Sustainable Investing
A Path to Long-Term Profit
Finding the Right Balance
By Carl Hess and Carole Judd
sustainable investing is not simply a way for investors to express their
beliefs. it also makes it possible to create a long-term investment plan
recognizing what is socially beneficial as well as profitable.
“some say the principles
are a call to align their
investment programs with
their missions and values.
Others counter that the
pRi may conflict with a
legal duty to invest assets
solely in the interests of
fund beneficiaries.”
Nearly all institutional investors have a time horizon
extending beyond the present. So it is important
to balance the immediate prospects for their
investments with the future potential to generate
returns. In other words, investors need to consider
whether their investment plans are sustainable.
Principles for Responsible Investment
Towers Watson’s investment business recognized this
need when it signed the United Nations Principles
for Responsible Investment (PRI). This charter
helps investors to consider whether and how their
programs reflect sustainability. The principles urge
investors to consider the environmental, social and
governance (ESG) implications of their investments
(see below). (More details are available at unpri.org.)
The United Nations Principles for Responsible
Investment
We will incorporate ESG issues into investment analysis and decisionmaking processes.
We will be active owners and incorporate ESG issues into our ownership
policies and practices.
We will seek appropriate disclosure on ESG issues by the entities in
which we invest.
We will promote acceptance and implementation of the Principles within
the investment industry.
We will work together to enhance our effectiveness in implementing the
Principles.
We will each report on our activities and progress toward implementing
the Principles.
26 towerswatson.com
Some regard the principles as a call to align their
investment programs with their missions and values.
Others counter that the PRI may conflict with a
legal duty to invest assets solely in the interests
of fund beneficiaries and question whether broader
issues are a proper concern for the fiduciary. We
believe ESG factors offer a compelling investment
proposition that all institutional investors, not just
the socially conscious, should consider as part of
their asset management.
Compelling Arguments for ESG
The figure on page 27 illustrates why this is the
case. It looks at potential investments in two
dimensions: whether they have a more or less
favorable return expectation (vertical axis) and
whether an investment’s effect on broader society
might be, or might be perceived to be, for good or
for ill (horizontal axis). Presumably, asset owners
would want to avoid opportunities with low potential
for returns (the two lower quadrants) and seek
investments with better potential (the two upper
quadrants). But this classification of investments
is insufficient. The investments falling on the left
quadrants labeled “Harmful” are subject to external
risks that others are not, and those negative
social perceptions (externalities) may hurt future
returns. In other words, the sustainability of these
returns could be in danger. By externalities we
mean the effects of economic activity (production
or consumption) that produce unpriced costs or
benefits to unrelated parties, whether to other
companies or, more generally, to society.
Attributes of potential investments
First-quadrant (high return, socially beneficial)
investments have, by definition, both positive
prospects and a lower risk of negative social impact.
A responsible investor would do well to monitor both
aspects to ensure that status is maintained over
time. Second-quadrant investments have favorable
return prospects, but face heightened social risks.
These risks need increased monitoring, which
might include engagement with management for
those more active, well-resourced investors. Thirdquadrant (low return, socially beneficial) investments
would normally be the province of funds with a
strong sense of social responsibility rather than
a mandate to maximize assets. Finally, the use of
the two-dimensional approach confirms the desire
to avoid poor investments in the fourth quadrant,
which hold poor prospects of returns in addition to
uncertainties from their societal impact.
High
Return expectations
Certain economic activities place greater strain
on the social compact than others. Regardless of
one’s belief in climate change, no one wants to live
next to an active smokestack. Admittedly, there will
be some activities, such as executive pay, where
reasonable people can disagree over desirability.
The key consideration here is that societies — and
their empowered agents, governments — may hold
businesses that create these strains accountable.
Their response may not reflect the actual impact of
activities or the economic value these businesses
received from their actions. We have previously
identified the current period as one of re-regulation,
in which the voice of government will be regaining
strength. As with many cyclical phenomena, there
will probably be a tendency to overregulate before
the cycle reverts. So the risk from regulation will
likely heighten. If this is true, there is a compelling
case to consider this risk’s impact, since it may
have a pronounced effect on future returns. More
speculatively, the growth of social media poses an
increasing risk: Reputations can be quickly made or
broken as news goes viral. The risk is that a secondquadrant investment (high return, harmful) with rosy
prospects can quickly become a fourth-quadrant one
(low return, harmful).
Beneficial
2
1
Low
Social impact
Harmful
4
3
Traditionally, institutional asset owners have
financial objectives — value creation that meets
needs such as matching liabilities for pension funds
or endowment spending targets. The dominance of
financially biased objectives will drive these asset
owners to the top two quadrants. While the mission
remains largely financial, greater awareness of
external risks could lead to a change in behavior and
investment strategies.
