We all know the conundrum. Transformation is a necessary precondition for South Africa to prosper in a material and social sense. Yet how do we invest in enduring transformation? Not the kind where the caterpillar eats too much, cocoons itself away from the world and emerges from its chrysalis as a seductively emblazoned butterfly that dies after a few days.
With a pension savings endowment of over one trillion rand, one increasingly prominent funding source for transformation that is mooted by Cosatu and (most recently) Kgalema Motlanthe while he was President, is to prescribe that a certain percentage of assets be earmarked for socially desirable investments. While one can sympathise with the temptation to prescribe asset investments, this should be a wholly unnecessary inducement to make responsible investment choices. Responsible investment across environmental, social and corporate governance (‘ESG’) has extensively been shown to make good commercial and investment sense. Moreover, the credit crisis has highlighted our vulnerability to systemic issues and reinforced the need to approach investing more holistically.
The South African investment community has been effective in critiquing the dangers of reintroducing prescribed assets. However, most efforts stop there. Responsible Investments (RI) make up a fraction, no more than 1%, of total pension fund assets, and that number has been static for a long time. The surest way for pension funds to stave off prescription is proactively to increase their own understanding of and exposure to responsible investments. However, they seem reluctant to engage hands-on, as actuary, Rob Rusconi concluded: “…socially responsible investing occupies a very small space in the investing actions of South African retirement funds. There are still few funds dedicated to socially responsible investment and it would seem that hoping for change to come, in significant scale, from the supplier could result in a long wait”.
The apparent impasse needs to be broken if we are to avoid prescription, and suggests a need to understand why there is a reluctance to embrace responsible investing, whether this makes sense, and finally, what can be done about it.
To address the first issue, there are probably five traditional investor arguments against ESG integration in investment decision making: The first stems from modern portfolio theory, in which the guiding principle is to seek diversification across uncorrelated asset classes to enhance risk-adjusted return. This has been dispelled for two reasons; diversification benefits are insignificant after a certain critical portfolio size, resulting in a negligible impact for the addition or exclusion of investments thereafter. Moreover, companies that pursue good corporate governance may offer relatively different and beneficial diversification benefits.
The second argument states that the sole fiduciary responsibility for trustees is to maximise investment performance. This notion has been thoroughly discredited, first by the Freshfields-UN study quoted below, and more recently, in response to an introspection of how the current financial crisis could be avoided.
The Freshfields-UN investigation into the legal framework for incorporating Environmental, Social and Corporate Governance (ESG) factors into investment decision making across most developed country jurisdictions, found that “… the links between ESG factors and financial performance are increasingly being recognized. On that basis, integrating ESG considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions.” In a prescient observation, foretelling some causes of the current crisis, the investigation goes further to emphasise the importance of integrating long-term horizons in the interests of sustainable performance in an investment world which places a dangerous emphasis on extracting short-term gains. “The essence of business is the sustainable evolutionary adaptation of its activities to emerging opportunities and risks in its markets. Making profits means making sure the conditions for future profits are being put into place and this is rarely coincident with maximizing short-term profits. A business builder builds an edifice for coming generations.” In South Africa, there can be no more direct contribution to the future growth and stability of our society than the sustainable provision of far-reaching delete and infrastructure. It should be both a right and a benefit to pension fund members to invest in that future.
The United Nations Principals for Responsible Investment Secretariat issued a response to the global crisis in March which reiterated the need to evaluate risks more meaningfully by incorporating ESG factors. “We need to recognize that investors can, and should, be part of the response to this crisis and that responsible investment has an important role in mitigating future such market failures … better regulation … is also necessary… However, regulation alone cannot prescribe well-functioning markets, which are based on high levels of trust, accountability and transparency among market participants.”
Thirdly, RI is criticised for being unavoidably subjective. This is sometimes true for ethically based funds, in particular, but in general, responsible investment themes respond to broad societal concerns. Again, the Freshfields study noted that “Fiduciary duties evolve over time according to changes in social norms and the values of society and, to a degree, technological and market changes. It is, for example, very unlikely that paying equal wages to men and women or subsidizing public transport for the poor, elderly or disabled would be regarded as breaches of fiduciary duties in the 21st century but all were so regarded not very long ago.” Christian Ragnartz from the Swedish Pension Fund AP7 puts it more bluntly: “As long as the world looks and acts as it does today, fiduciary responsibility is abused if investors do not take ESG into consideration”.
