Green capitalism

Everybody pays when companies pollute and cheat. So big institutional investors have a legal mandate to be socially responsible.

Published December 8, 2004 8:00PM (EST)

Whenever confronted by pesky issues it doesn't want to deal with, Wall Street has a simple retort: "Walk, don't talk!" Hence the rationale for what is called socially responsible investing.

But it has never been simple to figure out exactly how to be responsible. Consider, for example, the letter businessman Paul Hawken, coauthor of "Natural Capitalism," wrote in early 2003 to the Green Money Journal complaining about the existence of McDonald's in the social investment fund run by Domini, one of the leaders in the field.

"What does socially responsible investing mean?" asked Hawken. "Is it a way for upper-middle-class people to launder their money? ... Getting kids [hooked] on junk food doesn't qualify. If the business model is corrupt, then it hardly matters if a company uses recycled paper or provides day-care."

In other words, the practice of negative (or ethical) "screening," in which socially responsible investment (SRI) funds avoid investing in anything from purveyors of sins such as tobacco and gambling to corporations that engage in nefarious environmental and labor practices, is little more than a marketing ploy -- an exercise in green-washing.

Another critique holds that SRI screening is counterproductive because the principle of keeping one's hands clean of the objectionable companies is tantamount to ignoring the worst corporate environmental and human rights criminals. "If the company is doing something you don't like, don't sell the company," corporate governance activist Robert A.G. Monks told social investors at their annual gathering, SRI in the Rockies, last year. "It's your company. Change the company!"

In fact, many Americans don't have much choice. Although individuals owned as much as 80 percent of publicly traded equity in the United States in the early '70s, today their stake has dropped to less than half. Today, institutional investors such as pension funds control over half the shares in corporate America. Individuals still own most of that stock, of course, but decisions on what to buy and sell are made through representatives who invest our money on our behalf: so-called fiduciaries that are legally required to manage these trusts and vote their proxies in the sole interest of the people whose money they manage. These behemoths, through their holdings, in effect own the entire economy -- and may even control the entire global economy.

These mega-institutions cannot just abandon ship when companies don't perform, or engage in what some might consider politically reprehensible practices. As Monks points out again and again in his books and in his other writing, they -- we -- are stuck owning most of corporate America.

That does not mean that investing cannot be political or even moral. On the contrary, it can -- and must be. A strong case can be made that if pension funds and other institutional investors are to truly meet their legal obligations, they must promote a socially responsible agenda. Not because they are nice guys, but because it is in the long-term interest of the shareholders they represent.

Mega-institutional investors have different incentives than individuals or small stock pickers with narrow portfolios. So argue economics professors James P. Hawley and Andrew T. Williams, coauthors of "The Rise of Fiduciary Capitalism." Since institutions such as CalPERS -- California's huge public employees pension fund -- are virtually stuck in their investments, the professors contend, these leviathans invest for the long term whether they recognize it or not. By default.

The upshot is, since institutional investors own huge swaths of the entire economy, they absorb many of the costs that individual companies don't pay for or reflect on their balance sheets but that are bankrupting society at large. In the language of economics, these costs are called "externalities."

Milton Friedman describes an externality as "the effect of a transaction ... on a third party who has not consented to or played any role in the carrying out of that transaction." Monks calls corporations "externalizing machines."

The most blatant examples: the costs of environmental and health problems caused by manufacturing. A company that produces old-style plastic garbage bags, for example, also produces toxic chemicals that leach out into drinking water when the bags break down. The plastic bag manufacturer forces society as a whole to pay the cost of cleaning up these chemicals and for the health problems they cause, thus externalizing part of its cost of doing business. It is these externalities, of course, that we usually think of as "social issues."

To put it another way: Over time, institutional investors absorb the externalities produced by the companies in one part of their portfolio in other parts of their portfolio.

How does this work? Consider, for example, a company that is downstream from a company polluting a river. If the water is polluted and the downstream company needs the water, it will have to pay the cost of mitigation. This adds to the cost of its input, which will add to the cost of its output.

