Social Finance, from ESG to SRI: Opportunities and Challenges

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By Tim Rourke TIM ROURKE is Vice President, Relationship Management and Pension Practice Lead at CIBC Mellon. He is responsible for our pension, corporate, government and insurance client relationships across Canada. Tim has more than 30 years of asset servicing experience.

Conventional wisdom for many years held that “social” factors had no place in the business world, and that organizations had to either be socially/ethically focused or turn a profit, but not both. Today, such is not the case, as many for-profit businesses engage with environmental, social and governance concerns and consider the broader implications of their activities as part of business plans, for example increasing employee engagement with corporate social responsibility efforts, achieving cost efficiencies through environmentally sustainable practices, or recognizing the importance of enforcing human rights across a supply chain. Likewise, many charities are applying business principles such as founding “social enterprises” to fund their non-profit operations. Attention has more recently turned to the power of investment activities to deploy capital to achieve both financial and social returns – particularly amid the recognition that it is possible to achieve necessary or even desirable financial returns while considering social factors. This space has a vast array of terms and activities such as socially responsible investing, sustainable investing, impact investing and environmental, social and governance (ESG) investing. Social finance BNY Mellon has undertaken research to understand and collect this space under the umbrella of “social finance.” According to BNY Mellon, social finance refers to any investment activity that generates financial returns and includes social and environmental impact. Social finance encompasses diverse investment strategies and products across asset classes that

knowledge leadership / september 2015

deliver a range of risk-adjusted returns and align with different investor motivations and goals. Social finance includes four primary strategies: socially responsible investing (SRI), environmental finance, development finance and impact investing. These strategies are united by their common purpose to deliver both financial returns and positive social and environmental impact. However, the objectives differ for each of the strategies in terms of how explicitly or intentionally they strive for positive social and environmental outcome. ESG trends capturing attention globally and in Canada According to BNY Mellon research, ESG trends are rapidly reshaping the economy and presenting significant risks and opportunities for mainstream investors. By 2050, the world population is expected to grow by more than 30 per cent to more than 9.5 billion people—the majority of this growth is happening in urban areas in the developing world, adding to the challenges of an already resource-constrained world. This is just one of many trends that present opportunities for mainstream investors to shift large amounts of capital to investments that generate value for investors and positive impacts on society. BNY Mellon calls this “social finance at scale.” Ignoring the risks presented by these trends has implications for investors. Natural resource constraints, global health threats, social instability, and demographic changes are already presenting business leaders with challenges and shaping decisions which in turn can impact future business and investment performance.

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Questions and key actions for plan administrators to consider: 1. What are the plan’s fiduciary duties as they apply to investing?

Global Social Finance Market Size More investors recognize the importance of these global trends to their investment decisions and are adjusting their investment management strategies accordingly. In Canada, according to the Responsible Investment Association (RIA), as of December 31, 2013 assets managed under sustainable guidelines increased from $600 billion to more than $1 trillion in just two years. This robust growth represents a 68 per cent increase in responsible investment assets under management.

2. How are the plan and its investment managers currently defining and measuring ESG factors, if at all? 3. Should the plan consider revising its approach to ESG factors? If so, how will the plan incorporate the views of its various stakeholders? 4. Plan sponsors should review their decisionmaking process, understanding the financial impact of their decisions and ask if the plan itself contains any restrictions. 5. Plan sponsors should take steps to clearly and properly document their decisions

Source: BNY Mellon research report, Social Finance at Scale: Creating Value of Mainstream Investors

