Earlier this month, a coalition of investors filed resolutions at four corporations whose members sit on the Board of the US Chamber of Commerce. The filers called for Accenture, IBM, Pepsi, and Pfizer to “review their policies and oversight of political expenditures, especially through trade associations,” according to a release by coalition member Walden Asset Management.

The Supreme Court’s January 2010 Citizens United decision explicitly permitted unlimited, anonymous political spending by private organizations, including unions and corporations. This decision has already sent waves of undisclosed money through the US political system. In the November elections, out-of-state oil companies spent millions on a California ballot proposition, while the Chamber spent almost $30 million on campaigns nationwide, according to BusinessWeek:
 

Earlier this month, the US Social Investment Forum (SIF) released its 2010 Report on Socially Responsible Investing Trends. The Report has been a standard reference for the American SRI market since the first was produced in 1995. (MSCI is one of two lead sponsors of the 2010 Trends Report.)

SRI has grown steadily over that period, and since 2007, its growth has accelerated dramatically. While total US assets under management grew less than 1 percent, sustainable/SRI assets expanded more than 13 percent over the past three years.

Along with other data to support this growth story, the Report also explores themes that deserve wider notice. These include the pivotal role played by institutional investors; the expansion of "positive" environmental, social and governance (ESG) integration methods; and how public policy changes are driving further ESG integration by investors – including those who aren’t explicitly “socially responsible.”

On August 23, the Wall Street Journal published an editorial by Dr. Aneel Karnani that questioned the value of corporate social responsibility (CSR). His argument was directed against “pleas” and “appeals” for executives to “act voluntarily in the public interest and against shareholder interests.” He called CSR “irrelevant or ineffective,” an “illusion, potentially a dangerous one.” A reader unfamiliar with the term might surmise that CSR is actually a dangerous chemical, like DDT.

The socially responsible investing (SRI) community, as expected, took issue with Dr. Karnani’s column. Social Investment Forum (SIF) CEO Lisa Woll wrote to the Journal, countering the polemic with real-world evidence about the positive impact of corporate sustainability efforts. (With permission from SIF, Ms. Woll’s letter is printed in full at the bottom of this article.)

Besides its empirical shortcomings, Dr. Karnani’s case also betrays a methodological flaw that is both common, and instructive: While we can tell what he takes issue with, it’s never quite clear who he’s talking about. Here is the plainest statement of his thesis about corporate social responsibility:

Trend stories are a staple of the news media, and two articles this past weekend explored the prospects for socially responsible investing (SRI). What’s interesting is that one story (in the Boston Globe) found that SRI’s trend line points up, while a piece in the Financial Times asked why its growth has stalled. This divergence comes because the Globe considered the US market, where SRI mutual funds have kept growing even as mainstream equity funds shed billions. The FT looked at a lagging market for SRI: Germany.

The FT reporters found “rather typical” explanations for Germans’ lack of interest in environmental, social and governance (ESG) integration. But it should be noted that the ESG community has taken concrete steps towards answering skeptics in Germany, and around the world. These steps include ongoing academic research into the performance impact of ESG integration, and an initiative to develop standardized metrics for comparative evaluation of company performance. MSCI’s ESG team has supported both of these efforts.

In the aftermath of the global financial crisis, many investors have grown concerned about standards of corporate governance. In fall of 2009, the European Commission released a study of corporate governance monitoring and enforcement practices in its member states. The study was undertaken by RiskMetrics Group in collaboration with BusinessEurope, ecoDA and their affiliates, and Landwell & Associates and their affiliates.

In most EU states, national governance codes set rules with which corporations must comply, or else explain why they have not complied. The RiskMetrics study found support for "comply-or-explain" regimes, but also found "some deficiencies," including "unsatisfactory level and quantity of information on deviations by companies and a low level of shareholder monitoring."

Institutional investors may have a fiduciary duty to consider environmental, social, and governance (ESG) factors, according to a new study from the United Nations Environment Programme Finance Initiative (UNEP FI). In reporting on "Fiduciary Responsibility," Social Funds' Robert Kropp expressed the uncertainty that still surrounds the question of ESG-related fiduciary responsibilities:

"The report argues that consultants may well have a legal duty to proactively raise ESG issues with their clients. The report also recommends that ESG issues be embedded into legal contracts between asset owners and asset managers."

As the case for managers' ESG-related obligations under securities and trust law is still open, UNEP FI says, ESG proponents should encourage clients to demand integration from their advisors. For now, asset owners, not courts, must drive ESG integration – though lawmakers may yet embed responsible investing into managers' obligations.

