Netting Down to Zero in the Financial Markets: Not Before Ironing Out the Creases
Despite all the talk and self-congratulatory announcements by market participants, COP 26 must acknowledge that the financial markets have not fully embraced ESG. What precisely is the reason for this? The question is usually answered by reference to a lack of convincing empirical data, but is there more to it than that?
First, we must recognise the limitations of the markets themselves. Governments are rightly encouraging everyone in the financial markets to play their part. This feels a little like being asked to forget the modern idea that representatives will deal with the issues of the day and go back 2500 years to Ancient Greece to when citizens were required to actively participate in politics. Yet in a two-way market, there will always be someone ready to buy what someone else is selling. One person’s divestment for sustainability reasons is another person’s opportunity for short-term profit. While this may be unedifying and reminiscent of Wall Street in the 1980s, it is the reality.
Arguments that ESG policies produce long-term value assume that Descartes and Kant were right in their assertion that we are rational animals. They were wrong; we are not. In any event, such research tends to speak to longer term investors more than short term investors. 30-year views expressed by pension funds are important, but there is a mismatch between their time horizon and the climate change clock, which we are told will run down far sooner.
There must be recognition that short-term investors have a key role to play here. The 120 trillion dollars of assets under management that have signed up the PRI principles might attract the headlines, but it’s the ratio of short-term to long-term investors that is the important metric. Short-term investors sweeping up cheap-but-dirty assets disposed of by long-term holders only supports that view. End investors hold the solution to that issue.
Second, is the effect of investment manager conflicts of interest. This is not something that is spoken about in polite company, but conflicts abound. Where an investment management firm nakedly pursues its own moral agenda using other people’s money, there is the potential for a problem. Not only can this give rise to a legal problem, but it also means that capital is at risk of being reallocated for the wrong reasons and in the wrong direction. The preponderance of “research”, in the very loosest sense of the term, by NGOs pursuing their own agendas only encourages and reinforces this dynamic.
Financial regulators seem to have become cheerleaders for sustainable finance and the little regulation that there is concerns disclosure and taxonomies. As useful as that may be, it is light touch and totally mismatched to the risk to the market presented by the influence of NGOs and investment manager conflicts of interest.
The Principles for Responsible Investment (PRI), the leading proponent of responsible investment, which boasts not one but two UN bodies as partners, also has a crucial role to play here. The success of the PRI will increasingly be measured as much by its willingness to delist those who put its initiative at risk, as it is by its ever-growing list of signatories.
The primary measure of promoting signatory accountability to the “Principles” is the mandatory annual reporting requirement, but it is the PRI’s “serious violations policy” that is designed to pick up adherence issues outside of the cycle. It would be wrong to assume that this is only intended to capture signatories who have faced regulatory, legal and/or financial sanctions in this area. It is more realistic to consider the mundane.
An investment manager’s conflict of interest is a case in point. A fiduciary cannot simply exercise its decision-making power in its own interests. An ESG decision taken by an investment manager in circumstances where its personal interest conflicts with its duty is a breach of fiduciary duty. Is this, in and of itself, “serious” for the purposes of the PRI’s serious violations policy?
The no-conflict rule exists as a matter of high policy to instil in fiduciaries the highest standards of integrity. It is enforced strictly pour encourager les autres. Pensioners have every right to expect that the investment manager managing their nest egg will make decisions in their best interests, and not deploy their hard-earned money in the pursuit of its own agenda. A decision taken for this ulterior purpose can therefore only be described as “serious”.
If the effect of the conflict of interest is to tempt the fiduciary to deliberately shut its eyes to freely available information saying one thing relevant to the investment or divestment decision, and to privilege information known to be false or biased saying quite another, the breach of duty is egregious. It is dishonest. Where that decision is likely to influence others in the market, the need for action under the PRI serious violations policy is arguably even more compelling. In most, if not all, cases the signatory will have certified to the PRI that it has a policy on managing conflicts of interest in the investment process. Conduct that renders such a self-certification unreliable is surely an additional aggravating feature.
Third, there needs to be a major reappraisal of the relationship between certain blocs. While COP 26 might focus on the divide between China and the West, it is not the whole story. In the context of the financial markets, the gap is between offshore and onshore. Some European politicians and certain corners of the media have an unhealthy obsession with places such as the Cayman Islands. For political expedience, they paint these places as “tax havens,” but that is a solecism that fails to understand their vital role in an interconnected global economy.
If they wean themselves off their addiction to bashing these places, they will see that these jurisdictions are a solution not a problem. They are host to a significant proportion of the world’s short-term capital – the very capital that is needed to address the current challenges. Political leaders should support these jurisdictions and recognise the interconnectedness and complementarity here.
The inevitable big picture communiques of COP 26 are one thing; in the financial markets, it is ironing out these creases that will give effect to them.