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What are SRI & ESG?

Sustainable & Responsible Impact (SRI) Investment ...
Environmental, Social, & Governance (ESG) factors

Editors Note:

Many people think of social investing as only Screening (avoiding tobacco, etc.), but screening alone has minimal impact unless combined with the more powerful tools of Shareholder Engagement and Community Investment.

This article explores these two higher-level strategies that allow investors to more effectively align investment decisions with social concerns, values, and personal or institutional mission.

The acronym "SRI" has been defined in a variety of ways over the years, including as:

—  Socially Responsive Investment
—  Socially Responsible Investment
—  Sustainable & Responsible Investment
—  Sustainable & Responsible Impact investment


The THREE LEVELS of SRI


To best understand the three levels of SRI, an analogy may be drawn to the environmental axiom Reduce–Reuse–Recycle, which describes a progression in which recycling is the point of entry, or lowest-impact activity.  While necessary, recycling alone is not sufficient to reach long-term environmental goals.  To be most effective, every citizen is called upon to engage in the higher-benefit activities of reducing and reusing.



A similar progression occurs in social investing, with the three key SRI strategies:

(1) Shareholder Advocacy, (2) Community Investment, and (3) Screening.  Though most people think of SRI as simply applying avoidance screens to their portfolios (to exclude tobacco, for instance), as with Reduce–Reuse–Recycle there are clearly defined levels of benefit in which screening is an entry-level activity, while community investment and shareholder advocacy are the higher-level activities that lead to greater benefit.

(1) SHAREHOLDER ADVOCACY is the prime catalyst for the social investment movement.  First used in 1972 by the Episcopal Church when it filed a social resolution on South African divestment, shareholder activism (or engagement) employs the proxy resolution process  —  dialogue with management and the filing of resolutions to be voted on by all shareholders  —  both to educate and to advocate for improved corporate practices.

The dialogue and resolution filing process generates a great deal of pressure on corporate executives, while directing public attention to important social, environmental, and workplace considerations.  This powerful tool has energized many inspiring turnarounds in companies' social, environmental, and corporate governance practices.

(2) COMMUNITY INVESTMENT directly helps those who have traditionally been denied access to capital and other meaningful banking services.  These investments bring hope to low-income communities throughout the United States and overseas because they provide affordable housing, create jobs, and help responsible small family businesses get started.

(3) SCREENING began with the churches, which in the 1920s decided to exclude the so-called 'sin stocks' from their portfolios.  Today the term screening describes either the inclusion or exclusion of securities based on social, environmental, or other criteria.

It is important to note that all investors  —  social or otherwise  —  begin the investment process with vigorous financial analysis.

Following this, the SRI investor then evaluates a company’s social and environmental qualifications as well. These additional layers of research give social investors insight into some very subjective areas, which can be thought of as management's foresightedness. It is axiomatic that the more foresighted a management team is, the more likely they are to run a company well and outperform their peers.

Social investors seek profitable companies that also evidence good employee relations, strong records of community involvement, excellent environmental practices and policies, respect for human rights (both here and overseas), and safe, useful products. Conversely, they avoid (screen out) investments in firms that fall short in these areas.

Because of the greater depth and additional nuance of SRI research, it is common for SRI analysis to boost or stabilize financial performance by either: (a) avoiding corporations whose sub-standard practices can result in liabilities that risk shareholder value, or (b) discovering opportunities in areas that 'numbers-only' Wall Street analysis may overlook.

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Keep in mind, the screens that an individual investor may use to buy-and-sell have little direct impact on a company’s social performance. This is because (with the exception of an IPO) the company does not know what an individual investor does, or why they do it. This is discussed in more detail below.

However, the screening research done by SRI analysts can alter company behavior  —  because it lets a company know it is being evaluated on these kinds of issues, and the research process itself places these items squarely on a company's radar screen.

This distinction has practical implications for the individual investor: in order to have a beneficial effect, an individual cannot just invest and screen their portfolio in isolation (such as at a non-SRI brokerage or advisory firm). In order to be heard they must join ranks with the community of social investors  —  and channel their voice with others' through the megaphone of SRI analysts who have the ear of the world's corporations.


