Responsible Investments: Are They Important?

Has a ‘fair go’ for consumers and investors died a slow death in the Australian financial services industry through rotten culture and disregard for ethics and morals, leaving the industry’s social contract in tatters? The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (Royal Commission) has certainly dug the dirt on financial service providers and their poor conduct in relation to customer services and experience. But what about lifting the lid on who organisations are working with and where they source their investment opportunities? Should responsible investments be as important as customer service and experience?

Talking about ‘responsible investments’ really means talking about both socially responsible investing (SRI) and environmental, social and governance (ESG) risks both of which are very different to the financial and regulatory risks we are used to seeing and managing in the financial services industry. ESG risk management is more prevalent in the retail and manufacturing sectors, partly because of existing legislation globally addressing the issue of human rights violations and poor labour practices, which has resulted in those sectors auditing their sometimes lengthy supply chains in response to growing consumer scrutiny.

It would be unfair to say that the financial services industry has been blind to ESG risks, but it is no secret that many focus primarily on the governance-related ESG factors arising from the ASX Corporate Governance Principles and associated corporations legislation.

What is and isn’t ESG?

ESG focuses on mitigating three types of risk:

Environmental: how a company views itself regarding environmental conservation and sustainability. It can include energy consumption, waste disposal and pollution, land development and deforestation

Social: a company’s relationship with its employees and vendors; it can include working conditions such as slavery, health and safety and how supplier values align with corporate values

Governance: corporate governance including the corporate decision-making structure, the independence of the board, the treatment of minority shareholders and executive pay.

Identifying what isn’t ESG is even more important. The assessment of ESG risks is often confused with SRI. SRI involves factoring in client-driven themes and superimposing them onto investments to make them ‘good’ portfolios from a moral perspective. This may mean avoiding certain products such as tobacco or activities such as weapons manufacturing as these may be viewed as ‘bad’ investment choices for a portfolio. While both SRI and ESG seek to address a variety of ESG concerns such as human rights, climate change and ethics, the way each is applied to the investment differs.

Why is ESG Important?

ESG responsible investment is a holistic method of investing and risk management where the sole purpose is financial return and stability. To ignore ESG factors is to ignore risks and opportunities that have a material effect on the returns delivered to clients. The benefits experienced by an integrated ESG risk management strategy differ for investors, asset managers and companies.

For investors, consideration of ESG factors has moved from a ‘nice to have’ to a ‘need to have’ over the past decade. The reasons for this vary but can be attributed to the changing demographic of the global investor base which now includes more women and millennials and a shift in risk appetite resulting from growing pressure to keep ahead of the game. Recent research demonstrates that factoring in material ESG risks during the investment process can help generate high-quality return streams which are likely to be more stable over the long term.

Asset managers are becoming more aware of the key risks and opportunities associated with each company or asset which their clients may wish to deal in and this allows them to better price assets, reducing the risk of overpaying for an ESG risky product or investment.

Companies are now also towing the line because of the shift in appetite and awareness among investors and asset managers. Five years ago, only 25 per cent of the 500 largest companies globally were producing sustainability reports, compared to 80 per cent in 2017. But the production of reports on sustainability are no longer enough. Companies are starting to recognise that ESG risks are just as important as traditional financial risks. 

How Does Modern Slavery Interact with ESG Risk Management? 

We like to think that slavery doesn’t happen on our doorstep, that human trafficking, forced labour, forced marriages and child labour are confined to places of conflict, poverty or natural disasters. But the truth of the matter is that it happens in developed countries, just like Australia

There are currently 4,300 people employed in Australia, ‘off the books’, in labour intensive work within the food and agriculture production sector, textiles, retail and technology industries, the majority of whom are migrant workers. While these industries are more vulnerable to ‘modern slavery’ by their nature (they have complex and constantly evolving supply chains spanning several countries), no industry is immune, and the financial services industry is no exception (see our previous articles Modern Slavery Part One and Modern Slavery Part Two).

It is becoming easier for companies to identify instances of slavery because of the enactment of legislation globally which has promoted compliance with anti-slavery practices and put the issue of transparency in relation to this issue on the corporate agenda. Australian companies who operate in the UK, such as BHP Billiton and Lend Lease, already report on their anti-slavery efforts as part of their UK compliance obligations.

To meet increasing ESG risk concerns, Australian companies such as Woolworths and Wesfarmers have established the Retail and Supplier Roundtable Sustainability Council to act against abuses occurring within their supply chains. Australian investment managers, Pendal Group, note that “modern slavery is not just a human rights issue; it is also a financial issue with potential material implications for investment portfolios”.

Blowing the Whistle on Poor ESG Risk Management

If misconduct is occurring within Australian organisations, those organisations should not be protected from exposure on the basis that those within the organisation are too afraid to speak up. As part of an organisation’s ability to manage their risks and maintain the trust of the community, employees must be given the opportunity to raise concerns over conduct which may have an adverse effect on employee and investor moral and ethical compasses, share price and consumer desirability. Risk management is not just restricted to ethical conduct or traditional financial risk.  ESG risk such as poor working conditions, failure to audit supply chains, inappropriate corporate structures or unfair treatment of minority shareholders are all risks that can have a real effect on an organisation’s finances and reputation and can trigger an employee to ‘blow the whistle’.

The industry has already been put on notice that a comprehensive and effective whistleblowing program will be required with the proposed introduction of the new Enhancing Whistleblower Protections Bill (see our previous article here). Stakeholders are already encouraging organisations to take action to address their exposure to ESG risks such as modern slavery, human rights and climate change. Organisations that establish a comprehensive whistleblowing program, consolidate supplier arrangements, audit ESG risks and build loyalty through greater transparency will join industry leaders to repair the fallout from the Royal Commission.

What Next?

The rise of investor awareness of ESG risks in the last decade, combined with an inevitable shift in regulatory tolerance, has brought issues of risk to the top of board agendas. Meaningful disclosure of risks integrated with comprehensive and effective risk management procedures can and will contribute to an organisation’s competitive advantage and strengthen long-term financial stability. Don’t be left standing in the cold asking “what went wrong?”.


Financial Services Updates

Financial Services Updates