"We need to live off the interest"

In his introduction to the 101-page report, Achim Steiner of UNEP FI says that the economic crisis "requires us to review the economic models this century has inherited from the last one." He places particular emphasis on the environment, declaring that "we are living off the Earth's capital – we need to live off the interest."

Towards this end, "Fiduciary Responsibility" describes how some shareholders have begun to consider the ESG performance of the companies they invest in. While the report does not prove that ESG integration is a fiduciary duty, it does offer practical reforms that would help create such duties. For example, UNEP FI calls out signatories of the Principles for Responsible Investment (PRI): "…In order to maintain their membership, all asset manager and asset owner signatories [should be required to] embed ESG issues in their legal contracts."

UNEP FI also says that government should redefine the work of fiduciaries:

"Global capital market policymakers should also make it clear that advisors to institutional investors have a duty to proactively raise ESG issues within the advice that they provide, and that a responsible investment option should be the default position. "Furthermore, policymakers should ensure prudential regulatory frameworks that enable greater transparency and disclosure from institutional investors and their agents on the integration of ESG issues into their investment."

Commentary on ESG and Fiduciary Duty

"Fiduciary Responsibility" is the sequel to a 2005 UNEP FI study, called the "Freshfields report" after the consultants who prepared it, that helped spur the creation of the PRI. The new report includes a literature review of "practical developments" in ESG integration; the results of a survey of how major investment managers approach the topic; and commentary from UK and US experts in fiduciary law.

Quayle Watchman Consulting describes how attitudes and laws have changed since 2005. In the UK, the law now impels corporate directors to consider the broader effects of their decisions:

"Under current United Kingdom company law legislation, the Companies Act 2006 (the '2006 Act') imposes duties on company directors to report on the environmental and social impacts of their business activities. "[Guidance] on the duty of directors to promote the success of the company under section 172 of the 2006 Act, which is the principal replacement duty for the common law fiduciary duties of company directors, also adds that 'success' is to be judged in terms of long-term increase in the value of the company rather than short-term gains."

The obligations of directors have changed, but Quayle Watchman notes that "the government declined to introduce amending legislation to clarify the position of pension fund trustees." While trustees may consider ESG factors in their investment decisions, there is no legal imperative to do so. Quayle Watchman considers the roots of trustees' "short-termism":

"There appears to be resistors to responsible investing which relate to deeply-rooted characteristics of the investment decision-making system including: the mandates that pension funds and their investment consultants set; the systems for measuring and rewarding performance (which focus on peer comparison and beating benchmarks rather than on fulfilling the long-term liabilities of pension funds); and the competencies of service providers (e.g. sell-side analysts). "The effect of this resulting short-termism is that less attention is paid to responsible investment matters than is appropriate–these issues are too long-term in nature to affect the day-to-day behavior of fund managers."

Asset Owners Must Lead Their Managers

Quayle Watchman explains how investors, "in the absence of government legislation or regulations, codes of practice or guidance," can build a long-term perspective into capital markets. They note the impact of the PRI program, which has attracted more than 550 signatories, representing approximately $18 trillion in assets under management.

Responsible investment, conducted at this scale, has helped shift the financial sector's priorities. "Fiduciary Responsibility" cites Bloomberg's placement of carbon emissions data on its terminals as evidence that sustainability is now a mainstream concern.

In the aftermath of the global financial crisis, fiduciary duties may undergo a broader philosophical shift. According to Quayle Watchman:

"The courts accept, despite the widespread use of mathematical modeling, that investment is an art rather than a science, and that there is a wide spectrum of opinion on investment which may be held by advisers without an adviser acting negligently."

Last week, Responsible Investor reported that Adam Seitchik, former CIO of Trillium Asset Management, is joining London-based Auriel Capital Management. RI's Hugh Wheelan wrote that in hiring Mr. Seitchik, Auriel "is joining a growing number of hedge funds building strategies in the responsible investment space."

Why are absolute return managers becoming more interested in environmental, social and governance (ESG) analysis? According to Mr. Seitchik, the Principles for Responsible Investment (PRI) have spurred broader investor interest in ESG research. In a conversation on June 22, he discussed the impetus behind his move:

"Over the past few years, I've been intrigued by the growing interest of institutional investors in ESG. We're seeing more and more asset-owner signatories of the PRI, and more institutions that have joined the Investor Network on Climate Risk (INCR). "We're also seeing more ESG investors who are not [self-described] ethical investors, but pursue ESG integration in the context of risk mitigation and fiduciary duty."

