The Art of Sustainable Investing

Our new book, Sustainable Investing: The Art of Long-Term Performance, published by Earthscan in the UK on November 10, and Stylus Publishing in the U.S. on December 8, was conceived in the early summer of 2007 before credit markets crunched and the world economy experienced perhaps the worst financial shock since the Great Depression.

Its scope and purpose were also designed in advance of the UN Bali conference, which after years of inertia, laid the groundwork for a global deal to confront climate change. These two apparently unconnected developments symbolize the need for patterns of finance and investment that are truly focused on long-term value creation, and away from the short-term focused vision that has arguably led us to the immediate financial crisis we face.

Fortunately, a shift in this direction is already underway with the rapid growth in sustainable investing practice over the past two decades. Today’s rendition of sustainable investing covers all asset classes and all regions of the world. It has strong links to the pioneering ethical and socially responsible investment communities, but goes a number of steps further by placing the pursuit of financial returns in the context of the world’s economic, environmental and social challenges.

Over the past 30 years, a range of terms, notably social, ethical, green, responsible, socially responsible and sustainable — have been used to describe the emerging practice of incorporating extra-financial factors into investment decision-making. One woman’s “ethical investing” is another man’s “socially responsible investing,” and one firm’s “responsible investing” is another manager’s “sustainable investing.”

On reflection, this embarrassment of semantic richness is perhaps understandable for a rapidly evolving approach, where the final form has yet to be settled. In such a fluid field, we are well aware of the dangers of false precision.

Indeed, one of our contributors, Rod Schwartz, when trying to pin down socially responsible investment, revived John Morley’s dictum that “if you want a platitude, there is nothing like a definition.”

Yet it is also our strongly held view that not resolving these terminology disputes has led to a misperception that investing with one’s values inevitably leads to underperformance by definition, which could not be further from the truth, as our book details in greater depth.

Sustainable investing in our experience combines two profound appreciations. The first is that the best way of generating risk-adjusted returns in the 21st century is to fully incorporate long-term environmental, social and economic trends into investment and ownership decision-making. The second is that achieving global sustainability requires the full recasting of the world’s capital markets.

If the first speaks the language of financial value at the micro-level, the second refers to the imperative of structural reform at the macro-dimension. Sustainable investing thus provides an agenda for action for purely financially motivated investors eager to mitigate risk and benefit from upside opportunities, as well as for civil society organizations aiming to achieve social and environmental progress.

It encompasses the growing numbers of individual investors who wish to ensure that social and environmental factors are included in the ways they allocate their savings. It also draws on the rising tide of institutional investors who appreciate the growing financial materiality of environmental, social and governance (ESG) factors.

Added to this are cleantech investors who identify major potential for capital growth in companies providing solutions to mounting environmental constraints. And alongside these are investors explicitly seeking social as well as financial returns from new avenues such as microfinance. What unites these apparently disparate groups is an acknowledgment that value can now only be created on a long-term basis through fresh approaches to financial analysis, fiduciary duty and capital market regulation.

Currently, we observe five distinctive investment styles:

  • Ethical Investing: described as “an approach to investing driven by the value system of the key investment decision-maker.” and drawn from The Social Responsibility of the Investment Profession by Julie Hudson. In many cases, this equates to traditional social investing in the U.S. as well as to much of current socially responsible investing, and applies mostly to individual investors as well as to charities and foundations that have values as part of their mission.

  • Responsible Investing: described as “an approach adopted by institutional investors to start taking ESG factors into account in pursuit of their fiduciary duties to clients and beneficiaries.”

  • Cleantech investing: defined as the surge in investment into environmental sectors such as energy efficiency, pollution control, renewable energy sustainable transport, as well as waste and water management. Linked to this is the fast-growing practice of “climate change investing,” which may supplement clean tech with allocations to sustainable forestry, as well as in some cases to nuclear power.

  • Social investing: described as “an approach to investing that seeks to generate social as well as financial returns.” While ethical investing tends to focus on the consistency of investments with the investor’s value system, social investing examines outcomes in light of the impact on others, often those most disadvantaged in society.

  • Sustainable investing: described as “an approach to investing driven by the long-term economic, environmental and social risks and opportunities facing the global economy.” What distinguishes current practitioners of sustainable investing from the other approaches is the conviction of their commitment to systematically integrate environmental, social and economic factors into the valuation and choice of assets and the exercise of ownership rights and duties. [For example, Joe Keefe of Pax World defines sustainable investing as the “full integration of environmental, social and governance factors into financial analysis and decision-making.” See Keefe, J. (2007) ‘From SRI to Sustainable Investing’, Green Money Journal, Summer 2007]

In the book, we use these distinctions to compare the financial performance of different types of funds.

Sustainable investing is also distinct from the investment mainstream, not least in its approach to time horizons. We would describe the mainstream as “an approach to investing that applies conventional financial theories to the valuation and selection of assets and the exercise of ownership rights.”

Clearly, as the importance of environmental and social factors becomes part of the conventional wisdom, so the investment mainstream will adopt aspects of the sustainable investing agenda. Indeed, a growing share of the world’s capital assets is already incorporating at least parts of the sustainability agenda.

The McKinsey Global Institute has calculated that the value of public equities, as well as corporate and government bonds, amounted to some US $120 trillion in 2006.

Our “rule of thumb” estimate is that at most between one-tenth and one-quarter of this figure is now on a sustainable investing trajectory, but with the bulk of this limited to early stage shareholder engagement rather than active deployment of capital.

[The upper band of this estimate is drawn from the 2008 assets under management supporting the Carbon Disclosure Project of US$67 trillion. To deal with the issue of double counting, we have simply halved this figure and then compared it with the overall total given by McKinsey. The lower band is derived from the assets under management supporting the UN Principles of Responsible Investment, which in May 2008, amounted to some US$13 trillion.]

One final clarification. SRI started out standing for “socially responsible investment.” More recently, it has begun to spell out “sustainable and responsible investment.” For us, the evolution of this acronym describes the generational shift that is now underway, and when we use SRI as a catch-all, we mean it to cover the five investment styles we have identified.

To date, sustainable investing has proved itself as a powerful addition to the investment landscape. The years ahead, however, are set to be increasingly dynamic as sustainability emerges from a niche to transforming the rest of investment management, in the process becoming the new mainstream.

Cary Krosinsky (pictured at the top of the article) is Vice President for Trucost Plc as of June 2008. Trucost has built the world’s most extensive database of more than 700 emissions and pollutants of more than 4200 public companies around the world and uses this data to help portfolio managers understand their carbon footprints, helping lower them while maintaining and enhancing performance.

Nick Robins (left) is Head of the HSBC Climate Change Centre. Nick has 20 years experience in promoting sustainable development and corporate responsibility in financial markets, business and public policy research.

Nick Robins and Cary Krosinsky are authors of Sustainable Investing: The Art of Long-Term Performance.

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