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The Morality Play

Is the growth of "ethical" investing a real issue for finance, or part of reputation management and best left to public relations?
Tony McAuley, CFO Europe Magazine
September 1, 2007

Diageo, an €11 billion maker of some of the world's most famous alcoholic drinks such as Smirnoff vodka and Guinness stout, has an ambiguous distinction: it is a constituent of the FTSE4GOOD stockmarket indices, designed to include only those companies that meet an array of ethical criteria, while also being a major holding in the Vice Fund, which sets out to do the exact opposite — invest only in stocks that are, as its prospectus puts it, "deliberately socially irresponsible," that is, alcohol, tobacco, gambling and weapons. Diageo is joined on both the "good" and "bad" for you lists by similarly renowned purveyors of booze brands, Heineken and SABMiller. The anomaly can be taken as shorthand for the confusion endemic to the world of ethical investing.

The Vice Fund was launched by Dallas, Texas-based Mutuals Advisors in 2002 specifically as a retort to the growing ethical, or "socially responsible investment" (SRI), sector. It has outperformed the S&P 500 index by a ratio of almost two-to-one since its launch, giving investors an annualised total return in the high teens. The FTSE4GOOD tradable indices, on the other hand, have underperformed comparable tradable indices over the past three years, according to FTSE. The FTSE4GOOD Global 100 index, for example, had a total return of about 49% in the three years to May, while the FTSE Developed Large Cap index posted a 62% return, and there were similar gaps on indices covering Europe, the US and the UK.

However, despite its relatively good performance and low minimum investment ($4,000), the Vice Fund remains tiny by investment industry standards, with assets at the end of July of just $124m. There have been no notable emulators of the Vice Fund — Willis Owen, a British fund broker, generated much publicity a few years ago when it announced plans to launch Europe's first vice fund, but dropped the idea after only a tepid response.

The SRI sector, on the other hand, has boomed, accounting now for an estimated 12% of managed funds in the US and a growing slice of the investment pie in Europe (see "Saintly Surge" at the end of the article).

It is little wonder, then, that few companies trumpet their inclusion on the Vice Fund. At the same time, many make a considerable effort to woo the SRI sector, emphasising their corporate "social responsibility." Though difficult to measure, the impact of SRI is starting to be felt. "When we go to meetings with investment houses these days they'll frequently have one person from ethical funds." says Jann Brown, CFO of Cairn Energy, a £300m (€441.5m) UK oil and gas producer. "It's premature to put numbers around [the capital markets impact], but as that grows over time those links will be defined and explored more."

Even companies with apparently no hope of making it onto any ethical investment lists do have a go. Referring to the unanimity among ethics-focused funds to screen out tobacco companies, Hermann Waldemer, Switzerland-based CFO of Philip Morris International, says, "I have to respect the decisions of those fund managers, but I would like to bring up a couple of points for their consideration. Anyone with common sense will accept that people smoked in the past. The Indians smoked. Today people smoke; and there will be a sizeable segment of smokers in the future. Accepting anything else would be unreasonable. Now, would you prefer to have that in the hands of big, responsible companies, like Philip Morris International, British American Tobacco and Japan Tobacco, or would you want a zillion tricky entrepreneurs all over the place?"

It's a change-the-subject line of argument that Nick Naylor, the preternaturally smooth tobacco industry spokesman in the film Thank You for Smoking, would be proud of. And it's a line that Waldemer feels a need to put forward even though the investment case for Philip Morris and other large international tobacco companies is astonishingly good (see "Thank You for Smoking").

The "Good" v "Vice" examples shed light on a long-running debate about whether investors do, or should, care about non-financial criteria. Despite little evidence of a correlation between financial performance and ethical criteria, it seems that investors care about it more and more. And as SRI is burgeoning, the question for CFOs is now how, rather than whether, they should address this growing investment lobby.

Hearts and Minds
Earlier this year, the debate about the merits of ethical investment was brought into sharp focus when Bill Gates responded to a series of articles in The Los Angeles Times. The paper had accused the $35 billion philanthropic foundation that bears his and his wife's name — and whose investment policy is overseen also by Warren Buffett — of hypocrisy for investing in firms with questionable records on issues such as the environment and usurious lending.

