In a recently published book entitled “The Road to Long Finance: A Systems View of the Credit Scrunch”, NSFM member Michael Mainelli and his colleague Bob Giffords reach a similar conclusion. They argue that encouraging competition is preferable to introducing misguided regulations for a number of reasons. Firstly, competition provides a form of supervision, with market participants scrutinizing each other’s behavior and keeping each other “in check”. Additionally it is cheaper for taxpayers to let a few small firms fail periodically than to rescue the large ones systematically.

Regulation is also perverse in that it creates unintended consequences that can in turn increase systemic risks. For instance, regulation and the “compliance culture” led to a homogenization of investment behaviors and strategies, reinforcing the herding phenomenon already fuelled by instant information flows and the pressure to deliver performance in the short run relative to a few benchmarks used by the majority of investors/traders. Finally, public policy has several objectives and this often results in good intentions turning into recipes for disaster. Fanny Mae and Freddy Mac come to mind because what is now qualified as “reckless predatory lending practices” was in many ways induced by government policy to encourage affordable housing in the US.

Against this backdrop, the authors believe that “the promotion of competition, then supervision, then regulation should be the order of discussion with an objective of promoting ‘open’ markets (…) rather than the dogma of ‘free’ or ‘regulated’ markets”. They offer a number of recommendations for any actors with a stake in creating more resilient and sustainable financial markets. For the general public, they question whether our collective preference would go to “quick fix solutions” or a competition-driven environment that would lead to more diversity, trust, greater emphasis on cooperation and mutualisation and local control.

Interestingly, these contrasting paths closely resemble some alternative futures presented recently at the Finance Lab, an initiative led by the WWF, the Institute of Chartered Accountants, of England and Wales, reos partners and Oxford Said Business School. Maybe there are some intellectually synergies worth exploring there.

PRI signatories got together in Sydney last week at the annual PRI conference to review their progress on implementing the Principles for Responsible Investment and to discuss the role of the PRI initiative in the aftermath of the financial crisis.

Whilst there is no doubt that the PRI has grown substantially (membership has practically doubled since the subprime crisis, reaching 540 members in mid-2009 or a total of US$ 18 trillion of asset under managerment) and that the initiative has become an influential voice in the financial industry, there is still a daunting gap between what it stands for and seeks to promote and the extend to which signatories are currently walking the talk.

Out of the six principles that signatories have committed themselves too, the first 2 are arguably the ones that require a real fundamental shift in their  investment practices. Principle 1 calls for the systematic integration of sustainability considerations in investment analysis and decision-making processes. It was voted the most difficult principle to implement by PRI signatories in the 2008 annual survey – by far (it received twice the amount of votes than any other principle).

Publicly-listed equities have been the obvious place to start. The PRI Secreteriat estimates that 5% of the total US$ 27.2 trillion equity market is managed by asset managers who have signed up to the Principles and are therefore “subject to ESG integration”. On the one hand this is good news for investors because it means that there is still an information advantage in considering long-term issues that are currently mispriced by the market in their investment strategies. But on the other hand it also raises the question of whether this is enough to sway the market (to the point where it recognises the fair value of the stock by efficiently pricing in sustainability factors) and most importantly whether this re-allocation of capital towards more environmentally-minded and socially-responsible companies will be sufficient to usher a transition towards a sustainable, low-carbon economy.

In this year’s PRI report, 94% of signatories indicated that they perform “some integration” of ESG factors in investment processes. Unfortunately, the report does not provide much granularity so it is difficult to estimate whether this is limited to negative screening or whether there is a process in place to systematically analyse ESG issues and feed them into financial valuation and stock recommendations. When asked “to what extent have you integrated RI/ESG issues into your internal active investment decision-making processes?”, only 55% of asset managers responded “to a large extent”. It is no wonder that only about 15 of the 1,518 strategies that Mercer has rated on the basis of how consistently the fund managers incorporate ESG factors into valuation have been assigned the highest ESG ratings.

SAM is one of the most established sustainable asset manager. For over a decade it has been collecting and analysing sustainability strategies for a large number of stocks and refining the way this is taken into account in in-house valuation models. This year for the first time, SAM contributed a case study to the PRI report, outlining its approach to integration. It has also recently published a study demonstrating how this contributes to alpha generation. Hopefully this will inspire other investors to continue to develop ways to make sustainability performance count in investment decisions so that the market as a whole can progressively become more efficient at rewarding leaders rather than laggards.