Of course, it's hard to know whether a particular corporation in a downstream model will be hurt or how its stock price might be affected. The downstream firm might be able to pass that cost onto consumers -- if it's not in a competitive industry. But if it is in a competitive industry, it may not.

"There are many variables," Hawley says, "and the devil is in the details. But changing the cost of the inputs affects the economy in a way that it would not otherwise be affected. And someone has to absorb that cost."

We already know taxpayers and consumers take their hit. But so do institutional investors and other businesses. That is the gist of Hawley and Williams' argument.

Nor is this just an economic issue. For fiduciaries, it is a financial, or "total return" issue.

"If you are looking at [negative] externalities, the portfolio by definition has to be underperforming," Hawley says.

This is so provocative it bears repeating. If there are negative externalities -- climate change caused by carbon emissions, an accumulation of hormone-mimicking substances (so-called endocrine disrupters) in the world food chain, a mega-pension fund's portfolio is by definition underperforming.

Ironically, this is good news for progressives, who usually fight over so-called externalities in the political arena. Institutional investors and their shareholders keep a close eye on the total return earned by their portfolio. And as soon as you use the phrase "total return" in the same context as "fiduciary," you are talking about fiduciary responsibility. That's important language to know. It means the fiduciary has a legal responsibility to manage the shareholder's money to maximize "a portfolio's total return."

But if there are negative externalities, he's not doing that. He is, in fact, shortchanging the investor. So if a pension fund wants to boost performance of its portfolio across the board, then it should do its best to ensure that none of the individual companies it is invested in are doing business in such a way as to hurt the prospects of the other companies in the portfolio.

The importance of properly defining fiduciary responsibility can't be overemphasized. Look at it this way. When activists want to change a "system," they look for a strategic lever, something like the tiller on a sailboat. The idea is this: You move the tiller just a tad, and you can shift the direction of the entire boat. In this metaphor, of course, the tiller represents fiduciary responsibility and the boat represents our entire economic system.

With this in mind, Monks (who helped rewrite the Employee Retirement Income Security Act (ERISA) law during a short stint at the Labor Department in the mid-'80s) and others have clamored for a broader definition of fiduciary duty. They claim retirees want not just enough money to sustain themselves but also a clean and civil world -- and not just for themselves and their children, but for their grandchildren and their grandchildren's grandchildren. "The trust does not exist in a vacuum," he says.

Enter Hawley and Williams, who now make a case for this kind of common sense by using the language of economics. What they suggest is profound: By ignoring environmental and social externalities, institutional investors are in fact abrogating their obligations as fiduciaries to the millions of American individuals on whose behalf they invest.

Let's be clear about this. It means that for fiduciaries to make the most money on behalf of their beneficiaries, companies need to stop creating negative externalities. In other words, they must do exactly what progressive activists want them to do! Not because they are nice guys, but because it is in the long-term interest of shareholders who own these companies.

The professors go on to argue that it is thus part of a fiduciary's job to become a social activist, too -- by engaging with corporations and taking action in the political arena to eliminate negative externalities like toxins in the environment and promote positive ones like education and training.

Some institutional investors seem to agree. Last November, Connecticut state Treasurer Denise Nappier convened a conference of institutional investors at the United Nations to demand that corporations disclose the impact of climate change on their operations and its risk to their financial statements. That followed on the heels of 2003's Carbon Disclosure Project, in which 87 (albeit, mostly European) investors representing $9 trillion in stock market capitalization queried the top 500 companies in the world about the impact on their market cap of their greenhouse gas emissions -- and what they were doing about it. That's up from 34 institutions representing $4.7 trillion that requested the same disclosure 18 months before.

In the lexicon of finance, as this makes clear, many SRI issues boil down to a question of "risk" and risk analysis -- something fiduciaries other than hedge funds don't normally engage in. "Risk analysis is as much art as science," Hawley says, pointing out that contingent legal liabilities from breaking the law or harming people are hard to calculate. "In my mind, Enron and all the standard corporate governance scandals are a form of unmonitored risk and were not adequately monitored by most funds."

Except by the screeners at various SRI funds. Most SRI funds avoided virtually all these so-called corporate governance scandals during the past two years. (All, that is, except Enron, admittedly the mother of them all. Of course, nobody's perfect.)

