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Do Signatories To The Principles For Responsible Investment Practice What They Preach?

While pockets of ideologically-driven ignorance remain regarding sustainable investing, such as the U.S. Department of Labor, mainstream investor investors now recognize the value to their clients and beneficiaries  of incorporating material environmental, social, and governance (ESG) issues into the asset allocation and portfolio construction strategies. One consequence of this is that there are now around 3,100 signatories (asset owners, asset managers, and service providers) to the Principles for Responsible Investment (PRI) with a total of $110 trillion in assets under management (AUM). PRI signatories commit to six principles:

  • Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.
  • Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.
  • Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.
  • Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.
  • Principle 5: We will work together to enhance our effectiveness in implementing the Principles.
  • Principle 6: We will each report on our activities and progress towards implementing the Principles.

The work of PRI is to be lauded. It has played a fundamental role in improving investment decisions for the clients and ultimate beneficiaries of asset owners and asset managers. At the same time, it is important to understand if asset owners and asset managers who are its signatories are putting these principles into practice. Here some work needs to be done. Some useful insights can be gained in a recent paper “Analyzing Active Managers’ Commitment to ESG: Evidence from United Nations Principles for Responsible Investment” by Soohun Kim of the Georgia Institute of Technology and Aaron S. Yoon of Northwestern University. They studied 474 active U.S. funds managed by 86 different investment management firms during the period 2006 to 2017. The purpose of their study was to compare fund flows (e.g., new money going into and out of the fund), changes in fund level ESG scores, changes in voting patterns, and changes in fees and performance. The results are surprising and somewhat counterintuitive and raise some important questions. When I asked Professor Yoon why and he and Professor Kim did this study, he replied: “UN PRI is no doubt one of the most important ESG initiatives, but no one has bothered to examine the follow through of asset manager signatories. We felt that it was important to understand whether signatories were doing a good job and who were the better performers amongst them.”

First, in terms of fund flows, in the six quarters after a firm becomes a signatory to the PRI, it experiences a positive average fund flow of 4.9 percent for the next six quarters. This means that investors who care about ESG regard PRI membership as a positive signal. The investment firm benefits by getting some combination of more money from existing clients and money from new clients. This finding makes sense. After all, Principle 1 commits the firm to incorporating ESG issues into investment analysis and decision making. Furthermore, Principle 3 commits the signatory to seek disclosure on ESG issues by the companies in their portfolio. This disclosure can heighten the company’s attention to ESG issues, thereby improving its performance on them with a benefit to financial performance. In another paper, “Corporate Sustainability: First Evidence of Materiality,” Yoon and Professor George Serafeim of Harvard Business School and Dr. Mozaffar Khan of Causeway Capital Management very convincingly show the good performance on material ESG issues as defined by the Sustainability Accounting Standards Board contribute to financial performance.

Unfortunately for these clients, and raising a flag for sustainable or ESG investing, “fund returns significantly deteriorate post signing the PRI despite signatories’ enjoying higher aggregate dollar revenue (Figure 1).” Although fees do not go up, the investment firm receives higher revenues due to greater assets under management. For this set of firms, becoming a PRI signatory is good for them but not good for their clients.

The discrepancy between these two findings, and the large and growing body of empirical evidence showing a positive relationship between ESG performance on material issues and financial performance, could be explained by the difference between words (commits to principles) and deeds (actions for putting these principles into practice). This study suggests this may indeed be the case. The authors examine “whether signatory asset managers change their portfolio holdings to incorporate ESG” by creating a fund level ESG score. Somewhat surprisingly, they “do not find any meaningful changes in fund-level ESG performance.” In other words, becoming a signatory to the PRI does not lead to an increase in a fund’s ESG score.

A variety of ESG data vendors provide information that can be used for constructing these scores. However, it is a well-known fact that there is a high level of disagreement among these rating agencies. In other words, one firm may give a company a high rating on an overall ESG score or some component of it, while another firm gives it a low rating. (For a discussion of the reasons why see “Aggregate Confusion: The Divergence of ESG Ratings” by Florian Berg, Julian Kolbel, and Roberto Rigobon). To address this issue, the authors use ratings from the three major rating agencies: MSCI, Sustainalytics, and Truvalue Labs (I am an advisor to Truvalue Labs). As shown in Figures 2, 3, and 4 below, this finding holds true for all three rating agencies. There is virtually no difference in the fund’s ESG score post-PRI membership.

