Does Socially Responsible Investing Work? And How To Do It Exit, Voice, And Loyalty
July 26, 2016
by Adam Jared Apt
Recently, Bruce Greenwald carried out a virtual Fireside Chat with Li Lu, the founder and chairman of Himalaya Capital. Greenwald and Lu covered multiple topics during the discussion, addressing everything from the value investor's approach to appraising businesses and what he had learned from his great friend Charlie Munger. The duo also discussed China's economy Read More
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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 all sorts. The appropriate degree of regulation—proponents and opponents usually generalize about the effects of overall regulation, when they should be talking about the purpose, effectiveness, cost, and collateral results of any particular regulation—is too vast and unrelated a topic for this essay. Note that Milton Friedman, who strongly opposed most commercial regulation, simply took it as a given in his essay on social responsibility; his argument there concerned the obligations of corporations beyond what was required by law. The history of financial accounting shenanigans alone is enough to suggest that good corporate governance cannot be accomplished solely through imposition from above and has to be achieved through the good faith and diligence of investors and managers, with the help of outside forces. And as for sustainability, one of the most promising approaches to control toxic emissions that must be tolerated and cannot be totally eliminated is government-organized “cap-and-trade” programs, which use market mechanisms to allocate costs efficiently. (Of course, these must be accompanied by monitoring mechanisms and laws and bureaus to detect and punish cheating.)
In the matter of corporate social responsibility, then, it is not reasonable to look to government to supplant the market. And even in socially responsible investing, government intervention through political interests can be pernicious. Politicians, who indirectly hold sway over vast public pension funds, and, like their electorate, mistake short-term financial self-interest and job security for economic savvy, will all too readily try to direct the funds’ managers to finance community projects, ostensibly because this constitutes—so they will claim—impact investing. Undoubtedly, interests other than civic good motivate such interventions. Politicians already have a very sorry record as custodians of public pensions. It would be far more efficient and honest to fund community projects directly through taxes than indirectly through pension investments, whose likely shortfalls will have to be made good with taxes decades later.
Some detractors of the modern economy would rather that corporations not merely assume social responsibility but also engage in some measure of philanthropy, that is, charity and the provision of “public goods,” the economists’ term for consumable things that are available to all, and whose consumption by one does not exclude its consumption by others. Examples of public goods are fresh air, clean water, transportation infrastructure, national defense, fire-fighting, and so forth, but may be reckoned to include also parks, libraries, primary and secondary education, public art, public radio, and so forth. The list reflects one’s political perspective. (Libertarians reckon that there are few public goods other than national defense.) Many of these public goods are provided by governments, but they can also be provided by private groups. There is no bright line between socially responsible corporate behavior and philanthropy, not least because, as I noted earlier (in Part 1), some philanthropic behavior on the part of a corporation can serve its interest in profit. But still, the complaint that corporations aren’t sufficiently philanthropic arises from a fundamental misunderstanding of or objection to the way our economy works. Our world does, indeed, make room for corporations whose sole purpose is philanthropy; these are what we term “not-for-profit” corporations. (Libertarians reckon that there ought not to be not-for-profit corporations or charity; if something is worth providing, it’s worth providing for profit.) They don’t have owners, and we don’t tax them. (Not-for-profit corporations are also subject to principal-agent conflicts, but in their case, the principals are the donors and sometimes the beneficiaries.) Some non-profits, like hospitals and universities, can be very similar to profit-making corporations. And there exists a small number of cooperatives and companies with alternative ownership structures, like REI and Patagonia, the makers and retailers of outdoor recreational clothing and gear, that have dual business and social purposes. But by and large, when our concern is corporate social responsibility, it is with effects that are concomitant with or incidental to the pursuit of profit, rather than with the primary purpose of the for-profit corporation. If a public corporation’s primary purpose is deemed objectionable, for example, if all that the corporation does is to manufacture guns or junk food, then the socially responsible investor may not care about its degree of social responsibility; he or she will shun the corporation altogether.
