What was arguably the first stock exchange was set up in a courtyard in Amsterdam in the early 17th century, to facilitate trading shares in the Dutch East India Co.
“You could already indicate that, given my religion, I do not want to finance ships that only carry soldiers to kick the living daylights out of people far away,” says Maarten Biermans, head of sustainability policy at Rabobank in Utrecht. “Then 100 years later the Quakers in England said we won’t do guns and slaves. The whole notion of introducing non-financial indicators is literally as old as investment.”
The argument might seem twee to some, but is compelling. If Europe’s early mercantile capitalists saw a place for ethics in investment decisions, what is different about today’s society or markets that should rule them out?
Yet while modern markets set great store by upright conduct and respecting the law, ethical choice has been sidelined.
The usual history of responsible investing is that it began with ethical funds excluding sin stocks like alcohol, tobacco, pornography and weapons.
Then it moved on to taking a holistic view of each company’s environmental, social and governance characteristics and integrating it into the investment decision. ESG is seen as an extra guide to corporate health, so poor ESG performers need to offer more risk-adjusted return to justify buying them.
About four years ago, the cutting edge view in responsible investing circles — including at the Principles for Responsible Investment organisation, which functions as the discipline’s Vatican — was that responsible investing was not about ethics, which were faintly old-fashioned. ESG investing was important, but justifiable entirely in terms of better financial outcomes.
This was a great narrative. ESG investors could look the hardest-nosed client in the face and declare: if you put your money with us, you aren’t going soft and won’t give up a penny, versus regular investing.
This remains the orthodoxy. It has held sway as the responsible investing movement has risen to its greatest heights. The global Paris Agreement commits the world to making finance flows sustainable; the European Union has launched a fleet of policies that come close to enforcing RI.
Under the shelter of this selfish definition of ESG, the PRI redefined investors’ fiduciary duty to their clients. The old view that investors should only consider their customers’ financial wealth was slung out, and replaced with a duty to take account of ESG concerns.
Looking after number one
Many voluntary initiatives are now moving finance in a sustainable direction. One of the highest profile is the Taskforce on Climate-related Financial Disclosure.
The TCFD wants all securities issuers and investors to declare how climate change is going to affect their business, long term, and what they are doing about it. This should help investors see the risks and move their capital from hands which are going to lose money from climate change to others which know how to make money. The transition to a clean economy will be accelerated and the risk of catastrophic asset price collapses should be lessened.
In modern ESG style, market forces — investors seeking their own enrichment — will bring this change about, if given the right information.
All involved in sustainable finance urgently wish the TCFD success. But its being valuable and vital does not mean it is sufficient. Investors thinking more about climate change and adapting to it will move the economy in the right direction. But there is no economic or scientific reason to believe they will move it far enough, fast enough.
Consider small island nations — Fiji for example. The rational ESG investor might decide: climate change is going to get worse; Fiji is on the front line of sea level rise and bad weather; I’m going to move my money to higher ground. A solar park in Arizona, perhaps.
This might be the right decision for the investor’s clients; a harsh rationalist might even argue it was right for the climate; but it certainly wouldn’t be welcome in Fiji. It raises the prospect of ESG-aware investors being in the forefront of capital flight that magnifies the damage of climate change.
“The TCFD flipped over the usual question of what is a company’s impact on the environment to what is the impact of the environment on the company,” says Biermans. “Now we have the risk departments of financial institutions starting to pay attention — that’s a real win. However, we should not lose sight of the original question: what is the impact of the company on the environment? These are all tools to make sure that financial markets are more aligned with the challenges of climate change, but that doesn’t mean you just move away and let everybody fend for themselves.”
Real estate investors, practising ESG, can move their money to properties in the top half for energy efficiency. But that will not ensure these buildings are green enough to cut emissions to a sustainable level.
“The current two dimensional ESG approach of risk and reward, as developed in part by the PRI, will not get us to 2°C or the Sustainable Development Goals,” says Gavin Power, chief of sustainable development and international affairs at Pimco in New York. “I know within the PRI governance and executive there have been a lot of discussions about moving it to the impact space, which is the third dimension and frontier.”
