Responsible Investment in Emerging Markets and CalPERS’s new 8 principles in EM

In Kuala Lumpur a few thousand airmiles ago, my feature presentation on Responsible Investment in Emerging Markets covered three segments, firstly the State of RI in EM, secondly the Future of RI looking to 2012, and finally the Challenges and Opportunities for RI in EM thru 2012 by invitation of The International Corporate Social Responsibility Conference 29th-31st July, 2008. The state of RI in EM in 2008 reflects the broader RI movement history. Responsible investing has grown over the past 30 years in piecemeal fashion driven by issues – think napalm, apartheid, SOX and NOX, Darfur - and waves of investors from institutional and retail segments, as Steve argues in our forthcoming paper [Lydenberg & Sinclair, forthcoming Journal of Business Ethics, 2008]. Indeed, sometimes the changes at micro level are curious - one SRI fund tracked out of Boston (Dreyfus Third Century-DRTHX) has been seeing big inflows these first weeks of August. The main focus of RI has been and remains on equities - the stocks of large, publicly traded corporations. This emphasis on equities is perhaps accounted for by the emphasis within the early RI movement on changing corporate behavior in positive ways and the desire of religious investors to avoid companies involved in morally questionable lines of business. It also skews away from where much of the ESG investor action in EM happens, in fixed income, family-owned small/medium enterprises [SMEs], and company capital projects.

Malaysia has since 2006 required all listed companies to report on their corporate responsibility policies and programs to Bursa Malaysia, the Malaysian Stock Exchange, and the Malaysian Treasury has been active in describing listing CSR requirements. But listed equities always only form a small portion of economic and business activity, especially in SE Asia where family wealth and private companies, as well as parastatal companies, form a major component of capital ownership and business activity. If sustainability or CSR aims to cover more ground, asset classes from the investment horizons outside of equities must be covered. Currently we are scoping a more comprehensive view on private equity and high net worth investor activity.

Demand for ESG in investment analysis coverage in developed countries has led to increased and improved supply [off a nothing base]: mainstream investment houses, such as Société Générale, F&C Asset Management, HBOS, Citigroup Smith Barney, JP Morgan Chase, Merrill Lynch, UBS and Goldman Sachs have in recent years established in-house research teams that conduct analyses for their investor clients on such issues as climate change, renewable energy, water, human rights, nutrition and diversity. Some of it is eased along by the Enhanced Analytics Initiative [EAI], but as a mate reports even this year in 2008, the EAI offering for EM investors is thin. I agree with Marcel Jeucken of PGGM, the second-largest Dutch pension fund, that there is “low hanging fruit in EM from an ESG perspective” [Responsible Investment Landscape Report: Asset Managers, 2008]. PGGM considers EM from a human rights perspective including covering “oppressive regimes” [undefined], and they reportedly cover fully 1,000 EM companies of the 4,000 companies universe screened. EM is sometimes regarded as an illiquid asset class, based on the volatility and some settlement challenges.

Direct and Indirect

In my EM session, one sensed the audience leaned forward when I covered the roles of investors within a country and into a country, foreign versus local capital, a truth in tension in EM. The 1997 Asian currency meltdown was a “where were you when…” moment in the region’s history ["Soros" remains a four-letter word]. The ‘97 crisis, as one local expert explained; “took away not just the investor focus and funds but internal drive as well”. What foreign investors think, and do, is important to Malaysian investors. Today the regional rivalry with Indonesia, Singapore, Thailand and similar countries is real. The conceptual framework I developed for the PRI in EM Project [now being taken on by my former intern, Narina Mnatsakanian, recruited from KPMG Netherlands] on investors directly or indirectly into EM was usefully adapted for the Malaysian presentation.

The graphic [see above] illustrates the role of portfolio flows in EM, and three points of investor exposure – including the third category where GE fits in, noting that for the first time ever, in fiscal 2007 more than 50% of GE’s revenue came ex-USA. Going forward, the relative power of family wealth, private companies and company capital investment including M&A must be factored into the thinking. The EM Investor framework explains the relative roles of foreign portfolio, local portfolio as well as company supply and demand chains across borders into EM. For example, in February 2007 California Public Employees’ Retirement System [CalPERS] committed US$400 Million to a new private equity vehicle focusing on global emerging markets in Eastern Europe, Latin America and Asia.

