Financial decisions not value-free

Financial decisions not value-freeMore than sixty years ago, psychologist Abraham Maslow advanced a theory that he termed the 'hierarchy of needs' which explains the way that — as each human need is met — we strive towards increasingly cerebral goals. It is this hierarchy of needs that helps explain why Australians saw the environment, a century ago, as a foe to be tamed, whereas today its beauty is highly prized. More prosaically, our yardsticks for the value of an asset have broadened from basic measures of its immediate economic capacity to encompass non-financial, perhaps even non-empirical, benefits such as future prospects and aesthetics. How might financial decisions contribute to higher needs, specifically sustainability?

What is sustainability in the context of finance? Googling 'sustainable investing' or something similar throws up thousands of hits covering reports, advice and money sinks at the United Nations, non-government organisations and financial institutions. Most of this is a long-winded recitation of platitudes, with little actionable advice. The reason, of course, is that the meaning of financial sustainability is not clear, not even to banks promoting their green credentials.

To me, sustainability covers multiple topics — particularly the environment, society and economy — and minimises the harmful future impact of decisions. This especially includes impacts that are either not included in conventional analysis (so-called externalities) or those that are diminished in value today by discounting future cash flows. Thus adopting 'sustainable objectives' signals a bias towards longer term goals and places greater value on less quantifiable future costs and benefits. This raises two important challenges. The first is that a longer-term perspective will axiomatically incur immediate expenses or opportunity cost. The second is that a more distant horizon introduces greater uncertainty, which imposes the need for risk management across a longer time frame and over a wider set of exposures.

More specifically, sustainability in finance avoids harmful impacts, now and in the future, on markets, financial institutions and firms. Sustainable investors will not seek short-term gain if this increases market volatility and uncertainty, and renders markets less efficient; similarly firms will promote stabilising strategies, including ethical dealings, with an eye to longevity. Investors will seek out financial institutions that adopt sustainable practices, including refusal to fund damaging projects and a preference for promoting stability in markets. Finally sustainable investors will commit their funds — whether as equity or debt — to firms with sustainable business practices and products.

Although most investors still ignore sustainable factors or pay only lip service to them, their decisions could promote sustainability in three ways: choice of financial institution; investment strategy; and investment selection. Consider each in turn:

Choice of Financial Institution

Most investors need to use financial intermediaries such as banks, stock brokers, and advisors. These institutions have ample information to assist (or otherwise) customers with particular needs. In short, they can tailor the allocation and cost of capital and management of financial risks to promote sustainability. Thus, to invest in sustainability one should prefer banks that have signalled a sustainable bias, for instance by adopting the 'Equator Principles' that ensure they only fund projects that meet minimum environmental and social standards, irrespective of local requirements.

Investment Strategy

Turning to investment strategy, this relates to allocation of funds between asset classes (shares, property, bonds and so on); the level of borrowings we choose; and the nature of trading. Sustainability avoids short-term goals such as a high turnover of investments or focusing on short-lived arbitrage, and avoiding securities or funds with speculative intent. Investment objectives should be matched to long-term needs, with borrowings that can be confidently serviced and an income stream that will meet future requirements. Some funds should be deliberately directed towards helping to finance start-up firms that have difficulty accessing capital, but have sustainable technologies and business models that offer breakthrough opportunities.

Investment Selection

Financial decisions not value-freeThe final choice relates to individual investments. Superficially this seems simple: select from the wide range of funds and firms that are described as ethical, socially responsible or green. Few of these, however, meet the test of sustainability. For a start they typically underperform the market over the long term: our definition of sustainability eliminates investments that are inefficient. Second, many of these funds use coarse filters such as industry classification or products sold to eliminate investment candidates: refusing to invest in politically incorrect, although quite legal, firms promotes little beyond the feelgood factor.

Many funds take a narrow view of sustainability, and focus, for instance, on minimising use of non-renewable natural resources. Similarly, firms will affect a sustainable stance to give the appearance of being sensitive to the issue, rather than having any real commitment to its substance. Unfortunately, too, most lists of sustainable-type investments are based on questionnaires that do not get to the heart of a firm’s strategy, and whether it really contributes to sustainability.

A better selection tool is required, and fortunately some guides do exist. Generation Investment, for instance, is a fund manager partly owned by former Vice-President Gore that chooses its investments using a broad set of sustainability criteria. The Dow Jones Sustainability World Index identifies leading companies from a mix of long-term economic, environmental and social criteria. Both include General Electric, and have a heavy tilt towards leading banks and technology innovators. The Dow Jones Index is 16 per cent resource companies and 13 per cent industrials, with around 16 Australian firms including BHP Billiton, Tabcorp and Westpac Bank.

Although there is a dearth of useful information on truly sustainable investments, markets have a propensity to generate information, and we can expect knowledge gaps to be closed in coming years and facilitate sustainable investing.

Sustainable investing requires an eye to long term risks. Intuitively, unsustainable practices have adverse financial consequences, so financial risk is closely linked to risks from non-sustainability. Whilst hard to identify, these latter risks involve possible damage to the long-term viability of a firm or market. Some are behavioural such as unethical practices, poor quality products and weakening reputation. Other risks are sourced in products or processes that have long-lived effects and so could prove damaging in the future. To complicate this issue, many of these risks are — true to Maslow — evolving in light of new technology, and with changing social and economic systems.

If from this article you have concluded that sustainable investing is complex then you are correct. The other objective of this article is met if you still remain committed to using your financial decisions to promote sustainability. Investors are buyers of financial products and services and this affords them a unique opportunity to shape the nature of markets and financial institutions. Financial decisions are not value-free, and investors should not be shy to use their power to promote sustainability.

 

 

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