Iggo's insight

Be Responsible

The logic of responsible investing comes from its appeal “of doing the right thing”. If responsible investing reduces risks and contributes to better outcomes, then it is beneficial to individuals and society alike. The case should be made that responsible investing creates a better outcome to the investor because it reduces risks and raises future welfare. It is becoming central to how money is managed. In the equity space, the growth of impact investing as a driver of equity strategies is really the saviour of active investing.         

 

High in the Alps

The annual gathering in Davos for the World Economic Forum has attracted the usual amount of attention from financial news services. Again, climate change and responsible investing have been at the centre of Alpine discussions. The financial sector is certainly keen to be seen as doing something to help the global economy transition to a lower carbon footprint. Asset managers and bankers alike are committed to further integrating environmental, social and governance factors into their business models and helping to direct capital to economic activities that attract fewer ESG risks and, importantly, have a positive impact on the future world by helping achieve progress towards what the United Nations have characterised as Sustainable Development Goals. While cynics might scoff at the idea of a lot of rich financiers flying from all around the world to suggest that the system that delivered their wealth in the first place needs to change, the reality is that change is happening whether led by CEOs or not. Today, it is difficult to find an asset manager that has not put responsible investing at the forefront of its business model. Recognition of the risks to life as a result of climate change is at record levels and all aspects of economic behaviour are changing to try and combat it. Consumers are changing their spending habits to support more sustainable production, packaging and transportation. Companies are investing to shift towards more sustainable business models in terms of energy use, waste production, and social impacts. Buildings are being erected that are more energy efficient and from materials that are more sustainable than concrete and glass. More and more, economists are factoring in climate change risks to long-term economic growth forecasts. This will become important for government policy as the impact of climate change on weather events, the physical infrastructure, health and agriculture become more evident and require public money to combat. Central banks and supervisors are starting to incorporate ESG into their systemic risk models. I am not sure that the public is ready yet to trade away economic growth for a safer planet, but the public mood has definitely swung towards greater recognition of climate and other risks to the extent that it is impacting individuals’ behaviours and leading to a swell of public opinion demanding more activist public policies.

 

Utility

Humankind generally wants good outcomes and better futures. Our species has delivered better standards of living since cavemen began fashioning tools out of twigs and stones. The intrinsic desire to achieve greater happiness and wellbeing was incorporated into the study of economics by thinkers like Jeremy Bentham and John Stuart Mill in the 19th century. They hypothesised that humans make choices on the basis of the utility derived from the outcome of those choices, allowing decisions to be ranked with preferences for those choices that deliver the higher levels of utility. Generally, consumption generates utility for individuals (there is also the concept of marginal utility but that is for another discussion). Consumption is governed by income but within that constraint consumers are able to make choices that deliver the maximum level of utility or as Mill put it, the “greatest happiness”.

 

How we think about the future

I have been thinking about responsible investing in this context. Consumption delivers utility. However, subject to the income constraint, utility is also generated by the prospect of future consumption. Individuals consume today and save to consume in the future. Indeed, the very act of saving suggests that a level of future consumption generates a higher level of utility than maximising current consumption. The current discounted utility of future consumption depends on a number of factors. One is the expected rate of return. A second is the expected certainty of that rate of return, essentially the volatility of returns from the savings-investment strategy. I would also argue that there is a third factor that impacts on the current utility of future consumption and that is the expected quality of life in the future. If one thinks that the future world is going to be a horrendous place, then the incentive to delay consumption is not going to be very high.

 

RI can boost utility

Responsible investing can be looked at in this context. If we assume people save (and purchase investment products with those savings) because they are maximising their utility function through the expectation of higher consumption in the future, then we need to think about the risks to that utility. The volatility of the returns of any investment strategy is linked to the risks to which the capital is exposed – the economic cycle, interest rates, inflation, creditworthiness and the ownership of business models across a range of economic sectors. What ESG investing does is identifies the non-financial risks that can create volatility of returns through time. For example, being exposed to industries that are seeing a significant change in consumer demand because of the increased awareness of the damage done by carbon emissions, such as the growing demand for electric vehicles. These ESG risks need to be identified and the materiality of those risks need to be assessed. They can materialise and impact financial returns through changing consumption, regulation of through the realisation of negative externalities (pollution, social impact etc). As such, ESG should be primarily seen as an approach to managing risk and through embedding ESG into the investment process, investment strategies can improve the risk-return profile. Reducing risks coming from ESG exposure should boost returns over time as ESG investing should curtail the left-tail of the distribution of returns. Thus an ESG approach can boost the utility of future consumption by reducing risk and smoothing investment returns.

 

Impact aims to deliver a better future 

An increasingly important aspect of responsible investing is impact. While ESG focuses primarily on managing the risks that come from exposure to ESG factors, impact is concerned with investing in activities of producers of goods and services that will improve the quality of the future world. It has become a standard approach in impact investing to target activities that help achieve one or more of the UN’s Sustainable Development Goals (SDGs). These goals include climate action, reducing poverty, gender equality, life on land and in water, and sustainable cities and communities. Impact investing focuses on how companies navigate through product evolution and how their operations can contribute to achieving these goals and thus improve the welfare of future generations. To this extent, impact investing generates utility for today’s investor in that it aims to improve the quality of the future, something which, in turn, has a positive impact on the extent to which future consumption can be enjoyed. Individuals will get greater pleasure from consuming if they feel that the future world is one where there is control of climate risk, reduced inequalities and better quality of health provision globally, than they would in a world where there has not been progress towards these goals. Of course, ESG investing will also have positive public externalities for the future through the allocation of capital favouring activities and products that do improve the quality of life and not favouring those that create negative social and environmental costs.

 

Be selfish and save the planet

In time I fully expect these trends to be confirmed in better investment returns as a result of ESG integration and impact investing. Certainly the theme of impact is surely the way forward in equity investing given that it is focussed on technological change and innovation of processes that reduce “costs” and improve productivity and wealth creation. That is the normal course of economic history but today, because of technology and the need to address climate and other risks, the speed of innovation and the disruption that can bring to traditional business models is tremendous. Indeed, the increased pace at which society is craving for transition to a lower risk future and the pace at which business is adapting make an irrefutable case for active equity investing. Only active managers to allocate capital to those companies that have the greatest contribution to economic evolution. They will not all be winners, but there will be winners and active managers have a better chance of spotting them. For now, the message for me is clear. Responsible investing provides greater utility to the investor because it has the ability to reduce the risk to investment returns without necessarily reducing the actual return while also allowing for a better-quality future when the savings come to fruition. One can be altruistic and selfish at the same time. The utility created by this approach is both enjoyed by the individual and by society as a whole. It is win-win and the planet has a better chance of surviving. We should all be responsible investors.

 

Diminishing utility

I wish I could be as optimistic about the quality of the future for Manchester United. But that’s enough of that depressing subject.  

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