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Why responsible investment falls

short of its purpose and what to do

about it
Purpose The purpose of this paper is to demonstrate failures of self-regulation
among RI actors following the current economic crisis. It also seeks to propose
specific regulations for the investment business. The paper questions whether
financial capitalism can support sustainability.
Findings The paper finds that RI/SRI/ESG best in class portfolios are challenged
for various reasons; engagement activities are challenged due to the structural
inadequacies in the industry; SRI fund managers themselves do not use SR; CSR
does not address strategic core business matters; conflicts of interest on the way
plague the investment supply chain; and private equity may enable progress in RI.
Socially responsible investment (SRI), or its reincarnation as responsible
investment (RI), represents the voluntary non-governmental approach by the
financial community to reforming itself. It claims to be a more responsible form of
financial management, and as such should have spotted the roots of the finance
crisis and worked to have the system deal with the excesses at an early stage. It
should at least have saved investors from severe losses by pulling money out of
shares early on or advising clients to do so. RI also sees itself as a vehicle for forcing
business to internalize social and environmental responsibility.
Responsible Investment:
Responsible investment is an approach to investment that explicitly acknowledges
the relevance to the investor of environmental, social and governance factors, and
of the long-term health and stability of the market as a whole. It recognises that the
generation of long-term sustainable returns is dependent on stable, well-functioning
and well governed social, environmental and economic systems.
Responsible investment can be differentiated from conventional approaches to
investment in two ways. The first is that timeframes are important; the goal is the
creation of sustainable, long-term investment returns not just short-term returns.
The second is that responsible investment requires that investors pay attention to
the wider contextual factors, including the stability and health of economic and
environmental systems and the evolving values and expectations of the societies of
which they are part.
The underlying principle of RI/ESG/SRI is that a pension fund or asset manager can
make a competitive return on investment for principals by buying the stocks of
companies that go about their business in a way that actually improves
environmental and social conditions in the world while making a good profit. The
idea is that the concept of sustainable development, expressed in companies

through CSR programs, is taken up in the investment world by giving preference in

portfolio composition to the better environmental and social performers and/or by
influencing companies to achieve better ESG performance in practice.
RI could conceivably take on a watchdog and lobbyist role in a socially and
environmentally responsible market economy, but this will only come about

new regulatory measures;

B tough legal enforcement with real sanctions; and
B strong independent NGO supervision to investigate and put pressure all
along the investment chain.

Mainstreaming: from SRI to RI

SRI has gone from a niche product sponsored by ethically motivated independent
fund managers in the 1980s and 1990s to a product offered by most mainstream
financial institutions. As assets in SRI funds become an increasingly significant
percentage of total assets under management[4], the hope has been that this
movement would become an agent of change for environmental improvement,
increased economic justice (starting with fair compensation in the workplace), and
the adoption of longer investment horizons better reflective of pension needs.

Prevailing modes of SRI function

Best in class
Best-in-class involves preferentially investing in companies with better governance and management
processes and ESG performance. It should be understood that there is no commonly

acknowledged definition for critical criteria, no accepted minimum set of criteria, no

concept of what the weighting of the different criteria should be in the overall
assessment of a companys or sectors ESG performance.
This lack of standards should result in notably different RI portfolios; however, one
sees remarkable portfolio similarities across funds. Why?
First, half a dozen specialized ESG rating agencies supply ratings to most RI fund
managers since very few institutional investors or fund managers have sufficient
internal staff and competency to do their own analyses. Just as too much reliance on
the credit rating agencies creates bad credit decisions, too much reliance on the
ESG raters can create biases and misleading judgments about ESG quality.
Second, a major factor driving portfolio similarity is that most RI funds focus on
large cap companies and their managers seek to avoid deviating from a market
index like the MSCIWI, the Footsie or the EuroStoxx. RI funds usually have tracking
errors of three or less and their managers use software such as APT and BARRA to
control volatility risk.

Active ownership involves investors using their formal rights (e.g. the ability to vote
shareholdings) and informal influence (e.g. their ability to engage) to encourage
companies to improve their management systems, their ESG performance or their
reporting. Engagement with public policy makers is increasingly seen as an integral
part of active ownership.
Engagement is the term generally used by asset managers to refer to all the
modes of action whereby a portfolio manager seeks to influence the behavior of a
corporation of which it owns shares, as regards some aspect of policy or practice on
an ESG matter. Engagement can range from dialogue with companies to voting in
opposition to management at the general assembly. It can be done by institutional
investors singly or acting in concert with other investors or with NGOs.
In the 1970s, SRI worked by means of categorical exclusions. Categorical exclusions
can be fashioned for many different categories, and investors can choose which
categories they wish to negatively screen out of their portfolios.
Negative screening involves excluding companies from the investment universe on
the basis of criteria relating to their products, activities, policies or performance.
This includes sector-based screening (where entire sectors are excluded) and normbased screening (where companies are excluded if they are considered to have
violated internationally accepted norms in areas such as human rights and labour
standards). Positive screening involves preferentially investing in companies or
sectors on the basis of criteria relating to their products, activities, policies or
performance. Tobacco has probably become the most widely implemented
exclusion category, yet this has had no effect on the survival of tobacco companies.
They are going strong and continue to grow in sales and profits by expanding in
emerging markets, as well as specifically targeting the young and women.
Thematic funds
Thematic funds invest according to specific themes, such as the aging of the
population (in which case they invest in health care providers, drug companies,
nursing homes, special equipment manufacturers, and so forth), or environmental
protection (in which case they invest in pollution control equipment, alternative
energy, recycling, waste management, energy efficiency systems, reforestation and
the like). In general, thematic investors are not concerned with broader ESG or
ethical issues.
Private equity: the next frontier in RI?
A private equity investor is an owner that has the authority and capacity to act as
an active owner on all matters, has a seat on the board, and the power to unseat
management if needed.
The next frontier in RI effectiveness will be if and when the large private equity
funds take charge of progress on the environmental agenda of the companies in
their portfolios. In 2008 the assets in PE funds reached e2 trillion.

