Poor governance can lead to spectacular corporate failures. In most cases – Enron, Parmalat, Lehman Brothers, MF Global, and major US and European banks — shareholders aren’t the only ones to lose out; bondholders are also affected.

It should be second nature for institutional investors to pay careful attention to corporate governance as a source of both risk and opportunity. As owners of, or lenders to, companies, they have a duty to seek out good governance but also be on the alert for conflicts of interest between their objectives and senior management. Poor governance can lead to spectacular corporate failures. In most cases – Enron, Parmalat, Lehman Brothers, MF Global, and major US and European banks — shareholders aren’t the only ones to lose out; bondholders are also affected.

The global financial crisis also exposed public finances to the effects of private governance risk and led to a dramatic loss of confidence in the underlying structure and operation of international financial markets.

Aside from governance, environmental and social problems also present considerable, if less obvious, risks to investors. There are compelling examples where these factors have played a significant role in a credit rating downgrade, default or even collapse of a company. BP, TEPCO and Lonmin are recent examples of companies that have suffered significant financial losses due to issues outside traditional considerations of balance sheets and governance. These companies have seen their costs of capital rise (BP yields jumped to as much as 8.7 percent following the Deepwater Horizon oil spill), and the value of their outstanding bonds or credit default swaps (CDS) fall dramatically.

The relationship between credit quality and, for example, a company’s health and safety performance or energy efficiency is inevitably complex. Creditworthiness is a function of a company’s profitability, productivity, competitive position, as well as estimated future value and cost of capital. All of these elements can be linked to ESG factors. Climate change regulations can increase capital expenditure and erode an energy company’s margins. Significant fines for polluting activities can reduce cash flow. Child labour scandals can destroy brand value. Corruption cases can lock companies out of government contracts, while the exposure of fraud can see investor confidence evaporate overnight. Equally, good employee relations can increase productivity or reduce the risk of damaging strikes.

Investor impetus

In signing up to the PRI, institutional investors commit to incorporating ESG factors into their decision-making processes. They do this in the belief that these issues can affect long-term investment performance across all asset classes.

Pension funds, insurers and other asset owners allocate a significant proportion of their funds to fixed income. For the average pension fund, this is roughly a third of all assets. Investment-grade corporate and sovereign bonds are typically considered the bedrock of institutional investors’ portfolios from a risk perspective. The characteristics of fixed income, combined with its role of providing a stable source of income, lend this asset class particularly well to a risk-averse approach.

In interviews with working group members4, it seems the focus has historically been on assessing the potential exposure to downside risks. Christoph Klein, managing director at Deutsche Asset & Wealth Management, which manages US$1.24 trillion of assets, says the aim of using analysis on ESG factors is to uncover hidden risks. The CAD184.7 billion (US$176 billion) Canadian pension fund Caisse de dépôt et placement du Québec uses ESG as a risk flagging tool — effectively a starting point for discussions among the investment team, according to Director Marie- Claude Provost.

“ESG can raise issues of risk that have not been raised by traditional analysis. It’s a more comprehensive way of looking at risk.”

George Dallas, F&C Investments

Aside from financial risks, failings relating to ESG factors pose significant risks to an investor’s reputation. Speaking at the PRI’s 2013 annual conference in Cape Town, Bill McGrew, a portfolio manager at US$261 billion US pension fund CalPERS, reported how important it was for the fund’s external managers to show they understand and consider ESG risks in their investment process, but stated that it is equally important that CalPERS’ reputation is not damaged by the actions of companies to which it lends.

This question of reputational risk to underlying investors has a growing capacity to be exploited by a range of social interest groups and NGOs using social media channels as an initial platform. The recent divestment campaigns in the US are an early example.

Other drivers for responsible investment relate to an investor’s particular mission or mandate. Adherence by issuers to certain norms such as human rights conventions is a common requirement for investors. Many asset owners — especially those representing public sector workers or charities — consider long-term social and environmental stewardship to be part of their responsibility to their beneficiaries.

“We have retirees who depend on us now for the income they live on, but today’s 25-year-old participant may well be relying on us four or five decades from now to translate those investments into a steady stream of lifetime income,” says Roger Ferguson, president and CEO of the US$542 billion US teachers’ pension fund TIAA-CREF. “By virtue of our mission, we’re in it for the long haul.”

For investment managers, the impetus comes first and foremost from customers. “It’s all about client demand,” says Meg Brown, a consultant at £34.8 billion (US$56 billion) UK-based fixed income manager BlueBay Asset Managers. Brown estimates that up to a half of all clients ask about its capacity to identify and report on ESG-related risks.

“There is almost always a question about ESG capabilities in RFPs. We don’t win mandates because we’re good at ESG, but we would certainly lose them if we didn’t cover it.”

Christoph Klein, Deutsche Asset & Wealth Management

Discussions about corporate governance and sustainability in investment mandates, Request for Proposals (RFPs), and meetings between fund managers and their clients are currently focused on investment strategies rather than outcomes. Asset owners are more focused on mitigating downside risk than on outperformance, and tend not to be prescriptive.

There may also be a case for looking at ESG factors as leading indicators of creditworthiness. Investment managers may overweight higher-yielding bonds where the rest of the market has failed to identify the potential for significant ESG improvements, e.g. a brewery introducing new technology to improve water efficiency or to better manage energy demand or emissions profiles in its supply chain.

Whatever the impetus for learning and taking action, interest is clearly growing.