Does socially responsible investing work?
Advocates of socially responsible investing generally assume and assert that it is efficacious, or will be, given enough time. These claims, as well as those of its detractors, have seldom been subjected to rigorous and unbiased tests. There are practical and psychological reasons for this: Success is difficult to measure, and, anyway, most partisans are happier and less inconvenienced by assuming the results than by measuring them.
SRI, like politics, arouses such powerful emotions that partisans, both for and against, willfully misconstrue clear statements and logical arguments about it.
Undoubtedly some, and perhaps many of those who write and agitate for stock divestment, as they try to advance various causes, are anti-capitalists, but those who engage more fully over the full range of socially responsible investing, and most certainly those who invest their own funds in conformity with notions of socially responsible investing, willingly accept and approve capitalist processes (though hypocrisy always stalks the domain of ethics). But such is the intensity of feeling about the subject, some of it generated on the one hand by self-righteousness, and on the other by a smug sense of intellectual superiority deriving from a sketchy knowledge of basic economic theory, that I fully expect my comments that follow to be misunderstood, even if I’m being clear.
The question of the efficacy of SRI is really two questions: First, does it achieve its social ends, and second, does it produce good investment results, or at least investment results that are no worse than the results of traditional investing?
The clearest single example of SRI having its desired effect may be the change of regime in South Africa. I doubt that that even the most fervent advocates of divestment from companies that were doing business with South Africa would claim that divestment alone was responsible for the change, but I’m sure that all would assert that it was an important factor. Still, a skeptic could fairly ask whether this is not post hoc, ergo propter hoc reasoning.
The financial economist Ivo Welch and colleagues, using econometric methods, in a paper published in 1999, tested the hypothesis that divestment was indeed a contributory factor in the change of regime. Well, actually, they couldn’t test the hypothesis as so worded, so the question they asked was, “how [did] prices and institutional shareholdings change in response to social and political pressures around the voluntary divestment decisions of U.S. firms with South African operations?” And they concluded that “the announcement of divestment from South Africa, not only by universities but also by state pension funds, had no discernible effect on the valuation of companies that were being divested, either short-term or long-term.”
But this, while a cautionary addition to our understanding of the issue, is by no means a conclusive answer to the original question, which might be better answered by the methods of the historian than by those of the economist. It is at least conceivable that a true historian, the kind who slaves at the paperface deep in the archives, will find minutes from a South African government cabinet meeting, where someone tells President F.W. De Klerk that foreign corporations are threatening to pull out of the country and the economic pressure is becoming insupportable. In truth, I doubt that any single piece of documentary evidence so dispositive will come to light, but the answer may well be illuminated by the historian’s techniques in which the economist is unlearned. As Arlette Farge writes of archives, “The goal is not for the cleverest, most driven researcher to unearth some buried treasure, but for the historian to use the archives as a vantage point from which she can bring to light new forms of knowledge that would otherwise have remained shrouded in obscurity.”
At one remove from measuring the actual results of socially responsible investing is the measurement of the effectiveness of ratings of the social responsibility of corporations, which might be used by investors. The standard rating system of this sort (originally provided by Kinder, Lydenberg, Domini Research & Analytics, now MSCI ESG Research) was evaluated in an academic study that found that, while this rating system’s measures of environmental “concern” had some small predictive value, its measures of environmental “strength” did not.
Apart from the divestment paper, there is little published evidence bearing on the systematic effectiveness of SRI. I’m sure that many of those impact investors who are financing distinct, local projects at home or across the world are following their investments closely and know whether these projects are successful or, if not yet concluded, on course for success, but we don’t know how many of these projects fail or fall short; we don’t otherwise know if divestment efforts are having their desired effect; and we don’t know if “green” investments are supporting projects that would otherwise have got by with old-fashioned bank, stock, or bond financing.
