Fostering Development and Socially Responsible Investment

Transcription

1 Fostering Development and Socially Responsible Investment Committee on Global Thought at Columbia University 1. Introduction Global imbalances in international capital markets are commonly identified as a cause of the 2008 financial crisis. The imbalances are characterized by the investment of capital surpluses of large developing countries into equity and fixed-income markets in developed countries. The uneven distribution of global capital accumulation leads one to consider whether SWFs may have too much exposure to developed country markets, and how financial market stability may be promoted through, for example, the development of deeper, more liquid developing country capital markets. Socially responsible investment (SRI) may be one mechanism for addressing these global imbalances. While SRIs and conventional investments in developing countries are clearly distinct issues, the paper explores how they might be linked together. The ability of socially responsible investing to fulfil the diverse investment objectives of SWFs is also considered. After briefly reviewing the main contours of global imbalances, we explore connections between SWFs, development finance, and SRIs. The implementation of an SRI strategy requires finding the right balance between rate of return and environment, social, and governance performance. We thus consider several possible investment rubrics and examine the Norwegian Government Pension Fund Global s strategies. The final section examines green investing, microcredit, and considers Keenan and Ochoa s (2010) recent proposal for an international mezzo-finance vehicle. 2. Capital Flows and Reserve Management One important question is why capital appears to flow from emerging to developed economies in a way not justified by apparent marginal capital returns (Lucas, 1990). Reasons for this may be due to fundamental features of the relevant emerging economy such as the impact of technology, institutions, or government policy on productivity. Another explanation might be imperfections in international capital markets (see Causa et. al for further discussion). With their allocation puzzle, Gourinchas and Jeanne (2009) take a slight different but related approach. They question why capital appears to flow upstream, that is more to countries that invest and grow less (ibid., 1). Their focus is on the cross section of developing

2 2 countries, where apparently low productivity countries (such as Madagascar) receive too much capital relative to fast growing high countries (such as Korea). 2.1 Reserve Growth Driven to a large extent by current account surpluses, the developing world has experienced a remarkable accumulation in reserves. Between 2001 and 2007 they increased from $1 trillion to $5 trillion. The growth in SWFs is connected to the increase in reserves. The growth is not, however, uniform. India, for example, has accumulated reserves primarily through net capital inflows (Griffith-Jones and Ocampo 2008). In Latin America, on the other hand, reserve increases have been an important mechanism, especially in the period between 2004 and At one level, the growth in commodity-based SWFs represents a reaction to the wastefulness of the 1970s commodities boom. In contrast to that period, countries are looking to save part of recent surpluses to smooth consumption over time. The growth of export-based SWFs is based on the persistent current account surpluses. We can distinguish stabilization from savings-based SWFs. The rationale for the latter is that countries might want to use the proceeds from the sale of non-renewable resources to smooth consumption over generations. In contrast stabilization funds smooth the impact of fluctuating fiscal revenues or export receipts. Griffith-Jones and Ocampo (2008) also distinguish financing and development funds. The former might explicitly be designed to absorb budget surplus or fund deficits, while the latter may be targeted, for example, at infrastructure investment. 2.2 Reasons for Reserve Accumulation. Griffith-Jones and Ocampo (ibid.) also identify two rationales for foreign exchange reserve accumulation in the literature: competitiveness and self-insurance. In terms of the first, the literature on the second Bretton Woods regime is informative. They argue, however, that the recent literature favours the self-insurance view, with countries accumulating reserves largely in reaction to the financial instability of the East Asian crisis. Both of the given rationales address the need to mitigate real exchange rate volatility. The question then becomes why countries chose this form of self-insurance, rather than, for example, capital account regulations. Jeanne and Rancierre have a model of the optimal reserve level which depends on the probability and the size of the sudden stop, the consumer s risk aversion, and the opportunity cost of holding reserves (2009: 2). Accumulating reserves is also less costly where interest rates, and sterilization, are low. Griffith-Jones and Ocampo (2008) extend this analysis by identifying four motives for accumulating foreign exchange assets. The wealth substitution motive, refers to the transformation of a natural resource into a financial asset. The second is the resilient surplus motive, and references a structural surplus that is largely resistant to exchange rate