“it cannot be questioned
that certain economic
activities place greater
strain on the social
compact than others.”
As previously mentioned, institutional investors will
want to avoid, or at least manage, the risk that a
second-quadrant investment with rosy prospects
quickly falls into the fourth quadrant. Thus there
is merit to incorporating requirements to consider
external factors that may impact investment
outcome in investment manager mandates as well
as in investment decisions. Such mandates should
lead to a better long-term, sustainable investment
program in which the manager integrates ESG
thinking into investment decisions and takes a more
active ownership role.
Quadrant Drift
The above neatly follows the way we have set up
the two-by-two grid. But if investments in the first
quadrant are clearly superior, they will be in demand,
potentially reducing their future return expectations
and dropping them into the third quadrant. Similarly,
the fourth quadrant contains inferior investments
and will be shunned, causing their prices to fall
until they move into the second quadrant (higher
expected returns). We can imagine a world where
the bulk of the investments lie in the second and
third quadrants. Portfolio management then becomes
harder, but more reflective of the real world.
Emphasis 2011/3 | 27
Carl Hess
Specializes in
investment strategy
and asset/liability
management.
Towers Watson,
New York
Carole Judd
Specializes in
investment thought
leadership.
Towers Watson,
Reigate
“The
“
key consideration
here is that societies —
and their empowered
agents, governments —
may hold businesses
that create these strains
accountable.”
From a bondholder’s perspective, there is evidence
that good corporate governance leads to reduced
default risk and better credit ratings. Credit analysis
typically incorporates factors that affect a company’s
ability to meet its future obligations (both interest
payments and repayment of capital). In many
situations, the impact of externalities is more likely
to be negative for bondholders, since cost increases
affect the ability to service debt. And bondholders
have little ability to influence corporate change through
engagement. Consequently, we would argue that
any shifts across quadrants by bond investments
are more likely to be downward from the first and
second quadrants, to the third and fourth. In other
words, there is significant downside faced by credit
investors not integrating ESG thinking into their credit
analysis. The distribution of credit returns — a high
probability of small positive returns and a small
probability of large losses — makes such integration
an important component of risk management.
Future Trends
Institutional investors are often criticized for being
removed from their ultimate investments and
not acting as owners. By redefining mandates
to integrate ESG thinking, the gap between the
responsible asset owner and decisions made at
the corporate level will shrink. Second-quadrant
investments will be attractive only if strategies and
practices are adopted that will move them toward
the first quadrant. The trend toward engagement
is gathering pace. Broader acceptance of the
benefits of an integrated approach is evidenced by
the growth in the number of PRI signatories.
An allocation to mandates that target specific
ESG-related themes such as clean technology
would historically be regarded as the domain of
investors with a broader mission that encompasses
nonfinancial factors. As such, it could be argued
that such investments would typically lie in the
third quadrant. Renewed government interest in
regulation may be reflected by greater oversight
of the environment and the impacts of climate
change. Pressure to adapt practices and additional
costs will make some investments less financially
attractive than initially thought, resulting in a drift
to lower quadrants. For other companies, such as
28 towerswatson.com
those developing clean technology alternatives, it
may provide a strong impetus to their businesses.
Previously, they may have been regarded as thirdquadrant investments, but as beneficiaries of
increased regulation they could move into the first
quadrant. There may, therefore, be an early-mover
advantage for some investors who seek to exploit
these opportunities.
But being an early mover in such circumstances
is not without hazard. Regulation may be slower
to come and in a different form than anticipated.
Companies focused on innovation may also fail in
their delivery of that innovation. Such investments
could remain in the third quadrant for longer than
the asset owner could tolerate. It is imperative
that these asset owners have sufficiently strong
beliefs and time horizons to withstand these strains.
Regular reassessment of the value proposition will
be an integral part of managing the risks associated
with such a strategy.
Sustainable Investing Will Gain
Momentum
Sustainable investing is a relatively new concept
that is likely to be more influential over time as
a greater body of empirical results is collected.
This experience will enable asset owners to refine
how they invest, using theory and practice. But
its dynamic nature will place heavy demands on
the governance arrangements of responsible
investors. For some time, we have urged institutional
investors to match their investment aspirations
with their governance capability. We believe
there is a compelling investment proposition for
the consideration of ESG factors, and that all
institutional investors should consider them when
managing assets. All institutional investors should
ensure they have the governance arrangements in
place to meet these challenges.
For comments or questions, call or e-mail
Carl Hess at +1 212 309 3800,
[email protected]; or
Carole Judd at +44 1737 274329,
[email protected].