Edited by Cary Krosinsky and Nick Robins. London: Earthscan, expected late 2008
Chapter 16: FIDUCIARY DUTY, CLIMATE CHANGE AND SUSTAINABLE INVESTING
Stephen Viederman
Since the beginning of the industrial revolution at the end of the 18th century, human impact on the environment has increased exponentially. Scientists observe that since then “Earth has endured changes sufficient to leave a global stratigraphic signature distinct from that of the Holocene or of previous Pleistocene interglacial phases, encompassing novel biotic, sedimentary and geochemical change.” Anthropocene is the word they created to delineate this new epoch.
It has not been until the last few decades that economics and finance began to recognize the relationship between the physical and social world on the one hand, and the economic world on the other. What had been identified as externalities by the economists, and intangibles and extra financial factors by investors, have recently began to be seen as material, and as a result, are becoming more integrated into financial decision making. Mainstream mega-firms, like Goldman Sachs, Deutsche Bank, Lehman Brothers, State Street Global, Societe General and others have recently started using social and environmental factors in their financial analysis in some of their specialized investment offerings. They see a market and they are offering products. A few even speak of the climate imperative as a driving force financially and politically. But the process has not yet become the norm.
In this essay I will offer a redefinition of fiduciary duty for the Anthropocene, the era of climate change, and discuss the role of sustainable investing in meeting the challenge.
Fiduciary duty
Pension funds, foundations, endowments and religious institutions, among others, are by definition long-term investors. To meet their fiduciary obligations they have a legal responsibility to exercise reasonable care, skill, caution, and loyalty to the purposes of the trust. For public pension funds in the United States this is interpreted as maximizing financial returns on investment for their beneficiaries. For foundations and endowments the same standards apply with greater flexibility, but also are usually framed in terms of maximization of profit.
There is, however, legal opinion that these institutions are not constrained with regard to the use of ESG factors. “In our view,” the 2005 report by a leading international law firm, Freshfields Bruckhaus Deringer, sponsored by the UNEP Financial Initiative states, “decision-makers are required to have regard (at some level) to ESG considerations in every decision they make.” In 1997 William McKeown, a lawyer at a leading New York firm, concluded, “In order to fulfill their responsibility to see that the corporation [foundations and non-profit organizations] meets it charitable purposes, they may have a duty to consider whether their investment decisions will further those charitable purposes,
or at least not run counter to them.” But in the absence of case law, and in the presence of inertia, maximization of financial return remains the goal.
The largest global investors have not rushed to embrace these approaches, at least not in the United States. Finance committees have generally been very slow in their approach to investing in new funds that have social and financial goals. Data on performance has been difficult to compare and benchmarks are not readily available because there is no standard approach to sustainable investing. This wariness contrasts committee embrace of newly developed purely financial investments that ‘promise’ high rates of return in the short-term. In the testosterone-driven world of institutional investing, maximizing returns is still the gold standard, and presumed to be the standard necessary to meet obligations of fiduciary duty.
Research has shown that at the U.S. financial institution executives “are willing to sacrifice economic value in order to meet a short-run earnings target. The preference for smooth earnings is so strong that 78 percent of the surveyed executives would give up economic value for smooth earnings.” In addition the authors found “…that 55 percent of managers would avoid initiating a very positive net project value if it meant falling short of the current quarter’s consensus earnings.”
Exxon Mobil represents a paradigmatic case of the conflict between short-term and long-term profit generation. The world’s largest corporation by market capitalization is an old-fashioned oil and gas company that identifies itself now as ‘”taking on the world’s toughest energy problems.” In November 2007 Rex Tillerson, Chairman and CEO, publicly stated for the first time “it is increasingly clear that climate change poses risks to society and ecosystems that are serious enough to warrant action—by individuals, by businesses, and by governments.” Exxon has, however, refused to respond to a shareowner proxy resolution asking the company to “adopt a policy on renewable energy research, development and sourcing” Given the long lead time to develop alternatives and renewables, and the approach of peak oil, renewable energy investment would contribute to their profitability in the next decades. Similarly, with their GHG emissions increasing, they have refused the request of shareowners to set goals for reducing their GHG emissions. Though highly profitable now, are Exxon’s profits going to be sustainable, and is Exxon Mobil in its pursuit of profit now limiting options for future generations?