Julie Gorte, director of social research at the Calvert Group, says her fund's screens represent many areas of risk that many other investors don't pay attention to and that manifest themselves in the financial performance of companies. "We are really protecting our investors against some of those downside risks that have gone unrecognized by the market," she says, citing environmental performance as an example. "A company that is really good at managing its environmental footprint or taking proactive steps to keep pollution out of landfills or out of airsheds or watersheds is going to be better positioned almost no matter what for any new environmental legislation that comes down the pike."

Bruce Herbert, president of Newground Social Investment, a shareholder advocacy and asset management firm in Seattle, adds that social risk analysis also offers insight into "management foresightedness," a "subjective area" but one that is in fact the mark of successful companies. "Management that is thinking ahead in areas where it's not yet required to by the books," he says, "[is] likely to be looking ahead in all areas of [its] business."

Is this really rocket science? No. In fact, it suggests that certain types of social screening and analysis (though not all) by smaller-scale mutual and pension funds -- those not stuck invested in virtually the entire economy -- may well be a necessary component of fiduciary duty for the larger investors.

In other words, it's not just socially responsible investing. It is just plain vanilla responsible investing.

So how does the performance of SRI funds compare with that of the orthodox capitalists who practice mainstream investing? In a nutshell, when you look at rigorous studies done by financial people for the past 15 years, no pattern of overperformance or underperformance emerges. "Socially screened mutual funds seem to have about the same performance as other funds," says Lloyd Kurtz, a senior portfolio manager at Nelson Capital Management, a division of Wells Fargo in Palo Alto, Calif. "The case has been made fairly convincingly that performance is competitive." Kurtz, a dyed-in-the-wool number cruncher who can cite every nuance in every study, lists them on his personal Web site.

Of course, performance depends on what you mean by the term "SRI." Most of the studies to date have been done on what Kurtz calls a "consensus type of social portfolio": either the Domini social index or something similar. There's been much less done on, say, Roman Catholic or Islamic investing, two other constituencies that do social screening.

But Kurtz, a conservative chap ever conscious of his fiduciary duties, may be understating his case. He also points out that the Domini index has beaten the S&P 500 by about 1 percent per year for the last 15 years. "Although the literature shows a tie -- and I think a tie is probably the right answer -- you have this anomalous outperformance over a long period of time," he admits.

Meir Statman, a professor of finance with no ties to the SRI industry at the Leavey School of Business at Santa Clara University, in Santa Clara, Calif., has been studying the performance of SRI funds for at least 15 years -- and is more willing to go out on a limb.

"Generally if you look at Domini, which is the oldest index going back to 1990, it has done better than the S&P 500, properly adjusted for risk levels and so on," he says. "At least we know the claim that you sacrifice returns by choosing socially responsible companies is simply not so."

But if social screening arguably makes good analytical sense from an investment perspective, the question arises: Does it really function to effect social change? Answer: Probably, but not the way most people think. And certainly not by itself. Imposing shareholder democracy is a necessary part of the game.

Companies have a bottom-line incentive for getting on with the "social" program. An increasing proportion of corporate value -- stock price, market capitalization -- is imbued in various intangibles such as intellectual property, brand name or goodwill rather than bricks and mortar. No doubt this is why, for example, Philip Morris changed its name to Atria and is now spending all kinds of money supporting do-gooder environmental causes and providing local sponsorships.

"The more important intangibles are, the more important your reputation is," Gorte explains. "If your reputation suffers, you can lose a load of value in a very short time. And it's not backed up by bricks and mortar that you can sell to liquidate the debt."

And management cares about the stock price.

This may explain why, as Gorte reports, companies now call every single time they are removed from the Calvert Social Index, clamoring to know what they have to do to get back on. Calvert also has had calls from companies not on the index but that are interested in being seen by Calvert as socially responsible. Calvert shares its research, tells them where they need improvement and says it will consider adding them to the index if improvement materializes, she says.

So what is the power of social screening? "It's really the bully pulpit of social opinion," she says. "It's about the company's social license to operate."