Rediscovering impact
Like many terms in ESG, “impact” has a contested meaning.
The Global Impact Investing Network tracks a highly diverse $230bn market of social and environmental impact finance that lies outside conventional listed securities markets. The average deal size is $3m. Two thirds of the investors seek market returns for the risk, the rest positive returns below market rate. But mainline financial institutions largely ignore it.
Nevertheless, in mainstream markets, impact is becoming respectable.
The word has been embraced by the green and social bond market, to describe the environmental or social effects of the projects to which proceeds are allocated. Investors study these and report to clients on the “impact” their money has had. Some call green bonds impact investments.
In March, the PRI produced a guide for asset owners: How to Craft an Investment Strategy. The 26 page booklet contains some striking passages. Without directly telling asset owners what to think about ESG, the document hints very heavily that those that do not agree with five propositions may consider it “a warning sign that [their] strategy has a short shelf life and will need to be re-evaluated”.
Point 2 in the catechism is “Is positive real world impact an explicit part of your primary objective for investment results?”
On the next page, a diagram shows how, out of three investments with equivalent risk and return, some investors might prefer the one with the best impact. Most green bond investors would put themselves in this category.
A second diagram shows how investors with impact as a “primary objective” would prioritise this “even at the potential expense of risk and return”.
Without wanting to make a bold statement, the PRI is clearly guiding investors to think once again about the real world effects of their investment choices — essentially, morality.
“We are really on the brink of a pretty radical sea change in impact investing generally and in fixed income specifically,” says Power. “The old ethical field evolved into ESG and we are now seeing that moving into impact, where investors are looking for some intentional outcomes from how they invest.”
Behind this change is the urgency of climate change and the prominence of the Paris Agreement and the Sustainable Development Goals, which the financial sector is called on to assist.
“What bankers and investors realise is that doing good is coming within their time horizons, within the tenors of their loans and investments,” says Roland Mees, director of sustainable finance at ING in Amsterdam. “The door is closing with regard to climate change. If we do not take certain urgent actions now we will lose the opportunity to reach the 2°C scenario.”
Bridging the gap
Obviously, governments are responsible for filling the gap between what society needs and what markets will finance. But if investors are allowed to engage the ethical parts of their brains once again, there may be much they can do to help.
Christoph Klein, a former credit hedge fund manager and managing director at Deutsche Asset Management, now runs a start-up multi-asset manager, ESG Portfolio Management, in Frankfurt. “ESG allows me to work on the triple win,” he says. “To reduce the risk of the portfolio, to see opportunities for enhancing returns, and the third point, to enhance stakeholders’ lives. If we can have a positive impact for many people involved, I’m happy to spend extra time in analysis and engagement.”
Banks and other service providers are keen to assist. “We have had clients coming with two or three of the Sustainable Development Goals and saying ‘can you help us find stocks and bonds that have a positive impact regarding these?’” says Marcus Pratsch, head of sustainability research at DZ Bank in Frankfurt. “‘Can you provide a portfolio where it’s highlighted which company is contributing to which SDG?’”
DZ’s environmental, economic, social and governance (EESG) research and rating system includes an impact analysis, covering how sustainable are the effects of the issuer’s products.
Green loans, in which companies can pay lower interest if they hit sustainability targets such as an ESG rating, can be used with impact in mind.
“We are willing as a bank to do green loans with the big mass of smaller companies,” says Mees. The margin reduction could get companies working on sustainability. “People need a motivation to do things, an incentive to go through the hassle. If they can be nudged then they tend to get on the move.”
Investors are not going to become charities. Equally, as Wolfgang Kuhn, a former bond investor now at the ShareAction NGO, puts it: “If we go towards 10°C of warming, we are close to extinction, and risk and return have no meaning.”
Between the imperatives to make money and to save the planet, there is not one formula for correct action. There are choices.
“People need to understand that by investing you make judgements, in a way about life and death,” says Kuhn. “These judgements need to be explicit and people need to be courageous and stand for something. By boiling it down to risk you can’t capture the complexity of the world and what we are trying to preserve.”