Adding to the ESG Toolkit

Mr. Seitchik said that Auriel will serve these investors with "our institutional investment platform, focused on risk-adjusted return. Our firm focuses on absolute return investing, but we can also deliver long-only strategies." To explain how Auriel could integrate ESG factors into its strategies, Mr. Seitchik described a hypothetical long/short fund:

"Investors are currently offered long-only themed strategies like clean-tech, or green energy. We are adding to the toolkit – ESG research can help support a strategy that goes both long and short. "If you are able to hedge, you can reduce risk across a portfolio. Let's say an institution is interested in risk management around ESG in general, or specific areas such as biodiversity loss, or sustainable forestry. You can construct a two-part portfolio – an active long-short portfolio attached to an index fund. You might get exposure by tracking an index, but then go short on a particular holding. You can reduce overall portfolio risks without having to disrupt the existing index fund strategy. "What really matters to investors is their overall risk and return. We look to provide not a single fund, but an investment platform that can be adapted to the needs of clients."

Why Now?

In our conversation on Monday, I mentioned another recent RI article on Philips' commitment to more responsible investment of its employees' pension fund. Mr. Seitchik agreed that this is an important step: a private, for-profit institutional investor is joining the nonprofits and governments that have traditionally pursued ESG integration. Asked to speculate on why Philips might be doing this, Mr. Seitchik laughed and said, "They're Dutch."

He was only partly joking. Mr. Seitchik cited broad European involvement with PRI, INCR, and other multi-stakeholder initiatives as an impetus for ESG integration. He also mentioned Philips' role as a leader in energy efficiency technology. "Hopefully this will spread to more US companies as well, though US capitalism really does follow a different model than European or Japanese capitalism, and is evolving in its own way," he said.

The Commitment to Advocacy

I pointed out that along with committing signatories to change their own practices, the PRI also ask them to promote responsible investment by others.

"That's right," Mr. Seitchik said. "PRI signatories have signed on to a broader project, beyond changing their own practices. They've joined a network of investors, and PRI provides progress reports and does other work to sustain and expand that network."

In that spirit, I asked if Auriel will promote ESG integration to all of its clients. Mr. Seitchik gave an intriguing response:

"Auriel will be agnostic on this question. Our ESG efforts are focused on those institutions that are seeking these types of solutions, such as PRI and INCR signatories, and foundations interested in mission-related investing. We think it would be presumptuous to approach the market and say: you should definitely integrate ESG into your strategies. We surely will have clients who do not, and this is a client-focused initiative, responding to what we believe is real and enduring demand."

At Auriel, ESG strategies will only be integrated into client portfolios where there has been a specific request to do so. "Now, if we're successful, and better returns can be attributed to our ESG strategies, then that will expand demand."

"That said, I've staked my career on this," Mr. Seitchik said. "I think the commitment to mitigating ESG risks and seeking opportunities will mature, and become more widely shared. As more asset owners participate in ongoing initiatives like PRI, responsible investing will become a permanent and pervasive feature of the global economy."

As the Obama Administration seeks to overhaul financial regulation, a multi-trillion-dollar coalition of investors has argued that the government should require corporate disclosure of climate change-related risks. Climate Risk Disclosure in SEC Filings – a deceptively modest title – calls for replacing the current hodgepodge of voluntary disclosure with a federally mandated reporting regime.

Ceres, the Environmental Defense Fund, and other sponsors of this Corporate Library-produced study formally presented their findings to the Securities and Exchange Commission (SEC) in a June 12 letter.

Perhaps the most provocative assertion in Climate Risk Disclosure is that voluntary disclosure, much like the "self-policing" practices that have supplanted direct regulation in many industries, is inadequate to its task.

"Climate change is for many companies a material risk," the authors write. They argue that the SEC, in its role as guarantor of the transparency of American securities markets, is already obligated to demand broad, uniform reporting of corporate climate-related risk exposure.

What are the Risks?

Climate Risk Disclosure authors Beth Young, Celine Suarez, and Kimberly Gladman sum up the risks that corporations should prepare to face:

• Physical risk from climate change
• Regulatory risks and opportunities related to existing or proposed GHG [greenhouse gas] emissions limits
• Indirect regulatory risks and opportunities related to products or services from high emitting companies
• Litigation risks for emitters of greenhouse gases

Broad Exposure, Limited Disclosure

Most companies, even those from the sectors that emit the most GHG, do not do enough to inform shareholders of how climate change threatens their business models. The report's authors reviewed climate risk disclosure in SEC filings from Q1 2008:

"[The study] evaluates the current state of climate risk disclosure by 100 global companies in five sectors that have a strong stake in preparing for a low carbon future: electric utilities, coal, oil and gas, transportation and insurance…. "Fifty-nine companies made no mention of their greenhouse gas emissions or their position on climate change, 28 had no discussion of climate risks they face, and 52 failed to disclose actions to address climate change. Even more telling, the very best of disclosure for any of the companies could only be described as 'Fair'–and only a handful of companies achieved this ranking."