It is also interesting to note the absolute level of the scores. In all cases, they are just at or a little above or below the average. This suggests that there is no “aspirational effect” of an investment firm joining the PRI as a way of improving the ESG performance of its funds. But nor does becoming a signatory make an average performer a superior performer.

Of course, a good argument can be made that it is too simplistic to evaluate ESG integration by looking at an aggregate ESG score. A sophisticated investor may consciously invest in a company that is underperforming and ESG with a strategy of using engagement to improve its ESG performance—and hence its financial performance. Principle 2 calls for signatories to be active owners and to incorporate ESG issues into their ownership policies and practices. Here too there is a question of whether deeds match words. In examining the proxy voting of the firms, “we do not observe a meaningful change” in the aggregate. In fact, “PRI signatories are 30% more likely to be silent on environmental issues,” although “PRI signatories sometimes voice their concerns on social issues.” But the bottom line is clear. Becoming a PRI signatory does not lead an investment firm to be more aggressive in it voting policies with respect to ESG issues.  

What to make of this? A cynic could say that becoming a signatory to the PRI is a form of greenwashing by asset owners and asset managers. They seek to wrap themselves in the rainbow robe of its six principles but then do very little to put them into practice. I do not subscribe to this interpretation. After all, following Principle 6, the PRI requires signatories to report every year according to a rigorous framework and some signatories make these publicly available. Those who fail to comply will have their membership revoked. That said, this doesn’t happen very often, and the PRI really has no way of verifying the veracity of these reports. It depends on the honesty of its signatories.

Perhaps there are ways the PRI could be more effective in supporting and evaluating its members’ adherence to its six principles. As suggested by Chris Fowle, Director of Americas, “PRI agrees that urgent progress is needed if we are to meet global sustainability targets, such as the Paris climate agreement and the UN SDGs. Through our guides, reporting requirements, research and policy activities, and engagement with our signatories, we will continue to drive progress towards a sustainable financial system. We will fully consider this research – as we do with all relevant academic research – to inform our work and that of our signatories.”   

The PRI can’t do this alone. There are three other issues that need to be addressed, two of which are the responsibility of regulators. One consequence of sustainable investing going mainstream, is that more and more funds are being labeled as “green.” As with any product, the government needs to set standards for what qualifies. An important step in that direction has been taken with the adoption by the European Parliament of the Taxonomy Regulation “a classification system for sustainable economic activities – that will create a common language that investors can use everywhere when investing in projects and economic activities that have a substantial positive impact on the climate and the environment.” Many technical details remain to be worked out. And this taxonomy does not cover social issues where the technical details are even more difficult.

One of these difficulties is the fundamental one of what data will be used in defining “green.” For this reason, the EU is also conducting a review of its 2017 Non-financial Reporting Directive. The goal here is to establish standards for ESG reporting by companies. In a previous post, I have suggested the best way for these standards to be developed so that they are of the same quality as the accounting standards we have for financial information. This will enable companies to better manage and report on their ESG performance; it will enable PRI signatories to better implement principles 1,2, and 3; and it will make it possible to develop rigorous standards for funds that want some type of ESG product label.

The third issue is the mismatch between Principle 2 on engagement and how firms are voting their shares. Since this is public information, it is the responsibility of those who buy these funds to challenge the firms on their voting records—as is happening more and more frequently. Just as consumers have the right and ways to point out if products they buy do not meet their stated attributes, they should be able to do so with investment products.

Thanks to the PRI, we have a clear set of principles defining sustainable and responsible investing. Thanks to the work of academics like Kim and Yoon we gain insights into what must be done to improve the ability of PRI signatories to live up to its principles.  When asked what his plans were for further research in this area, Yoon replied “One of the biggest issues for implementation of ESG from the asset managers perspective is the ESG’s link to shareholder value for the many of the reasons that we already know (e.g., disagreements in ESG ratings). I will continue to do more work on identifying the circumstances in which ESG can lead to improved shareholder value.”

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