In a carefully argued statement, the foundation's chief operating officer, Cheryl Scott, explained that it had decided it was best to concentrate on grant-giving, which itself has "encouraged good actions" from some companies by involving them in philanthropic projects. But the foundation doesn't want to guide investment managers, Scott wrote, other than to exclude companies whose activities it finds "egregious" or present a conflict of interest with their philanthropic activities. So far, this approach has only screened out tobacco companies.


Echoing the philosophy of the vast majority of investment funds, Scott added, "The issues [surrounding what makes a morally acceptable company] are quite complex. Should a company get a failing score if 1% of its output is used in cigarette packaging, or if 1% of its stores' sales are in tobacco?" Monitoring, also, was extremely difficult and the Gates "believe there would be much room for error and confusion in such judgments and that divesting from these companies would not have an effect commensurate with the resources we would divert."

This agnostic approach to investing chimes with recent research. Alan Murray, a professor of accounting and corporate social responsibility (CSR) at the University of Sheffield's Management School in the UK, has been studying various research that looks at links between financial performance and CSR, while also undertaking his own. "I've been researching this for ten years now and found it's terribly difficult to get studies that are comparable," Murray says. "I looked at about 150 studies that examined the interaction between social performance and financial performance, using all kinds of measurements. Early results were contradictory or inconclusive, but more recent studies suggest that there is some form of positive relationship. However, that is only part of the story."

In a study with colleagues — "Do financial markets care about social and environmental disclosure?" published in Accounting, Auditing and Accountability Journal last year — Murray found that companies with greater disclosure tended to show higher returns. "But that's what they said about Enron," he adds. "We could not say, 'Therefore companies with a good social performance performed better,' because we did not establish a connection between disclosure and performance, for one thing. And there are so many other variables that it would be unwise to draw that conclusion."

Murray followed up with interviews of company executives and fund managers. "The bigger, more sophisticated companies, especially in environmentally sensitive industries, thought there was a market impact [of CSR efforts], but were unable to put a figure on the value. They seemed to regard it in terms of reputation on one hand and risk management on the other."

A new study by the European Centre for Corporate Engagement (ECCE), a Netherlands-based think-tank, suggests that European finance heads are sceptical about whether ethical investing influences operational and financial performance. Nonetheless, they are increasingly focusing on the more measurable parts of SRI, particularly governance.

Surveying CFOs and investor relations officers from more than 300 European companies, the ECCE study found that a majority (60%) thought brand image and reputation were the factors most affected by social responsibility initiatives. Most of the respondents felt that a company's environmental and social policies had little or no effect on its market value or ability to raise capital, though most also believed that good corporate governance could help raise market value and lower borrowing costs.

In addition, a previous ECCE study last spring found that finance executives thought that good scores on social issues were rewarded less than bad ones were punished in terms of brand image and reputation.

In short, finance executives view environmental, social and governance issues primarily in terms of risk and they tend to interact with investors on that basis.

This is certainly the case at William Hill, Britain's largest listed gambling company, with revenue last year of £900m, and the only gambling company on the FTSE4GOOD indices. Although William Hill's finance team hasn't been the main driver in its CSR effort, Nilay Patel, its head of corporate finance, says, "Investors inevitably ask us about the risks of regulation, how that is going to impact on our business. But it is a relatively small proportion of what they are interested in."

Nonetheless, both the gambling and alcohol industries make considerable efforts to lobby for light regulation, and sometimes this crosses over with the investor relations effort. Diageo, for example, has a dedicated group alcohol policy director, Gaye Pedlow, who did a similar job in the 1990s in the tobacco industry for BAT.

Her role covers a wide range of activities. She is a member of various lobbying efforts, for example, such as the Alcohol Education and Research Council, a government-funded operation, set up at the end of the 19th century to reduce drunkenness which now advises the UK government on alcohol policy. At the same time, Pedlow is Diageo's main liaison with the SRI community, whose focus on risk is made clear in a report by Henderson Global Investors, a fund management group, of a meeting with Pedlow. "We met with Gaye Pedlow to learn more about the application of its marketing code. Diageo recognises the potential risks to its brands from irresponsible marketing, and is now upgrading its standards and introducing a worldwide approach to both eliminate inappropriate advertising and positively communicate the responsible drinking message. We encouraged the company to disclose more to investors on the application of its marketing code."

