The Evolution of SRI: Introducing Version 3.0
Society adopts innovative technologies by a process that business schools describe with an “S-curve,” as on the graph below. The vertical axis represents the rising percentage of society using the technology while the horizontal axis represents time.
In the first stage early adopters represent a small, slowly rising percentage of society. At a certain point, however, the adoption rate accelerates sharply, steepening the curve, as the technology’s benefits gain widespread acceptance. Once fully diffused through society, the adoption rate levels off and the curve flattens.
For the past 30 years socially responsible investing (SRI) has steadily gained mindshare in society. SRI’s focus on sustainability and environmental, social and governance (ESG) risks is becoming widely accepted – on Wall Street, in corporate boardrooms, and among the investing public in general. We’re moving into the steep, accelerating part of the S-curve.
It’s an exciting time and, indeed, we’re on the cusp of a major transition in both the investment discipline itself and its impact on society. Appreciating SRI’s evolution can help us understand the changes that lie ahead.
SRI 1.0: Ethical Alignment
In its earliest and simplest form SRI 1.0 was (and is) about screening. Screening excludes certain companies from one’s investment universe based on their negative social profiles while including others with more positive or at least neutral profiles. On this approach, SRI means avoiding the bad guys and profiting from the good (or at least okay) ones. Even today, this is what many people think of as SRI.
In 1988 I hosted an SRI conference whose keynote speaker was David Jones, a former vice president for public relations at a major pharmaceutical company. David’s speech was titled, “Radicals, Romantics and Realists: Different Approaches to Corporate Social Responsibility.” It landed like a bombshell.
He told the audience that as head of PR he considered it a “win” when his company was put on some group’s “no buy” list. Why? Because it meant the group was effectively self-censoring. If they weren’t shareholders, they had no voice in his company. He didn’t have to deal with them.
On the other hand, he noted the dread the CEO felt at the prospect of facing the notorious activist, Sister Regina, at the annual shareholder meeting. As a shareholder she would attend in her nun’s habit and ask informed, pointed questions about the company’s performance on various social issues. Jones said the CEO would do almost anything to avoid that PR nightmare, agreeing to Sister Regina’s proposals in advance if she would withdraw her proxy resolution.
Jones then drew a distinction that is underappreciated even today. He said that if one’s goal in pursuing SRI is personal ethical alignment (not profiting from activities one objects to), avoidance screening is a perfectly adequate means to that end. However, he also said if one’s goal in SRI is social change, avoidance screening was ineffective and possibly counterproductive.
Ethical philosophers put this distinction in terms of “self-regarding” vs. “other-regarding” moral objectives. Jones’ first point was that avoidance screening is a self-regarding exercise. His second point was that if one’s goal in SRI is other-regarding, screening is beside the point. Screening – as Wittgenstein famously said of philosophy – “leaves the world as it is.”
Jones’ central message was clear: If you want to change the world by changing corporate behavior, you need to be a shareholder and use the power that voice gives you.
SRI 2.0: Activism
The shareholder activist approach to social change is SRI 2.0. Over the past fifteen years this approach has gained precedence and come to be seen as a requirement for state-of-the-art SRI. But shareholder activism itself has evolved over time.
In the beginning shareholder resolutions made appeals to corporate managements based on moral suasion (see Sister Regina). That is, they urged companies as corporate citizens to do the right thing because it was the right thing to do.
Over time, shareholders began to identify the connection between companies’ social performance and their financial returns. The environmental coalition Ceres (which Trillium created) is perhaps the most notable example of this approach, having connected the dots between environmental issues like climate change and the risks they pose to long term corporate profitability.
Ceres took environmental issues straight into the corporate wheelhouse: profit-seeking. As economist Milton Friedman provocatively asserted in his critique of corporate social responsibility (I paraphrase): the social responsibility of corporations is to seek profits. Period.
Whether or not you agree with Friedman, it’s true that shareholder appeals that rely on moral suasion fail to engage the core energies of a firm. Such appeals tend to be fielded by investor relations officers, PR flacks, etc. – i.e., not people who set corporate strategy or drive operating units.
