Bringing About Real Corporate Change in Bad Industries

Socially responsible investing has been around for several decades, dating back at least to the launch of the Calvert Social Investment Fund in 1982. Since then, ethical investing has brought about many improvements in the way companies conduct their business.

Only today, however, does socially responsible investing stand ready to fully come of age and realize its potential as a force for sustainable and ethical behavior among major participants in the world economy.

Over the past several decades, the world economy has been subject to two dominant influences: increasing global integration and increasing reliance upon market-based economic structures.

These two influences, supported by technological innovation, have worked interactively to present national governments with significant regulatory challenges. In some cases, they have made effective regulation impossible to enact. In others, they have diluted regulatory initiatives to the point where enacted regulation is hollow and ineffectual.

Faced with a global sprawl of disparate and often conflicting regulation, it has been all too easy for corporations to avoid responsibility by arbitraging regulation to find the least restrictive environments.

In the United States, for example, the implied threat and resulting fear is that companies will simply relocate their operations to a more tolerant jurisdiction. That effectively puts a muzzle on lawmakers, often rendering them mute in the face of potential injustice.

Socially responsible investing, however, creates an effective mechanism that enables the markets to self-regulate in the current global environment. Simply put, capital is the only practical force capable of restraining capitalism’s own excesses.

Socially responsible investing examines a company’s environmental, social and governance practices, referred to as “ESG” in the parlance of practitioners.

Within these three pillars reside the chief risks facing the global economy. They are environmental degradation, social dislocation and the undermining of confidence in capitalism itself, due to disingenuous and opaque governance practices.

These also happen to be the overarching risks facing those responsible for the allocation of global capital. To date, several factors have held ESG investing back from reaching its full potential.

Until recently, most socially responsible investing applications have focused on excluding “bad” companies — with varying definitions as to what constitutes “bad.” For example, many socially responsible investors seek to strip certain industries and companies out of their portfolios.

Examples may include alcohol, tobacco, firearms and nuclear energy. This approach allows investors the opportunity to allocate in accordance with their value systems. However, as many academics have suggested, negative screening undermines sound investment management processes.

Perhaps a better approach would be to identify those companies in the relevant sectors that are the most environmentally and socially responsible and are governed most effectively.

In this way, some companies would be rewarded for responsible and ethical behavior by having greater access to capital. Companies that act irresponsibly and unethically will be punished by being denied access.

A second drawback to socially responsible investing has been that it has historically been nondemocratic. As a practical matter, the raw input data needed to define ESG efficiency is extensive and highly complex.

Significantly, the key metrics must be applied to a broad universe of thousands of global stocks and bonds. Its sheer complexity makes ESG data inaccessible — and often incomprehensible — to the vast majority of investors.

Only when investors are fully empowered with fair, impartial and transparent tools for measuring a company’s ESG compliance with socially responsible principles will socially responsible investing become relevant in the vast cross-section of global capital formation. As long as standards are expensive, arcane and inconsistent, broad-based acceptance will fall short.

A final drawback is that, to date, many corporate executives have viewed corporate social responsibility (CSR) at best as an investor relations’ initiative — and at worst as a cynical public relations stunt. This has tarnished the image of ESG investing.

For example, BP had to deal with major environmental issues — pipeline leaks on the Alaskan tundra, a refinery fire in Texas and an offshore oil rig blowout in the Gulf of Mexico — even as it stood behind its totally organic sunflower logo.

Apple has presented itself as socially responsible, a friend to man and child alike, even as it employed sweatshop labor through its Chinese contractors.

Similarly, JPMorgan Chase had presented itself as the very model of good governance, a position that lost some credibility with the revelation of losses caused by a corporate deformity known as the “London Whale.”

The point here is not to single out these three companies, although our opprobrium may be fully warranted. Rather, it is to underscore the complex issue of duplicitousness in corporate principles.

The only effective way to diminish this duplicity — and to mitigate the risks associated with it — is for owners of capital to make corporate managements increasingly more accountable for maintaining sustainable ESG operations.

Only when there is consensus that strict adherence to sound ESG principles is a positive determinant of corporate performance and risk — and not some Pollyannaish expression of do-goodism — will it take hold.

Today, these drawbacks are being addressed both by market forces and the technology that drives those forces. ESG investing is rapidly transitioning to a “best in class” approach that is inclusive and respectful of key investment considerations.

ESG data and ratings are becoming more readily available at lower cost, democratizing the functionality of the process. And shareholders are becoming more cognizant of the risks associated with noncompliance with ESG standards and what that means in terms of risk and reward.

These three steps will put capital back in control of capitalism and allow CSR investing to finally come of age.