Six months on (!!) and some of the thinking around pension fund reforms is finally trickling through the system. A few months back Frank Jan de Graaf and Keith Johnson, two leading members of the Network for Sustainable Financial Markets (NSFM), released a paper on “Modernizing Pension Fund Legal Standards for the 21st Century”. The recommendations it contained were picked up by the OECD and included in the drafting of its revised guidance on Pension Funds Governance.

Frank Jan and Keith argue that not only are pension funds in need of reforms, they represent huge pools of capital and have a considerable influence on the financial markets. Their investment decisions can have a big impact on the real economy and their success in meeting their liabilities depends on the ability of companies they invest in to create value in a sustainable way. So any reform needs to go beyond fixing the current problems (e.g. improving risk management processes) and consider ways to integrate long-term considerations in pension funds’ incentive mechanisms, governance structures and investment processes.

As mentioned in the paper, a study published in the Rotman International Journal of Pension Management found that better governed pension funds outperformed poorly governed funds by 2.4 percent per annum during the four years ending December 2003.

One of the ongoing problems it clearly identifies under the current arrangement is the conflict of interest between pension fund participants / beneficiaries and their agents in the service provider chain. As Professor Amin Rajan highlighted in a recent study on “DC and DB plans: Strenghtening their delivery”, “There is a widespread perception in the pension world that the investment industry is perverse in one crucial sense: its food chain operates in reverse, with service providers at the top and clients at the bottom.  Agents fare better than principals.”

With that in mind, Frank Jan and Keith offer a series of recommendations, ranging from developing a “fit for purpose” qualifications for pension fund board of trustees to publishing a statement of  investment beliefs and mission and minimising conflicts of interest through appropriate compensation structures and audited policies on managing conflicts of interest.

As mentioned earlier some of these recommendations have been incorporated in the revised OECD guidance on pension form governance. Change won’t happen overnight but this is certainly a good step in the right direction.

Many thanks to all NSFM members who provided ideas, feedback and support in drafting and disseminating this paper.

Ahead of the annual gathering of world leaders in Davos, the World Economic Forum (WEF) has released an important publication, which uses a scenario approach to gain some insights into the future of the global financial system. This is a very welcome contribution. In the context of a rapidly shifting landscape, scenarios-building techniques can really help all of us understand the key drivers that are shaping the financial industry, identify the critical uncertainties that could dramatically affect the way things play out and provide an effective way to map out the alternative, yet plausible, futures that might unfold as a result.

What I particularly like about scenario-building is that it forces people to think beyond their “wishful-thinking” scenario and prevents them from getting stuck in a binary “black or white” view of the future. Through a creative, yet robust and well-researched process, these techniques first help open our minds to the realm of possibilities and potential impacts, in order to create a set of alternative realities. This in turn can help us prepare better for the future, minimising the “unintended consequences” of our actions and helping us to recognise the signals of profound change in order to navigate this fast-changing landscape.

In that respect, the WEF report offers a great tool for policy-makers and anyone who has a stake in the future of the financial industry (i.e all of us). It starts off with a pretty gloomy outlook of the next few years.  It foresees that “over the near-term (2009-2012), the dominant trends in the global financial system will continue to be deleveraging, adaptation to increased government intervention and a weakening of cross-border economic activity”, against the backdrop of a sharp fall of net private capital flows to emerging economies  and a substantial drop in the volume of global trade in goods and services.

Following an in-depth review of the potential winners and losers, the WEF reports present a set of four scenarios:

(1) financial regionalism – a world in which post-crisis blame-shifting and the threat of further economic contagion create three major blocs on trade and financial policy, forcing global companies to construct tripartite strategies to operate globally.

(2) fragmented protectionism – a world characterized by division, conflict, currency controls and a race-to-the bottom dynamic that only serves to deepen the long-term effects of the financial crisis.

(3) re-engineered Westerm centrism – a highly coordinated and financially homogenous world that has yet to face up to the realities of shifting power and the dangers of regulating for the last crisis rather than the next.

(4) rebalanced multilateralism – a world in which initial barriers to coordination and disagreement over effective risk management approaches are overcome in the context of rapidly shifting geo-economic power.

The whole report is very insightful and well worth a read. Interestingly, it also outlines the scenario approach it has used in great details. It even provides an appendix on how scenario-thinking can help any institution take strategic decisions, by gaining new insights and uncovering their blind spots.