Corporations also assume a fiduciary duty to their owners although it is not necessarily solely to maximize shareowner wealth. Rather, they are required only to carry out the “lawful directives of shareholders”. Thus, managers can engage in activities that reduce shareholder wealth as long as they “do not engage in fraud or self-dealing and make rational, informed decisions”. But they too, despite case law that supports this conclusion, are driven by the market to achieve the highest profit.
The climate challenge to investing as usual
At this time, the beginning of the third century of the Anthropocene, climate change is the greatest human-induced challenge we face. The need to mitigate and adapt to the effects of climate change is likely to be the defining issue of the 21st century and must be approached urgently and seriously.
Although often framed as an environmental problem, climate change is much more. It is a social, ethical, and moral problem. It is also truly a global problem from which no one can escape.
The question of what is a maximum rate of return comes into question, however, when we consider the risks of climate for the society, with both short- and long-term ramifications. Is maximization of profit sufficient if the so-called extra financial returns accelerate the consequences of climate change? Is a company operating in the best interests of its long-term shareowners if it fails to take actions now that will give greater assurance of high returns later, just so they can achieve maximum short-term financial returns?
What good is a maximum rate of return on investment if it fouls the air, poisons the water, degrades the land, changes the climate, and contributes to greater inequalities among people? Is it sufficient for some of us to reap financial return and to consume the products and services resulting from these investments, while all of us, and our children and grandchildren, face the prospect of increased morbidity and mortality, and, except for a few, a decreased quality of life? Societies including economic systems will be disrupted and that is not good for the companies themselves.
In effect, all of the world’s population is a universal owner of the climate problem. It is the object of the world’s corporate productive capacity and the externalities of that production, while only a very few of us reap the financial benefit. Investment is not only about how much you expect to earn. Investment is also risk, about how much you can afford to lose. How much can universal owners afford to lose in the face of climate risk?
A Redefinition of Fiduciary Duty
What is ultimately needed is a new and more meaningful definition of fiduciary duty for the Anthropocene, a definition that accepts that the financial world and the social and environmental worlds are one and the same. There is no triple bottom line. There can only be a single bottom that offers positive social and financial returns against which all business decisions must be measured. Fiduciary duty must transcend the solely financial responsibility of the company or the institutional investor to maximize profit. Fiduciaries must also consider the social and environmental consequences for the investors, the beneficiaries, and the society-at-large. We are all universal owners, as shareowners and stakeholders.
This redefinition must give weight to how ESG factors, more broadly understood than at present, affect both risks and opportunities, now and in the future. Let’s look at some of the key words that currently define fiduciary duty.
“Profit”, originally meaning to ‘advance’, and now defined in terms of ‘benefit’, must go beyond financial benefit. Maximizing financial profit, advancing it to its upper limits, provides goods, services and employment, but also diminishes social benefit in the real world. Money is necessary but not sufficient. As Robert Monks, investor and corporate governance activist, observes, “The primary thing that workers need for their retirement [is] money, but don’t workers also need a safe, clean, decent world in which to spend it. These ends are not economically exclusive…” Even the wealthiest among us cannot escape the assaults of climate change. As food riots around the world in April 2008 demonstrate, the poor can take no more as climate changes add further burdens to their lives.
“Prudent” in the 14th century meant to be farseeing. Today the dictionary defines it as being circumspect, wise, and exercising good judgment. The prudent financial person now looks through the rear view mirror to conform to what has been done, rather than looking through the windscreen to see what must be done.
As financial transactions and investment vehicles become more specialized and complex, fiduciary duty must expand to encompass our greater knowledge and understanding of the long-term social and environmental costs as well as benefits associated with investment decisions. Risks as well as opportunities must be assessed more prudently in the context of climate change. This includes the science and economics of climate risk, and also the political processes, nationally and globally, that will effect investment decisions. Investment committees may argue they do not know how to do this. They use consultants to increase their comfort with exotic financial instruments, so too can they bring in climate and policy specialists. Lack of knowledge is not a reasonable response for inaction by fiduciaries.
Fiduciaries will need to seek out those investment managers and consultants that are already implementing investment programs that focus on the integration of ESG factors with financial decision-making. This is not portfolio screening. They should explore different investment strategies that channel funds into new areas that are focused on climate solutions that will lead to long-term growth and sustainability, and will carry less risk and liability.