It is significant that Climate Risk Disclosure looks at the insurance sector, along with industrial sectors that directly produce and consume large quantities of fossil fuels. Assessing, pricing and managing risk is what insurers do, yet US firms made little mention of their exposure to their customers' climate change risks:

"Eighteen out of 27 [researched insurance] companies (67%) had no mention of climate change or related risks anywhere in their SEC filings. Twenty-three out of 27 companies (85%) failed to disclose their emissions or a statement on climate change, while 24 out of 27 companies (89%) omitted disclosure on actions to address climate change, despite the wide range of opportunities for new, climate-related insurance products."

Climate Risk Disclosure notes that non-US insurers like Swiss Re, Munich Re and Zurich Financial did a better job.

Why are US firms lagging? The Ceres/EDF study suggests a simple answer: European companies face climate change in a more demanding regulatory climate.

What does Voluntary Disclosure Hide?

Climate Risk Disclosure provides a useful summary of why voluntary disclosure, like other forms of "self-regulation," tends to fall short of its promises:

"First, because it is voluntary, companies without a positive story to tell can simply decide not to disclose. In this way, disclosure will be skewed toward companies that are better positioned to address the risks and opportunities presented by climate change. … "Second, voluntary disclosure tends to focus on opportunities related to climate change while omitting or downplaying the risks. [A] 2007 KPMG/GRI study found that in sustainability reports, 'companies reported far more on potential opportunities than financial risks for their companies from climate change.'… "Third, voluntary disclosure is not uniform, frustrating efforts to benchmark companies against one another. … "Fourth, companies making voluntary disclosure tend not to quantify the financial impact of risks and opportunities. … "Finally, voluntary disclosure lacks the enforcement mechanism that comes with mandatory disclosure requirements."

Largest Investors Must Prepare for the Broadest Risks

In a preface to Climate Risk Disclosure, Anne Stausball of the California Public Employees' Retirement System (CalPERS) writes:

"CalPERS has a widely diversified portfolio that is impacted by all segments of the economy. The fund also has a long-term perspective, since it must meet beneficiaries' retirement needs now, and long into the future. As such, we must be aware of shifting conditions and liabilities affecting companies in our portfolio."

CalPERS is a leading member of the Ceres-led Investor Network on Climate Risk (INCR), a coalition of investors managing around $7 trillion of assets. Ms. Stausball notes that in 2007, CalPERS and the INCR petitioned the SEC "to ensure that publicly traded companies disclose material financial risks from global warming in securities filings, as required under existing securities law." [Emphasis added.]

The new Ceres/EDF research supports this contention: the SEC is already obligated, by the terms of existing rules, to require mandatory disclosure.

Item 303 and the Materiality of Climate Risk

Climate Risk Disclosure explores the various regulations that define what all publicly-traded companies must tell their shareholders, including "Item 303." The report says that the obligations of this rule, according to SEC statements, "encompass both financial and non-financial factors that may influence the business, either directly or indirectly." In summing up the implications of Item 303, the authors issue an unequivocal challenge to the SEC:

"The risks and opportunities created by climate change clearly fit within the range of factors to which Item 303 applies. The scientific consensus and improved ability for scientists to quantify likely climate change impacts preclude an argument that climate change is not a 'known' trend or uncertainty. The rapidly changing [environmental] regulatory environment introduces the possibility that past financial results will not be indicative of future results, and the effect is certainly material for many companies."

Also see these related KLD Blog articles:

Pension Trustees Must Prepare For Climate Change: New Study from UNPRI

Some Carbon Footprints are More Equal than Others: Trucost Studies Carbon Intensity of Mutual Funds

Social Investment Forum Calls for Global Regulatory Reform

World's Largest Industry Faces World-Changing Risks: Insurance Companies Prepare for Climate Change

The Madoff Madness and the Banking Crisis: At one extreme, trustees must dodge sociopathic fraudsters; on the other, they must avoid the hubris of "the smartest guys in the room."

Modern Portfolio Theory and the legal thinking it's influenced address the problem by means of risk analysis and diversification. This approach has limits, as Investments & Pensions Europe reported recently: "Dutch pension funds have lost €166m to the Ponzi scheme run by Bernard Madoff, Wouter Bos, the Dutch finance minister has claimed."

The Age Before the "Prudent Man"

In other times, courts have taken different views of how a trustee should deal with risk.