3 3 appreciation. Both the wealth and resilient motives justify the savings type of SWF. Indeed in the authors' view, these are the only, in some sense, legitimate rationales. The countercyclical (or stabilisation) and self-insurance motive (to combat hot capital flows), must be weighted against the costs of sterilizing the monetary effects of booming foreign exchange inflows when there are no fiscal surpluses to undertake that function (ibid., 27). As the authors note, selfinsurance, while individually rational, may contribute to the global imbalances and the systemic fragility of the global economy. The problem in their view is insufficient collective insurance. Simply asking developing countries to appreciate their currencies is wrong and will not solve the structural problems (ibid., 23). One impact of the increasing use of SWFs to manage excess reserves is the increased demand for risky assets. The assets held traditionally in reserve management (typically Treasuries) are no longer seen as bearing sufficient yield (Mezzacapo 2009: 36). The currency denomination of assets held by SWFs is naturally affected by policies around exchange rate management. Mezzacapo cites studies performing simulations which find that reserve portfolio bias explains the phenomenon of capital flowing from developing to developed countries. Liquidity considerations are thus an important explanatory factor. With the increasing role of SWFS we may have a reversal of this trend. 3. Development Finance A question arising out of our discussion of capital flows is whether investors should seek to redirect capital to emerging and frontier markets. And if so, what sort of initiatives ought to be considered. As noted by Santiso (2008), SWFs have the potential to make a meaningful contribution to economic development. He suggests that if SWFs, allocate 10 per cent of their portfolios to emerging and developing economies over the next decade, this could generate inflows of $1,400 billion, more than all OECD countries aid to developing economies put together (ibid., 1). His brief highlights some high profile SWF emerging market investments. Long-term SWF investments may assist emerging markets through reducing volatility. Others have made similar points. World Bank president, Robert Zoellick (2008), called for one-percent of SWF capital to be invested via the International Finance Corporation into Africa, as part of the World Bank Sovereign Funds Initiative. 3.1 Socially Responsible Investment Aside from development, we also need to think more broadly about Socially Responsible Investment. SRI has become an increasingly prominent topic in recent years, and global initiatives have been launched - such as the United Nations (UN) Global Compact and the UN Principles for Responsible Investing (UNPRI). In Europe, SRI assets under management reached 1.03 trillion in 2005 (Landier and Nair, 2008b).

4 4 Landier and Nair (2008b) and Heal (2008) provide important overviews of the implementation of a socially responsible investment strategy. Landier and Nair color code different types of investors according to two key questions: what are your beliefs, and how much are you willing to pay for them? (Landier and Nair 2008b: 2). YELLOW investors feel morally obliged to avoid companies that are incompatible with some of their values. Any other investment behavior would be immoral. They make their decision irrespective of the cost to themselves or whether their course of action has any impact on company policy. They tend to avoid sin industries, such as tobacco or gambling. RED investors are at the opposite end of the SRI spectrum. They are not motivated by moral concerns and do not tolerate investment strategies that have any negative impact on rate of return. SRIs are made due to the belief that the responsible company will outperform their peers in the coming years. BLUE investors are pragmatic. The only reason they invest responsibly is if the financial cost is small and they believe their investment will yield a world more closely aligned with their values. As they note, the yellow policy is ineffective, since companies might not change their business but they might change the way they do business if they see a realistic chance of attracting responsible investors (Landier and Nair 2008b: 3). Preferable in their view, is to exclude irresponsible companies, rather than screening entire industries (this is the industry agnostic approach). Innovest and WWF (2008) make a similar point about negative screening of industries or sectors, noting that this can negatively impact geographic and risk diversification. With this is mind, Landier and Nair (2008b) recommend the following steps to responsible portfolio construction: Step 1: Collect information on responsibility Step 2: Remove companies that do not pass the bar (in terms of environment, product safety, and employee treatment). Note though that implementation requires reliable measurement around these criteria, as well as a degree of consensus around the causes. Step 3: Select the right mix of industries 3.2 Norwegian example. Clark and Monk have detailed how the Norwegian Government Pension Fund Global (GPFG) marries long-term investment objectives with various ethical commitments. While they