Fiduciaries will need to review their entire portfolios, not only individual assets or asset classes. Isolated investment decisions affect total portfolios that in turn have societal effects. For the larger fiduciaries, the Universal Owners, the financial and ESG bottom line is inevitably portfolio-wide. Initially a large long-term investor may benefit from a company in their portfolio externalizing costs, but ultimately there will be a reduction in returns overall as the externalities negatively affect returns in other companies and assets. Raj Thamotheran and Helen Wildsmith suggest because they are Universal Owners collective action by large pension funds could improve long-term market returns.
Fiduciaries must see themselves as shareowners not simply as shareholders, and assume the responsibilities that go along with ownership. Owners are stewards of the capital that has been entrusted to them, and cannot be passive. Being a responsible shareowner implies corporate engagement, minimally through the development of proxy voting guidelines and procedures for ESG factors, and voting of proxies. In addition, fiduciaries must demand greater accountability and transparency from the companies in their portfolios on climate factors, and policies and programs to mitigate and adapt to climate change. These will reduce financial risk and social risk.
Fiduciaries are rightfully sensitive to the legal implications of their decisions. They should ask their lawyers how to accommodate these new responsibilities and obligations, rather than ask them if they can. There is now a significant body of research that an analytical approach to financial decision-making that integrates the risks and opportunities identified by social, environmental, political, and cultural issues can compete with traditional investing styles, and produce social and environmental benefits as well.
Fiduciaries should also be aware of and involved with the formulation and execution of public policies that govern financial firms, transactions and markets, and climate risk.
The corporation as the most powerful economic institution in the world will determine the social and environmental state of the world, as much if not more than governments and international organizations. As the effects of climate change become more visible it is incumbent on institutional investors and corporations to exercise these fiduciary duties now. With climate change, as with most things, inaction is the worst action.
Sustainable investing and a redefined fiduciary duty
Sustainable and sustainability, as the terms are now generally used, cover a wide range of meanings. The Environment is the primary and sometimes exclusive focus of most sustainability discussions. “Sustainability” came into common use in the 1980s in response to growing environmental concerns. The environment is also conceptually clearer than most social areas, and data are more readily available and can be shown more convincingly to correlate with financial performance. Social incorporates economic and financial factors, as well as political and cultural issues. Governance is a measure of a company’s ability to integrate E and S into its management structure, decision-making, and action, to be prudent, farseeing.
To be truly sustainable equity and justice must be addressed in ways they are not now.
The term ‘extra-financial’ underlines the historical separation of finance from the real world, ‘extra’ referring to ‘beyond what is normal’. Arguing that these factors are necessary for long-term financial returns, however, makes them ‘financial’ factors, despite the fact that they have been disregarded for centuries. The difference now is the realization of their scale and impact.
“Full integration of ESG factors” raises significant questions concerning the limits of our understanding of what these factors are, how they interact and how they can be measured. “Not everything that counts can be counted,” Albert Einstein observed in his Nobel acceptance speech, “and not everything that can be counted counts.” In addition, it raises issues relating to the limits of so-called corporate social responsibility, an ill-defined term that is often used as a substitute for ESG.
Is the desired outcome the achievement of “long-term shareholder value”, and/or meeting the needs of present and future generations? How are these outcomes related to each other and to financial decision-making? What are the time frames? Clearly implied is the desire to change corporate behavior since the impetus for sustainable investing reflects the financial systems’ inability, as presently structured, to incorporate consideration of the long-term and future generations. Sustainable investing has still to make clear how it is part of the process of sustaining the society rather than just the investing.
To be seen as more than a new name for an old process, sustainable investing will need to address more seriously than it has the application of E and S particularly. A product, such as tobacco, could be excluded because of its impact on human health and the attendant social costs. But what about products relating to family planning and abortifacients that are decried by some and strongly approved by others who might otherwise agree on many other corporate activities? What about defense contractors? Critics have often chided social investors for not being serious by using exclusionary defense screens. They argued that people might not like wars, but defense is nonetheless necessary. Can an environmentally sensitive investment fund be considered as sustainable if it does not assess other aspects of a company’s performance, such as diversity in the workplace, a living wage, and its impact on the community?
Corporate social responsibility and corporate citizenship are buzzwords that have created a whole new industry. What are the limits on corporations that constrain the practice of sustainability? The answers to this question are essential in understanding what sustainable investing can legitimately expect from companies, and what issues are systemic and beyond their grasp and interventions. The latter will require action in other arenas, political and conceptual.