Steven Lydenberg, chief investment officer at Domini Social Investments, does not disagree. But he contends that the purpose of screening goes well beyond how one particular company is run. Take tobacco screening, for example. "It's not that tobacco should be illegal," he says. "It's that society is not dealing with the problem of tobacco in a way that makes sense. It's not a problem the company can solve. It's a problem that society has to solve. And we're using the statements on investments to say this is society's problem and we're hoping that the fact that we're raising it through divestments will keep it in the public eye."

The clearest example of this: the South Africa divestment movement of the l980s, a formative moment in social investing. The Rev. Leon Sullivan, an African-American on the board of General Motors, had developed a set of principles regarding labor practices in South Africa. If a company signed on to these principles, their labor performance was graded on three levels. "You had a wide range of options for divestment dealing with a range of political situations in various shades of gray," he recalls. "It allowed people to divest, which was front-page news. And it put international pressure on the government by going at it through this corporate route."

This no doubt frightens critics of screening like CalPERS administrator Steve Westley, who told Fortune magazine last December that social issues should be legislated -- no small task in a corpocracy, of course. "Vote with your heart," he said. "Invest with your head."

Never mind that such an artificial bifurcation is not just disingenuous but downright dangerous. In the real world, of course, the head and heart are part of the same corporeal body, and when the heart stops, the body dies. The same metaphor applies to corporate bodies, which ultimately derive their sustenance from the living planet and its inhabitants.

When all is said and done, many SRI professionals agree that "engagement" is a more effective tool for influencing corporations than selling stock. Engagement, which involves nuance and negotiation, is usually nonconfrontational. It begins with something as seemingly innocuous as writing letters and requesting information but can escalate into shareholder resolutions and proxy battles. A lot of engagement happens behind the scenes. "For every shareholder resolution we file, we probably have three to four engagements where we're asking the company to do something," Gorte says.

In fact, Calvert and many others file shareholder resolutions only when the conversations stop -- or hit a dead end. Even then, though, if negotiations over an issue continue and advocates are pleased with their progress, they withdraw the resolution. Remarkably enough, that happened this year. Environmental shareholder activists withdrew global-warming resolutions they had filed with five of six electric companies they'd targeted as the largest emitters of greenhouse gases when the companies agreed to produce reports on climate change published by the board or a committee of the board.

"We've been working with the companies to design the studies," says Sister Patricia Daly, executive director of the Tri-State Coalition for Responsible Investment, in Caldwell, N.J., "and agree on a variety of consultants just so that this is a legitimate report and liability numbers are accurate." A veteran environmental shareholder activist with 25 years' experience, Daly was the lead negotiator for a powerful coalition of social investors.

"For many years," she explains, "I've always said the most successful resolution is the one shareholders don't see because there's an agreement. [But] last year Ford broke that model. We had withdrawn the resolution because of some of the plans they had put on the table. Part of the withdrawal agreement was they went ahead and published the resolution in the proxy and we together issued a statement regarding what was going on.

"So now I say the best shareholder resolution is the one we've withdrawn but shareholders see it anyway," she adds.

But even if shareholder resolutions pass, they are not legally binding. Does that mean shareholder democracy is much ado about nothing? In many respects, unfortunately, yes. Monks, who has spent 20 years trying to change the system, does not exaggerate when he compares shareholder democracy to the political democracies of the former Soviet republic and Eastern bloc.

But you still need a stick when the carrot doesn't work. That is why Lydenberg argues that screening is also necessary. "Engagement without screening is voice without exit," he says. "You don't have to use it often. But you need the [threat of possible] exit to make the voice effective."

Most screening has not occurred on the scale of the South African divestment; nor can it. There are simply too many social and environmental issues to contend with. That's the bad news. The good news is that management quivers when the votes against its policies rise. "In the post-Enron era, any company that is not responsive to shareholders looks like it's got something to hide," says Chris Fox, director of investment research at the Coalition for Environmentally Responsible Economics, or CERES. "That only increases the scrutiny."

By Ellie Winninghoff

Ellie Winninghoff is writing a book about social investing.

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