Does Socially Responsible Investing Work? And How To Do It Exit, Voice, And Loyalty
July 26, 2016
by Adam Jared Apt
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In Part 1 of this essay, we considered what it means to own a share in a company, and what a company’s management owes its shareholders. We saw how the interests of corporate management are not necessarily aligned with the interests of shareholders, and we considered the two schools of thought concerning what corporate social responsibility ought to be: whether the sole responsibility of management should be earning as much as possible for the shareholders within the constraints of law, or whether corporations have broader responsibilities to “stakeholders” and society at large. There was a period of ferment during the 1970s and 1980s that saw both the rise of an effort to improve corporate governance with respect to the financial interests of shareholders, and the rise of socially responsible investing (“SRI,” which has deep historical roots in religion), to motivate the adoption of broader corporate social responsibility. We also saw that there is no simple definition of either corporate social responsibility or socially responsible investing. The expression “ESG,” for “Environmental, Social, and Governance,” embraces activism by investors in the pursuit of both improved governance and broader social responsibility.
Part 2: Does socially responsible Investing work? And how to do it – In Aid of Corporate Social Responsibility and Good Governance
Since the 1990s, there has been a movement—a very, very small movement, and mostly foreign—to produce the data needed to evaluate the social responsibility of corporations, by integrating measures of their social responsibility into financial reporting.
Financial accounting rules have evolved over the centuries, and in every country, there is now a standard-setting authority, either governmental or quasi-governmental, that sets rules for corporate financial reporting, in quarterly and annual reports. In the last fifteen years, there has been an international organization, the International Accounting Standards Board, that has promulgated international financial accounting standards, and it has worked with the national accounting authorities to harmonize the international with the entrenched national standards. In some countries, like the U.S., the harmonization may be a prelude to replacement. Corporate financial reports, which contain much else besides the basic and required accounting data, already often incorporate text and notes reporting on the social and environmental effects of the companies’ activities.
The new movement would extend the existing national and international financial accounting standards, which already, to a small degree, quantify the unquantifiable, like “goodwill,” with new numerical data representing hard-to-measure environmental and social costs and benefits. The economist Diane Coyle has pointed out the challenges confronting such a revolution in financial accounting:
Accounts are of limited use when it comes to revealing tradeoffs, particularly tradeoffs between present gains and future costs. It’s very hard to tell whether a company is, say, cannibalizing its own future revenues by gouging customers right now. But environmental sustainability hinges on those kinds of calculations. Building a new office or bringing a new product to market is bound to have some environmental impact, but it’s difficult to forecast what the effect will be. To complicate matters further, it is often difficult to measure a single company’s contribution to any particular environmental effect. Causing an oil spill is one thing, and a firm can perhaps measure its own specific emissions or pollution. But how should any given firm account for the cost of its own carbon emissions when virtually all economic activity contributes to global warming? Even if a company can accurately measure all its harmful outputs, how is it supposed to calculate the precise cost those outputs impose on everyone else? How can externalities such as climate change, which involve vast, complex processes, be represented on the balance sheet of a single corporation—even a large one?
And she concludes, “[T]he intellectual challenge of replacing traditional financial accounting is significant, but the political challenge of implementing it would be even tougher.”
Very recently, Patrick Bolton and Frédéric Samama have suggested a complementary financial means of improving corporate governance, one that, again, trusts investors to make better decisions if given help. This is predicated on the supposition that managers’ short-term outlook is a consequence, at least in part, of the lack of loyalty to corporations by their shareholders. It is demonstrable that, overall, portfolio turnover has increased greatly over the last several decades (even after you subtract the activity of the high-frequency traders, who would necessarily distort the turnover statistics), which is another way of saying that investors formerly held stocks for a long time after buying them, and now they typically hold stocks for only a few months, on average, before selling them and buying others. (Until the so-called “Go-Go” years of the late 1960s, the annual turnover rate in stock mutual funds averaged around 17%; since 1980, it has averaged 61%, although most recently it has fallen to 41%, still a high number. In contrast, the turnover in an S&P 500 index fund is less than 5% a year.) Bolton and Samara propose that corporations give investors an incentive to hold stocks much longer than they currently do. This incentive would take the form of “loyalty shares” or “L-shares”—the name is a deliberate nod to the vocabulary of Albert O. Hirschman—that would be warrants (not actually shares) issued to buyers of regular stocks. These warrants would be options to purchase additional shares of the issuing corporation at a favorable price after some specified time had elapsed, but only if the shareholders continued to hold the original shares for that length of time. (The span of time, in years, and the price at which the new shares could be purchased are both matters to be determined; the concept is the important thing.) Investors could still sell their shares after only a short time if they wished, but they’d have a financial inducement to hold them longer, that inducement being the possibility of buying even more shares in the same company at a favorable price. Bolton and Samama point out that when Warren Buffett rescued Goldman Sachs during the recent financial crisis, Goldman’s inducement to Buffett somewhat resembled their proposed L-shares. But this was a customized, one-off deal.
Alternatives to socially responsible investing
It goes without saying that one alternative to accomplish the same objectives as SRI is government dictation to companies that they must pursue corporate social responsibility. It really does go without saying. For all the vilification of some large corporations, there have been almost no public calls in recent decades for governments to take them over, and on the contrary, in Europe and America, there has been a steady reintroduction of captive enterprises that were owned, subsidized, or guaranteed by governments, into the natural habitat of the market. Moreover, the record of productive enterprises controlled by governments is not one that fosters faith in government-imposed corporate social responsibility. Consider the environmental record of the Soviet Union, or the governance, sustainability, and employee-friendly practices of Chinese corporations today.
This is not to say that there isn’t a role for government in the economy beyond the mere enforcement of contracts. Besides imposing standards for financial accounting and reporting, there is regulation of