promote sustainable development

Thu, 23 Jun 2016 10:14:43 +0000

In late 2015, African countries finalised the drafting of the Pan-African Investment Code (PAIC). What is the added value of this continental instrument related to the regulation of foreign investment?

The year 2015 was a crucial one for Africa regarding the negotiation of the first continent-wide investment agreement: the Pan-African Investment Code (PAIC). Although this legal instrument – presented in the form of a treaty – is not yet officially adopted, it reflects an African consensus on the shaping of international investment law. It has been drafted from the perspective of African developing and least developed countries focusing on Sustainable Development Goals (SDGs). The PAIC contains a number of Africa-specific and innovative features, making it a truly unique legal instrument.

The main objective of the PAIC is to foster coherence and consistency with respect to the rules and principles that will govern investment protection, promotion and facilitation on the African continent. As such, it has the potential to become a sustainable solution to solve the puzzle of international investment agreements (IIAs) in Africa.

The puzzle of IIAs in Africa

African countries adopted the large bulk of their bilateral investment treaties (BITs) between the mid-90s and the early 2000s. Traditionally, BITs were concluded with capital exporting countries, mainly from Europe. African states hoped that the establishment of international rules to protect investment intended to ensure stability and predictability, would promote and attract foreign capital into their economies. Today, African countries have signed around 870 BITs or IIAs, which corresponds to about a third of all IIAs signed worldwide.[1] However, since 2002, there has been a marked decline in the number of BITs signed by African countries.

Aside from BITs, regional investment agreements have emerged in the African context due to the proliferation of regional economic communities (RECs). Within West Africa, there are three RECs: the West African Economic and Monetary Union (UEMOA), the Mano River Union (MRU), and the Economic Community of West African States (ECOWAS). Central Africa has two groupings: the Economic Community of Central African States (ECCAS), the Economic and Monetary Community of Central Africa (CEMAC), and the Economic Community of Great Lakes Countries (ECGLC). In the Eastern and Southern African sub-regions, six groupings coexist: the Common Market for Eastern and Southern Africa (COMESA), the East African Community (EAC), the Inter-Governmental Authority on Development (IGAD), the Indian Ocean Commission (IOC), the Southern Africa Development Community (SADC), and the Southern African Customs Union (SACU). North Africa shares two RECs, namely the Arab Maghreb Union (UMA) and the Community of Sahel-Saharan States (CEN-SAD). Today, in this complex mosaic, 28 countries retain dual membership, 20 are members of three RECs, the Democratic Republic of Congo belongs to four RECs, and six countries maintain single membership.

Most of these RECs adopted legal instruments concerning the regulation of foreign investment.[2] From the 1970s to the 1990s, various treaties were concluded to enhance cooperation and harmonisation in the area of investment, such as the 1965 CEMAC Investment Agreement, the 1982 ECGLC Investment Code, and the 1990 Arab Maghreb Union Investment Agreement. ECOWAS adopted two protocols that relate indirectly to foreign investment: the 1984 ECOWAS Protocol on Community Enterprises and the 1979 ECOWAS Protocol on Movement of Persons and Establishment. More recently, in 2007, COMESA developed a modern investment agreement, which was intended to establish the COMESA Common Investment Area. However, the agreement has not yet entered into force and the economic community is currently renegotiating its content. The 2006 SADC Protocol on Finance and Investment is another recent text which has been adopted in the region. The EAC has also launched various investment initiatives, notably adopting a model investment agreement in 2006 (which was revised in late 2015).

Consequently, each African REC has at least one instrument relating directly or indirectly to investment. However, the picture becomes more intricate when one considers that many African states are simultaneously member to two or more RECs. While regional economic integration is generally perceived as benefitting the economy and fostering foreign and domestic investment, the multiple and overlapping commitments in various RECs make Africa’s integration efforts in relation to investment harmonisation inefficient. Nonetheless, recent developments give hope for more harmonised economic integration. In the summer of 2015, the SADC, COMESA, and EAC launched the Tripartite Free Trade Area (TFTA), which seeks to promote the harmonisation of trade and investment arrangements amongst the three RECs as a step towards the wider goal of African continental integration.

