A new report concludes that while socially responsible investors are ahead of the mainstream on many issues, such as transparency, corporate governance and predatory lending, they did not foresee the global credit crisis any better than the mainstream financial community.

The report, The Financial Crisis: An Environmental, Social and Governance Perspective, was commissioned by the Social Investment Organization (SIO) through the Fund for Action on Investment Responsibility (FAIR) and released at this year’s Canadian Responsible Investment Conference in Winnipeg.

“It is fair to say that like the mainstream financial community, the SRI community failed to fully appreciate the risks inherent in the financial markets leading up to the global crisis,” the report states. “Socially responsible investors, by and large, were not clamouring for greater disclosure of sub-prime mortgage-backed securities or for more meaningful and accurate credit ratings.

“In hindsight, it is clear that the combination of securitization and systemic risk was one that warranted the attention of socially responsible investors, regulators and others.”

Consultant Rob Gross of CR Strategies, who co-authored the study, says the structured financial products involved were “so opaque that it’s not surprising they were missed. The SRI community did identify a number of contributing factors to the financial crisis, but in terms of the outcome, the results really weren’t that much different.”

The report says that the current crisis does provide “grim” evidence of the problems caused by a lack of transparency and the proper disclosure of risk. “Until the broader investment community embraces the notion that social and environmental issues are critical to the long-term performance and sustainability of companies and, in fact, represent real potential risk, it seems likely that calls for greater transparency will go unheeded.”

However, the financial crisis does provide advisors with an opportunity to reinforce the message that chasing short-term returns can have devastating consequences. “Socially responsible investors should take advantage of this opportunity to call for more attention to long-term performance and away from the lure of daily and quarterly returns,” the report states.

The report’s key recommendations include

  • that environmental, social and governance (ESG) factors be fully integrated into investment decision-making processes;
  • that there be greater transparency on ESG factors;
  • that executive compensation support long-term performance; and
  • that the lessons of the financial crisis be used to anticipate and mitigate the effects of future crises.

“This episode has lessons for long-term investors of all types, whether or not they approach investment from a socially responsible perspective,” says Eugene Ellmen, executive director of the SIO. “It also contains lessons for regulators, which need to address the deficiencies in disclosure rules to create an environment of open and transparent information on environmental, social and governance issues.”

However, Ed Waitzer, former chair of the Ontario Securities Commission and a champion of financial re-regulation, says investors should be modest in their regulatory expectations. “Regulatory frameworks simply run down over time,” Waitzer suggested in a speech at the conference in Winnipeg. “There’s a myth that we can measure rules with precision.”

Behaviour is difficult to regulate, he added, noting that a “herd” mentality created risk in the system in the first place. “Existing regulatory frameworks have been ineffective or misleading. We need to embed sustainability into organizations.”

Such an approach would place the industry in a better position to tackle larger, more pressing concerns, such as climate change. “The environmental and social impacts will be catastrophic and long-lasting,” the FAIR report warns. “Climate change must be tackled with a sense of urgency.”

“This crisis does give social investors [and advisors] the opportunity to focus on other hidden risks, like climate change and human rights,” says study co-author Ian Bragg. “These issues are also important to financial performance but haven’t been fully acknowledged by the mainstream community.”

In addition, lack of adequate governance, lack of transparency, gaps in regulations and the proliferation of opaque and complex financial products are not necessarily unique to the financial crisis, the report suggests. “For example, developing markets for alternative energy technologies and carbon appear to pose some of the same potential for failure as the market for mortgage-backed securities.”

“If the financial crisis isn’t enough to get the attention of the mainstream community, what will be?” Gross asks.

Doug Watt is an Ottawa-based writer and editor and co-founder of SRI Monitor, a blog on socially responsible investing.