I explained our experience of ex-country investors sitting in San Francisco, London or Zurich who use a tool like the MSCI Barra EM Index as universe and benchmark for their EM exposure. The last public data had Malaysia represented 3.052% with $79,193 market cap and 58 companies, the ninth largest allocation and fifth of five ASEAN countries in the top 10. Malaysia is a major component of an EM perspective. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. The embargoed website lists the MSCI Emerging Markets Index as of June 2006 consisted of the following 25 emerging market country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. In the UN context of course, Taiwan’s massive market cap [US$ 688bn at 31 Dec 2007] was wished away to cater to the China politics.

The perspective of foreign investors may be as influential as sovereign ratings agencies, and of course they are self-reinforcing. This week the price of South Africa’s long delayed electricity grid upgrades just got a lot more expensive when all three ratings agenices downgraded ESKOM debt, forcing the treasury to promise to underwrite it and the path to the World Bank to be trodden once again.

Eight Principles

In the institutional investment space, whatever US giant CalPERS does is watched closely, slightly less than more paparazzi friendly targets in California, like Britney Spears or Jack Nicholson… Noteworthy for EM investors, in December 2007 the CalPERS Investment Committee moved away from a negative-screening-on-country approach in existence since 1989 toward a new principles-based approach to investing in the emerging markets in lieu of the existing country list and permissible equity market analysis adapted from the FTSE All Emerging Index [evidence of CalPERS market power and the competitive nature of the index business that they chose not to use the industry de facto standard, MSCI EM Index]. Apparently, the time and resource costs out-weighed the ESG benefits - former CalPERS analysts admitted the policy consumed hundreds of hours of staff and consulting time. In April 2007 when the review was announced, Mark Anson — CalPERS’ former chief investment officer and then chief executive officer of Hermes Pensions Management Ltd., London [he returned stateside a year ago citing personal changes], wrote in an e-mail to Pensions & Investments “I am encouraged by statements of Chuck Valdes and other board members to review the emerging markets policy. Emerging markets are the most dynamic part of the equity markets, where change is rapid and investors must be both prudent and flexible to achieve the best possible long-term returns.” Media also reported the emerging markets list had cost the fund 2.6 percentage points annually in performance — or $401 million in opportunity costs — from Aug. 1, 2002 through Dec. 31, 2006. Together with busloads of citizens from targeted EM countries, clearly an unwieldy but well-intentioned effort that attracted debate over the years, as far back as 2002.

The new approach, GLOBAL PRINCIPLES OF ACCOUNTABLE CORPORATE GOVERNANCE, was reported by Cal PERS as “continues CalPERS’ policy of being a positive influence for improved practices in emerging markets, while increasing the opportunity set for CalPERS’ managers”. The eight principles cover a mix of ESG factors, including the major of political institutions, illustrating a delicate crossover of investor and the public sectors [extracts below]:

· A. Political Stability – including what I rate as the more important factor, Civil liberties: 3. Independent judiciary and legal protection:

· B. Transparency – including elements of a free press necessary for investors to have truthful, accurate and relevant information [biggest ticket item for me] and stock exchange listing requirements [more on the Brazilian experience at BOVESPA next week].

· C. Productive Labor Practices.

· D. Corporate Social Responsibility and Long-term Sustainability - Includes Environmental sustainability and the Global Sullivan Principles of Corporate Social Responsibility [see new website at http://www.thesullivanfoundation.org/gsp/default.asp].

· E. Market Regulation and Liquidity – including “little to no repatriation risk”.

· F. Capital Market Openness .

· G. Settlement Proficiency/Transaction Costs

· H. Appropriate Disclosure

The document introducing “The Global Principles of Accountable Corporate Governance” describes the framework by which CalPERS puts into action its proxy voting responsibilities in addition to providing a foundation for supporting the System’s corporate engagement and governance initiatives. The aim is “to achieve long-term sustainable risk adjusted investment returns”. It is unclear how this objective will be measured, and over what time horizon. CalPERS does break new ground in developing their own approach that does not naively map to a smorgasbord of acronym international initiatives, similar to the Fins and Danes. CalPERS also offers some material on their universal owner perspective, namely “[CalPERS] has chosen to adopt the term "shareowner" rather than "shareholder." This is to reflect a view that equity ownership carries with it active responsibilities and is not merely passively "holding" shares. Perhaps the strongest takeaway for any investor is the quote from CFA Institute’s take on Corporate Governance: “For corporate governance structures to work effectively, Shareowners must be active and prudent in the use of their rights. In this way, Shareowners must act like owners and continue to exercise the rights available to them.” (2005 CFA Institute: Centre for Financial Market Integrity, The Corporate Governance of Listed Companies: A Manual for Investors)