In December 2006 the Harvard Business Review ran a piece devoted to this problem called “Strategy and Society: The Link Between Competitive Advantage and Corporate Social Responsibility.” It argued that the most effective appeals to corporate social responsibility are those that offer firms some strategic commercial advantage.
Such appeals don’t ask for altruism from corporate management. Rather, they attempt to enlighten management’s self-interest, that is, to engage the firm’s profit motive by demonstrating a connection between a social good and improved financial performance.
The adoption of nondiscrimination policies for gay, lesbian, and transgender employees in the workplace is a perfect example. It’s the “right” thing for companies to do, but it also gives them a competitive advantage in hiring and retaining talented employees who happen to be gay, and hiring and retaining talented employees is a key challenge of every firm. This is why 89 percent of Fortune 500 companies have adopted such policies. It’s a social good, to be sure, but it’s also good for business.
Over the past thirty years the evolution of SRI has proceeded along two converging tracks. One has taken us from a self-regarding concern with personal values to an other-regarding, activist focus on social change. The other has moved us from a rhetoric of moral suasion to a demonstration of the financial import of social issues.
Each of these developments naturally broadened SRI’s engagement with traditional investors and corporate managements. Together, they converged on a formula that today defines SRI’s distinctive contribution to society: translating social goods into profit-seeking concerns for both corporations and traditional investors.
At the heart of such translation is the notion of “shared value,” that social good and financial return needn’t be opposing values in a zero-sum game; rather, they can be two different expressions of a single positive outcome. This is certainly the case with companies adopting non-discrimination policies for gay, lesbian, and transgender employees in the workplace. It is both a social and a commercial good.
This shift to a more integrated perspective has led to the incipient “mainstreaming” of SRI. Today stock analysts from Goldman Sachs to UBS are beginning to pay attention to ESG factors and issues of sustainability. They’re doing so not out of altruism or any left-leaning political sympathies, but because they think it can help them make money – and that, I submit, is the key to SRI Version 3.0.
SRI 3.0: ESG Alpha Factors
By harnessing the advanced quantitative methods now available to professional investors, SRI 3.0 will take the field’s genius for translation to the next level. SRI 3.0 will identify, test, refine and systematize an evolving set of demonstrable ESG “alpha factors” – that is, quantifiable environmental, social and governance factors that measurably improve corporate financial performance and investor returns. This is what SRI 3.0 looks like.
At Trillium we are actively developing a new investment vehicle that we believe will be state-of-the-art SRI 3.0. It will rigorously integrate quantifiable ESG risk and opportunity factors with traditional investment metrics in the stock selection process. As importantly, our design will allow us to track quite precisely the “alpha” or excess return generated by each investment input, including ESG factors. In this way we will create an ESG laboratory for advancing our understanding of sustainable investing.
This sort of rigorous quantitative analysis of ESG factors wasn’t possible even three years ago. Why? Because enough companies weren’t publishing ESG and sustainability data, for one. We can thank groups like the Carbon Disclosure Project and the Global Reporting Initiative, Ceres, and our fellow shareholder activists for getting companies to publish such data.
You also couldn’t do this sort of analysis before due to a lack of database vendors collecting and organizing ESG data. Today, three of the largest financial data purveyors in the world have moved aggressively into the space: Bloomberg, Reuters and MSCI each now have ESG offerings.
So the use of “quant” tools for SRI is very much a cutting-edge endeavor. (Indeed, the Wall Street Journal reported on the project last November in an article titled, “Quants and Do-Gooders Unite.”1) We see it as part of a more general, accelerating move up the S-curve of a way of thinking about business, society and the planet that has driven SRI for nearly 30 years.
Demonstrating in hard statistical terms the impact of ESG factors on corporate and investor performance will be a long term project, to be sure. But as we and others succeed you can bet that traditional investors will take note, as will corporate managers. Better corporate and investor performance is not a partisan issue. Eventually, we won’t even call them “ESG factors.” They’ll just be things that smart investors and able corporate managers pay attention to.
1 The Wall Street Journal, November 2, 2010