The future of responsible investing (part 1)

Introduction

This is the first article of a series authored by Dr. Rob Bauer in which he shares his personal perspective on the responsible investing phenomenon in two parts. In this first article, he takes a look back at the past two decades in which responsible investing transformed from a niche product to a hyped set of investment solution services. In the second and final part, he highlights several implicit trade-offs and conflicts of interest that materialize in the many manifestations of responsible investing such as divestment, engagement, and ESG-integration strategies, and encourages asset owners and asset managers to discuss their financial and non-financial objectives.

Humble beginnings

“Responsible investing: beyond the hype?” was the title of my inaugural speech when I started my “Institutional Investors” chair at Maastricht University (Bauer, 2008). The speech back then summarized my view on the responsible investment hype in the prior decade (the 1990s) and gave a preview for the years to come. At the time, I expected this hype to end soon – as any hype does by definition – and predicted a gradual integration of its relevant parts into mainstream investment practice.

Responsible investing as such would become archaic if not obsolete.

How wrong I was back then. Challenging the theories on the rise and fall of hypes, the responsible investing movement evolved into an almost sacred utterance with magical and spiritual powers that promised high returns and low risks. At the same time, these investments were set up to save the people and the planet. Observing this movement today, I wonder whether it was largely induced by smart marketers who, riding the waves of civil society’s multifaceted concerns, created a plethora of responsible (investment) products. Moreover, many of those products have fuelled a conspicuous consumption pattern: consumers have used the spending on luxury goods (e.g., buying an expensive electric car) and services (e.g., responsible investing products) as a public display or signaling device which has helped them attain or maintain a certain social status (Riedl and Smeets, 2017).

Alternatively, and certainly a less cynical observation, the hype becoming a trend may also have been consistent with a sincere and authentic awakening of those who had prudently watched over large sums of money that the people had entrusted to them. These agents increasingly started realizing that certain risks and opportunities related to environmental and social challenges that companies were facing could impact investors’ long-term bottom lines in material ways. Additionally motivated by explicit demands put forward by civil society, asset managers and asset owners started building a multifaceted set of responsible investment products and services. While exclusion and divestment were buzzwords in the previous century (as a matter of fact, both still are highly in the money), the first two decades of the twenty-first century can be characterized by the introduction and implementation of many new investment concepts. The explicit integration of environmental and social information into investment decision-making, active ownership strategies, and impact investments made its appearance.

These two sides of the same coin are consistent with how I prepared for my interactions as an academic with the responsible investment industry during this period. In the first decade of this century, I was confronted with many sceptical views on the integration of non-financial information into investment decision-making. In frequent interactions with the investment community, I tried to show the other side of the coin backed by objective evidence of an increasing number of high-quality academic studies that had emerged in the meantime.

However, in the last few years, I have been regularly confronted with proponents of responsible investing who seem to follow a mantra that deems all activities in this space valuable, worthwhile, return-enhancing, and risk-reducing. This mantra again spurred me to increasingly challenge their opinions by again being inspired by sound academic contributions in the field¹.

What drives responsible investing?

Why do we expect retail and institutional investors to wholeheartedly embrace responsible investing? This question is not easy to answer. Investors operate in certain legal and societal contexts that are the key drivers in accounting for differences in their sustainable investments. Laws relevant to, for instance, pension funds; the laws’ interpretations; and subsequent trajectories differ markedly per jurisdiction, as do regulatory bodies’ attitudes towards the responsible investment topic. When browsing legal scholars’ contributions to this discussion, references to the prudent person rule often occur (also known as prudent man, prudent investor, or prudent expert) in which prudence and loyalty play important roles. In general, pension fund boards must manage their capital with the care, caution, expertise, and competence that beneficiaries expect from a reasonably competent and reasonably acting pension fund (Maatman and Huijzer, 2019). The loyalty principle requires trustees to give priority to the beneficiaries’ interests under all circumstances. If trustees fail to do so and thereby harm their beneficiaries, then they are liable in principle. Failing to investigate the impact of climate change on the risk to investment portfolios, and not acting on obtained insights, could be an example in some jurisdictions (e.g., the EU) of not following the prudent person rule.