ENGAGE or AVOID?

Key to understanding shareholder advocacy is the concept of engagement vs. avoidance. Many investors do not realize that selling a company’s stock on the Exchange (screening, or avoidance) has virtually no direct impact on the company. This is because on a Stock Exchange, the money does not go to-or-from the company; the Exchange facilitates the transfer of stock from one third-party owner to a subsequent owner  —  such that the company may not even know the transaction took place.

In this way, buying on the Exchange is very similar to buying a used car. When you buy a used car the money goes to the car-lot owner  —  not to the original car manufacturer. Likewise, when you sell, your payment comes from the next buyer. Either way, the company has nothing to do with the transaction.

Screening involves these kinds of ‘secondary’ transactions which the company is typically not even aware of, which makes it impossible for them to change their behavior. On the other hand, owning shares opens the door to shareholder rights and creates access to the proxy, the possibility of dialogue with management, and interest by the press.

If you think about it, companies that engage in questionable activities would like nothing better than if everyone who disapproved of their practices sold their shares and never darkened the doorway again.

Using shareholder rights, engaged social investors look to solve problems by facing them  —  using their proxy rights to improve a company's policies or practices. Over the decades, shareholder engagement has led to an impressive array of win/win successes involving a broad range of detrimental social and environmental issues that otherwise  —  left unchallenged by selling the shares and walking away  —  would continue today.


FOUR MEASURES of SRI's SUCCESS

(1) Dollars Under Management.

Social investing becomes increasingly powerful as it continues to grow.  SRI assets now total over $2.7 trillion  —  up more than four-fold from $639 billion in 1995.  SRI monies constitute more than one out of every ten dollars under professional management in the United States.  Community investing rose 84.3% in just four years  —  from $14 billion in 2003 to $25.8 billion in 2007 (the most recent year for which data is available).  Even during recent market downturns, the rate of investment flows into SRI assets has consistently outstripped the rate of growth in non-social assets.  This increase fuels the push to better link companies to sustainable business practices  —  a trend that benefits all investors.

(2) Growth in Shareholder Engagement.

In social terms, the 2003-2010 proxy seasons will come to be viewed as a watershed period.

As never before, the previously distinct worlds of traditional institutional investors and socially concerned shareholders found common cause in efforts to bring control, transparency and accountability to executive suites and boardrooms around the world.

Fueled by a string of unparalleled corporate and Wall Street scandals starting in 2002 and continuing on to present, shareholder engagement has become increasingly effective (and necessary) as a curb to corporate excesses.

Social resolutions increasingly are initiated by large institutional investors (such as State and City pension funds, like CalPERS and the City of New York), and frequently prompt companies to undertake substantive changes that are both profitable and beneficial for the public as well as investors.

Issues of particular interest to shareholder activists today include climate change, disclosure of corporate political contributions, and the elimination of persistent environmental toxins in products and packaging.  As well: controlling excessive executive pay, requiring board candidates to win majority votes, and other measures to ensure full board accountability.

(3) Rule Changes at the SEC.

In 2004 the Securities and Exchange Commission (SEC) began enforcement of a groundbreaking new rule that required mutual funds and large money managers to disclose how they vote proxies  —  which until then had been voted in secret, a practice that led to many conflicts-of-interest.

2009, the SEC reversed a Bush-era policy that restricted shareholders' ability to ask about the financial liability arising from corporate practices in environmental and social areas.

2010, the SEC directed companies to disclose to shareholders the business risks and opportunities associated specifically with climate change.

2010, the SEC adopted new rules for 'proxy access,' allowing large, long-term shareholders to propose independent candidates for elections to the board of directors.

(4) Competitive Performance.

Despite Wall Street’s persistent efforts to discredit SRI, it has been amply demonstrated that social screens and shareholder engagement do not automatically harm financial return  —  and in many cases improve performance while avoiding liability.  A sampling drawn from more than 300 important academic studies demonstrates the benefits of SRI and ESG investment approaches:

Click here for a long-term chart that shows social investment's outperformance compared to the S&P 500.