5 5 do not view GPFG s approach as best practice (but see Myklebust 2010), they recognize that it is a source of the Fund s political legitimacy. They identify two aspects to the NGPF s ethical objectives. Firstly, are its attempts to join corporations in promoting best practice. Secondly, is its policy of naming and shaming corporations and industries that breach the Fund s social and environmental justice ethical codes (Clark and Monk 2010: 14). The ethical directives of GPFG represent the views of the Norwegian state. The GPFG sits inside the Norges Bank, its asset manager is Norges Bank Investment Management (NBIM), it employs Norges Bank staff, and its investment guidelines are ultimately determined by the Ministry of Finance. As noted in Clark and Monk, there are three components to best practice: The fund should exercise ownership rights based on, international conventions. The fund should use negative screening of companies that produce weapons whose use violates fundamental humanitarian principles. The fund should exclude companies from the portfolio that constitute 'considerable risk' of corruption, environmental degradation, and the violation of human rights These guidelines are provided by a 5 member Council of Ethics sitting within the Ministry of Finance. The Council can recommend that the asset manager, NBIM, exclude companies from its portfolio. For its part, NBIM exercises the ownership rights of the Fund to influence the corporate governance of companies it holds in its portfolio. As pointed out by Clark and Monk, such ethical considerations and the organizational structure to implement them, may have efficiency costs (in the sense of return). 1 Of course the political legitimacy of the fund as a whole may rely on the incorporation of these considerations. Clark and Monk though suggest that in the long-run, this inefficiency may result in the progressive illegitimacy of the Fund. A few comments on the Norwegian example might be in order. The three components of ethical investing in the Norwegian context are not co-extensive with how SRIs are understood more generally. Rather SRI is about collectively determined norms. Thus, one might think that a global SRI index is more appropriate. The argument Clark and Monk present is that ethical investing in the Norwegian context is about domestic legitimacy. For other SWFs, the major concern is growing protectionism against investments in foreign markets. SRI in this case might be a strategy for international legitimacy by signalling the norms and standards underpinning one's investing strategy. In thinking about SRI, we need to consider carefully the appropriate procedure for determining whether an investment is ethical. It may be appropriate for this procedure to be transparent, for the benefit of domestic and/or foreign constituencies. There are also various 1 Measurement here is difficult, since ESG may be considered relevant to long-term performance. So we likely need to look at a suitably lengthy horizon.

