Exchanges and Responsible Investment

Author Name: 
Dan Siddy

The United Nations Conference on Sustainable Development in Rio de Janeiro this month underlines why responsible investment is becoming an important strategic issue for a growing number of exchanges, and provides a timely opportunity to take stock and contemplate the where we may be heading next.

The formal agenda of Rio+20 focuses on two main themes: how to build a green economy to achieve sustainable development and lift people out of poverty; and how to improve international coordination for sustainable development. The UN has highlighted seven areas for priority attention, including decent jobs, energy, sustainable cities, food security and sustainable agriculture, water, oceans and disaster readiness.

Responsible investment is one of many topics and special interests running alongside (and seeking to influence) the official discussions of world leaders in Rio. A wide cross-section of pension funds, asset managers, service providers, regulators, exchanges and other organisations (including WFE) participated in discussions and policy dialogue on responsible investment. Key forums in Rio before, during and after the main summit itself include the Sustainable Stock Exchanges 2012 Global Dialogue (led by the UN Conference on Trade and Development (UNCTAD)), and the annual conferences of both the International Corporate Governance Network (ICGN) and the Principles for Responsible Investment (PRI).

PRI provides a convenient way to provide the definition of terms that must inevitably precede any discussion of responsible investment. Launched in 2006, the PRI initiative is today supported by over 1,000 investment institutions representing combined assets under management of approximately $30 trillion. The six PRI principles highlight the environmental, social and governance (ESG) dimensions of long-term investment and ownership, principally in the context of pension funds and other large institutional investors. The responsible investment orthodoxy represented by PRI holds that ESG issues can affect shareholder value in companies and thus the performance of investment portfolios. Managing these issues is consistent with fiduciary responsibility, requires active ownership, and should be a mainstream part of good investment practice. The business case for responsible investment – and the kinds of ESG issues that responsible investors focus on at company, sector and fund level - are intrinsically linked to the macro-level challenges of sustainable development (see box: global megatrends driving responsible investment).

The ‘universal ownership’ hypothesis is also an important concept for the rationale, practice and future of responsible investment - and to the future role of exchanges and regulators in this. Large institutional investors (such as the many pension funds that make up PRI’s core membership) indirectly own a significant share of the world’s production capacity because their investments are spread across a large number of companies in many industries and countries. Such universal owners will also often have a very long investment horizon – possibly even inter-generational. The fundamental characteristic of a universal owner is that it cares (or should care) not only about the governance and performance of the individual companies that compose its portfolio, but that it also about the performance of the economy as a whole. Universal owners “own” the economy and therefore bear the costs of any shortfall in economic efficiency and reap the rewards of any improvement. They therefore have an incentive to look closely at ESG issues in order to reduce negative externalities (e.g. pollution and corruption) and increase positive externalities (e.g. from sound corporate governance and good human capital practices).

The democratisation of ownership – as so eloquently explained and argued by Stephen Davis and his co-authors in their book The New Capitalists - is also another key piece in jigsaw puzzle. Forty years ago, corporations were owned and controlled by a handful of wealthy individuals. Financial institutions speaking for small investors owned just 19 per cent of stock at the typical US company. Today, such funds own more than half of all US stock. In Britain, for example, 54 per cent of all UK stock was concentrated in the hands of private individuals in 1963. Today they control less than 15 per cent, while institutions representing the savings of ordinary men and women hold more than 70 per cent, up from 25 per cent in 1963. Similar economic shifts of economic power are evident in many other markets, from Germany and Japan to Brazil, India and South Africa. The owners of the world’s corporate giants are no longer a few wealthy families or state agencies: they are the tens of millions of people who have their life savings invested in exchange-operated markets right around the world. These grassroots owners have ideas about value and accountability that differ markedly from those of Wall Street players, tycoons or politicians. Civil ownership is beginning to change things in profound ways.

These forces create a strong argument for it being in the enlightened self-interest of exchanges (as well as investors and indeed all sections of the financial ecosystem) to take a degree of ownership in sustainable development and its manifestation in responsible investment. The common sense in this is well illustrated by the scale and scope of things that WFE member exchanges, and WFE itself, are doing in practice.

WFE’s 2009 report, Exchanges and Sustainable Investment, provided the first global analysis of exchanges’ activities in this field. Prepared by Delsus Limited, it highlighted a range of sustainability initiatives led by ‘first mover’ exchanges, spanning responsible investment indices and guidance on corporate sustainability reporting (particularly in developing markets) to the creation of specialised markets and services in areas such as carbon trading and clean technology. Sustainable Stock Exchanges: a report on progress (March 2012) provides the most recent update on such activities and initiatives. Commissioned by Aviva under the Sustainable Stock Exchanges Initiative, this report by Responsible Research maps exchanges’ actions to improve corporate ESG disclosure. It also captures important feedback from exchanges on the strategic significance of responsible investment and the challenges that they face. Also relevant here is another Aviva-commissioned report launched in Rio this month, Trends in Sustainability Disclosure: benchmarking the world’s composite stock exchanges, by Corporate Knights. This provides a valuable analysis of sustainability disclosure practices by issuers on 35 exchanges, and ranks those exchanges (or, more properly, markets) accordingly. The top 10 include the Netherlands, Denmark, South Africa and Brazil. The bottom 10 include Russia, South Korea, Canada, the US and India.