How decisions on the eight principles are made, and indeed the relative weightings on decisions [for example, when would a country perspective on China trigger a review?], may reflect the pragmatism necessary in investment in general, and especially in ESG. I look forward to the first review of the new principles based approach next year, and comments from similar institutional investors I met this year in Singapore, Rio de Janeiro, Cape Town, London, New York, Boston and Dubai. As many before us have learned in sustainability+investment, the pragmatic trumps the politics.

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?

Investment as Usual is Broken [Part 1 of 3]: Valuing ESG factors in equity analysis

Investment as usual is broken. The emergence of environmental, social and governance [ESG] factors in the twenty-first century has challenged the core of business thinking and strategy. Corporations are changing, sustainability has risen to the level of the C-suite, P&G recently appointed their first “Corporate Sustainability Officer”. But the “Chief Sustainability Investment Officer” is much further off. WSJ covers this amongst other "title inflation" items in Dec

Enhancing current investment analysis by integrating material ESG factors will offer better pricing of future risks and opportunities.

Global financial stock now stands at US$140 trillion and growing, according to McKinsey, 2007 based on the latest 2006 data. The value of total global financial assets—including equities, government and corporate debt securities, and bank deposits—expanded to US$140 trillion by the end of 2005, an increase of $7 trillion from a year earlier . But many of the investment decisions are being driven by decision-makers who completed their studies before Google, more influenced by Gordon Gecko of “Wall St” than Al Gore! The sea-change in the way corporations are facing up to our changing world has yet to catch up to the inertia of investment professionals on Wall St, in the City of London and other major investment centers. Investment as usual fails to integrate ESG factors properly. I'm more open for entertainment though - word is there's an update to Wall St, and heck in the past 20 years, cannot say there's no material.

It has become accepted wisdom that “business as usual” will inexorably lead to humans consuming more than the carrying capacity of this one earth’s natural resources, from fossil fuels to potable water to clean air. Investment as usual – the practice of investment management - needs to make a similar adjustment as companies are making in assessing a sustainable future. Matthew J. Kiernan, founder of Innovest Strategic Value Advisors, says traditional financial analysis captures only a quarter of a company's risk and competitive profile. Risk-adjusted returns must reflect a broad and long-term understanding of materiality, within the bounds of fiduciary duty and applied across portfolios and asset classes.

In July, 2007, the United Nations Global Compact annual event keynote address was made by Goldman Sach’s Anthony Ling on behalf of the financial community . It is also true that Hermes has led an engagement on iron and steel companies in the Brazilian supply chain slave labour case. Goldman Sachs presents ten reasons for incorporating ESG factors, three of which were i. experience with risk and return balance, meeting liabilities including identifying global social and environmental challenges, e.g. secure energy supply, climate change, water shortages, BRICs growth, and increasing awareness of ESG issues by analysts and investors. The Goldman Sachs analyst team based in London released a 179-page equity research report titled "GS Sustain" in which it recommended 44 companies based on a combination of companies' ESG performance and fundamentals.

Goldman argued that its picks based on this formulation, both in the U.S. and abroad, outperformed the Morgan Stanley Capital International World Index by 25% over the past two years. A neat approach to selling the quality of your investment ideas. It has been wonderful to watch the London-based team grow from just 2 in 2005, to about 8 now, with more attention from institutional investors than even the GSAM itself. There's an old legend about leaving to find you way, and getting respect in foreign lands, no? Abbey Joseph Cohen will be interviewed by Maria Bartiromo on WSJR next week, maybe it will come up and give the initiative a push...

A recent report by McKinsey indicated investor community ranked only ninth amongst factors leading corporate managers to address societal concerns now and in the next five years. CEOs ranked employees as the stakeholder group that has the greatest impact on the way companies manage their societal expectations. The 391 CEOs surveyed representing 230 organizations in Private/Public, State-owned & NGOs. 90% of company CEOs participating in the United Nations Global Compact said they are doing more than they did 5 years ago to incorporate ESG factors into their strategies. Socially irresponsible business practices might make it harder for companies to attract and retain talented people.

But where is the voice of the investor?