Businesses often believe they have to trade off the longer-term health of the business, economy, environment and society in favour of short-term financial outcomes. This focus on short-term financial returns has led to a series of corporate scandals, starting back in the 1980s and progressing through to the ongoing global financial crisis (GFC).
Governments responded to these scandals by increasing regulation, especially in the areas of governance, internal controls, remuneration and financial disclosure, but this resulted in boilerplate disclosures and no real change to fundamental business thinking.
Investors and financiers are starting to take more meaningful action. The Equator Principles, UNEP-FI and the UN Principles of Responsible Investment (UN PRI) aim to promote more responsible and sustainable investment and financing. Many financial institutions have signed up, established policies and procedures, trained staff and started on the road to responsible investment, but again this is not enough to change investment behaviours and incentives.
The impact of the GFC on the global financial markets has made financial institutions stop and rethink how they make investment and financing decisions, as George Soros has written in his book, The Crisis and what to do about it:
"The severity and amplitude of the crisis (GFC) provides convincing evidence that there is something fundamentally wrong with the prevailing (investment) theory and with the approach to market regulation that has gone with it."
The traditional model of assessing the health and future prospects of investee organisations by using historic financial analysis, plus or minus a premium or discount for quality of management, failed to get the right answers without further inputs.
The missing input is strategically relevant sustainability, or environmental, social and governance’(ESG) information. This can provide investors and financiers with better understanding of the long-term prospects for businesses. For a service-based organisation, key information may include market growth, customer and staff satisfaction and loyalty. For a mining company, key information may include available reserves, environmental and climate change impacts and health & safety.
Responsible investors are now analysing the ESG performance of organisations within each sector. This helps them to prioritise allocation of capital and funding to those that demonstrate they understand their material ESG risks and opportunities, have adapted their strategies accordingly and, as a result, can deliver more sustainable long-term results.
Responsible investment is becoming mainstream, as can be seen by the fact that many organisations are building ESG assessments into their investment modelling. Reuters andBloomberg now provide ESG information on investment analysts’ screens.
Robeco and Booz & Co recently estimated that responsible investment, rather than values or ethical based investment, will grow 25 per cent per annum to $US26.5 trillion assets under management by 2015 (15-20 per cent of global total). It will be higher in Australia, as most major industry superfunds and asset managers have signed the UN PRI and are committed to driving not only responsible investment themselves, but also working with reporting organisations to provide relevant and material ESG information.
So what does this mean for my super?
The key question to ask is: does your financial institution (fund manager) really understand responsible investment, and has it taken early action to mitigate investment risks and maximise opportunities? Let’s consider this question in light of some bank announcements made in the last few weeks.
First, the Commonwealth Bank (CBA) announced it had all but written off its (1996) $25 million investment in the Hazelwood coal-fired power station, one of Australia’s dirtiest brown coal plants. The write-down came as the Victorian government was negotiating with the plant's majority owner, International Power, on a compensation package to close a quarter of Hazelwood’s generation by 2014 and so lower Victoria’s greenhouse gas emissions. What we do not know is whether CBA also wrote down any part of their loan book to coal-fired power stations, and whether there is any longer-term potential impairment.
Although there is no legislated cost of carbon in Australia, there are already significant implied value impacts for businesses with high greenhouse gas producing assets based on expected (inevitable) changes in regulations and customer expectations to combat climate change. Has your fund manager identified those high-emitting assets in your portfolio and taken action to remove the risk? Do you have an embedded loss (equity or hidden in the loan book) in your portfolio waiting to happen?
Second, Westpac announced in its annual sustainability report a new investment policy to "avoid involvement in transactions which support the establishment or long-term continuation of inefficient and high carbon-emitting assets into the future." In effect, Westpac will not invest in new coal-fired power stations unless they are already committed, or unless the emissions generated can be reduced significantly.
This is an example of a ‘trade-off’, where Westpac now sees the environmental and social ramifications of supporting new high-emission transactions as outweighing the potential financial returns. This is a very big step to drive investment towards more sustainable and low-carbon energy sources and we endorse Westpac’s approach as prudent ,given the potential for sudden ground shifts in customer sentiment and government policy on this highly emotive issue.
Are you happy if your fund manager invests further in financial institutions and projects that finance and invest in coal-fired power stations, particularly brown coal stations, which are likely to be the first shut down to reduce emissions? Can you pick when to exit? Is this the best use of your investments for the long term? Is there likely to be a significant write-down at some point?
The most surprising investment story of last week was the statement of the Verve Energy chief executive. It was revealed that funding for a $150 million project was conditional on a confidentiality pledge. The bank had insisted on a confidentiality clause as part of a finance deal for a coal power station so its name could not be revealed for fear of reputational damage. According to The Australian Financial Review, the chief executive was “really shocked when the issue of reputational risk was raised by the bank”. It took 48 hours for the name of the bank, ANZ, to be published.
The fact the bank knew there was a "reputational risk" associated with the transaction demonstrates they were conscious that making the investment might have a backlash, but they still went ahead. Hiding behind a contractual clause actually makes the investment decision worse, from a transparency and governance perspective. On the face of it, there appears to be a lack of understanding of what responsible investment is all about. Although ANZ has been working hard on their sustainability agenda, this transaction and how it was handled does show that responsible investment is not embedded throughout mainstream investment and financing decision-making.
Under the new Westpac policy, this investment could possibly still have been made. However, it would have been subject to many internal controls testing the validity of the ‘trade-off’, and the rationale for the decision would have been reported publicly.
Even if your fund manager (or financial institution) understands the longer-term ESG issues facing the investee companies in your super fund, is ESG thinking embedded in the trade-off decision-making at all levels? Or do managers and staff still revert to deliver short-term financial outcomes?
ESG risk is impacting valuations, capital allocations and funding. A few leading financial institutions are taking steps to not only integrate a carbon price into the cash flows underpinning their investment decisions, but are also attempting to value and ‘cost’ other material ESG factors (ie. customer loyalty, employee productivity and retention in a service organisation). Organisations that have not yet started on their journey to sustainable business practices, and financial institutions that have not yet adopted responsible investment practices, need to get moving, or risk an uncertain future.
For the super fund member, the questions are: Is your super fund being managed by someone who understands longer-term ESG risks? Have responsible investment practices been embedded effectively throughout all levels of the organisation? Can your fund manager demonstrate investment in sustainable organisations and projects, and rejection of ones with poorer ESG strategies and a short-term focus?
If you don’t know – ask!
Nick Ridehalgh, Director, Kiewa Consulting, a consultancy focused on embedding sustainable business practices and decision-making, as well as strategically aligned integrated reporting.
Jon Jutsen, Executive Director, Energetics Pty Ltd, Australia’s leading climate change and resource efficiency consulting company.