The recent crisis in confidence elicited by a string of corporate governance scandals from Enron to WorldCom may be an indication that financial analysis needs to evolve. The governance and criminality issues raised by Enron and WorldCom are not directly related to social responsibility and sustainability, but they are indicative of the neglect by management of the con- cerns of stakeholders like investors, communities, employ- ees and environmental groups. Socially responsible investors see the Enron scandal in the context of the sys- tems that allowed it to happen right under our noses. These scandals give all investors the opportunity to advo- cate for some fundamental systemic changes.

Socially responsible investing offers investors some use- ful tools to help close the gap between business as usual and the contemporary global challenges of social and environ- mental responsibility. And while the government should avoid being overly interventionist, it has an important role to play in making capital markets more responsive to some complex social and environmental issues.

Investment capital does not neutrally make us money to put our children through university or provide us with security in our retirement. Social and environmental externalities are not adequately priced, valued or disclosed in the market. Market imperfections cause anti-social distortions for which we nonetheless pay in other aspects of our lives, be it in the form of increased personal taxes (or cuts in gov- ernment services), the need to purchase personal protection products like air purifiers for the home, or reduced overall health and quality of life. The marketplace, with its quarter- ly obsessions, simply isn’t designed to be especially effective in promoting positive and innovative initiatives that create long-term value.

To look beyond the investment bottom line does not imply forgetting profits. It involves seeking modes of wealth creation that pursue personal, social and ecological benefits in addition to financial gains.

Social and environmental issues are not disconnected from financial value. As the Conference Board of Canada points out, intangible assets, like brand and reputation ”” which are themselves increasingly connected to social and environmental performance ”” now compose over 50 per- cent of a company’s value. The exposure to such intangible assets has brought increased risks to investors, and neither the risk nor the true value of the firm are captured in tradi- tional financial metrics.

While it has existed for centuries, socially responsible investing (SRI) is now occupying new and wider space, in response to some of the limita- tions of conventional financial markets.

A number of individual and institu- tional investors, such as charitable foun- dations, religious organizations, trusts, investment pools and pension plans, have begun to question the prudence of ignoring social and environmental con- siderations related to the companies held in their investment portfolios. The Social Investment Organisation, the Canadian national network promoting the practice of socially responsible investment, estimates that as of June 30, 2004, $63.65 billion falls under the SRI umbrella; that is, 3.5 percent of the total investment market in Canada. This amount represents a 24 percent increase from the $51 billion in 2002.

SRI has been defined as the process of selecting or managing investments according to social or environmental cri- teria, while still including all the financial decision-making processes that are a part of prudent investment management.

Social and environmental issues are inherent- ly complex, and there is no universal standard or recipe for taking them into consideration. Perfection in SRI is unattainable. Corporate activities, and investment in them, have social and environmental effects that do not yield to ready quantification. Still, these effects could affect investment per- formance as profoundly as currently quantifiable and measurable criteria.

One can find various types of SRI in the marketplace. One strategy is ”œscreening,”œ where investment attrac- tiveness is based on certain social and/or environmental indicators. This may involve excluding certain compa- nies from the portfolio because of non- financial material risks, an inconsistency with investor values, or concerns with the collateral damage the stock generates. CalPERS, (California Public Employees’ Retirement System), for example ”” the largest pension fund in the US, with US$180 billion under management ”” engages in a number of exclusionary screens. As of 2000 they decided to exclude tobacco stock from the portfolio due to the unprece- dented amount of legal, regulatory and legislative action in the industry, which could substantially reduce share value.

CalPERS also excludes emerging markets that ignore international labour standards, on the grounds that these countries are not able to support institutional investments. A few months ago, they adopted a policy that restricts the system’s private equity gen- eral partners from investing in compa- nies that outsource public sector jobs. The then president of the board, Sean Harrigan, said that ”œmoney provided by public workers should not be used to cannibalize public jobs and cost taxpay- ers more money in the end.”

Inclusionary screening, on the other hand, involves proactively seek- ing corporate social opportunity leaders and companies that generate collateral benefits: this includes investing in alter- native energy companies, natural food companies, and companies that have outstanding relations with employees and other stakeholders.

Another SRI strategy is referred to as community development investing, or economically targeted investment (ETI). This involves redeploying capital to neg- lected sectors like innovative environ- mental technologies, inner-city redevelopment and micro-enterprises or cooperatives, which are typically exclud- ed from mainstream financing but often have market-grade returns commensurate with risk and collateral (social) benefits. Sustainable private equity, or sustainable venture capital, is another important emerging area, by means of which investors can encourage eco-innovation.