By formulating their own investment rules, African RECs play a prominent role in the development of international investment law. They have adopted investment instruments which they consider to be more adequate in light of the specific needs of African countries, the most recent of which seek to combine attracting foreign investment with achieving sustainable development objectives.

The aforementioned COMESA Investment Agreement is an innovative text. It contains significant reform approaches aimed at achieving more balanced investment protection and ensuring that investment benefits flow back to local communities. It also constitutes an attempt to render investment provisions clearer and more predictable. The 2006 SADC Investment Protocol, for its part, states the need to integrate foreign investment into the larger framework of sustainable development. In addition to this protocol, SADC also adopted a Model BIT, which has at its heart the sustainable development concerns of developing countries.[3] Today, it is considered as one of the leading models as regards treaties that not only focus on the protection of foreign investors, but also on sustainable development considerations. The SADC Model and the COMESA Investment Agreement have received tremendous attention in the current discussion on reform of the international investment regime.
The PAIC and the challenge of investment facilitation in Africa

At the continental level, the African Union (AU) has been mandated by its member states to enhance the political and socio-economic integration of the continent and promote sustainable development. Currently, the most important integration endeavours undertaken by the AU are the establishment of the African Economic Community by 2034, and the creation of the Continental Free Trade Area (CFTA) to be finalised by 2017.[4] In regard to the harmonisation of the African investment regime, the AU also appears to be the most appropriate organisation to initiate measures intent on disentangling the complex web of intra-African BITs and investment instruments adopted by African RECs.

In the spirit of enhanced economic integration, African ministers responsible for continental integration decided in 2008 to start working on a comprehensive investment code for Africa: the Pan-African Investment Code (PAIC). The declared aim of the initiative was to attract greater investment flows to the continent and to facilitate intra-African cross-border investment. A group of independent African experts – composed of representatives from various African RECs, academia, and the private sector – has drafted the text over several years, proceeding in two phases. In the first phase, the group compiled African best practices in the field and elaborated a first draft. The second and decisive phase, which took place throughout 2015, consisted in finalising the PAIC text at the expert level. Two meetings of African independent experts were held for this purpose in May 2015 in Tunisia and in September in Mauritius. Experts from AU member states then reviewed the work of the independent experts during a continent-wide meeting in Uganda that took place in December 2015.

What is the potential added value of a continental instrument related to the regulation of foreign investment? As shown above, African regional integration is based on a complex web of legal instruments. As such, the overall landscape of investment law in Africa is very fragmented, which is counter-productive for African integration and for investment facilitation. When foreign investors, from Africa or elsewhere, invest in an African country, they currently have to comply not only with national laws and the investment contracts concluded with the host state, but also with the two or more regional instruments applicable in a given state, as well as with any potential BIT between their home state and the host state. The different levels of legal commitments raise many issues, in particular concerning their interrelationship, and this uncertainty regarding applicable or prevailing rules constitutes a serious challenge for investors in Africa.

The PAIC, which would be applicable to any investment made in AU member states, has the potential to solve the problems of legal uncertainty and fragmentation. The issue of the relationship between the PAIC and other investment agreements is addressed in the draft text of the PAIC, which clarifies that: “Member States may agree that in the case of a conflict between this Code and any intra-African BIT, investment chapter in any intra-African trade agreement, or regional investment arrangements, this Code shall take precedence.” This crucial provision on the relationship between the PAIC and other investment agreements in Africa, despite its soft language, highlights the significance of the PAIC, which would thus seek to ensure continent-wide coherence and legal certainty for the purpose of investment facilitation.
The PAIC and the “Africanisation” of international investment law

With a continent-wide instrument such as the PAIC, Africa provides its own investment rules. Over the last sixty years of international investment law practice, African countries have been perceived as investment rule consumers. African economies did and still do rely heavily on international private capital commitment. In the hope of attracting more foreign investment, various African countries thus concluded numerous BITs with capital-exporting countries, accepting the pre-drafted BIT models of these countries. Today, however, African states have initiated a shift and are increasingly becoming investment rule providers. The PAIC reflects this trend towards the “Africanisation” of international investment law in the current context of reform of the international investment regime.