6 6 technical challenges to implementing SRI, such as the accreditation of suitable investment opportunities, and the development of measurement, reporting and verification technologies and standards. A global SRI index might provide clarity and remove some of the administrative burden in this respect. The two areas of SRIs we will focus on in this survey are green investment and microcredit. 3.3 Green Investing. Innovest and WWF (2008) have written a survey of some of the key areas around fund management and carbon emissions reduction. In particular their report considers the potential role of SWFs. As long-term investors, it is crucial, for SWFs to recognize how climate change can affect investment value. Climate change has the potential to impact not just individual companies, but whole sectors and economies. Failing to account for environmental degradation in GDP may induce a false trade-off between growth and environment (CMEPSP 2009). Similar considerations should be kept in mind in the context of SWF investments. One way of approaching climate change challenges is with SRI strategies. In some sense, long-term investments, such as in climate change mitigation can be likened to making a SRI. In times of general budgetary stress resulting from, for example, a climate change induced disaster, the sovereign may be forced to draw on the resources of the SWF. In this setting SWF investment in climate change mitigation in countries with climate change cost exposure can represent a hedge. Whether such investing represents a hedge depends on how tightly ringfenced, de jure and de facto, the liabilities of the sovereign and the SWF are. Alternatively, consider a fund with long-term social security or medical liabilities. Then investments in pollution-reduction may be appropriate, since a healthy population is in the interests of the SWF. Furthermore, investments into tangible assets, such as universities might also count as SRI if, for example, one of the country s objectives is the eradication of illiteracy. Innovest and WWF (2008) identify three strategies in the implementation of SRIs Negative screening to exclude undesirable companies or sectors Positive screening to select companies with better environmental, social and governance (ESG) performance; and Shareholder advocacy and engagement to improve company behavior. Used less often is pioneer screening. Funds employing this strategy invest in the bestperforming companies against a specific theme or criterion, such as management of natural resources (ibid., 34). The report echoes Landier and Nair s concerns about screening whole sectors. It also notes that advocacy and engagement, which might include recommending companies to better disclose carbon emissions, can be costly and limited to a small number of the corporations in which a fund invests. The most popular approach is best-in-class screening.

7 7 In this scenario, stocks are selected within each sector of a given index, potentially lowering risk by balancing their portfolio across all sectors (Innovest and WWF 2008: 34). ESG factors can be, and have been, incorporated by some public pension funds through bottom-up best-in-class stock selection and top-down theme driven investments (for example, environmental themes). Sovereign wealth funds still lag behind public pension funds in incorporating all of these approaches. SWFs will need to carefully monitor their portfolios for the risks emanating from future carbon regulation. The costs of complying with a low carbon regulatory regime vary widely across companies within a sector, and between sectors. SRI techniques might be profitable through investing in companies with superior management of climate-driven risks and opportunities, engaging strategically with companies on climate change issues, and investing in clean tech and renewable energy (ibid., 45). At present opportunities for SRIs exist through various SRI indices and tracker funds, some exchange traded funds, thematic investment funds, and venture capital and private equity funds. In terms of the possible role for SWFs, Innovest and WWF provide various examples such as developing indices evaluating (2008: 14): companies contributions to long-term solutions essential for a low-carbon future... the innovation potential of companies to meet the needs of new markets in a low carbon economy... the companies with potential to provide low carbon solutions for the lower income market segments in developing countries... companies providing services which help customers transition to a low carbon society and therefore most likely to be winners in a resource-constrained economy. The GPFG does make use of the strategies of shareholder advocacy and engagement, as well as negative screening. Innovest and WWF (2008) argue, however, that implementation into decision-making could be more systematic, and it might consider, for instance, a thematic fund for investments in environmental technologies (ibid., 15). They thus recommend two potential options for the GPFG (and by extension other SWFs). A first approach would be to follow current best practice as demonstrated by various pension funds including: strategic engagement with companies and collaboration with other institutional investors; best-in-class positive screening (selection) towards low-carbon investment opportunities; and investment in environmental technologies. The second approach they describe is more ambitious (and could be use alongside the first) and involves SWF investors

