Is Sustainable Responsible Investing (SRI) More Than an Ethical Decision?

Published on June 22nd, 2015 | by

Future SRI Investing

With cash-strapped and debt-ridden governments, sustainable development experts are turning to private SRI investors to address the gap in social and environmental initiative spending. A UN paper titled Private Sector Investment and Sustainable Development estimates that approximately US$5 trillion to US$7 trillion per year will be required to address sustainable development needs, with an additional US$44 trillion required for clean energy alone.

Founded originally in the 1800s, the sustainable, responsible investing (SRI) industry was primarily pursued by religious organizations. Ethical considerations limited “sin” stock, such as companies operating in the tobacco, alcohol or gambling industry. SRI limitations were further expanded by the Religious Society of Friends (Quakers) to include slavery and war around 1900. Later on in the 20th century, SRI centered around political movements such as ending apartheid in South Africa and abstaining from investing in military weapons during the war in Vietnam. The most recent SRI strategies have focused on environmental initiatives such as fossil fuel divestment and green bonds, not only for ethical considerations but also for the financial risk of climate change and stranded assets.

Definition and Size of SRI Industry

The Forum for Sustainable Responsible Investment (US SIF) provides the following definition for SRI:

“Sustainable, responsible and impact investing consider environmental, social and corporate governance (ESG) criteria to generate long-term competitive financial returns and positive societal impact.”

The US SIF Foundation reported that approximately US$6.57 trillion or one in six of US-domiciled assets were employing SRI strategies at the start of 2014. Since individuals of the millennial generation (born between 1980 and 2000) are particularly interested in SRI and expecting to come into a chunk of change from inheritance and increased salaries in coming years, the SRI industry is forecasted to grow.

Range of SRI Product Offerings

Sustainalytics describes the range of products available on the SRI spectrum:

1) Traditional

  • Traditional investing has no limitations on investments.

2) Responsible Investing

  • There are no limitations on investments but shareholders advocate for corporate policies that promote environmental, social and governance (ESG) issues.

3) Social Responsible Investing

  • Screens are employed that limit the investment universe. A positive screen uses a best-in-class approach where investments are only made in strong ESG leaders. Negative screens can also be used that limit entire “sinful” industries or companies that are notorious for their harmful business practices.

4) Impact Investing: Thematic Investing

  • Impact investing focuses investments on a particular issue, such as clean energy technology or employee safety. Thematic investing provides this focus without sacrificing competitive returns.

5) Impact Investing: Impact-First

  • Similarly, impact-first investments target a cause, but there may be a trade-off in profits so long as the initiative is effective.

6) Venture Philanthropy

  • Venture Philanthropy is “social enterprise funding in a variety of forms with a range of return possibilities” where “investor involvement/support is common.”

Range of SRI Investor Types

A paper by NYU categorizes the following investor types:

1) Yellow

  • Yellow investors feel a moral obligation to invest “responsibly” and their demand is inelastic to the return of the investment (they will invest using SRI strategies no matter what the cost).

2) Red

  • Red investors are motivated by the financial benefits of SRI and indifferent to moral considerations. They believe that SRI companies will “outperform their peers in the coming years.”

3) Blue

  • Blue investors are prepared to make sustainable, responsible investments provided the financial trade-off is not substantial and such strategies will effect change.

Interestingly, the paper notes that the most effective strategy for blue investors is to not exclude entire industries from their portfolio as the limited portfolio cannot reap the benefits of diversification. It makes the point that excluding an entire industry eliminates the financial incentive for a “sin” company to change ESG policies. If entire industries are included and a best-in-class or worst-in-class approach is used, a tobacco company will be motivated to ensure their practices are more in line with ESG principles than their peers. In other words, with this strategy they don’t have to be faster than the lion, they just have to be faster than their friend.

Is the Return on a Responsible Investment Comparable?