Driving growth The growth in responsible investment activities can be traced to many factors, for example the increasing number of companies who recognize the importance of ESG. Against a backdrop of rising public concern around environmental and social issues, no company wants to be seen as part of the problem. There’s no shortage of examples of what happens when players end up on the wrong side of public expectations. For example, the 2010 BP oil rig collapse in the Gulf of Mexico was one of the most publicized environmental disasters of our time thanks to social media and the internet. Not only did BP take a charge of US$43 billion in civil settlements and penalties in connection with the spill, but the negative fallout in terms of public relations was significant. The Bangladesh garment factory collapse of 2013, with the loss of 1,129 lives, is another example; a number of Canadian, American and European retailers ended up in the news, not because they had any ownership stake in the factory but because their suppliers did. In the wake of the tragedy, the firms suffered a hit to their reputations, with some agreeing to pay compensation to families of the victims. In September 2015, the Volkswagon emissions scandal led to a loss of more than €14 billion in market capitalization. The company’s CEO resigned, and Volkswagon set aside €6.5 billion to cover anticipated fines, lawsuits and other resolution costs. The lesson here is that there can be both reputational and financial consequences for companies that fall short of expectations of responsible conduct.

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More investors recognize the importance of these global trends to their investment decisions and are adjusting their investment management strategies accordingly.

Defining Social Finance According to BNY Mellon1, social finance enables investors to achieve financial returns while also incorporating and mitigating ESG risk, generating long-term value, and creating positive impacts on society. Social finance can present investors with compelling investment opportunities for a number of reasons, including: 1. Offers attractive risk-adjusted returns - There is now evidence that investors can achieve attractive returns and drive positive societal change. Some research shows that companies that are considered leaders in ESG performance enjoy lower cost of capital and strong stock performance. 2. Incorporates ESG related risks - Social finance offers another way to evaluate and incorporate risk. Companies that include social and environmental impact as part of business decision-making are better equipped to manage short- and longterm risks stemming from a variety of stresses and systemic shocks, including climate change, policy shifts, commodity price volatility and political instability. 3. Meets growing client demand for social and environmental impact - Demand is growing for social finance products, thanks in part to interest among clients and beneficiaries to align investment decisions with their values. For millennials and women – two growing investor demographics – the desire for positive impact is even higher. 4. Protects and generates long-term value - Addressing social and environmental challenges contributes to the long-term health of the economy, from which investors benefit. Rising demand for food and resources globally, coupled with the likely effects of climate change, will continue to change the way we create investment value in the long run.

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Source: BNY Mellon research report, Social Finance at Scale: Creating Value of Mainstream Investors

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Looking back almost 20 years, attitudes towards the consideration of non-financial factors in investment decision-making have done a 180-degree turn.

Times have changed Closer to home, social finance impacts are already emerging via investor demands and regulatory changes. In particular, pension plan sponsors are now beginning to investigate implementing ESG solutions. Looking back almost 20 years, attitudes towards the consideration of non-financial factors in investment decision-making have done a 180-degree turn. Where once pension funds argued that they could not consider these because their sole fiduciary obligation was to make sure that the plan’s pension liabilities were covered, the opposite view has now taken hold. Part of this change in attitude can be traced to the landmark 2005 Freshfields report that concluded that plan sponsors can take non-financial factors into account when evaluating investments. Significantly, the study also found that, in certain cases, failure to consider ESG issues may constitute a breach of fiduciary duty. What ESG means to Ontario pension funds ESG’s effect on Ontario pension funds will come into play with the upcoming regulatory changes to Statements of Policies and Procedures (SIPPs). Effective January 1, 2016, existing pension plan administrators must file SIPPs with the Financial Services Commission of Ontario (FSCO) within 60 days. Prior to these regulatory changes, while every pension plan registered in Ontario was required to have a SIPP, the SIPP did not have to be filed with the regulator. Now, plans registered on or after January 1, 2016, must file the SIPP within 60 days of the plan’s registration. In addition, SIPPs must now include information about whether ESG factors are incorporated into the SIPP and, if so, how the ESG factors are addressed in the plan’s investment strategy. Any SIPP amendments must be filed within 60 days after the amendment is made. The regulatory amendments do not require plan administrators to include ESG factors in their investment decision-making process; the requirement is limited to disclosing whether or not ESG factors are considered when making investment decisions. If ESG factors are incorporated in the plan’s investment strategy, then plan administrators must disclose how the ESG factors are incorporated.

