The Big Picture of Responsible Investing: An Interview with Rob Lake
To better see “the big picture” of responsible investing, which emphasizes environmental, social, and governance (ESG) issues, we spoke with Rob Lake, an independent advisor who helps asset owners invest responsibly. Lake has had a long career in this field: He was previously director of responsible investment at the Principles for Responsible Investment, in London; head of sustainability and governance at APG asset management, in Amsterdam; and head of corporate engagement at Henderson Global Investors, in London.
CFA Institute: How has responsible investing evolved over the years?
Rob Lake: In the last 30 years, we have seen various approaches to incorporating environmental, social, and governance issues into investment. The first generation was overtly “ethical,” focused on excluding “unacceptable” products and activities from portfolios. In most countries this was largely a retail investment phenomenon; its classic expression was in the campaign for divestment from South Africa. The contemporary incarnation of this “ethical” approach is the exclusion of certain weapons and other products by some asset owners. The 1990s in particular saw a wave of “green investment,” as awareness of environmental issues grew. G joined E and S, thanks to corporate scandals such as Enron, WorldCom, Tyco, Parmalat, and others.
How would you describe the responsible investing approach today?
Today’s institutional approach to responsible investment starts from the observation that a range of environmental and social issues are increasingly significant in business and investment terms. Issues such as climate change, water stress, resource scarcity, ageing populations, and human rights in supply chains are shaping markets, consumer preferences and government regulation. Companies need the right governance to align their strategy with these trends and protect their investors’ interests.
And the financial crisis has taught us that it is not just companies that need good governance — it is the market as a whole. Long-term investors in particular — such as pension funds, sovereign wealth funds, and some family offices — are acutely aware of all this. At the same time, these institutions want to demonstrate that they are themselves socially responsible. The explicitness with which this is expressed varies across investors and markets. Some public pension funds have a legal obligation to be “socially responsible” — as in France; “to take ethics and the environment into account” (Sweden); or to disclose a policy on environmental and social issues (Denmark; UK, on a comply-or-explain basis). These obligations sit alongside “conventional” financial return requirements and do not supplant them. Others — like the big Dutch funds — are not legally required to be “responsible”; but they are highly attuned to their beneficiaries’ expectations in this area and those of the society around them. So while there is diversity among investors and across countries, the common thread in contemporary responsible investment is about recognizing new factors that are relevant to returns, particularly in the long term.
The financial crisis has also prompted many asset owners to explore new ways to achieve traditional objectives. Staying closer to the real economy — by investing in their own country’s infrastructure, for example, often in partnership with government — can help to achieve investment targets while de-coupling funds from risks embedded in complex financial structures, and at the same time cultivating a “license to operate” in the eyes of regulators and beneficiaries.
Do you think ESG issues are more about investment risks or opportunities?
The balance of risk and opportunity in ESG issues varies by sector, market, and asset class. Some companies are exploiting huge opportunities in energy and resource efficiency, for example, both in their own operations and in providing new products and services to customers. Cutting energy and resource costs is good for the bottom line and good for the environment. Good health and safety in natural resource extraction is an indicator of operational efficiency and good risk management. Every company has a board (including unlisted funds): bad governance is a risk; good governance an opportunity.
To what extent traditional investing does not consider ESG issues?
Very few people believe the market is perfectly efficient. Active management might be a zero-sum game overall, but for individual investors it can work. The market regularly mis-prices ESG risks. Did prices accurately reflect BP’s poor environmental, health, and safety and compliance record in the US, Lonmin’s workforce relations difficulties, or Massey Energy’s safety issues? All three companies suffered incidents that destroyed huge amounts of shareholder value (Deepwater Horizon, the Marikana demonstrations and shootings, and the Upper Big Branch mine disaster).
Investors with a long time horizon and a strong focus on underlying drivers of earnings and cash flow might well be more aware of these issues than those with shorter-term strategies who follow market movements more closely. But even here there is a risk of what the Nobel Prize–winning psychologist Daniel Kahneman, in his book Thinking, Fast and Slow calls WYSIATI — what you see is all there is. In other words, assuming that information we’re not aware of doesn’t exist or is not relevant. Explicitly focusing on ESG extends the “information horizon” and reduces the risk that WYSIATI will undermine returns.