And it doesn’t stop there. The WEF is planning to take this work forward and use it as the basis for a strategic conversation with stakeholders all over the world:

“In phase two, the World Economic Forum aims to build on the insights of this report and explore opportunities for collaboration to help strengthen the global financial system. This will involve an examination of potential future sources of systemic risk as well as opportunities toreposition the industry for sustainable long-term growth, to ensure economic stability and prosperity of both the financial and real economies.”

This is a great opportunity to get engaged and rethink the fundamental purpose and mechanisms of the financial market. We are all stakeholders after all.

In this context, the release of 2 new books on “sustainable investing” by highly respected practitioners in this field is a very timely contribution. Published wihtin a few weeks of each other, the authors provide valuable insights about this “enhanced” approach to investing, which has been gaining momentum over the last few years and which, in my view, is reaching a tipping point. Why? Because we are currently at the critical juncture where a convergence of forces is making sustainable investing more compelling than ever.

Firstly, this “integrated” approach to investing has evolved from a pioneer experiment to a more mature, credible and tested investment philosophy. This has allowed more practitioners – beyond the early adopters – to consider the merits of sustainable investing without having to step too far outside their comfort zone.

At the same time, society’s collective consciousness has never been so “green”. Following Al Gore’s Inconvenient Truth, we have witnessed a surge in people’s interest for anything green. Financial products for retail investors have arguably been the last to be “greened” but demand in this area is also growing rapidly, as Claudia Langer reminded investors at the TBLI conference in Amsterdam last November (listen to her inspiring speech here: claudialanger_64kb.mp3).

Finally, the credit crunch and ensuing financial crisis have revealed some of the systemic failures of the financial markets, thereby providing us with a “once-in-a-lifetime” opportunity to rethink market mechanisms and re-align them with the fundamental purpose of financial markets, i.e. to allocate capital efficiently in order to meet the needs of people in an increasingly resources-constrainted world. In some way, sustainable investing is all about making financial markets “fit for purpose” for the 21st century reality.

So against this backdrop, sustainable investing has clearly become more relevant and legitimate. In fact, it now has for the first time a unique opportunity to become mainstream. And in some way, the publication of these 2 books is in itself a sign of mainstreaming, showing that the concept is ready to be adopted by a wide range of interested readers from all walks of life (and in particularly by those whose pensions might be at stake).

And after reading these 2 books, I believe we have reasons to be optimistic.

In “Investing in a Sustainable World”, Matthew J. Kiernan, the founder and CEO of Innovest, describes what he sees as the “Sustainable Investment Revolution”. In a very insightful and personable way, he traces this investment philosophy back to its origins, offering colourful accounts of the many characters that helped shape the vision, promote the idea (for instance through innovative industry initiatives such as the EAI, UNPRI, Ceres, CDP, etc) and make it happen. Leading pension funds and other financial institutions that dared to be different come to mind – and Matthew provides a great overview of their leadership in that area.

Most importantly, Matthew offers by far the most articulate “business case” for sustainable investing. He demonstrates the relevance of sustainability issues (i.e. environmental and social considerations) for financial analysts as they try to assess the intangible value of a company (which makes up close to 80% of a company’s valuation), and shows how ESG issues can provide useful indicators for the quality of management and its ability to create sustainable value for shareholders in an increasingly resource-constrained world.

Furthermore, Matthew looks at all the arguments commonly put forward by skeptics in the financial industry and turns them on their head. ESG issues can’t be quantified? Neither can other apsects of a company’s intagible value that are neverthless incorporated in financial valuation models. Sustainability investing doesn’t guarantee outperformance? Neither does active stock picking – on average.

Finally, he provides some excellent guidance on cutting-edge approaches to integrating sustainability in financial analysis. Whilst he recognises that there is no magic formula, he describes many practical ways to incorporate sustainability factors in fundamental analysis (e.g trend analysis, modelling marginal abatement cost of environmental resources).

No doubt Matthew’s book will one day be seen as a living testimony of “history in the making”. Matthew has already made a sizeable contribution to the “Sustainable Investment Revolution” (through his leadership at the World Business Council for Sustainable Development; and in creating Innovest and subsequently turning it one of the most successful independent sustainability research providers), and the fact that he has published this book and given us an open honest insight into his thoughts and his vision is an amazing gift.

In a completely different style, “Sustainable Investing – the art of long-term performance” provides a panoramic review of the state-of-the-art best practices across the field of sustainability investing. