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The Actuary The magazine of the Institute & Faculty of Actuaries

Socially responsible investment

In recent years, social and environmental topics have never been far from the news headlines. World poverty, climate change, the scarcity of natural resources, human rights abuses, and corporate misconduct have all received considerable press coverage. In this context, it is hardly surprising that a MORI poll in June last year found that 65% of the general public thought it was highly important that companies took social, ethical, and environmental issues seriously. When questioned on attitudes to ethical investment, 65% of respondents expressed an interest with 24% stating they would be prepared to invest ethically, even if it resulted in lower financial returns.
Among UK institutional investors, legislative changes have been pivotal in heightening interest in socially responsible investment (SRI). For pension funds, an amendment to the 1995 Pensions Act (which became law in July 2000) required trustees to disclose the extent to which social, environmental, and ethical factors are taken into account in their investments. In the charity sector, boards of trustees are now under a legal obligation to ensure that investments are compatible with the charity’s stated aims.

Somewhat quirky?
Coverage of SRI in the financial press has typically focused on areas of the stockmarket that are avoided, presenting it as a somewhat quirky form of investment that sits firmly outside the mainstream. Avoidance of areas such as armaments, tobacco, alcohol, nuclear power, oil exploration, and mining are highlighted, often leading to the conclusion that funds following an SRI approach have a much narrower universe of stocks to select from than is the case with conventional actively managed portfolios. However, a comparison with active investment styles that are regarded as mainstream (such as value, growth, and income) casts doubt on this argument.
For example, consider a UK equity income fund that aims to produce a portfolio yield 25% greater than that of the FTSE All-Share Index. Meeting this income objective would normally result in little or no representation in lower-yielding sectors of the UK equity market such as pharmaceuticals, household products, and IT, and an underweight position in sectors with a higher proportion of low-yielding stocks such as food producers and media. The investment universe for such a fund would typically be made up by around 6065% of the FTSE All-Share Index. In practice, this percentage is not dissimilar to the investable proportion of the UK equity market available to a fund that follows a social and environmental screening process.

The view is that a company’s ability to manage its exposure to social and environmental risk is becoming increasingly relevant to long-term financial performance. The conviction that such an approach enhances investment performance has been strengthened by firms back-testing the performance of companies in the FTSE All-Share that demonstrate better environmental governance and have superior valuation and earnings momentum characteristics. Figure 1 shows how these companies have strongly outperformed those companies excluded by this selection process.

Company selection
Rather than aiming to analyse all environmental and social factors, those that are likely to affect corporate earnings are prioritised. The main inputs are geopolitical trends, regulatory developments, sector and corporate governance, social, environmental, and ethical factors, and financial data. The aim is to identify companies that are addressing governance, social, environmental, and ethical factors in a constructive manner, while avoiding companies that are not. Suitable stocks are selected through rating companies according to their product sustainability, and their management vision and practice.
Product sustainability is the extent to which a company’s core business is helpful or harmful to society or the environment. Companies whose core products help to overcome some of the main hurdles to sustainable development for example alternative and renewable energy and biotechnology achieve a high product sustainability rating. Likewise, businesses whose products or services have a low environmental impact and offer some benefits for a more sustainable future would also earn a higher rating. An example is a water company that is committed to meeting environmental standards through cleaning up coastline and effective waste management.
At the other end of the scale are those businesses whose products are in conflict with sustainable development, which are given a low rating and excluded from an SRI mandate. For example, tobacco stocks are unacceptable given the impact of smoking and passive smoking on health and the cost of treating individuals, as well as the impact of tobacco production on the environment. Similarly, armaments and nuclear power (given the environmental risks and liabilities related to decommissioning), airlines, road building, and companies whose core business is the manufacture of ozone-depleting substances would also be avoided if sustainability criteria are strictly employed.
In between these ends of the spectrum are companies whose operations are broadly neutral for sustainability, and those whose activities create sustainability problems but where there exists scope for strategic change. In practice, the latter are often the most difficult to gauge and in these cases, fund managers would aim to assess whether a company has recognised the environmental and/or social impact of its activities and is actively addressing these factors. A good example is the oil and gas sector, where proportion of reserves that are derived from low carbon energy sources (such as natural gas) are determined and the efforts each company is making to research and develop sources of renewable energy are evaluated.

Engagement with companies
Fund managers generally meet senior management of most major UK companies in which they invest at least once a year as matter of routine practice. These meetings with companies are often aligned with research themes that have a broad impact, a good example being climate change. In practice, engagement efforts are focused on areas where they can have the most effect. Investors have an interest in ensuring the company’s financial success, so the discussions with companies must be constructive. Efforts are prioritised according to our legitimacy and influence as shareholders, which is determined either by the size of the holding in a company or by the financial impact of social, environmental, or governance issues affecting the business.
As institutional investors, fund managers are often operating in tandem with regulators, non-governmental organisations, customers, and the media to increase pressure on companies to improve management of social and environmental matters and corporate governance. These overlapping concerns can make it difficult to gauge the success of engagement efforts. However, there are occasions when the dialogue with companies has resulted in changes directly attributable to specific activities.
Returning to the example of the energy sector highlighted above, historically SRI funds were unable to invest in Premier Oil due to the company’s involvement in Burma and its lack of disclosure on environmental performance. As an example, however, rather than simply viewing the company as a unsuitable investment, Morley (a member of UKSIF, the UK Social Investment Forum) continued to engage with Premier Oil on the environmental impact of its business activities and its approach to corporate social responsibility, encouraging it to adopt a more enlightened policy. The company ceased operations in Burma over a year ago and has adopted a successful stakeholder consultation approach, making considerable progress in ensuring that indigenous communities receive tangible benefits from its operations. On the environmental front, Premier Oil has been praised by the United Nations Environmental Programme (UNEP) and held up as a case study on how to operate in environmentally sensitive areas.

On a broader front, Morley is also looking at corporate reporting and, in 2001, encouraged companies to disclose environmental information in the report and accounts. Over 40% of FTSE companies have now responded by publishing environmental information and this policy is being extended in 2005 to require all FTSE 350 companies to disclose information on major social, environmental, and ethical risks.
There is a lot more to SRI than simply avoiding a pre-defined list of non-permissible investments, and in the longer term the successful alignment of corporate, social, and investor interests will generate enhanced returns consistent with sustainable development.