Finally, an increasingly prevalent SRI strategy is to use the leverage of share ownership to improve compa- nies’ social and environmental per- formance. This strategy is often called ”œshareholder engagement,” and it encompasses various means, including negotiating with companies for change, using voting rights at the annual general meeting (referred to as ”œproxy voting”) to vote according to certain principles, and filing share- holder resolutions to persuade other shareholders to support and mandate management taking certain actions.

A record number of shareholder proposals have been submitted for vot- ing at Canadian annual meetings this year (110 by the time of writing). Significant issues raised include exces- sive executive payouts and poor corpo- rate social and environmental disclosure. Shareholder action can make companies more responsive to changing external conditions, increasing long-term prof- itability and sustainability. Management does not always see the wisdom of this approach. Blinded by history, tradition and self-interest, corporate management often opposes such measures, arguing that they are impractical or too expen- sive. But shareholder advocacy can give clout to stakeholder voices that would otherwise be silent or ignored and that represent material risks to the company.

How shareholders vote on corporate business can affect financial performance and investment returns. New require- ments for mutual funds to provide infor- mation on their proxy voting policies and voting records to unit-holders on request are set to take effect June 30, 2005, but no such requirement is on the table for pen- sion funds. The Shareholder Association for Research and Education (SHARE) attempts to fill this gap. Each year, SHARE surveys Canadian investment managers and proxy voting services on how they voted proxies on behalf of pension plan clients. The 2004 survey results raised con- cerns that votes are being decided based solely on management’s recommenda- tions rather than on the merits of the pro- posal, concerns that echo an August 2004 report from the US Government Accountability Office (GAO), which found that ”œconflicts of interest exist in proxy voting and occur because of the various business relationships that may influence a proxy voter’s vote.”

Meanwhile, another private-sector disclosure development has emerged that gives further credence to SRI: the Carbon Disclosure Project (CDP). This project has significant institutional investors signing a global request for disclosure of information on green- house gas emissions from the FT 500 largest companies in the world. In 2003, 35 institutional investors, repre- senting $4.5 trillion, had signed on; in 2005 there were 145 institutional investors, representing $20 trillion; and today 300 of the 500 largest cor- porations in the world report their emissions through the CDP Web site.

Cynics will argue that no one gets rich by being responsible, but despite commonly held assumptions, research shows that there is no finan- cial penalty for investing in a socially responsible manner. Socially and envi- ronmentally responsible stock indexes outperform their conventional coun- terparts. In the past 10 years, the Domini Social Index (a basket of 400 socially responsible stocks in the US) has returned 12.9 percent a year (to December 31, 2004). This is consider- ably higher than the Standard & Poor’s 500-stock index, at 12.1 percent.

In Canada, the Jantzi Social Index (a basket of 60 socially responsible stocks) has been operating for only five years, but in the five years ending December 31 2004, the Jantzi index returned 4.1 per cent a year, compared with 2.3 percent for its conventional counterpart, the TSX 60 index.

Further, the Canadian public sup- ports SRI. In 2003, Environics Interna- tional found that 88 percent of Canadian investors believe the financial community should pay more attention to social and environmental issues. Nine in ten Canadians strongly (55 percent) or somewhat (35 percent) support ”œrequiring companies to publicly report their social and environmental perform- ance”; over eight in ten Canadians strongly (39 percent) or somewhat (43 percent) support ”œrequiring pension funds to publicly report whether or not they take the social and environmental performance of the companies they invest in into consideration”; and nine in ten Canadians strongly (54 percent) or somewhat (36 percent) support ”œmaking tougher laws around corporate environmental and social behaviour.”

Despite increased real-life evidence of the value of SRI, and despite Canadian public support for SRI, the greater financial community remains skeptical, ill-prepared and unwilling to provide Canadians with socially respon- sible investment services. According to its 2004 industry survey, the Social Investment Organization found only 37 out of 173 asset management firms that manage assets with social responsibility or sustainability screens. In the mutual fund industry, out of an estimated 2,000 funds available to Canadians, only 55 screen their investments according to social or environmental criteria.

No doubt, the financial communi- ty’s training has something to do with it. Business education fails to educate students on roles and responsibilities, despite the reality of an increasingly interconnected planet. A recent task force report by the business-school accreditation body AACSB Internation- al (the Association to Advance Colle- giate Schools of Business) found Canadian and US schools wanting in the whole area of teaching corporate social responsibility and ethical leader- ship. It added that schools must do more to ”œsocialize students in the obli- gations and rewards of stewardship, including the concerns of multiple stakeholders, and the responsible use of power.”

With pressure from the accreditation body, business schools will evolve to provide the new analytical skills required for the new economy, but in the meantime, a minority Canadian government may be tempted to listen to its electorate and take cues from governments around the world, which are beginning to establish clearer boundaries on issues of social, environmental and governance responsibilities. With the appropriate boundaries
set, the market can perform fairly while minimizing the need for governmental refereeing. Canada is lagging behind. Advancing on these issues will be a core contributing factor to Canada’s competi- tivity and stability.

