Universal owners are waking up to the fact that their sustainability is in danger from systemic risks, but forgoing short-term gains for long-term stability is far from easy.
The UK Financial Conduct Authority’s (FCA) new bumper discussion paper on sustainable finance places a spotlight on systemic risks, which include climate breakdown, biodiversity loss, inequality and anti-microbial resistance (AMR).
In the 97-page document, currently under consultation, the financial regulator says it wants firms to identify and respond to these types of systemic and market-wide risks. It notes that investors can’t diversify away from them, so they have an important impact on returns. This is an issue of particular importance to universal owners that are exposed to the whole economy.
But, in the same breath, the FCA also says the “systemic stewardship” needed to address these risks is arguably harder and more complex than investors’ traditional approach to engagement, giving rise to conflicts of interest that are more difficult to manage.
Fiduciary duty concern
Herein lies the challenge: while a growing number of large asset owners are waking up to the fact that there’s “nowhere to hide” when you own large chunks of an economy, the present investment paradigm does not easily lend itself to tackling systemic risk, says Maria Nazarova-Doyle, Head of Pension Investments and Responsible Investment at British life insurance and pensions company Scottish Widows.
While the picture is shifting, prevailing interpretations of fiduciary duty primarily consider financial risk and return, she says, with the use of ESG factors permissible if demonstrably financially material to the portfolio.
But, ESG factors cannot be treated like financial factors, Nazarova-Doyle explains. “How can you easily model the impact of employees not having a living wage which could potentially lead to widening inequalities and further stratification in society, which will ultimately hit companies’ profitability and affect the economy negatively? It’s nearly impossible.
“Once you realise you are a universal owner, you also realise how difficult it is to specifically model that impact in basis points return to your fund. So, a lot of pension funds are stuck, saying we know it’s really important, but I can’t easily put numbers on the page to prove it.”
The work done over the past decade on modelling climate change risk is starting to tackle this issue, says Paul Lee, Head of Stewardship and Sustainable Investment Strategy at UK-based investment consultants Redington, with investors applying these learnings to other systemic issues such as inequality – a major risk for long-term returns given its economic drag.
He says a big shift in mindset is under way, with large asset owners realising there are limits to engaging with individual companies on particular issues. So, they are instead thinking about their role more broadly in influencing change across systems. This includes collaborating on engagement, thinking more actively about regulatory issues and engaging with governments.
Marisa Hall, Head of non-profit Thinking Ahead Institute (TAI), also stresses the importance of collaboration to effectively address systemic risks. “By working with corporations through engagement stewardship, by working with individuals in terms of incentives, by working with governments in terms of regulation and lobbying, you can effectively have this multiplier effect and a disproportionate impact by working with others,” she explains.
The TAI has been a key thought-leader on systemic risk, with co-founder Roger Urwin having written extensively on the issue. Hall says to develop an internal approach, an investor should define its own system and decide what are the boundaries of that system for creating value.
She said while for investors the boundaries of their system has been traditionally clients and their financial objectives, this is broadening to a more stakeholder-focused model with multiple objectives, such as financial and environmental, like net zero commitments.
This move to a broader system leads an investor to not just think about the efficiency of that system, but also its resilience, and the need to manage its systemic risks, she says.
This type of thinking isn’t widespread, however, with International Sustainability Standards Board (ISSB) Chair Emmanuel Faber and UN Special Envoy for Climate Action and Finance Mark Carney complaining last Friday that economies, governments and business were too focused on efficiency, leaving resilience as a “blind spot”.
Their comments reflect the conflict of interest in addressing systemic risk the FCA has alluded to – effective operational efficiency translates into company profits and hard cash, whereas the benefits of effective operational resilience are typically much less quantifiable.
But some investors are starting to shift. Mark Versey, CEO of Aviva Investors, said this month that it will look “unfavourably” on attempts to protect profitability and returns through disproportionate transfer of costs to stakeholders, including customers, employees and suppliers. Impact investment pioneer Sir Ronald Cohen has long talked about overthrowing the “dictatorship of profit” and weighting it against a company’s societal and environmental impact.
Kim Farrant, General Manager, Responsible Investment at Australian pension fund HESTA, tells ESG Investor: “As a long-term institutional investor, we are putting systemic issues, like the trade-off between public health and company profits, on the agenda so that boards and management consider the broader impacts on the economy and health system where many of our members work.”
Alongside French asset manager Amundi, HESTA has co-filed a shareholder proposal against Tyson Foods, calling on the US meat giant to align its business operations with the World Health Organisation’s guidance on antibiotic use in animals. Farrant says: “Investors shouldn’t leave responsible stewardship of capital up to regulators, given the significant financial risk AMR presents for our members’ investments.”
Farrant says overuse of antibiotics in raising livestock to better the business bottom line could see a decrease in annual GDP by nearly 4% by 2050 – an estimated US$100 trillion in total. She adds that AMR resistance can have dire health impacts such as increased loss of life and poverty, affecting HESTA members who work predominantly in health and community services.
Amundi and HESTA collaborated with US non-profit The Shareholder Commons (TSC), which has been filing shareholder proposals on systemic risk since 2020.
The US-based NGO is seeking to change investor behaviour through its activity, more so than corporate. Sara Murphy, Chief Strategy Officer at TSC, says it believes investors are getting shareholder primacy, which is codified in fiduciary duty, wrong when they fail to steward portfolios for systemic risks and value.
“Corporate boards are obligated to shareholders alone,” explains Murphy, who says TSC wants to call out the tension between shareholder priorities and wider stakeholders, where maximising profit can come at the detriment to others.
To this end, the TSC has filed proposals calling for companies to convert to a public benefit corporation (PBC) structure which allows directors of a company to better serve the interests of diversified stakeholders such as workers and the environment.
From alpha to beta
The maximising of profit at an individual company level can also come at the detriment to diversified investors, notes Murphy. To address this, TSC advocates for beta stewardship, which starts from the premise that individual company performance is responsible for at most 25% of the performance of a diversified portfolio, the rest is explained by the performance of the market. “Whatever marginal returns any individual company might direct toward their shareholders are dwarfed in comparison to the costs imposed,” says Murphy.
TSC files proposals focused on companies disclosing the costs imposed on society or externalised by their contribution to specific systemic risks. These risks include AMR, inequality, corporate governance failures, public health threats, and inadequate voting policies.
Last year, its resolutions garnered an average of 11% of external shareholder support, but Murphy notes that the proxy advisor industry has been “dreadfully resistant” to the entire notion.
“They say they don’t know if their clients are diversified and use that as a basis for resisting this type of approach.”
Murphy argues that the vast majority of investors are diversified and it’s not accurate to give advice as though their clients hold only one stock. “I think they’re ultimately doing a disservice to their clients and some of their clients have said as much at least behind closed doors,” she says.
Investor support, especially for proposals on social systemic risks, is currently lacking, says a UK-based asset owner, citing last year’s failed living wage resolution at food retailer Sainsbury. “Some asset managers that you would have thought would have been fairly progressive were against it.
“It is still a mindset that things like employee wages are a cost to be minimised. But you won’t hear shareholders say that dividends are a cost to be minimised.”