The lack of self-discipline in SRI

The RI or their firms failed to advise their clients to pull out of the stock market, get
out of their RI funds and go cash as the market was crashing in late 2007 or early
This confirms the aspect of agency theory that assumes the agent pursues his/her
own interest rather than the principals; but it falsifies the tenet that in the private
sector agents are self-correcting, because principals can change agents if they
underperform. When all agents act in the same way, principals have no choice.
When market discipline is absent, government regulation is required.

CSR, as defined by global corporations working through the WBCSD, the Global
Compact, and the UNEP FI, addresses or sidesteps matters that are crucial to
corporate citizenship as seen from the public interest. Companies justify voluntary
CSR with the business case:

The eco-efficiency argument is that money is saved when fewer resources are
used per unit of production (WBCSD, 2005, 2002).
The reputation risk argument is that, by consulting with NGOSs and civil
society, a company can avoid mistakes like Shells Brent Spar decommissioning fiasco in 1995.
The brand building argument is that, by showing good corporate citizenship,
a company can increase market share, gain favor with regulators for license
to operate approvals, and perhaps even reduce the chances of

There are two structural ways in which CSR fails. One has to do with the legal
protections accorded to companies, particularly limited liability. Limited liability, the
wonderful invention that has allowed for modern capitalism, allows risk-taking with
ones own or other peoples money. Emissions reduction does not take place until a
limitation or the threat of a limitation with financial benefits and/or penalties exists,
as was also the case with chlorofluorocarbons (CFCs), sulfur dioxide (SO2), and
other kinds of toxic waste. Unless a regulation puts a cost or benefit to an event of
pollution (an externality), internalizing it and making the business case,
companies do not change course in their core business.
The second failure of CSR is its absence in the key decisions that reveal the ethical
DNA of a company, such as:
1. Budget decisions: how much profit to serve up vs. how much to pay in salaries,
performance bonuses and stock options and their allocation to different employee
categories; how much to invest in R&D or in upgrading plant and equipment, pay
into the employee pension scheme, pay out as dividends, and pay in taxes.
2. Corporate financing strategy: borrowing too much can risk the survival of the
enterprise and force massive job losses but may be favored over the dilutive effects
of a new equity issue on existing shareholders or on managements stock options.

3. Lobbying: how much is right for a company to pay into political campaigns to
influence legislation in managements favor.

What needs to be regulated and how?

1. Command and control measures to limit executive compensation
The excesses of executive compensation could be curtailed with a simple set of
regulations limiting total compensation for executives, portfolio managers, and
traders of listed financial services companies to a reasonable multiple of the median
wage (for example, 20 or 30 times, as opposed to 200 or 300 times); stock options
not tied to long term value creation could be prohibited, as well as any form of

2. Administrative measures to limit the tyranny of the indices, tracking

errors and mindless investing
Encourage quarterly or semi-annual reporting of equity and bond fund performance
and performance comparisons, rather than the current emphasis on daily and
weekly comparisons, which serve to create chaos and excessive trading.
Abolish the global oligopoly of the Credit Rating Agencies. End conflicts of interest
by prohibiting payment by rated firms. Require risk assessment by individual
institutional investors or pools of institutions.
3. Administrative measures against short-termism
Require institutional investors to pay performance fees to managers (if any) only at
the end of each mandate cycle, typically no less than a three or five year period.
Set an upper limit for the allocation of passive investment strategies by institutions.
4. Market and command or control measures to make RI effective
Establish demand-pull by large government funds or pension funds, such as NGPF,
ABP, PGGM, CalPers, or FRR, to create supply and provide examples for others.
Command and control regulation on specific agendas, as the Swedish government is
requiring of the AP funds as regards executive pay.
5. Market and command and control measures for private equity funds and
The pension funds, insurers and banks that supply private equity with capital and
loans should make the implementation of an environmental agenda a precondition
of investment or lending. This could come about through: Voluntary action on the
part of the institutional investors. This has not happened to date in any significant
6. Ethics in core strategic business decisions

The challenge of capitalism is to find a way of more effectively harnessing selfinterested pursuit of growth and profits, as well as resources, for greater alignment
with the public good.