Opinions are mixed on whether sustainable, responsible investments are competitive with their peers. Arguments against SRI competitiveness draw on modern portfolio theory to argue that a reduction in the investment universe results in a lower expected risk-adjusted return. It can also be argued that the costs to assess, monitor and report on SRI companies take away from the net return. Some pro-SRI investors believe the market is mispricing ESG risk and ESG companies in the long run will outperform. The increased performance from ESG initiatives is attributed to increased employee engagement and satisfaction, reduced litigation costs and better risk management strategies, among other cost savings.

RBC analyzed the research in this space and concluded that SRI strategies “do not result in lower investment returns.” With that being said, RBC cautions that the studies reviewed are not without statistical errors which could affect the result. To draw stronger conclusions, additional empirical research is required.

Future Trends in SRI

A 2014 presentation by Responsible Investment Association highlighted that two “hot topics” in the industry are fossil fuels and green bonds.

  • Fossil Fuels

Fossil fuel divestment has made headlines in recent years from student petitions and lawsuits for university endowments to sell off their fossil fuel interests. Since fossil fuel companies account for approximately 25 percent of the S&P/TSX, divestment will dramatically reduce one’s investment universe, so this decision has not been taken lightly.

In 2012, Rolling Stone magazine published an interesting article on the 2°C target set at the 2009 Copenhagen climate conference. At the conference, world leaders “agreed that deep cuts in global emissions are required” to meet the scientific recommendation of limiting a temperature raise to less than 2°C to mitigate global warming. Scientists estimate that approximately 565 gigatons of carbon dioxide translates to just under a 2°C temperature increase. Now, there are an estimated 2,795 gigatons of carbon dioxide from unburned fossil fuels in reserve and already accounted for on company balance sheets. With the value of total reserves estimated at $27 trillion in 2012 (assumed to be US-denominated), an 80 percent write-off would be worth approximately $20 trillion. These unusable reserves are referred to as “stranded assets” and make the economic argument to sell off fossil fuel stock and reinvest in the green economy.

  • Green Bonds

TD describes a green bond as “a debt instrument issued to raise capital that is used exclusively to support projects with specific environmental benefits.” As for the size of the industry, “in 2014 issuances were over US$35 billion, more than three times higher than the US$11 billion issued the year before.”

The main topic in green bonds lately is the lack of standardization and transparency in the product. Investors currently holding green bonds are vulnerable to the risk that their bond may be exposed as “not as green as they thought”, causing demand and the price of the bond to drop – which adversely affects yield. A push to standardize the industry has been met with critics who say the cost to monitor and report will affect a green bond’s price competitiveness relative to its “brown bond” alternative.

Green bonds have often had a positive spread over Treasury bonds (government bonds) as of late since interest rates have been low. Beyond offerings by governments and international financial institutions (such as the World Bank), there’s been an upsurge in corporate green bond issuances. Bloomberg argues that these bonds can’t boast a better yield than their brown counterparts since they’re both backed by the same balance sheet and arbitrage would ensure equal pricing. However, they also note green bond benefits since corporations are able to secure a longer duration than that of traditional brown bonds. It will be interesting to see how this new industry develops as government interest rates inevitably bounce back.

Betting on the Wisdom of the Crowd

With everybody making bets on the winners and losers of climate change, will this provide an accurate estimation of the cost and risk?

After all, when citizens at a fair were asked to guess the weight of an ox, the average estimate proved to be surprisingly accurate. However, the wisdom of the crowd phenomenon only works when guesses are independent. If guessers are influenced by each other, then the range of guesses will narrow and the average will more likely “approach a misplaced bias”. With that being said, “if the group generally has good initial judgement, social influence can refine rather than degrade their collective decision.” A diverse spectrum of guessers also trumps a panel of experts in accuracy.

Taking all this into consideration, how much are you going to bet? How much are you going to leave exposed?

 

Picture Credit: StockMonkeys.com available at www.stockmonkeys.com – Edited


About the Author

With an Economics and Finance degree and experience in academic research and economic consulting, Alison attempts to explain the world in economic terms. She is interested in behavioural motivations and economic models that describe the individual as driven by factors beyond profit. She is particularly focused on finding solutions where the kind and compassionate route can also be the most profitable. Alison lives in Canada and enjoys rock climbing and running in her spare time.