Recently, however, a broad consensus has begun to emerge around a second view of ESG criteria. ESG factors are relevant because they may impact on the risk/return profile of a company. Companies with poor ESG practices may be at higher risk than companies with best practices in these areas. On this view, ESG criteria are relevant to prudent investment decision making, because they bear on the value of the securities under consideration. To ignore the health-based litigation risks of tobacco companies or the environmentally based risks of polluters is imprudent and can lead to inappropriate valuations of enterprise securities. Accordingly, analysis of ESG factors is essential to a prudent and comprehensive approach to securities valuation, and ignoring these factors fails to meet the requirements of prudence.
The latter approach to ESG investments has recently been codified in the Principles for Responsible Investment(PRI), promulgated under the auspices of the United Nations Environment Program (UNEP)Finance Initiative and the U.N. Global Compact. The PRI consists of a relatively simple set of six principles that were originally endorsed by some 20 institutional investors from all over the world. In Canada, the PRI have been adopted by the Canada Pension Plan Investment Board, Quebec’s Caisse de dépôt and British Columbia’s Investment Management Corporation, and are under active consideration at many other plans as well.
The PRI approach to ESG criteria reflects the underlying view that thorough securities analyses must include an understanding of material nonfinancial factors. In today’s world, the risk of reputational damage arising from poor ESG practices, the risk of shareholder lawsuits arising from poor corporate governance or the risk of unforeseen costs to be imposed through future regulation of carbon emissions are simply too great to ignore.
The PRI were also developed in conjunction with a legal review concerning the integration of ESG issues into institutional investment. The review was prepared specifically for the UNEP Financial Initiative in September 2005 by the London-based international law firm of Freshfields Bruckhaus Deringer. The Freshfields report considered relevant legal criteria across a range of jurisdictions and concluded that, in general, it was appropriate, if not essential, to consider ESG criteria in investment decision making within the risk/return securities valuation paradigm. On the other hand, the Freshfields report noted that the primary purpose of pension plans in particular was financial and did not support using pension funds to achieve ESG for purely political or social reasons.
With the PRI, and the accompanying Freshfields report, there is now ample support for the proposition that considering ESG risks and opportunities within the risk/return context of prudent portfolio investing is entirely appropriate. Pension funds that do not attend to these factors may have some explaining to do in the future.
Murray Gold is a partner with Koskie Minsky LLP in Toronto. mgold@koskieminsky.com
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