The sustainable stock exchanges landscape is a generally positive and dynamic one, albeit with some very important gaps and weak points, some difficult complexities and misunderstandings, and many remaining challenges and opportunities. The number of exchanges that are strategically involving themselves with responsible investment and sustainability issues – particularly in relation to ESG information - is growing. Those exchanges are increasingly locating internal responsibility for sustainability issues at senior management level. New sustainability indices continue to be a popular theme in emerging markets. There is also a growing sophistication and seriousness in the thinking and actions of several exchanges (and regulators) at the forefront, including new guidance documents and circulars on voluntary sustainability reporting and, in a few cases, progress on “report or explain” rules and integrated reporting requirements. WFE itself is closely involved with the ICGN’s Integrated Business Reporting Committee and with the International Integrated Reporting Committee (IIRC), as well as liaison and dialogue with PRI and the many other overlapping associations, initiatives and NGOs that focus on these issues. 

Brazil’s BM&FBOVESPA and South Africa’s JSE are both widely recognised as being at the cutting edge of sustainability issues in the global exchange community, and have been engaged in this field (both locally and internationally) for over a decade. One sign of the wider progress being made is that they were joined by NASDAQ OMX, the Istanbul Stock Exchange (ISE) and the Egyptian Exchange (EGX) in using Rio+20 to publicly affirm their commitment to working with investors, companies and regulators to promote long-term sustainable investment and improved environmental, social and corporate governance disclosure and performance among companies listed on their exchanges.

Investors’ discussions in Rio – and the active participation of exchanges (and some regulators) in those conversations - reflect the maturity and increasingly mainstream status of the responsible investment paradigm. Instead of asking “what is responsible investment?”, “why is it important?” or “what has it got to do with me?”, the key question being asked is “how do we optimize the use of responsible investment metrics in mainstream trading?”. The answer dominating the agenda is that we need to get more and better ESG data into the marketplace through a new global agreement on listing rules for corporate sustainability reporting. This represents a potentially game-changing emphasis on getting better ESG alignment in the investment value chain, and that is a positive thing.

Whether it is the most important priority, or a sufficient solution by itself, is debatable. One of the key findings in Responsible Research’s report is that nearly half of the exchanges responding to the survey cited investor ambivalence as a factor that discouraged exchange officials from further action: investors have not sufficiently rewarded/punished issuers on sustainability factors, which in turn makes it hard for exchanges to push the case for ESG disclosure. This is not inconsistent with the warning in Corporate Knight’s report that global ESG disclosure rates may be plateauing, for which they recommend urgent intervention by policy-makers. The demand-side pull from investors for ESG information (and the price signals they then send back into the market) may not yet be as strong, or as mainstream, as one might infer from the $30 trillion commitment behind the PRI or the $78 trillion controlled by backers of the Carbon Disclosure Project.  If responsible investment is facing some sort of market failure, then policy measures on tougher ESG reporting may need to be accompanied by complementary measures to make institutional investors more accountable for ESG too. The PRI is currently edging towards more robust self-regulation through a new reporting framework that will be piloted this year. In the meantime, as the accompanying article on South Africa’s Regulation 28 and Sustainable Returns initiative demonstrates, leadership on this seems to be coming from the advanced emerging markets.

Why are emerging economies like Brazil and South Africa taking a much more systematic approach towards building the architecture for responsible investment? Perhaps part of the answer lies in the fact that sustainable development is not such an abstract concept for them. In developed markets, responsible investment has developed a tendency in recent years to focus on the possibility that ESG issues can translate into alpha, and hence the priority is to generate the ESG data needed to feed company-level analytical engines and direct shareholder engagement and proxy voting resources to the right AGMs. The link with sustainable development has become obscured (indeed, the phrase is not used once in the six PRI principles). In emerging markets, big pension funds such as Brazil’s PREVI and South Africa’s GEPF, together with the market operators and regulators they work with, see a rather bigger picture that may have more to do with beta.

As with almost everything these days, the Rio+20 stage is ominously overshadowed by the towering backdrop of global financial crisis and beleaguered efforts at recovery. This is not just about weak investor confidence, market turmoil, policy paralysis and political brinksmanship. The cruel effects of inadequate and unstable financial, economic and policy systems on ordinary men, women and children are being beamed onto our Bloomberg terminals and living room TVs from Greece on a daily basis. The impacts in other countries – particularly emerging and frontier markets - are perhaps less well covered by the international media, but no less real: the unrelenting after-effects of the 2008 crisis have undoubtedly had a big impact on global progress towards many key sustainable development goals.

