Views on the integrity of global capital markets
13 January 2016

ESG Q&A with Steve Lydenberg: Investor Returns Suffer Under Weak “Systemic Frameworks”

Posted In: ESG

CFA Institute recently released Environmental, Social, and Governance Issues in Investing to provide investors with a better understanding of why ESG issues are important, and how some practitioners are integrating ESG analysis into the investment process. While investigating the importance of ESG issues to include in this report, we talked with a pioneer in the ESG field, Steve Lydenberg, CFA. He’s founder and CEO of The Investment Integration Project (TIIP), which aims to go one step farther than incorporating ESG analysis into the investment process — it wants asset owners and asset managers to consider how the investment decisions they make affect the systems around them that ultimately shape the market.

We recently talked with Steve about TIIP, how far ESG investing has come, and where it is headed.

Steve Lydenberg CFA

Steve Lydenberg, CFA, partner, strategic vision, at Domini Social Investments, in his presentation “Responsible Investment: Yesterday, Today, and Tomorrow,” at the 69th CFA Institute Annual Conference in Montréal.

Q: Steve, tell us a little about your background, your history with ESG investing and how that led you to start TIIP.

Lydenberg: I got my start researching the social and environmental records of companies in the mid-1970s with the Council on Economic Priorities under the leadership of Alice Tepper Marlin. We did year-long studies of single issues for single industries — environment in the steel industry, women and minorities in banking. In 1987, interested in the application of this research to finance, I joined Joan Bavaria’s SRI (socially responsible investing) asset management firm, now Trillium Asset Management, one of the first pure-play SRI shops in the US. And then in 1990, I joined with Amy Domini and Peter Kinder to found Kinder, Lydenberg & Domini, which ventured into what was then new territory: the creation of an SRI index, which now has a 25-year track record and is part of MSCI’s offerings.

I’ve always been interested in exploring the cutting edge of socially responsible investing — and thinking about fundamental issues now on the horizon line for responsible investment has led me to The Investment Integration Project.

Q: Can you tell us how ESG investing and ESG integration has changed/evolved over the past four decades?

Lydenberg: As CFA Institute’s Environmental, Social, and Governance Issues in Investing observes, we can now recognize that “systematically considering ESG issues will likely lead to more complete investment analyses and better-informed investment decisions.” It is not so much because the basic tools of ESG have changed over the past four decades that this recognition has come about. Faith-based organizations have screened out harmful products as far back as far as the 18th century; “corporate gadflies” concerned with democratic governance have engaged management as far back as the 1950s. What has changed is the availability of investment-relevant, company-specific ESG data, which has increased exponentially since the 1990s, as has our appreciation for the increasing interconnectedness of the financial, social, and environmental systems that investing is a part of. And, as we covered in a new op-ed with Responsible Investor’s ESG Magazine, we now have a deeper understanding that unless we pay close attention to the impact of the decisions that we as investors make not only can our portfolios suffer unexpected shocks, but these fundamental systems can be affected in unanticipated ways.

Q: Tell me about The Investment Integration Project (TIIP), what are your main goals.

Lydenberg: TIIP’s primary goal is to encourage asset owners and managers to understand how and to what extent their investment decision making impacts the environmental, societal, and financial systems they operate within, and how these systemic frameworks in turn impact their portfolios. Incorporating ESG factors into specific security valuation is a helpful step in this direction, but is there a cumulative effect of investments on these systems as a whole and vice versa? These are the questions that asset owners and managers, particularly those with long-term investment horizons, will increasingly need to explore.

Q: Could you spend a little time fleshing out what you mean by systemic frameworks, and perhaps give an example?

Lydenberg: We invest in a world built upon rich frameworks of natural resources and a highly sophisticated societal infrastructure including a well-functioning financial system — all of which have been built up over decades, centuries, and even millennia in the case of natural resources. Properly managed, investment decision making can serve to preserve and enhance these systems. The danger of undercutting and destabilizing them also exists. The 2008 instability in the global financial system cost investors dearly across the board. Today, the destabilization of our climate threatens our economies and investments in potentially substantial ways that are difficult to predict. Investment decisions have impacted these essential systems in the past, and will continue to do so in the future — and the health of these systemic frameworks will continue to have an impact on the performance of our portfolios. We believe it is possible to understand and manage risks and rewards at systemic levels while still achieving competitive returns at the portfolio level.