Harvard College v. Amory, 9 Pick. (26 Mass.) 446, 461 (Mass. 1830) was the case that first stated the Prudent Man Rule. The Massachusetts Supreme Judicial Court said that trustees should model their stewardship "on how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested."

The Court rejected Harvard's argument that the trustees should have invested in an annuity which would have been less risky than common stocks, but would have provided the beneficiary a much lower income. Harvard's position seems ludicrous today. It wasn't in 1830.

In rejecting Harvard's position, the Court quoted critically an English case (Trafford v. Boehm, 3 Atk. 440, 444, 26 Eng. Rep. 1054, 1056) decided 86 years earlier:

"Neither South-sea stock nor Bank stock[s] are considered as a good security, because it depends upon the management of the governors and directors, and [both] are subject to losses; for instance, it is in the power of the South-sea company to trade away their whole stock while they keep within the terms of their charter…. "But South-sea annuities and Bank annuities are of a different consideration; the directors have nothing to do with the principal, and are only to pay the dividends and interest till such time as the government pay off the capital, and it is not in their power to bring any loss upon them, and therefore are only and properly good securities."

Two things one should note here. First, the court held that annuities backed by government debt were appropriate trust investments. But stock shares issued by the same entities that sponsored the annuities weren't. It's this very limited scope of trust investing the Prudent Man Rule overturns.

The Lessons of the 18th Century's Bubble Economy

Second, note how the court contrasts the relative investment merits of "South-sea stock" and "South-sea annuities." Here one sees the aftershocks of probably the greatest financial and political crisis in Anglo-American history between the English Civil Wars and today.

The collapse of the South Sea Company in 1720 shook the British state to its core. The South Sea Bubble combined a completely fraudulent investment scheme with political intrigue and mad speculation in everything from real estate to trading voyages. (See generally Malcolm Balen, The Secret History of the South Sea Bubble (New York: Fourth Estate, 2002) and James Macdonald, A Free Nation Deep in Debt (New York: Farrar, Straus & Giroux, 2003), pp. 206-219, 223-29.)

It would be hard to identify an area of commercial law or of political and social history that the Bubble did not affect. Trust law certainly changed.

In 1723 the South Sea Company shareholders began receiving perpetual annuities backed by government debt (the Company's only asset) in exchange for their devalued shares. The "Bank" mentioned in Trafford is the Bank of England, then still a private institution but, from the South Sea Bubble onward, the unquestioned central bank for the Empire. It too issued annuities backed by government debt. But even its stock, the Trafford court held, was not a proper trust investment.

I can't imagine a swing in the law back to Trafford. But the devastation of pensions and other trusts, such as the Harvard University endowment (see Richard Bradley, "Drew Gilpin Faust and the Incredible Shrinking Harvard", Boston Magazine, June 2009) – whether caused by fraud, hubris or faith in failing models – will lead to changes in trustees' fiduciary duties.

On May 26, Responsible Investor reported on a new study calling for pension funds to better prepare for climate change. Pension trustees may even have a fiduciary duty to account for climate-related risk, according to study authors Craig Mackenzie and Francisco Ascui of the University of Edinburgh Business School.

Investor Leadership on Climate Change, written on behalf of the United Nations Principles for Responsible Investment (PRI), explores the role of investors in reducing global carbon emissions. As reported by RI's Hugh Wheelan, the study finds that this role will be immense:

"$10 trillion in capital, much of it expected to be private, will be required by 2030 to maintain carbon dioxide emission levels at a stable 450 parts per million in the atmosphere."

"The good news is that even such large sums of money are within the long-term capacity of the financial sector, as long as the appropriate public policy incentives are in place."

"[Climate change risks] will have impacts across the entire economy. This will make them difficult to hedge or avoid…. "Pension funds, particularly large pension funds, are universal investors, and they are so large that they tend to have long-term investment exposure to the whole economy…. Prudent pension funds have good reason to pursue cost-effective strategies to support climate change mitigation and adaptation."

• "['Business as usual'] assumes policy-makers will deliver the appropriate carbon pricing regimes....
• It assumes capital markets will be efficient at pricing risk and allocating capital....
• It forgets that equity investors are not merely providers of capital – they are shareholders and therefore owners of companies. …They have a unique position of leverage over the entities that, in one way or another, are accountable for most of our carbon emissions."

Investor Leadership on Climate Change explores the risks inherent in these assumptions, and how investors such as CalPERS are actively preparing for such risks. This preparation necessarily includes support for national and global carbon-pricing schemes. As Hugh Wheelan wrote, "Investors need to collectively influence public policy to correct what [the PRI report] says is an inability of markets to properly price climate change-related systemic risk."

For more information, see Investor Leadership on Climate Change at the PRI site.