Now the question is: what exactly are the best interests of beneficiaries? Is it merely the financial best interest as is the case in (the interpretation of) many Anglo-Saxon law contexts? Or is it also linked to other nonfinancial interests such as the ability to enjoy retirement in a world worth living? Inspired and convinced by recent developments, such as the emergence of the Planetary Boundaries Concept in 2009 (Rockström, 2009) and the launch of the United Nations Sustainable Development Goals (SDGs) in 2015, many institutional investors have started shifting gears in integrating environmental and social information into their objective functions². Contributing to a better world has become part of the mission and vision of many asset owners and, consequently, service providers in the asset management industry. This involvement increased the intensity by which the global financial industry developed new products and services in this domain.

Concerns

Opponents of this development often claim that investors have no direct role in solving societal problems (US Department of Labor during the Trump administration, 2018 and 2020). They argue that the people allocate this role to parliaments and governments in a well-functioning democracy. In such a context, laws and regulations would make sure that the will of the people – all of us are investors in some way – would be represented adequately in the long term. This logic may apply to some local or national challenges, but which government represents the planet and which environmental laws are truly applied and enforced globally? Moreover, does the average politician have a truly long-term mindset? Probably not.

Nonetheless, I agree with these words of caution voiced by opponents, but in another dimension. Having more objectives than instruments is a well-known problem that was put forward by Jan Tinbergen, the first Nobel Prize winner in economics (Tinbergen, 1952). Analogously, investors do encounter many trade-offs in decision-making, but these are rarely made explicit. Having both financial (e.g., adequate pensions) and nonfinancial objectives (enjoying retirement in a world worth living) may be hard to accomplish with just one instrument: the investment portfolio. At the very minimum, objectives need to be prioritized to avoid confusion or stalemates in investment management (Bauer, Christiansen, and Doskeland, 2022). Additionally, we may search for other instruments, such as better-functioning democracies that make nonfinancial objectives in the investment strategy obsolete³.

A related concern is that many asset managers and asset owners focus heavily on “doing good” in their investment strategies.

Private investments in energy transition initiatives are good examples. This relatively small subset of investments draws a lot of attention but does not suffer short-term pressures on returns and risks from the public market. It is related to several key SDGs (although the impact cannot always be precisely measured) and often contributes to the reputation of the institutional investors who are involved in it. However, these investors, in my observation, pay much less attention to “doing-no-harm” in such matters: solving the climate crisis will not necessarily remove injustices related to human rights abuses, inequality, workers’ rights, and many other topics that fall under SDGs. You simply cannot do it all. This observation is in fact another trade-off that investors must deal with and communicate about. Moreover, budgets for managing the products and services of responsible investments are constrained as well. Diligently checking all portfolio companies for whether they are involved in severe human rights issues in the supply chain is a tedious and costly task. Also, data quality and consistency are not necessarily a given (Berg, Kölbel, and Rigobon, 2022). The same holds for assessing whether these companies adequately compensate stakeholders for the costs and damage occurred. In other words, living up to the promises made in the OECD guidelines or upcoming EU regulations is a difficult task for companies and for those who invest in them.

Given these challenges, it is understandable that many investors highlight salient and easy-to-communicate “doing good” investments.

This article was also published in the VBA Journaal. illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability & Energy writers, their opinions do not necessarily represent those of illuminem.

References:

1. ABP Press Release, 2021, ABP stops investing in fossil fuel producers. Press Release, October 26, 2021.
2. Aegon Asset Management, 2021. Responsible Investment Framework.
   
3. Bauer R., 2008, Responsible Investments: beyond the hype? Inaugural speech Maastricht University School of Business and Economics.
   
4. Bauer, R., 2022, The Future of Responsible Investing, VBA Journaal, 150, 8:14