The developed world’s focus on more easily measurable environmental metrics is happening to the detriment of social impact. Investors are trained to focus on the most material risks and opportunities that are measurable, but this can miss the bigger picture, ignoring material risks and opportunities just because they are not easily put in a spreadsheet.
Regulation drives direction of changes
Regulators can encourage investors to improve their focus. In February, for example, the UK’s Financial Conduct Authority (FCA) issued Discussion Paper DP 23/1 “Finance for positive sustainable change: governance, incentives and competence in regulated firms” with the objective of seeing how firms embed a clear purpose relating to sustainability and “how firms’ governance, incentives and competencies align with their integration of sustainability‑related considerations and their commitments to contribute to positive change”.
We cannot help but notice the emphasis on environmental metrics at the expense of social.
We fully support the FCA’s objectives in creating a regulatory framework that is reflective of the Financial Reporting Council’s Stewardship Code. These initiatives should continue to improve stewardship activities among UK regulated firms.
However, we cannot help but notice the emphasis on environmental metrics at the expense of social. “Climate” and “net zero”[1], for example, appeared in the discussion paper 234 and 126 times respectively, while social is mentioned only 26 times.
Although the FCA Discussion Paper might not highlight social factors, it should improve focus on Governance, much like voluntary associations with the UN’s Principles for Responsible Investment (PRI) and the Stewardship Code. These two initiatives have shown that for a meaningful impact in stewardship, investors must have an in-depth bottom-up understanding of the businesses, industries, and specific circumstances of the companies in which they invest.
Engagement on proxy yields positive impact
This year we decided that in order to improve our stewardship approach, we would engage with management over every AGAINST recommendation by our proxy voting research provider. We found several factual errors in the research, and as a result of our engagement, the research provider amended its recommendations.
What has become clear is that aside from discovering factual inaccuracies, deep knowledge and understanding of a company’s situation permits far more than a binary FOR/AGAINST decision. A broad understanding of an investment firm’s proxy voting policies may allow fastidious adherence to those policies. But we believe that far more productive engagement is possible when proxy voting is undertaken by the analysts who understand in depth the relatively small number of companies that they follow. Rather than mechanically responding to a box-ticking exercise, we see considerable scope to reduce risk for shareholders by engaging with management, helping them to understand how they may be able to find more appropriate or lower-risk proposals to present to shareholders.
An interesting example came about recently following a proxy recommendation that we believe would have increased governance risk instead of reducing it. A company recently merged with a competitor, and will be undergoing merger integration over the next 12-24 months. The merged board will have two independent directors from each company, with term limits of five years. The independent directors from one of the companies had served for more than 10 years, and in April the research provider recommended voting against their reappointment as the term served will have been too long for them to be viewed as independent.
We engaged with management to discuss the excessive terms versus the risks inherent with having completely new independent board members over a critical integration period. We agreed on a compromise, namely to reduce the term of the independent directors to one year, during which most of the integration would have taken place. This would significantly reduce integration risk, and we would have a short period of one year before the appointment of new independent board members.
In another recent example, the proxy research provider’s recommendation was to vote AGAINST the remuneration of an Indian company’s CEO, primarily because the remuneration had not been linked to the company’s profits. However, s198 of the Indian Companies Act of 2013, standardises the way profit is calculated to avoid manipulation by managements. Despite management performing well during the pandemic, there are significant losses being carried forward. Under the s198 calculation these losses must be deducted from future profits.
On engaging with the management and indirectly with the remuneration committee, we agreed on a compromise with the company, that the Board should set revenue and EBITDA targets, thus linking remuneration with the company’s current performance. The proxy research provider amended its research recommendation to FOR with a qualification.
The Stewardship Code and the PRI help investors move away from box-ticking (e.g., reporting on how many times they voted AGAINST management) to using their industry knowledge and relationships to guide management to better governance outcomes, as we show in the two examples.
Social needs more focus
The regulatory efforts to help investors to focus on social measures are lacking, in our opinion. Investors are focusing on what can be measured inside the company, like privacy and data security, labour practices and diversity. But there is insufficient focus on the impact that these companies have on the companies’ customers and on communities and broader society through the products and services that they offer. These impacts, while admittedly difficult to measure, can be hugely more meaningful.
If there is one lesson that we learned from the pandemic, it was how closely we are connected to and dependent on the actions of people everywhere in the world. We would hope that this lesson would translate into investors being more aware of the social effects of their actions and striving to include them in their ESG processes to drive real impact. We would also like to see regulators increasing accountability for the social element of ESG, focusing on societal outcomes rather than introspective policy implementation.
However, the imbalance between the E and the S continues. We see this as a mistake because we believe that humanity’s biggest challenge is to meet the social needs of all within the environmental boundaries of our planet, and we cannot address the challenge without equal focus on the E and the S.
[1] Search included both “net zero” and “net-zero”
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Trinetra Investment Management LLP and are subject to revision over time. Trinetra is authorised and regulated by the Financial Conduct Authority in the United Kingdom.