Investment as Usual is Broken [Part 3 of 3]: next generation needs

State Street Corp.'s [STT] State Street Global Advisors [SSgA] has been slowly moving into some ESG-applied research for the past few years, because ESG factors are starting to become mainstream according to Bill Page, head of the company's ESG Team in Boston. Bill was my recent guest in the final session of MBA865 Sustainability in Investing Strategies where he was pitched by students’ investment ideas for the new SSGA Global Environmental Opportunities Strategies [GEOS] fund. Bill says his GEOS investment team is using ESG research for accounts of some rich investors and private institutional investors, such as endowments. His new strategy has secured its first mandate, and he is flat out covering demand.

Globally, the Principles for Responsible Investment [PRI] has emerged as an organizing theme for asset owners, investment mangers and their service providers. The PRI is an institutional investor initiative, launched in April 2006 by UNEP FI and the UN Global Compact. The PRI supports the work of UNEP FI in engaging financial sector, environmental responsibility goals of UNEP and the Global Compact’s 10 principles aimed at achieving the Millennium Development Goals by 2015. The PRI appreciates that, at least on paper, the informed end-investor drives all activities in investment value chain. Key factors like climate will be integrated when demanded by the market. Significant risks and opportunities for investment valuation will come with climate changed perceptions; from taxation and regulation, changes in weather patterns, technological innovations, shifts in consumer attitude and demand. There will be winners and losers in the transition to a low carbon economy: investors need information to determine how companies will be affected. Approximately 25% of global emissions were reported through CDP in 2007.

But where is investment practice today? Involved asset owners e.g. pension funds are exploring the boundaries. Pension funds have a business case for reducing negative and increasing positive externalities. CalPERS[i], the biggest U.S. pension fund, has identified the investment case for incorporating corporate governance as firstly, shareholders are willing to pay a premium for well-governed companies, secondly, a “corporate governance premium” can be captured to increase shareholder value, and thirdly, well-governed companies have a competitive advantage in attracting capital. Institutional investors have linked superior investment performance with strong governance according to research by Watson Wyatt and Oxford University. In September, 2007, a powerful group of investors and advocacy groups filed a petition with the US Securities and Exchange Commission asking the SEC to require publicly-traded companies to assess and disclose their financial risks from climate change. "Among the 22 petitioners - which include Environmental Defense, a US non-governmental organisation, and Ceres, a coalition of investors and environmentalists - are a group of major US and European institutional investors that collectively manage more than $1.5-trillion in assets" the FT reported.

UNISA’s Centre for Corporate Citizenship, the UNEP Finance Initiative and Noah Financial Innovation, together with the PRI, have found in their study that while most market participants think integrating ESG factors in investment practice is important and has a material impact on how companies are valued, few financial institutions or advisers are doing much about promoting this kind of investment. The 32 pension funds, 19 asset managers and 11 investment advisers involved (between them controlling more than US$700million) believed that ESG issues were material to a company’s value. But most were either doing nothing about responsible investment or had limited involvement.

Experimentation and development of new tools is progressing. A new biodiversity tool evaluating ecosystem services in the Food & Beverage Sector in the UK and Brazil is being beta tested by European investment managers supported by Flora & Fauna International and UNEP FI. In the past few months, several fund-of-funds -- hedge funds that invest in other hedge funds -- have sprung up to cater to the market for investments adhering to certain environmental, social and corporate-governance standards as WSJ 's Carolyn Ciu reported.

At the cutting edge of the new approach to investment as usual, are efforts being made in emerging and frontier markets. The PRI in Emerging Markets Project is aimed at integrating ESG factors into investment decisions impacting business in 25+ emerging markets and developing countries through December 2008. The logic model makes the compelling case for investors [both within and into emerging markets ] that increasing the visibility of ESG factors along the investment value chain in emerging markets by addressing systemic thinking of investors will reduce barriers to improved ESG performance in country.

Environmental, social, ethical, and governance issues are embedded in any firm's corporate strategy. Anything that affects a firm's business model can also affect the firm's financial performance - therefore its valuation - and these issues are no exception. The question posed is: “If business may be a positive driver for sustainability, and investors own or lend money to these companies across asset classes, can their active voice influence better ESG disclosure and action, thereby driving positive ESG performance?”

In emerging markets, perhaps a leapfrog in thinking will mirror the leapfrog in approach to telephony: many emerging markets – South Africa, Brazil, Thailand - have skipped the full deployment of fixed landlines, and made the leap to embracing mobile phone telephony. On 6 February 2008 in Geneve, Switzerland, an IFC consortium led by Standard & Poor’s Equity Index Services together with KLD and CRISIL, an Indian credit rating agency, will launch the first ever Indian company ESG index, featuring indexes with 50 and 100 companies scored on ESG performance. Carbon analysis firm TruCost together with investment firm CLSA is studying monetizing the environmental impacts of companies in the MSCI Emerging Asia ex-Japan index, as well as investment research, mandating identification of comparable and quantitative key performance indicators relevant for the largest listed sectors in India, Thailand, Malaysia, Vietnam, the Philippines and Indonesia, together with the World Resources Institute [WRI, wri.org].

