By 2025, 75 percent of the American workforce will consist of Millennials (those born between 1977 and 1995). This demographic is demanding greater corporate sustainability and willing to pay more for sustainable products, services, and experiences. As Millennials drive the trend towards sustainability and responsible consumerism across multiple areas, it is no surprise that they are also making a bigger name for investing responsibly.
What does it mean to invest responsibly? Responsible investment is most often defined as investment that promotes environmental, social, and governance elements/practices deemed as responsible, though it can also be a broader term for other types of similar investment. Using this definition, the environmental pillar most notably encompasses considerations of climate change in terms of physical and transitional risk for companies, given the projected impacts of climate change. It also includes risks related to resource scarcity (e.g. water), deforestation, waste, and pollution. Within the social pillar, topics include health and safety, employee relations, engagement with and consideration of local communities (e.g. indigenous populations), as well as working conditions throughout the supply chain (e.g. eliminating slavery and child labor). Under the umbrella of governance, executive pay (relative to employee pay), corruption, political lobbying, leadership diversity (e.g. executive team, board, management, etc.), and tax strategy may be key features. To reflect these three pillars, responsible investment is now more commonly known as ESG Investment, an idea and term which originated from a 2005 ‘Who Cares Wins’ conference and report.
ESG investment is different from an older term, Socially Responsible Investment (SRI), which more explicitly ascribes moral judgment. Consequently, SRI involves not investing in alcohol, tobacco, or firearms. Another distinction is that ESG investment considers ESG factors to have financial implications, as opposed to only ethical ones.
A sister of responsible investment is Impact Investing, which is a more proactive approach in investing with the ‘intention to generate positive, measurable social and environmental impact alongside financial return.’ In other words, a positive impact is valued above financial returns. Other terms to describe these variations of responsible investment include sustainable investing, mission-related investing, or screening.
Differences in Interpretation
The question of responsible investing is defined differently across cultures. In economies leading on sustainability innovation, responsible investing isn’t a matter of optimizing profits in a socially celebrated manner. Rather, the practice carries a moral obligation that reflects cultural values, making it closer to SRI. This form of investment has been observed in Scandinavia, where responsible investing was principally known as ‘Ethical Investing’ for a long time; the term is loaded with moral severity. This approach contrasts to the United States, where shareholder wealth maximization is valued significantly as part of fiduciary responsibility, regardless of societal impacts.
Responses from Investors
While demand for responsible investment products is increasing, institutional investors have mixed responses. Some have been slow to join the ESG movement under the guise that ESG investing interferes with the fiduciary responsibility of institutions. Meanwhile, others now see embedding ESG principles as part of an institution’s fiduciary responsibility. This change in mindset has been led by Al Gore, along with several other institutions. They seek to remove misconceptions that suggest that responsible investing can negatively impact a portfolio.
A study conducted by PwC found that – similar to Al Gore – 83 percent of Limited Partners surveyed ‘believe that better management of ESG factors will either improve returns or reduce risk, meaning that ESG management is part of their fiduciary duty.’ Risk is a central element in the decision to factor ESG principles into investing, as it can reduce future losses related to stranded assets. Likewise, it can provide an effective framework for dealing with unknowns, such as how to respond to an energy transition or resource scarcity. In the same PwC study, 18 percent of respondents indicated that they had actively withheld capital or withdrawn from an investment on ESG grounds.
According to McKinsey, over 25 percent of global assets under management are invested in line with the idea that ESG elements affect financial returns, whether in the form of performance or market value. The growth of responsible investment is most notably reflected in the decisions of some of the world’s largest institutional investors, including Norway’s Governance Pension Fund Global (GPFG), the Government Pension Investment Fund (GPIF) of Japan (which, although having some short-term struggles, is still committed to long-term sustainable investing), and the Netherlands’ ABP Pension Fund. The combination of action from large institutional investors and a growing demand for these products continues to drive the field’s growth.
While responsible investment has been building momentum, it is not all rosy. Responsible investment comes as a response to meeting global challenges; in that context, what is being done is insufficient. A BNY Mellon report emphasizes that the “annual global investment needed in developing countries in key sectors related to the proposed UN Sustainable Development Goals is estimated to range from US$3.3 trillion to US$4.5 trillion… Current investment in these sectors is around US$1.4 trillion, leaving an investment gap of between US$1.9 and US$3.1 trillion per year.” In a 2016 survey conducted by Teachers Insurance and Annuity Association (TIAA), only about 30 percent of investors who responded owned responsible investments, with half planning to own some in the future. These statistics leave significant room for growth in the field. In order to catch up to these ambitious targets and expand engagement in responsible investing, the responsible investment landscape needs to tackle a few key sticking points.
One key area to address is accessibility. Responsible investment financial instruments are still not universally available across investment options. Even when they are, language surrounding responsible investment can sometimes serve as a barrier to understanding and effectively using these tools. Teething out the distinctions between ESG, SRI, and Impact Investing can be tiresome enough, even without getting into the technical jargon that prevents people from accessing finance and investment to begin with.
The second issue to sort out is measurement. To say an investment is responsible is loaded with other questions, such as ‘Responsible to who?’ ‘Responsible under what/whose criteria?’ ‘When has one crossed the threshold from irresponsible to neutral to responsible?’ The answers to these are culturally contextual and vary greatly. In addition to not having a shared idea of what ‘responsible’ looks like, the areas covered under the idea of ‘responsible investing’, such as social good, can be inherently difficult to measure. While there are ways to measure impact, the field is still young, meaning that there are not yet mature best practices or universally agreed standards. Accordingly, it is difficult to compare one investment’s impact with another. Furthermore, once standards are established, it will be another task to ensure and audit the quality of data; this problem is already being worked on, as data quality gains greater importance in an era of big data.
This growing focus on responsible investment comes as the current and expected impacts of climate change become more severe; the IPCC recently warned that the world has until about 2030 to take significant action in order to avoid the most extreme impacts. Beyond defending a company against risks related to climate change, responsible investment plays a proactive role in curbing climate change by pouring more resources into the development and advancement of technologies and companies that reduce emissions. Responsible investment, supported by other financial tools such as carbon pricing and insurance, will play a central role in mitigating and adapting to climate change.
Image courtesy of Flickr. Originally published by S&S on November 20, 2018.