Internally, Pedlow reports to the head of CSR, Will Peskett, who reports to the director of corporate relations, Ian Wright, who, in turn, reports to the executive committee, including CFO Nick Rose. It is a structure that is becoming typical for larger companies.


Rules of the Game
As the SRI industry has grown, the organisations that devise and administer the criteria, such as the FTSE group, have evolved their rules for inclusion, but this has led to anomalies. The problem lies in efforts to have universal reference points — such as the International Labour Organisation's standards, the UN Human Rights Norms for Business, Kyoto criteria and so on — even though companies can operate under vastly different conditions across industries and geographies.

Peculiar inconsistencies can result. For example, Emblaze, a $350m Israel-based, London-listed technology firm that makes mobile phones and isn't involved in contentious environmental activity, was excluded from the FTSE4GOOD indices for the year to March 2007 on environmental grounds. Essentially, the firm's annual report did not state what its environmental policy is.

At the same time, Drax, a £929m UK power generator that substantially exceeded its CO2 emissions limits last year, was not excluded.

Although FTSE4GOOD claims Emblaze "worked hard" to get back on to its indices, Emblaze says it made no special effort. According to Hagit Gal, head of corporate finance and investor relations who's also in charge of CSR, "Emblaze's corporate responsibility policies have been enhanced over the past two years [as part of] normal business practice...We are delighted that the result has been publicly recognised through Emblaze's inclusion in the FTSE4GOOD index." But she insists the policy was not aimed at getting on to the indices.

David Harris, head of CSR policies at the FTSE group, says the inclusion criteria have been evolving. New climate change criteria that takes effect next year, for example, will make it harder for Drax as it requires heavy CO2 producing companies to reduce their greenhouse gas emissions by 5% a year. "We are not saying that every company in the index is perfect, but we are saying that they are doing more than their peers who are not in the index," Harris explains.

Drax, however, takes a similar line to Emblaze. Gordon Boyd, finance director of Drax, says, "We've committed to invest up to £167m in carbon-abatement technologies that will deliver a saving of over 3m tonnes of CO2 each year. If as a result of our actions we are retained on the FTSE4GOOD indices then, of course, we should be delighted."

One thing that CFOs are wary of is principles getting confused with paperwork. It didn't make much sense, for example, when Cairn Energy was dumped from the FTSE4GOOD, while more controversial companies remained.

French oil company Total was kept on the FTSE4GOOD indices after human rights criteria were introduced in 2002, despite the fact that it has been criticised directly by democracy leader and Nobel Peace Prize winner Aung San Suu Kyi for supporting the military dictatorship in Myanmar. Meanwhile, Cairn Energy, which had already passed stringent human rights criteria to raise finance from the World Bank's International Finance Corporation, was excluded for the year to September 2003.

"There was no suggestion that our practices were in any way deficient," according to its CFO Brown. "We just hadn't developed our good working practices into fully fledged policies and procedures."

Cairn set about formalising those policies, including hiring a human-rights consultant Alan Miller, director of consultancy McGrigors Rights. As Steve Welton, head of CSR and risk at Cairn Energy, explains, the company went well beyond SRI requirements and started running human rights workshops, adopted various international guidelines and established, with the IFC, a local lending company in Rajasthan, India, where it runs a major oil-and-gas operation. Cairn was back on the FTSE4GOOD indices a year later; but there was never an accusation of any underlying human-rights violations.

Is SRI box-ticking becoming too much of a pain? "Our corporate culture is that [CSR] is not something to be avoided, but with one caveat: when systems like this become onerous to administer that's when the focus starts to shift," says Brown. "Just like strong corporate governance. We all agree it's the right thing to do but it can get hidebound in red tape. I'd be disappointed if CSR initiatives went down that track."

Tony McAuley is deputy editor at CFO Europe.





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