We’re also starting to see academic evidence that ESG factors are mis-priced — for example, human capital, eco-efficiency, and general corporate sustainability practices. There is also evidence that companies that respond positively to shareholder engagement on climate change and corporate governance have outperformed.
Fiduciary duty is frequently invoked as an obstacle to taking account of ESG factors, on the grounds that they are not financially relevant. Given the extent to which the businesses on which investors depend for returns are having to respond to “megatrends” such as climate change, resource pressures, demographic change etc., this argument is hard to sustain. Fiduciary duty is also said to require a focus on short-term returns. However, the financial crisis showed that chasing short-term returns does not deliver healthy long-term returns, so this argument too seems flawed.
How would you compare the relevance of ESG issues in active investing versus passive investing?
Active investors can over- or underweight stocks or sectors on the basis of an ESG view; pursue thematic investment strategies; and engage with companies to promote improved responses to ESG factors. Passive investors can engage with companies and vote their shares. Benchmarks that reflect a stronger ESG conviction are now available. These are based on a belief that market prices do not fully reflect ESG factors and that different weightings from those of conventional benchmarks will deliver outperformance. These usually apply ESG as the only factor for adjusting the benchmark. I believe there is great potential for an “ESG smart beta” approach that combines ESG with other factors to create new products that reflect the complexity of the interactions among return drivers.
How relevant are ESG considerations in asset classes other than equities?
E and S issues can be strongly relevant in any asset class that is close to the real economy, and G is relevant across the board. In fixed income, many investors are now using ESG to gain an additional perspective on issuers and are reporting that it helps to give them a fuller understanding of risk and creditworthiness, for both sovereigns and corporates. Real estate accounts for 40% of global carbon emissions and has huge potential for energy efficiency improvements and therefore operational cost savings (leading to improved rental yields, reduced vacancies, and higher capital values). Recent work by the Principles for Responsible Investment shows that ESG is increasingly important in private equity exits and can affect valuations and deal terms. Infrastructure assets can be exposed to a wide range of ESG issues — environmental impact, health and safety, local community acceptance — that can affect planning consents and operational efficiency. Real assets like farmland, forestry, mining, or energy similarly have a range of real-world impacts that can affect their investment profile. Investors recognize this and are developing tools such as the Principles for Responsible Farmland Investment to address the challenges.
However, it is important not to assume that ESG will be financially significant in all asset classes and strategies. Sometimes any “ESG” signal will be very weak, or “conventional” research already covers the issues. It is important not to fall victim to WYSIATI; but also not to assume that because we now have an “ESG hammer,” everything we see is a nail.
Should we expect to see changes in the real world because of rising assets under management in responsible investing — and if so how can those changes be measured?
If “responsible investment” is different from “conventional investment,” it is reasonable to ask for evidence of the difference. Asset owners are increasingly moving from just asking investment managers to explain their processes to asking for specific evidence of how ESG factors have made a difference to individual investment decisions. This pressure is sure to grow. It is also reasonable to ask for evidence of changes not just in investment decisions but in the real world — the activities and impacts of the companies and assets in the portfolio. A key area where we are starting to see this is ESG changes made by companies thanks to investor engagement. Many companies have sharpened up their management of ESG issues following engagement — e.g., taking new action to improve labor standards in supply chains. Another area of focus is the carbon intensity of portfolios. Leading asset owners such as the UK Environment Agency Pension Fund, ERAFP in France, and GEPF in South Africa have assessed their carbon footprint and see this as an indicator both of risk in their portfolio and of their own contribution to addressing climate change.
Measurement is a huge challenge here. ESG disclosure by companies still makes it difficult to track real-world environmental and social performance. Aggregating up from company level to a portfolio is even harder. But the pressure on investors to demonstrate their positive impacts is strong. Asset owners’ beneficiaries want to see proof that their funds are making a difference. Managers who can help their clients meet this challenge will be well positioned.
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