  • McElhaney (2010) CSR [corporate social responsibility] is “not a passing fad or trend  —  it creates and protects wealth.”
  • Verwijmeren and Derwall (2010) firms with highest employee well-being scores have lower debt ratios, which reduces the probability of bankruptcy ... the authors find that firms with better employee track records have better credit ratings.
  • Belu and Manescu (2009) the study provides evidence for a "persistently positive link between strategic CSR and the economic performance of companies."
  • Statman and Glushkov (2008) find that companies with a variety of social positives tend to outperform the market.
  • Edmans (2007) found that stocks of firms on Fortune magazine's '100 Best Companies to Work For' list outperformed market averages, even after accounting for market risk, size, momentum, and style effects.
  • Barber (2006 & 2010) found that CalPERS’ corporate governance initiatives [shareholder engagement] created over $3 billion in shareholder wealth from 1992-2004.  [Reiterated by Barber in 2010.]
  • Guenster, Derwall, Bauer, and Koedijk (2005) find that Innovest environmental ratings have a significant relationship with both firm valuation and operating results.
  • Orlitzky, Schmidt, and Rynes (2003) perform a meta-analysis of past studies and find a statistically significant positive association between corporate social performance and corporate financial performance.
  • Bauer, Kees, and Otten (2002) measure the risk-adjusted performance of 103 German, U.S., and U.K. mutual funds for the 1990-2001 time period, and find no significant differences between SRI returns and those of unscreened funds.
  • Stone, Guerard, Gultekin, and Adams (2001) show that for the 1984-1997 time period, the implementation of social screens did not harm the returns of a stock selection model.
  • Gompers, Ishii, and Metrick (2001) demonstrate that firms with corporate governance practices that favor management over other stakeholders tend to have lower price/book ratios, and that firms in the bottom quartile of their corporate governance ratings had significantly below-average risk-adjusted returns over the 1990-1999 time period.
  • Dowell, Hart, Yeung (2000) show that between 1994 and 1997, U.S. multinational corporations with high global environmental standards tended to have higher price/book ratios than companies adopting local environmental standards, even after adjusting for factors such as industry membership, R&D intensity, and advertising intensity.
  • Repetto and Austin (2000) use discounted cash flow models and scenario analysis to show that the financial impact of future environmental regulation may be quite material (up to 11% of market value) for U.S. pulp and paper companies.
  • Russo and Fouts (1998) find that companies with better environmental records appear to have better-than-average returns on assets.
  • Hamilton, Jo, and Statman (1993) analyze risk-adjusted returns and find that socially screened mutual funds are statistically indistinguishable from unscreened funds.
            (for more, see www.sristudies.org/bibliography)

IN CONCLUSION, individual and institutional investors have the opportunity (and in some instances a fiduciary duty) to link their values with their investments.

Addressing financial goals while also encouraging corporations to improve their social and environmental actions is not just fiscally prudent, it is also strategically advantageous and contributes to a healthy, prosperous, and more just world.

~ ~ ~

Bruce Herbert is Founder and Chief Executive of Newground Social Investment.  Herbert, an Accredited Investment Fiduciary, is a former Governing Board Member of ICCR (the Interfaith Center on Corporate Responsibility), and was Co-Founder and first Director of the Northwest Coalition for Responsible Investment.

Mr. Herbert began his financial career with Merrill Lynch in 1984, and has practiced sustainable & responsible impact investment since 1986.

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Now enjoying its second decade, Newground Social Investment provides individual, institutional, GLBT, and not-for-profit clients with:

Socially responsive (SRI* / ESG*) money management that integrates investment decisions with social concerns and personal or institutional values.
Competitive financial returns along with positive social impact.
Financial coaching and Life Planning that creates peace of mind, a sense of integrity, and financial security.
Community investment for strong local benefits.
Shareholder advocacy for transformation, transparency, and accountability.

Newground is a fee-only Registered Investment Advisor serving institutions and individuals of means who are principled, proactive and inspired to make a difference with their investments.

    * SRI = Socially Responsive.., Socially Responsible.., or Sustainable & Responsible Investment
    * ESG = Environmental, Social, and Governance factors

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