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Commentary

Investor Stewardship at a Crossroads

Rickard Nilsson, Head of Stewardship Success at Esgaia, considers how asset owners can maximise long-term impact at a time of regulatory uncertainty.

Capital markets play a key role in influencing resource mobilisation. At a time when political division is delaying needed policy action, investors find themselves at a crossroads over how to act amid regulatory uncertainty.

Capitalism is governed by existing hard and soft law. As intermediaries with obligations to clients and end-beneficiaries, institutional investors are bound to play by those rules. Trying to play a more ethical game in anticipation of a developing rule book will put an organisation’s competitiveness at risk.

How can investors position against this, and implement a stewardship strategy that maximises impact over the long term for both clients and society at large?

The purpose of investor stewardship

The investment stewardship ecosystem reflects a complex web of stakeholder relationships and interests. From the underlying assets and the institutions owning them to clients, civil society, and the public sector, a myriad of actors influence industry practices, norms and policies.

From an investor perspective, the stewarding of assets generally entails selecting a board of directors who in turn assign and oversee management for the strategy and daily running of the asset. Investors can then choose to monitor and engage the asset, e.g. to build trust and align on longer-term plans. Engagement dialogues also play an important role in setting expectations and as an accountability mechanism when performance is lacking.

As evidenced in literature, and by the experience of many investors, good management practices are not adopted by many organisations because of cognitive, knowledge, incentive and capability barriers. Unsurprisingly then, research suggests that successful investment stewardship can increase returns, lower risks, and empower real-world outcomes – but needs to become more effective to have the intended impact.

The current state

Historically, investment stewardship has focused on individual company performance, generally perceived as high-cost monitoring. Normally only investors with large stakes would have sufficient ‘skin in the game’ to engage with a firm and undertake restructurings that truly increase productivity and investment efficiency. Today, practices are changing with institutional investors representing the single largest category of investors in public equity markets, and with the majority of portfolio performance due to overall economic development.

Most institutional investors’ portfolios now consist of hundreds, if not thousands, of holdings. Therefore, it seems obvious that investment stewardship should focus on reducing non-diversifiable/ market-wide and systemic risks to improve risk-adjusted portfolio returns. This reflects well the current direction of travel of many investors’ stewardship strategies, where collaboration has become a central tool for increased influence and voice.

Based on the economics of information, research shows how collaboration can work as an antidote to partial information problems and agency issues faced by companies. By producing and aggregating information from insiders and shareholders, it can add value otherwise lost under unilateral decision-making. As such, it offers a powerful mechanism to help align the interests of investors, companies and their stakeholders.

Regulatory uncertainty

In the current market, as public policy is generally not pricing in externalities, competition can drive companies to externalise negative environmental and social impacts at a cost to the broader society. This speaks of a market failure where doing the right thing from a societal point of view is not rewarded by the market.

Today, so-called mixed economies predominate because of the blend of markets and government, where regulation is supposed to correct market failures, such as pollution. However, as someone once told me, elected officials work through compromise, but systemic issues like climate change and biodiversity, do not. It has become quite evident that governments prioritise jobs and the economy in the short-term over certain long-term targets.

Because of the ineffectiveness of the current voluntary and statutory policy environment in shaping desired behaviours, the value of certain common economic, social, and environmental assets will continue to deteriorate. While we can expect regulators to step up their efforts in reining in cost-externalising business decisions, the finance industry and investors still have a role to play.

Valuing externalities

The cost of externalities for products and services can be extremely high, and insufficient pricing disguises their true cost and environmental impact. The reality is that valuing capital loss versus environmental and social gains and vice versa is very complicated, often being viewed as an ethical question. Societal concerns are multidimensional, making it difficult to assess performance. Further, companies are likely to have better information about the terms of the trade-off than investors. In such circumstances, it is unlikely that managerial preferences are perfectly aligned with those of shareholders.

To exemplify, as described in this article, imagine shareholders face a proposal where a company will spend a little more but will pollute less. In deciding their vote, investors will compare the cost of implementation vs the environmental and social benefits. If shareholders are well-diversified, the personal capital loss is negligible and vice versa. So, while large shareholders have been perceived as beneficial because they reduce agency costs, once externalities are considered, they may be detrimental because they put too much weight on profit relative to the social good.

The above situation speaks of complicated trade-offs, where shareholder voice can be powerful. As investor pressure is not limited by jurisdiction, it is less prone to capture than political voice, which can enable efficient enforcement of environmental standards and guardrails across regulatory regimes.

Where do we go from here?

Businesses inherently impact and are influenced by the societal values and ethical norms of the times. The case made in this article is that investors (and other stakeholders) can have an important role to play as ‘norm entrepreneurs’ or ambassadors on business conduct and corporate responsibility. But that requires a mind shift to system-level investing and stewardship.

In terms of effective investor stewardship then, to further maximise the impact for both clients and society at large, we need:

  • System-level stewardship, generally through articulating merit-based expectations and guardrails, and following through on those using public discourse, proxy voting, and engagement.
  • Improved stewardship strategies, moving from activities to outcomes, encompassing investors’ broader sphere of influence such as clients and beneficiaries, industry stakeholders, civil society, and the public sector.
  • Responsible action and lobbying from others in the investment ecosystem, including industry stakeholders, civil society, and the public sector. For investors, this comes back to engaging different stakeholders to align on and influence policies and practices.
  • Innovation for more effective stewardship and greater transparency, through improving market infrastructure, pooling investor resources, and enhancing comparability.
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