James Gustav Speth, now dean of Yale’s School of Forestry, has had a long and varied career at the intersection of the environment and policy. In a new book he concludes
After much searching and considerable reluctance . . . that most environmental deterioration is a result of systemic failures of the capitalism we have today and that long-term solutions must seek transformative change in the key features of contemporary capitalism.
He joins many others who have called for transformation of capitalism, or a totally new ism, calls little heeded by politicians, economists and businesses.
Systemic obstacles that corporations face under free market capitalism include:
• A commitment to full cost accounting that must be a factor in sustainable investing. Externalization of environmental and social costs is still the norm.
• Ability to avoid the focus on returns in the short-term that is seen even within the traditional social investment world. Today’s returns, the next quarter’s, but not the next quarter century’s, are the benchmark. In practice the future is discounted at a rate close to zero.
• A commitment to slow or no growth. Like a shark that must keep swimming to stay alive, so too must a company keep growing to survive. Fortune Magazine applauded Nike a number of years ago for creating a want for something no one knew they needed. Economic growth, at least in advanced economies, runs contrary to sustainability.
Solutions to the systemic issues requiring new paradigms of the economy and of finance are a long-term activity. The sustainable investing community has a role to play in the discussion and description of a transformed capitalism or a new ism. But this most also engage the intellectuals –economists and others—who are the keepers of the capitalism kingdom, and representatives of the broader population to ensure that their voices are heard in the search for something that works for all concerned. This process must begin now with a long-term commitment.
Companies are capable of more effectively addressing a number of issues that are possible within the limits of the capitalist, free market economic system:
• They can make greater commitments to communities by listening better to the people most affected and acting on what they hear;
• They can make greater commitment to the environment, to human rights, to equal opportunity, to providing a living wage with pension and health benefits to their workers, and to their global supply chains with particular attention to issues such as child labor, wages, and overtime.
Shareowners working together have demonstrated they can play a significant role in encouraging corporations to be more responsive to environmental and social concerns. The obligation to exercise ownership rights must be an integral part of sustainable investing.
On a more practical level, sustainable investing also requires greater data depth, breadth and quality than are now available. This need not be a constraint to begin but should be a part of a near-future agenda. Presently much of the data used are retrospective and historical.
Conceptualizations of criteria in general use are often spotty. For example:
• Corporate citizenship and corporate philanthropy are both oxymorons but are often used as stand-ins for ‘community’.
• Labor practice indicators are virtually non-existent, especially when the supply chain is long reaching down to smaller producers in less developed countries.
• Social and environmental reporting not audited by outsiders has to be approached with caution. Corporate Responsibility Officers are constrained by lawyers from telling the whole truth for fear of litigation. The important work of the Carbon Disclosure Project provides baselines for shareowners and governments to request setting limits on GHGs but does not provide suasion for companies, such as Exxon Mobil, to set goals. Owners must do that.
Leaders in sustainable investing will need to analyze the barriers to adaptation of this investment process and seek answers to the questions raised. This will need to be done within national contexts. As a Mercer study recently showed, there is considerable difference in the way that institutions in different countries respond to the idea of sustainable investing. The key decision makers and gatekeepers in institutions will need to be identified, and data gathered to create understanding of the process and desired outcomes. The cultures of finance committees immersed in the ways of financial investing must be considered and changed. Knowledgeable and skilled consultants able to guide institutions in their deliberations and direct them into sustainable investment vehicles are now in short supply. Change will not come about by itself. The sustainable investing community will have to give as much attention to the process of institutionalizing sustainable investing as to the substantive issues outlined above.
To become mainstream sustainable investing, given its long-term horizon and the short timeframe of the market, will need to demonstrate financial returns and social returns. We know that ESG factors are material and useful indicators of good financial performance. But the bottom line, an indicator of successful sustainable investing, will be that it can also facilitate over time movement toward a new economy that leaves options open for our children and grandchildren to live in a humane world. This should not be done apologetically. Sustainable investing is no more or no less a science and an art than mainstream investing despite the latter’s claims to science. Sustainable investing’s claim is that it will help to bridge the chasm between the economic and human condition.
Sustainable investing must play an important role in helping societies and individuals mitigate and adapt to climate change, reversing the consequences of conventional investing. Advancing social, environmental and financial benefits is the new fiduciary duty.