The PAIC contains several innovative features. It reformulates traditional investment treaty language, introduces new provisions (such as unprecedented provisions on due diligence and obligations for investors in relation to human rights, corporate social responsibility, use of natural resources, and land-grabbing) and omits certain investment standards completely (for instance, there is no mention of the controversial fair and equitable treatment standard).

The PAIC is intended to be a balanced instrument,meaning that it seeks to balance between investment protection and non-investment related public interests, as suggested by the innovative UNCTAD Investment Policy Framework on Sustainable Development.The PAIC does not depreciate the need to attract and facilitate foreign capital into Africa, yet this objective should not overshadow the long-term goal of sustainable development. Consequently, sustainable development plays a prominent role throughout the draft text of the PAIC. The very objective of the PAIC is “to promote, facilitate and protect investments that foster the sustainable development of each Member State.”

Africa will certainly continue to attract foreign investment in the upcoming decades, notably because of its natural resources, but not only. What is at stake now is determining how to regulate these investment flows, and which type of investment and investor operating in Africa should be protected under international law. The answer given by the PAIC is that it has to be investments that foster the larger interests and needs of African societies and economies, while preserving the environment. Thus, future foreign investment in Africa needs to be responsible and based on corporate sustainability.

As the international investment law regime is going through a period of review and revision, countries, regions, as well as international governmental and non-governmental organisations are discussing various reform approaches. The drafters of the PAIC were inspired by the current international reform discussion. Several of the ideas found in the PAIC text are what can be called “common approaches” in the international discussion on reform of the investment law regime as a whole. Such ideas mainly concern the reformulation of certain treaty standards, the inclusion of societal concerns, as well as the rethinking of investor-state dispute settlement. Africa, unlike Brazil for example, is not fundamentally contesting the system of IIAs. The PAIC is rather an attempt by African countries to shape an international investment treaty according to their own priorities. It shows that new IIAs are no longer based on either the North American or European models, and that other regions can meaningfully engage in shaping IIAs according to their level of economic development and social needs.

The legal nature of the PAIC is still uncertain. It might end up as a binding instrument applicable in all AU member states, as it might be adopted as a model treaty serving as a guide for individual member states’ IIA negotiations. The pros and cons of these two options constitute a political question and AU member states need to decide upon the issue with their relevant stakeholders. Whatever the outcome, the elaboration of the PAIC has allowed African countries to deliberate on their vision of IIAs and to build awareness amongst themselves regarding the broader implications of foreign investment as a tool for sustainable development. The PAIC thus endows Africa with a voice in the international debate on the future and reform of the investment regime. Further, its strong emphasis on SDGs bears the potential for the PAIC to become a model for innovation outside of Africa.

By Makane Mbengue, Associate Professor of International Law, University of Geneva.

Dinner time: Alliance 54′s Ernest with BBC’s David Whitehouse, Michael Jefferson former Chair, World Renewable Energy Council and Chief Economist, Shell Europe and others

Sat, 07 Mar 2009 15:42:01 +0000

After Business

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Need more? We also offer a Plus program where you can access source files and bonus tutorials .From graphics to web development, audio to video and more.

Home – From graphics to web development, audio to video and more
Portfolio – From our family of tutorial and resource sites
About – We also offer a Plus program where you can access source files and bonus tutorials
Audio to video and more, get the skills
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Table 1: Apple Product specs
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