Q: So why isn’t this something that is being done already?

Lydenberg: As we discuss in TIIP’s inaugural paper Portfolios and Systemic Framework Integration: Towards a Theory and Practice, it’s all too easy to believe that one’s portfolio-level investment decisions don’t affect the larger environmental, societal, and financial systems, that these systems operate independently of investors and are beyond our control — although we intuitively understand that the health of these systems is crucial to our investments’ success. To see and understand this feedback loop between portfolios and systems more clearly, we need studies that document the specifics of impact: How do specific investment practices increase or reduce risks for the stability of the financial system? How can they reduce the range of uncertainties under different climate change scenarios? How can they increase investment opportunities at the bottom of the pyramid? How can they create the physical infrastructure essential for an efficient and sustainable economy?

Q: Do we have the data we need today to properly incorporate ESG factors in the investing process?

Lydenberg: We are getting there. Organizations such as the Global Reporting Initiative, Sustainability Standards Board, and the International Integrated Reporting Council have made substantial strides in setting standards for the quality and format for disclosure of ESG data. And data providers such as MSCI, Sustainalytics, Vigeo-EIRIS, Bloomberg, and Thomson Reuters are making that data increasingly easy to access. Still, more work needs to be done on challenges such as the standardization, verification, and materiality of this data.

Q: Which ESG data or other tools do we need to have better information when making investment decisions?

Lydenberg: ESG data can shine a spotlight on issues material to long-term business success, such as employee relations, reputation, quality of management, and corporate culture. Specifically, data on environmental management systems, vendor standards, union relations, consumer health and safety, ethics programs, and the like can help identify areas where long-tail risks — the known unknowns — as well as companies’ day-to-day business models and stakeholder relations — can become a factor relevant to investment decisions.

Q: Getting back to the goals of TIIP, what can be done to get asset owners and asset managers to consider the system-level risks connected to their investment decisions?

Lydenberg: To help bridge that divide, asset owners and managers can take a number of steps: acknowledge the connection between investment decision making and systems-level risks and rewards; determine which systemic frameworks they can most appropriately and usefully focus on; and implement investment practices that allow them to manage risks and rewards at the systems level while simultaneously achieving competitive financial returns at the portfolio level.

Q: What timetable do you have in mind for getting more asset owners to consider these systemic issues behind TIIP? Five years, 10 years, is it already happening in places?

Lydenberg: It is with good reason that change happens slowly and incrementally in the financial community. Dialogue is now starting to take place among large asset owners such as CalPERS and PGGM about systemic risks and the management of environmental and social capital. Major asset managers such as BlackRock and Morgan Stanley are increasingly focused on the long term and sustainability. These concepts need to be carefully explored, their implications carefully evaluated, and appropriate tools for their implementation devised. At the same time, many of the systemic challenges faced today need to be addressed sooner rather than later if we are to inhabit a stable and thriving planet tomorrow.

Q: Finally, what is your vision for the ESG investing landscape a decade from now? What needs to happen for us to get there?

Lydenberg: By 2025 investors will clearly understand their ability to help manage systemic risks and rewards while achieving competitive returns that arise in a technologically empowered, globally interconnected world rapidly approaching 9 billion citizens. The acknowledgement by asset owners and managers of their ability to create systemic impact is the first step down that road. The rest of the journey, although challenging, will follow naturally.

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Photo credit: CFA Institute

About the Author(s)
Matt Orsagh, CFA, CIPM

Matt Orsagh, CFA, CIPM, is a director of capital markets policy at CFA Institute, where he focuses on corporate governance issues. He was named one of the 2008 “Rising Stars of Corporate Governance” by the Millstein Center for Corporate Governance and Performance at the Yale School of Management.

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