FSN: How Socially Responsible Investment (SRI) is driving shareholder value.

How Socially Responsible Investment (SRI) is driving shareholder value.

29th October 2007
A couple of weeks ago, the FTSE Group issued their September 2007 review of the FTSE4Good global index series. An additional 42 companies worldwide have recently met the FTSE4Good Corporate Responsibility standards and been added to the index. Of these, 22 are UK companies. 24 existing constituents have been removed – judged not to have the Index's criteria. It's difficult to assess the relative importance, (or unimportance) of this news to the UK corporate sector. What is notable, says Niki Leahy, FSN's senior writer, is the rising influence of indices such as the FTSE4 Good which measure and report on corporate social responsibility for the growing market in Socially Responsible Investing, (SRI).

It's difficult to assess the relative importance, (or unimportance) of this news to the UK corporate sector. What is notable, however, is the rising influence of indices such as the FTSE4 Good which measure and report on corporate social responsibility for the growing market in Socially Responsible Investing, (SRI). This reflects a greater interest by the investment industry in measuring how sustainability and corporate responsibility enhance corporate value creation.

The environmental threats to all businesses today are well known. They include changing consumer attitudes, more stringent environmental regulations, new green taxes and charges, threats of large scale climate change and a perceived scarcity of natural resources and energy. Good environmental management has been proven to be an integral part of good process control and product and process innovation. It also drives value creation by the avoidance of liabilities and the enhancement of tangible and intangible assets, as well as through lowering costs and creating revenue streams.

In addition, the financial consequences of environmental risks, including reputational risk, are growing in significance. In 2004, Cap Gemini Ernst & Young & GEMI released research which showed that 50 – 90% of a firm's market value can be attributed to intangibles such as environmental performance, 35% of institutional investors' portfolio decisions are based on intangibles particularly environmental performance, and that 81% of Global 500 investors rate environmental issues among the top ten factors driving value in their businesses.

For investors, environmentally driven innovation can provide significant commercial benefits. The management and reporting of environmental performance indicators by companies, which relate to resource use and waste generation, can be used to assess potential cost savings and revenue. Disclosure of CSR information indicates that a company is able to measure, monitor and manage the risks and opportunities associated with complex environmental issues which have a material impact on its bottom line.

The socially responsible investment industry has experienced tremendous growth and change since the mid 1990s – with a significant increase in the amount of assets under management. It was estimated recently that SRI funds account for approximately 14% of total assets under management, with the UK and the USA of leading importance. This reflects the growing recognition that corporate environmental damage such as pollution and waste, (externalities) are increasingly going to be quantified, with costs allocated to their sources. New laws, taxes, trading permits and regulations are internalising these costs with varying compliance cost implications for different companies and sectors. (For example, future EU laws restricting vehicle emissions levels on new cars and trucks may have very different effects on BMW, which has a greater number of high performance vehicles in its sales portfolio than Honda, which makes smaller, lighter vehicles with lower average vehicle emissions).

From early mutual funds which refused to trade in ‘sin stocks', SRI has developed into a significant, and increasingly mainstream investment process, in which environmental and social principles and values are integrated into financial objectives. In the UK , this has also been driven by the Pensions Review, (effective from 2000), which emphasised the importance of environmental risk management, and the Turnball Committee's Report on corporate governance. Pension trustees now have a recognised duty to address the financial risks posed by climate change and other environmental issues as part of their fiduciary duty to manage risk and maximise returns in their portfolios. The Association of British Insurers issued influential guidelines to listed companies on the disclosure on environmental risk in 2004. More recent initiatives by institutional investors include the Enhanced Analytics Initiative, the Carbon Disclosure Project, and the UK Institutional Investors Group on Climate Change.

The SRI industry is supported by a growing number of socially responsible stock indices, such as the FTSE4Good and the Dow Jones Sustainability series which track sustainability driven companies on a worldwide basis. In addition to these, several rating agencies have also entered the financial market which evaluate social and environmental issues. Rating institutions, indices and investment funds are the most important players in SRI, with rating institutions providing independent evaluation and information for stakeholders. SAM and SERM are highly influential research institutions with widely used models. Four rating models are apparent, the risk assessment approach, the sustainable value approach, (which focuses on corporate sustainability management strategies), the “industries of the future” approach, (focuses on pioneering companies and innovative products), and the management best practice approach. Many of the SRI rating agencies use between 50 and 100 performance indicators, which are usually grouped together under 20 – 30 benchmarks. Single indicators are regarded as meaningless because sustainability requires a holistic approach. After all, you can't be sustainable in one part of the business, and unsustainable in another.

Investment funds are the key players in SRI. In addition to using their financial power to direct investment to where they think best according to sustainability criteria, they can also actively engage in corporate decision making by exercising voting rights. According to the UK Social Investment Forum, 2007, there are three main strategies for SRI: screening, shareholder influence and cause-based investing. Screening can be either negative, (avoidance approach) or positive screening, (inclusion of those companies that contribute positively to society and the environment). As well as SRI fund managers, universal investors have a natural interest in changes in the internalisation of environmental costs because of their wider investment portfolios. Those firms that externalise costs to the detriment of others have a short term commercial advantage over those which are financially accountable for their environmental impacts. Estimating and allocating external costs provides an indication of future private costs as regulations are introduced. Some rating agencies and consultancies are relating a company's asset structure and risk profile to calculations of its ”economic value added”, (EVA).

SRI is difficult to define, and is often referred to under many guises, including “ethical investment”. The number of different terms used to describe it relate to fund managers and rating agencies needing to differentiate their funds from others. The ethical criteria of some funds are considered proprietary, and because many SRI products are screening the same companies, the way in which they do this becomes a source of differentiation. The financial impacts on companies of SRI funds are of relatively minor importance at present. However, the use of the screening criteria makes them far more important in how they interpret corporate behaviour and performance in a particular way. The value of rating depends very much on the quality of the information supplied, and on the difficulties investors have in assessing the extent of potential environmental liabilities. These depend on the outcome of national and international regulations and liability issues as well as specific impacts on particular companies. It is also very difficult to compare different ranking / rating schemes, particularly when different schemes have different objectives for measuring impacts and potential liabilities.

Environmental impacts are drivers which have a highly specific influence on shareholder value analysis . This evaluates the financial quantification of corporate strategy, and its component plans and measures. These measures relate to environmental investment programmes or increased environmental costs, which influence future cash outflows. Investment strategies can also influence cash inflows, such as future sales and reduced costs. The free cash flow balance represents the financial value of a particular environmental strategy. A fairly recent survey by Deloitte indicates the importance of the link between environmental intangible assets and shareholder value, with fund managers and analysts reporting that the ability to innovate, corporate governance and risk management were all systematically taken into account when valuing companies.

So what can be concluded from this brief look at SRI? It appears to reflect a trend towards the deeper investigation of the underlying fundamentals and intangible assets of a firm which drive performance. These are of interest to both value investing models and active fund management. The weight of academic research supports the view that companies that adopt an active and positive engagement with environmental and social issues can be both less risky in the long term and make good financial returns in the short term.

Socially responsible investors have increased the importance of measuring intangible assets alongside more traditional tangible assets, even though quantification of intangibles remains difficult. The investment and protection of intangibles requires new analytical skills based on in-depth specialist information. The UK 's largest companies have embraced environmental disclosure guidelines with varying degrees of credibility, and more will be expected of them in future. The challenge of measuring and disclosing environmental risks lies particularly with the second tier of public companies, many of whom have yet to achieve any disclosure of the environmental, social and ethical risks having a material impact on their business.

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