Stripped of jargon, sustainable development boils down to the causes and effects of poverty and prosperity, and our ability to deliver stable, durable and equitable economic growth. Markets are part of the problem and part of the solution, and stand to benefit (or suffer) like anyone else. The Arab Spring of 2011 provides only one of many reminders from recent history of what can happen when societies loose patience with unemployment, inequality, corruption, food shortages, energy price spikes, poor healthcare, inadequate water supplies, lack of access to education, pollution, loss of land, etc.

Prudent people think hard about these issues – or should do. The PRI’s updated strategy and workstream – also launched at Rio this month – sets out the goal of becoming “the pre-eminent global investor organisation focused on accelerating the transition to a more sustainable global financial system”. It promises a new emphasis (and increased resources) for the PRI’s work on research and public policy, and implies a strong desire to bring issues such as financial stability, systemic risk, universal ownership, market failures, short-termism and misaligned incentives more closely into the responsible investment domain. If successful, this opens up a great deal of common ground with regulated exchanges, and a much more tangible sense that interests are being aligned, than has been achieved over the last six years by focusing solely on the issue of ESG listing rules.

The need for institutional investors and regulated exchanges to find new and better ways to work together on crisis recovery, financial stability, sustainable development, responsible investment, market quality and smarter regulation is probably strengthened as much by what governments and the UN omit, fudge or postpone in Rio, as much as it is by what they do achieve. Some things are too important to be left to the status quo.

Global megatrends driving responsible investment

  1. Accelerating natural resource degradation, scarcity, and constraints driven to a significant extent by the explosive pace of industrial development, population growth, and urbanisation, especially in emerging market economies, such as those in Brazil, Russia, India, China and South Africa (the so-called “BRICS” countries);
  2. Dramatically increased levels of public and consumer concern and expectations for companies’ ESG performance, turbocharged by unprecedented levels of information transparency by which to assess it;
  3. Tightening national, regional, and global regulatory requirements for stronger company performance and disclosure of “non-traditional” business and investment risks;
  4. Accelerating economic interdependence internationally, so that economic, social and political shocks occurring in any single region are more likely to reverberate globally;
  5. Major demographic and economic shifts, concentrating the most rapid population and economic growth in emerging markets, particularly the BRIC countries;
  6. The expansion and intensification of both industrial competition and institutional investment into emerging markets, where ESG risks tend to be the most acute;
  7. The growing economic, sociopolitical, and competitive impact of major public health issues, such as HIV/AIDS, malaria and tuberculosis;
  8. The ongoing revolution in information and communications technologies, which has enabled and accelerated the emergence of a stakeholder-driven competitive environment for companies with unprecedented transparency and, therefore, business risk;
  9. The growing pressures from international non-governmental organisations (NGOs) armed with unprecedented financial and technical resources, credibility, access to company information, and global communications capabilities with which to disseminate their analyses and viewpoints;
  10. The “retreat of governments” - the erosion of national governments’ financial, political and managerial ability to solve major, global ES problems, with a concomitant increase in the burden (and the opportunities) for private sector corporations;
  11. A substantial reinterpretation and broadening of the purview of legitimate fiduciary responsibility to include companies’ performance on ESG matters;
  12. An institutional investor base that is increasingly sensitized to ESG issues, newly equipped with better information, and both willing and able to act on its concerns;
  13. A growing appreciation by senior corporate executives of the competitive and financial risks and benefits of ESG factors;
  14. A growing body of both academic and empirical evidence eliminating the tightening nexus between companies’ performance on ESG issues and their competitiveness, profitability, and share price performance.

Adapted from Kiernan, Matthew J: Investing in a sustainable world (2009)


About Dan Siddy

Dan Siddy is the Founder and Managing Director of Delsus Limited, a UK-based consulting and advisory firm specialising in sustainable investment and environmental finance. He is an acknowledged international authority on the environmental, social and governance (ESG) aspects of investment in emerging markets and has been closely involved in most of the major developments in this field over the last 10 years. His experience and networks span portfolio investment, private equity, banking and international development.

Dan has been both a formal and an informal advisor on ESG issues to the WFE for several years, and has spoken at a number of WFE conferences and events. An active member of the UN Principles for Responsible Investment (PRI) network, his current initiatives include helping PRI, the National Stock Exchange of India and leading European and US pension funds to collaborate on a “responsible investment in India” capital markets day to be held in Mumbai in September 2009.

Dan founded Delsus Limited in 2006 following a long career with the World Bank Group. The firm provides bespoke sustainable investment services in three main areas: strategy and policy; product development and business generation; and operational support at the transaction level. Clients include the World Federation of Exchanges, the International Finance Corporation, the InterAmerican Development Bank and a number of confidential private sector clients in the asset owner and asset management sectors.