The next generation of investment analysis must be ready to cover - explicitly or implictly - ESG factors in their investment analysis. Analysts will also be expected to act as investors, engaging firms directly to improve ESG performance, realizing the influence on the investment case may be bi-directional. A version of these comments was edited for the UN Chapel Hill Kenan-Flagler Business School's monthly publication for the Center for Sustainable Enterprise. I conclude this three part thoughtstream in the same way:

A New Approach to Investment Analysis

Environmental, social, and governance issues (ESG) are embedded in any firm's corporate strategy. Anything that affects a firm's business model can also affect the firm's financial performance—and therefore its valuation. ESG issues are no exception. Many bright minds have played with this, and will again - see back to the Cable & Wireless WWF effort To Whose Benefit? in 2003. The next generation of investment analysts must be ready to:

1. understand the industry/sector dynamics of key ESG issues
2. identify the material impacts of ESG factors on a firm’s corporate strategy
3. drive toward clarity on ESG data points delivered with consistency and clarity into the valuation process
4. make investment decisions presented over both short-term and long-term horizons

The next generation of investment analysts may also benefit their investor clients by acting as active investigators, engaging firms directly to improve firm ESG performance, appreciating the articulation and influence on the investment case may be bi-directional: investment analysts may not know all. “Investment as usual” will change as companies adapt their strategies to the realities of a connected, globalized world with creative talent sensitive to ESG issues. So too the next generation of investment analysts must change. And with each passing page of Dan Reingold's confessional "Confessions of a Wall Street Analyst", I become more certain of the need for these changes, and how they must be driven into the incentive structures for analysts. if the title "analyst" is ever to "get some respect" again.

The investment world is fast and pressure-filled. Investment professional mind “other people’s money” [OPM]. It is an awesome responsibility to act as the interpreter and fiduciary for the savings of others. Investment as usual must change with the next generation of investment analysts, integrating sustainability in investing strategies.

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[i] CalPERS Active Corporate Governance Program, William Sherwood-McGrew, Corporate Governance Officer, November 21, 2003 NYSSA CG Conference NYC.

Investment as Usual is Broken [Part 2 of 3]: who is doing the math?

Further thoughts from comments I prepared for “Investment as Usual,” for the launch of the Survey of Responsible Investment in South Africa, 2 October 2007 at Johannesburg Securities Exchange, Sandown, South Africa.

Key components of the investment value chain are addressing the breaks, however slowly and tentatively. Indeed, as far back as 2004, Morgan Stanley equity research stated “understanding corporate governance is critical to investing in telecom”, but evidence of impact on decision-making is scant.

In generating investment ideas, the Enhanced Analytics Initiative [EAI] is designed to use the ordinary business of the brightest investment minds who offer best investment research ideas, but explicitly including ESG factors. EAI is a consortium of buy-side funds [investment managers] allocating commissions to encourage ESG research. EAI, including BNP Paribas, the Universities Superannuation Scheme, Investec and Hermes, have agreed to spend 5% of brokerage fees with firms that focus on ESG indicators. The EAI has over thirty representative investors with just under US$4 trillion asset under management [AUM].

The EAI next meeting is 29 Jan in London, hosted by Investec, the mid-size investment manager that I watched grow during my retirement fund consulting days in Durban and Johannesburg thru the 1990's. In my view their South African roots mean they understand the gritty reality of sustainable development and balancing ESG and investment on any given Monday. The sustainability reporting itself has moved a long way up the lifecycle, to a point where no separate Investec CSR report is issued. The EAI six-monthly cycle is up, and an update to the assessment of the best sell-side research should be forthcoming on the website soon.

A pressing question from the latest iteration of the Carbon Disclosure Project [CDP] is: with all the carbon information disclosed, what are investors doing with it? 2007 saw the fifth iteration of the Carbon Disclosure Project Fifth [CDP5], with information on corporate carbon footprints supported by 284 signatory investors representing $41 trillion of assets under management, demonstrating a significant uplift from 2002 (35 investors representing $4.5 trillion). This largest collaborative investor engagement includes blue-chip institutions across all continents including HSBC, JP Morgan Chase, Bank of America, Merrill Lynch, Goldman Sachs, AIG, State Street, Allianz, Credit Suisse, Munich Re, Mitsubishi UFJ, Mitsui Sumitomo, AMP Capital, Swiss Re, Rabobank, ABP, CalPERS, Hermes.

But a question with seldom a direct answer is: but what are investors doing with the information? My first hand experience with shops in Manhattan, Boston, London, Geneve and elsewhere is: not much. A simple question I put to my MBAs at Kenan-Flagler is - at what price are analysts that cover Southern Company [SO] or Duke Energy [DUK] factoring in carbon emissions in their valuations today? Browse their investors page, and keep the coffee in the travel mug, it'll probably be getting cold.

With electric utilities having huge capital costs for new projects or development necessitating decades long investment horizons, it is unclear currently how investment analysts deal with the material impact of CO2 emissions and costs of green house gas emissions. Are SO or DUK even reporting to their shareholders on their green house gas emissions?