8 8 taking a leadership role in the low-carbon transition. Thus, in their example, the NGPGF would actively facilitate SWF co-ordination; engage with research firms and other stakeholders; develop further positive screening indicators; host conferences on Sustainable Funds Management; invest in education; and promote innovation through, for example, the establishment of a climate venture capital fund. 3.4 Microcredit. Keenan and Ochoa (2010), propose that the World Bank's Sovereign Funds Initiative be transformed into a new World Bank Group branch the Multilateral Sovereign Investment Agency (MSIA). Using the new branch sovereign wealth investors could invest in African equity, i.e. small- and medium-scale private enterprises in Africa (ibid., 1167). Previous assistance, they argue, has not generated the right kinds of incentives. There are two normative propositions underpinning Keenan and Ochoa's argument: first, that private investment should share the objective of development assistance, i.e. to enhance ordinary people's welfare; and second, that where the state is unable to protect citizens from human rights abuses, this duty is shared by those trading, or doing business more generally, with that state. Furthermore, the MSIA would be a repository of information on investor opportunities. It would encourage SRI compliance and provide expertise to private enterprise seeking outside investors (ibid., 1167). The model would roughly be that of a venture capital fund, and would have the feature of directly targeting enterprises rather than the funds being mediated through government Questions for panellists i. Do SWFs have too much exposure to developed countries? ii. How can we redirect capital flows to developing countries? iii. What sort of development finance can SWFs profitably provide? iv. Can and should SWFs apply SRI principles when constructing their investment portfolios? v. If the answer to the above question is yes, what sorts of procedures are appropriate for the implementation of SRIs? 2 Microfinance is another area where SWFs may make a meaningful contribution to economic development. Aabar has recently invested $54.2 million in Luxembourg-based funds with microfinance exposure. Abu Dhabi: Aabar invests $54m in Luxembourg funds, Syminvest, 11 July 2010,

9 9 References Causa, Orsetta & Cohen, Daniel & Soto, Marcelo (2006) "Lucas and Anti-Lucas Paradoxes," CEPR Discussion Papers Clark, G.L. and A. Monk (2010a), The Norwegian Government Pension Fund: Ethics over Efficiency, Rotman International Journal of Pension Management Vol 3, Iss 1, Spring. Chesterman, S. (2008) The Turn to Ethics: Disinvestment from Multinational Corporations for Human Rights Violations - The Case of Norway's Sovereign Wealth Fund, New York University Public Law and Legal Theory Working Papers. Paper Commission on the Measurement of Economic Performance and Social Progress (CMEPSP) (2009).See Gelpern, A (2010), Sovereignty, Accountability, and the Wealth Fund Governance Conundrum Draft July 19, 2010 Forthcoming in Asian Journal of International Law. Gourinchas, Pierre-Olivier and Jeanne, Olivier (2009) Capital Flows to Developing Countries: The Allocation Puzzle, June. Griffith-Jones, S and Ocampo, J.A. (2010) Sovereign Wealth Funds: A Developing Country Perspective Foundation for European Progressive Studies, May. Heal, G.M. (2008) When Principles Pay: Corporate Social Responsibility and the Bottom Line. May, Columbia University Press. Innovest and WWF (2008), Fund Management in the 21st Century: The role of sovereign wealth funds in a low carbon future, September. Jeanne, O and Romain Rancierre (2009), The Optimal Level of International Reserves For Emerging Market Countries: a New Formula and Some Applications, February. Keenan, P.J. and C. Ochoa, The Human Rights Potential of Sovereign Wealth Funds, Illinois Public Law Research Paper No ; Indiana Legal Studies Research Paper No. 132; Georgetown International Law Journal Symposium, Summer Available at SSRN:

10 10 Landier, A. and V. Nair (2008a) Investing for Change: Profit from Responsible Investment, Oxford University Press, November. Landier and Nair (2008b), Investing for Change: Profit from Socially Responsible Investment, at Lucas, R.E (1990), Why doesn't capital flow from rich to poor countries? American Economic Review Vol 80. Mezzacapo, S. (2009), The so-called 'Sovereign Wealth Funds : regulatory issues, financial stability and prudential supervision, European Economy, Economic Papers, 378, April. Mykleburst, T (2010), The Norwegian Government Pension Fund: Moving Forward on Responsible Investing and Governance, Rotman International Journal of Pension Management, Vol 3, Iss 1. Santiso, J. (2008) Sovereign Development Funds, OECD Policy Insights, No 58, Zoellick, R (2008) A Challenge of Economic Statecraft, Address at the Center for Global Development, April 2, available at