Report from the Field

Regular readers know our chief complaint about the investing world: too much emphasis on the individual financial performance of portfolio companies, and too little on how those companies affect the systems that underpin investors’ entire portfolios. When push comes to shove, this emphasis encourages individual companies to pursue profits that come at great cost to society and the planet, and consequently to investors.

Here we report on recent signs that the field is awakening to the danger some corporate behaviors pose to their portfolios.

This September, ICGN, a global network of investors with US$77 trillion in assets under management, published a report that emphasized the importance of systems to institutional investors:

As investment institutions grow in scale and become increasingly diversified, more investors can be considered as ‘universal asset owners or managers’, where their portfolios constitute a ‘slice’ of the global economy and whose performance is tied to the success of the economic system at large.

This means that sometimes the systemic effects of a company’s decision are more important than the decision’s impact on the company itself, so that value-maximizing shareholders may not always want an individual company to maximize its own returns. This recognition that a company’s interests are not always consistent with the interests of its shareholders in sustainable practices was confirmed in a White Paper released by the World Benchmarking Alliance during this year’s Climate Week NYC:

The sustainability performance of a company and its contribution to sustainable development today is simply not consequential enough to companies.

The WBA referred to this difference between what matters to companies and what is necessary to meet the type of sustainability goals that will support a healthy economy as the “corporate accountability gap.” This gap was reflected in a paper recently published by the CFA Institute in which Alex Edmans, a finance professor from the London Business School, explained that the investors in companies that contribute to climate change “don’t bear the consequences of climate change because polluting companies don’t have to pay for the damages they cause.”

These respected voices are making it clear that investors cannot address social and environmental concerns simply by asking companies to “do well by doing good.” The real world includes trade-offs. The implications of this reality were the subject of much of the annual PRI in Person Conference in Tokyo, a gathering of delegates from institutional investors with US$120 trillion in assets under management that focuses on responsible investing. System-level investing was a critical theme of the conference, which kicked off with a keynote from Japanese Prime Minister Fumio Kishida, who said:

Addressing social challenges through investment would encourage companies to drive change, enhance sustainability of our economies and societies, as well as harness growth potential of our world. This would, in turn, provide long-term financial opportunities to both investors and the beneficiaries who entrust their funds to the investors. This approach of responsible investment is something that would precisely embody elements of what is generally called “fiduciary duty.”

Not only did a G7 head of government publicly state the need for companies to prioritize economic and social impact, but he also tied that mandate to fiduciary duty.

And indeed, more than one session at the conference returned to this theme of fiduciary duty, which is the subject of A Legal Framework for Impact (LFI), a report commissioned by the PRI and prepared by powerhouse law firm Freshfields Bruckhaus Deringer. In a detailed analysis, the LFI shows how the fiduciary duties of investment trustees around the world mandate stewardship that protects the systems upon which diversified portfolios rely.

One session asked how investors could have systemic impact; it was moderated by TSC director Susheela Peres de Costa, with TSC director John Hoeppner participating as a panelist. Another session, which our CEO Rick Alexander moderated, provided an update on the Legal Framework for Impact project. The response from the audience to both packed sessions signaled the growing interest in the need for institutional investors to think systemically about their stewardship obligations.

The tendency to measure a company’s success on behalf of investors through the narrow lens of enterprise value is deeply embedded in the financial system. Until we reverse that proclivity and require companies to account to investors for their systemic, cross-portfolio impacts, we will continue to have a financial system that is programmed to fail. This message appears to be getting through.