For existing pension plans, plan administrators must file their SIPP with FSCO within 60 days after January 1, 2016. For plans registered on or after January 1, 2016, the SIPP must be filed within 60 days after the plan is registered. Also, any amendment to a SIPP must be filed within 60 days after the amendment is made. It should be noted that there may already be a partial ESG issue for all jurisdictions that have adopted the Canadian federal investment rules. Those rules require SIPPs to deal with the retention or delegation of voting rights acquired through plan investments. How proxies are voted is seen by many to be an integral part of the fiduciary duty to make investment decisions in the best interests of plan members. How a fiduciary votes proxies is part of the governance ‘G’ in ESG, so how proxy voting is addressed in the SIPP may also have legal implications and ought to be consistent with ESG disclosure. But what exactly could this new disclosure requirement mean for administrators of registered pension plans in Ontario? Some industry stakeholders believe it’s a signal that Ontario feels that ESG factors must be considered by pension plan fiduciaries, while others believe it’s simply an attempt to address transparency. Whatever the rationale, Ontario pension plans need to be careful when inserting any statement about this in the SIPP.

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More than just transparency

Mandatory ESG disclosure goes beyond transparency. At the very least, it acknowledges the potential importance of ESG for fiduciary investment processes.

The Ontario Report of the Expert Commission on Pensions, stated,

“…it remains somewhat uncertain precisely how, in practical and legal terms, the decisions of trustees and administrators to pursue socially responsible investment (SRI) can be reconciled with their duty to maximize the plan’s investment returns for the benefit of its active and retired members. However, there is a growing global consensus that trustees must at least have a considered and informed discussion on the issue.” Industry experts agree that the requirement to disclose information about whether and, if so, how, ESG factors are to be incorporated into the investment decision-making process does not provide legal clarity. They agree that it does mean there will be transparency, but it also signals that trustees must have a considered and informed discussion since they will not be able to reference ESG in a SIPP one way or the other without discussion about whether or how to take such considerations into account. However, mandatory ESG disclosure goes beyond transparency. At the very least, it acknowledges the potential importance of ESG for fiduciary investment processes. But it also shines a light on fiduciary liability for these issues. As a result, pension fund administrators need to understand and consider the relevance of ESG issues for their particular pension funds; for example, the degree to which ESG factors are incorporated. Sample Structures for ESG disclosure in SIPPS:

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No consideration: The plan explicitly contemplates investment/ financial performance only, with the exclusion of ESG factors.

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Additional lens: ESG analytics as an additional lens to assess value and to provide precautionary risk management.

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Tie breaker: Selecting between two otherwise equal investments subsequent to financial considerations being deemed equal or approximately so.

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Purpose-driven: An explicit focus, for example on impact investing where the social outcome is given equal or greater weighting to financial considerations.

ESG solutions Leveraging BNY Mellon, CIBC Mellon custody and accounting clients can access and benefit from social finance solutions such as ESG screening. With BNY Mellon Global Risk Solutions, clients can also measure their ESG performance and attribution to peer groups and industry leaders with data sourced from MSCI ESG Research, as well as monitor compliance by screening investment objectives and guidelines. BNY Mellon provides a wide array of social finance solutions including: •

Socially responsible investment funds

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Servicing environmental trusts and escrows, green bonds and insurance-linked securities

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Global depository receipt programs

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Glossary of Social Finance Terms social finance

Social finance is an approach to mobilizing private capital that delivers a social dividend and an economic return to achieve social and environmental goals. Mobilizing private capital for social good creates opportunities for investors to finance projects that benefit society and for community organizations to access new sources of funds.

socially responsible investing (SRI)

Also known as sustainable, socially conscious, “green” or ethical investing, it is any investment strategy which seeks to consider both financial return and social good. In general, socially responsible investors encourage corporate practices that promote environmental stewardship, consumer protection, human rights, and diversity.