To keep pace with the other juris- dictions across the world that are developing social, environmental and governance rules, Canada needs to amalgamate the current multitude of securities regulators into a single national regulator. While it is impor- tant that regulators do not become too prescriptive in terms of governance practice, it is essential that they do establish the basic expectations for public corporations in terms of their operating license. The Canadian Securities Administrators (CSA) should require public companies in Canada to clearly state their position on issues of social responsibility and sustainability and to disclose these positions to stake- holders and the public. This could mean requiring publicly listed compa- nies to report on these issues using the increasingly globally recognized Global Reporting Initiative (GRI) guidelines.

Another important boundary- setting zone is around pension funds. Pension-fund assets in Canada represent $550 billion. Insufficient oversight and accountability in pension-fund manage- ment could seriously hamper the pen- sions’ ability to deliver on the pension-fund promise to provide for life- time needs. This crisis would be aggravat- ed by longer lifespans. Following the precedent set in the UK and taken up by other countries, all pension funds in Canada should be required to disclose whether and how social and environ- mental considerations are taken into account in the selection, retention or realization of investments.

Many pension-fund managers believe that they cannot take a socially responsible stand because of their duty to maximize shareholder value for their clients. But asset managers and trustees have to begin questioning previously held assumptions on what constitutes and contributes to shareholder value. In a presentation on legal issues related to SRI given to the Ontario Society of Financial Analysts in January 2005, lawyer Murray Gold concluded that ”œno case rules out ”” and, indeed, the general fiduciary obligation requires ”” that trust investments be made with regard to all risk and return variables, including bal- ance sheet risks, business risks, technolo- gy risks, legal risks, governance risks and social, environmental and labour risks.”

The Canada Pension Plan (CPP) should be leading the way. The CPP Investment Board should undertake a portfolio review in order to understand the extent to which its investment portfolio is currently exposed to envi- ronmental, social and governance risks. While many believe the values-based arguments for SRI are legitimate ”” that the peace and security of our later years ought not to be financed by invest- ments that undermine the val- ues manifested in our public policies and public opinion ”” the mounting evidence of the financial case for SRI also underlines the need for the CPP Investment Board to take these issues seriously, to stop dismiss- ing them as a slippery slope into complex social issues that must be avoided.

Charitable foundations are another area of pronounced bifurcation between social/environmental goals and financial goals. Canadian law requires all foun- dations in the country to annually dis- burse 3.5 percent of their investment assets, but there are no requirements that the assets be managed with regards to remaining obedient to their social missions. These institutions ful- fill a unique purpose and enjoy a privi- leged tax status: the legislation should be clear and require directors of chari- table corporations, when making investment decisions, to consider whether the decision in question would further, or at least not hinder, the fulfillment of those charitable pur- poses. Again, such regulatory regimes are not just the dreams of tree-huggers ”” as of 2001, charities in the UK have been required to disclose the extent to which they take into account social, ethical and environmental issues in their investment policies.

Finally, community development investing and sustainable venture capital are SRI strategies that, if enabled by leg- islative incentives, could contribute greatly to the future well-being of Cana- dians. Micro-credit, cooperative enter- prises and other social and environmentally conscious small and medium-sized enterprises (SMEs) are typ- ically underfinanced by the mainstream financial institutions and yet, in the majority of countries belonging to the Organisation for Economic Co-opera- tion and Development (OECD), SMEs represent 95 percent of all business organizations and generate more than half of all private sector employment, and the survival rate of cooperative enterprises is almost twice that of investor-owned companies. Communi- ty-development investments should qualify for RRSP tax credits, and the fed- eral government should explore poten- tial frameworks to increase the role of Canadian banks in financing and sup- porting vibrant communities through community-development investing.

SRI applies a socio-cultural and bio- physical matrix over the dynamics of business, and it draws insight from these complex fields to work toward innovative value creation; it is an important part of maintaining public confidence in financial markets. SRI is about examining all material opportu- nities and risks, whatever their nature. Socially responsible investing is intu- itively right, even if current structures and beliefs incite fear and resistance to the integration of social and environ- mental criteria and traditional financial analysis.

Jurisdictions around the world are setting disclosure rules related to social and environmental considerations to reduce the need for more intrusive government intervention, but Canada lags in such initiatives. Simple regula- tory changes to securities regulators, disclosure rules encouraging trans- parency for pension funds, a portfolio review of the CPP portfolio to take stock of current exposure to social and environmental risks, disclosure requirements for charitable founda- tions on whether investment decisions further the fulfillment of the institu- tions’ charitable purposes, and enabling measures like RRSP credits to encourage Canadian investment in vibrant and sustainable communities are just a few ways that SRI might even raise both our quality of life and our business efficiency.

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