Linking Capital Markets and Sustainability
The NRTEE’s Task Force on Capital Markets and Sustainability held two years of consultations and studies to explore the links between environmental and social sustainability and financial performance in Canada. In its report, the Task Force highlights the important contribution of sustainability to long term value creation, and provides recommendations to address barriers to the integration of environmental, social and governance (ESG) factors into investment decision making.
Through consultations with close to 200 participants from the private, public, and civil society sectors, the Task Force concluded that “not only is there a financial return to business in pursuing corporate responsibility, but the pursuit of such policies should, can, and must be rewarded through the investment allocation decisions of fund managers in the capital markets.”
Yet while companies and pension funds are beginning to listen to the marketplace when it comes to integrating sustainability factors into strategic decisions, there remain significant market barriers.
“Canada’s collective future depends on the extent to which we are able to leverage our advantages in human, capital, and natural resources to serve present and future generations,” says the report.
Given growing global awareness of environmental issues, and the clear financial implications of climate change and related legislation, more investors and company executives are realizing the business risks and opportunities presented by environmental and social performance.
The shift is marked by initiatives such as the Carbon Disclosure Project, which seeks information from the world’s largest companies on greenhouse gas emissions, climate change risks and opportunities, adaptation and mitigation strategies, and climate change related technologies in use. The Project is an explicit recognition by a coalition of investment organizations representing more than US$40 trillion in assets that climate change has clear financial implications which should be considered by investors.
Like investors, many companies are also incorporating environmental and social factors into their business strategies, and communicating their actions to the financial community.
While some companies continue to implement narrow compliance initiatives or remain in a defensive, reactive mode, others are transforming their business models to gain a competitive advantage. Around one quarter of the S&P 100 Index and the S&P 1200 Index now adhere to the sustainability reporting standards set forth by the Global Reporting Initiative (GRI), and there is a growing body of research which suggests that firms who enact and report sustainability strategies outperform their peers.
Yet while some companies – including many in the FT500 - have responded to calls from various stakeholders for improved performance and greater transparency on ESG issues, the majority of large publicly traded Canadian corporations have not yet integrated sustainability policies, programs, standards, indicators, or audited reporting into their normal operating procedures. There are significant risks associated with failure to engage environmental and social issues, including questions of shorter-term competitiveness and longer-term viability, warns the NRTEE.
Similarly, while the rise of Responsible Investment has led to use of ESG information by more mainstream investors, many institutional investors still seek short-term returns through traditional financial indicators, placing investments at risk of losing long term value. As well, when investors do no reward companies for integrating ESG issues into their business decisions, they discourage companies from going any further.
Recommendations for sustainable value
Among the barriers identified by the Task Force were long held views among pension fund trustees that the consideration of such “non-financial” factors was in general conflict with fiduciary duty. This is despite research by world-renowned law firm Freshfields Bruckhaus Deringer which found that failure to take ESG issues into consideration in investment decision-making is actually a breach of fiduciary duty.
The report also outlines a lack of clarity over the definition of materiality and its inconsistent application and disclosure. This is particularly problematic given the highly material nature of many ESG issues, including diminishing ecological services, natural resources and often related social unrest.
An obsession with short-term performance by many investors also provides a barrier to long term sustainability. A lack of consideration, and the resulting undervaluation of ESG factors will “undermine economic efficiency, productivity, and growth through the erosion of the competitive advantage as well as the human, societal, and natural capital upon which industry depends,” says the report. This ‘short-termism’ is particularly relevant today, as companies and investors face serious long term risks related to climate change, including emissions regulations, extreme weather events, and ecological degradation.
The report presents a set of recommendations for overcoming barriers related to fiduciary duty, materiality, and short-term thinking to promote economic competitiveness and environmental sustainability. The Task Force submits that these solutions will encourage Canadian capital markets to not only catch up with our European counterparts in integrating ESG factors into investment decisions, but also gain a sustainable competitive advantage.
The recommendations include:
- Federal, provincial, and territorial regulations to require pension plans to disclose their incorporation of ESG issues in investment decisions and proxy voting.
- Adoption of voluntary ESG policies by all fiduciaries, including institutional investors, money managers, and fund trustees, and endorsement of the United Nations’ Principles for Responsible Investment.
- Clarification that federal, provincial, and territorial fiduciary obligations include the consideration of ESG issues that are financially material to investment decisions.
- Integration of ESG factors into all federal government funding for grants and projects related to capital markets, and in federal pension plans.
- Education of ESG issues in programs granting MBAs, CFAs, director education or trustee certification.
- Outreach by the Canadian Institute of Chartered Accountants (CICA) and the Canadian Securities Administrators to increase understanding of the material ESG issues that should form part of the Management Discussion and Analysis (MD&A) section of annual reports.
- Engagement of companies on the potential materiality of ESG issues by institutional investors, money managers, and trustees, and development of policies and guidelines for ESG reporting.
- Guidance by the Canadian Securities Administrators to encourage companies to disclose financially material ESG issues and use established reporting frameworks such as the Global Reporting Initiative (GRI).
- Assessment by institutional investors of the impact their investment policies and practices on sustainability, particularly the quality of the investment research and the alignment of fund manager compensation practices with long-term performance.
The full report, Capital Markets and Sustainability: Investing in a Sustainable Future, can be found here.
The Task Force asserts that without the integration of sustainability factors into capital market allocations, Canada will face long term economic, environmental and social losses. “Ignoring issues such as human rights or climate change within new international regulatory regimes is no longer an option…If we ignore the global trend to include “non-financial” risk factors in investment decision-making, we do so at our peril,” it warns.
As Dr. John Wiebe, Co-Chair of the Capital Markets & Sustainability Task Force and President & CEO of the GLOBE Foundation of Canada says, “There is a clear case for the links between environmental, social, and governance performance and the bottom line. A long-term vision of sustainability must incorporate all of these aspects.”
“As companies identify business risks and pursue opportunities related to the environment, investors must recognize the material impacts of these activities and adapt their decision-making processes. Failing to do so would be a breach of fiduciary duty and could lead to long-term erosion of their investments. For Canada to secure its economic competitiveness, social strength, and environmental quality for the long term, the integration of ESG factors into the capital markets is imperative,” he added.
For More Information: NRTEE