Environmental, Social and Governance (ESG)

ESG is a set of standards for an organization’s operations that socially conscious investors use to screen investments. Environmental criteria consider how a company performs as a steward of the natural environment. Social criteria examine how a company manages relationships with its employees, suppliers, customers and the communities where it operates. Governance deals with a company’s leadership, executive pay, audits and internal controls, and shareholder rights.

green bonds

Tax-exempt bonds which have similar features to regular bonds, but offer investors the opportunity to participate in the financing of ‘green’ projects, for example those that help mitigate climate change. The proceeds raised from the bond sale are placed in a subaccount, or are otherwise tracked, on the balance sheet of the issuer. The proceeds are used to finance green projects, potential Green Project categories such as renewable energy, energy efficiency, sustainable waste management, sustainable land use and biodiversity conservation. In a recent example, BNY Mellon was appointed by the Province of Ontario to service the province’s first green bond.

impact investing

Directing investment to generate specific beneficial social or environmental effects in addition to financial gain – for example, investing into companies that create jobs in low-income neighbourhoods, into clean technology enterprises or into non-profit agencies via social impact bonds. Impact investing is a subset of socially responsible investing, however SRI also encompasses passive or negative screens such as avoiding a certain sector or company. For more information, visit the MaRS website.

social impact bond

Social impact bonds (SIB) are designed to enable governments to raise private capital investors to generate positive return through investments into social good. SIBs derive their name from the fact that their investors are typically those who are interested in not just the financial return on their investment, but also in its social impact. In a common structure, SIBs are a contract with the public sector or governing authority, whereby the bond pays for better social outcomes in certain areas and passes on part of the savings achieved to its investors. Under a SIB, repayment and return on investment are contingent upon the achievement of desired social outcomes. If objectives are achieved, the investors earn a financial return in addition to achieving their social good goals. If the objectives are not achieved, investors receive neither a return nor repayment of principal. For more information, visit the MaRS website.

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http://research.cibcwm.com/ economic_public/download/ sep18_15.pdf

Social finance encompasses diverse investment strategies and products across asset classes that deliver a range of risk-adjusted returns and align with different investor motivations and goals.

Social finance impacts are already emerging via investor demands and regulatory changes. In particular, pension plan sponsors are now beginning to investigate implementing ESG solutions.

For more information, contact your relationship executive or account manager.

About CIBC Mellon CIBC Mellon is a Canadian company exclusively focused on the investment servicing needs of Canadian institutional investors and international institutional investors into Canada. Founded in 1996, CIBC Mellon is 50-50 jointly owned by The Bank of New York Mellon (BNY Mellon) and Canadian Imperial Bank of Commerce (CIBC). CIBC Mellon’s investment servicing solutions for institutions and corporations are provided in close collaboration with our parent companies, and include custody, multicurrency accounting, fund administration, recordkeeping, pension services, securities lending services, foreign exchange settlement and treasury services. As at June 30, 2015, CIBC Mellon had more than C$1.5 trillion of assets under administration on behalf of banks, pension funds, investment funds, corporations, governments, insurance companies, foreign insurance trusts, foundations and global financial institutions whose clients invest in Canada. CIBC Mellon is part of the BNY Mellon network, which as at June 30, 2015 had US$28.6 trillion in assets under custody and/or administration and US$1.7 trillion in assets under management. For more information – including CIBC Mellon’s latest knowledge leadership on issues relevant to institutional investors active in Canada – visit www.cibcmellon.com or follow us on Twitter @CIBCMellon.

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This article is provided for general information purposes only and CIBC Mellon and its affiliates make no representations or warranties as to its accuracy or completeness, nor do any of them take any responsibility for third parties to which reference may be made. This article should not be regarded as legal, accounting, investment, financial or other professional advice nor is it intended for such use.