Fourthly, the argument is made that the ‘business of business is business’ and that the point is to ‘stick to the knitting’. However, this ignores the broader benefits to the company concerned and the wider society of conforming to acceptable practices and naively assumes that compliance will happen without encouragement.
Lastly, trustees cite that there is insufficient information around RI, making it too difficult to do. A recent study by Unisa’s Centre for Corporate Citizenship highlighted some of the reasons for low interest and understanding of SRI in the SA pension fund industry – manifest in the low levels of investment. These are not insurmountable and mainly revolve around issues of understanding with respect to definitions of responsible investing and the need to believe that responsible investing will enhance financial returns. In a nutshell, the problem is not that investors are against investing in high social value outcomes per se, but that there is enough uncertainty and misunderstanding of how, why and where to do so to stop them actually doing it. Such uncertainty translates into avoidance, which translates into a lack of demand for products, which in turn, translates into a shortage of supply of appropriate product. The trick, then, is to break this negative cycle by letting investors see the way more clearly.
So what can be done? In the absence of a Damascus experience for pension fund trustees, and in the interests of avoiding prescribed assets, the international experience offers helpful pointers. The trend towards mainstream acceptance of ESG related investment is significant elsewhere. This is borne out by a number of initiatives, notably the United Nations Principles of Responsible Investment, Carbon Disclosure Project, Enhanced Analytics Initiative and the Investor Group for Climate Change. Most OECD countries exhibit RI of between 10%-15% of total investments.
Arguably the greatest influence driving responsible investing in OECD markets is a regulatory requirement for ESG disclosure from pension funds. The UK led the way here, with its Pensions Disclosure Regulation in 2000, which requires that pension fund trustees disclose in their Statement of Investment Principles the extent to which (if at all) social, environmental or ethical considerations are taken into account in their investment strategies. Subsequently many countries have followed suit, with Belgium, Germany, France, Sweden, Spain, Austria, Italy and Australia adopting similar disclosure regulations on pension funds. South Africa appears to lag these international trends, which is somewhat ironic given the business prerogative to comply with numerous transformation goals. It is also important to stress that the disclosure requirements overseas are soft touch. There is no prescription advocated. Rather, the required disclosure elicits an examination of what criteria should be used to assess retirement funds’ RI practices. This, in turn, has revealed the value of incorporating ESG factors which has eventually translated into sizable investments.
There are, of course, inevitable lessons that have been learnt, such as the criticism that regulators have fallen short of providing guidance on definitions around the policies, implementation and transparency of integrating ESG factors. South African legislation clearly lags global trends. Would it not be both less controversial and potentially more beneficial to reform Regulation 28 to mandate pension fund trustees to disclose their responsible investing strategy (if any)? The point is that they could choose to avoid doing anything, but it would no longer be through benign neglect. The global picture points to results which could be larger and encompass more goodwill towards responsible investing than any move to prescribed assets could hope to achieve.
To quote Rusconi again: “if socially responsible investing is to gain traction in this country and provide the impetus for development that this country so badly needs, then a great deal more needs to change than the attitude to SRI.” We have both the means and the opportunity to make effective investment decisions with which we can build a better future for all.
Christian Ragnartz from the Swedish Pension Fund AP7 has stated that the lack of action on SRI is the biggest market failure ever: “The consequence of the concept that ‘the market is always right’ is a cynical and irresponsible approach that belongs in the past when we did not have global common guidelines, or democracies for that matter. The seriousness of global warming is one example where the market has proved flawed. Climate change is the biggest market failure ever. Relying on market forces has so far led us into a dangerous situation where it is hard to see how investors could argue they had taken their fiduciary responsibility seriously. I am not suggesting that ESG guidelines would have solved the problem, but they would at least have given the investment community a greater chance to be part of the solution.”