Perhaps one reason that the effectiveness of SRI has not been evaluated further is that it can be difficult to formulate the proposition that is to be tested. Ivo Welch and Co. took one approach to this, which, as I argued, wasn’t sufficient to answer the question that we really wanted answered. And South African divestment was an easy case: We knew the ultimate goal of this form of SRI. We also knew the intermediate goals: Pressuring corporations into changing their ways of doing business in South Africa so that they would promote the dismantling of apartheid, or coercing them to withdraw altogether from doing business in the country. Welch has argued, by extrapolation from his analysis of the South African divestment campaign, that any divestment movement is likely to be ineffective. It’s an argument worth considering, but it’s premised on one ambiguous case.
Now consider the most prominent single movement today from within SRI’s range of activities, divestment from fossil fuel companies. We know the ultimate goal: Replacement of the fossil fuels on which modern civilization relies with renewable sources of energy. But what is the proximate, achievable goal? It is often said that the purpose of this current divestment movement is to “delegitimize” fossil fuels. What does this mean? Clearly, it doesn’t mean that oil companies’ corporate charters will be revoked, or that they will be delisted from stock exchanges. Does it mean that their stocks and bonds should no longer be regarded as appropriate vehicles for investment? If so, then this is tautologous: The goal of divestment is divestment. Does it mean that the use of fossil fuels will be discredited? If so, then shouldn’t advocates forgo driving cars with internal combustion engines and persuade others to do so, instead of or in addition to promoting divestment? After all, unless you’re a denier of anthropogenic climate change, fossil fuels have already been pretty well discredited in your eyes, and there may not be much room for further discrediting. If we can’t pin down what delegitimation is, then we can’t measure our progress toward achieving it.
There is a positive alternative to “delegitimation” as a purpose of divestment, and I will turn to this when I consider the investment results of socially responsible investing.
More fruitful for judging the effectiveness of SRI might be an enumeration of the achievements of Ceres, which works with both investors and corporations to promote environmental sustainability through agreed best practices, which they have codified as the Ceres Principles (for which, see Appendix A). With monitoring by Ceres, the participating corporations in its “network” may with some assurance be regarded as maintaining best practices for sustainability. That doesn’t mean, though, that they are good citizens along all dimensions of corporate social responsibility. For example, both Coca-Cola and Pepsico, two of the world’s largest producers and purveyors of junk food, are in the Ceres network.
Beyond the question of whether socially responsible investing has a practical effect, at least one scholar—not a financial economist, but a sociobiologist—has argued that socially responsible investing is ipso facto impossible, if by SRI one means investing for the greater good of humanity without the prospect of superior returns.
Beginning with Charles Darwin (1809-1882) himself, biologists and philosophers have struggled to explain altruism, that is, self-sacrifice for others, in the context of natural selection. “How can we reconcile seemingly altruistic behavior, where there is no obvious individual advantage, with [the] notion of natural selection maximizing individual fitness? Suppose we have a group of altruists in a certain area. While these altruists will do well among themselves, they will always do worse than the ‘freeloaders’ who accept the benefits bestowed by the altruists without incurring any cost. Thus, altruists will always be subject to invasion by selfish types and should decrease to the point of extinction.”
Sociobiologists extend the models of natural selection to the social behavior of not just animals, but also human beings. Richard Alexander (1930- ), a sociobiologist of the most uncompromising kind, has written thus:
It is difficult to imagine that anyone invests in the stock market for altruistic reasons; perhaps no one invests in anything at all (except relatives) without expecting (not necessarily consciously) phenotypic rewards that include some kind of interest on the investment.
If one supposes that Bill McKibben campaigns against investments in fossil fuel companies in order to improve the chances of survival of his descendants (from rising ocean waters?), the argument, though narrow, may be true, in a way that is nearly trivial. But it requires sophistic gymnastics to adduce the (not necessarily conscious) self-interested motives for, say, divestment from tobacco companies.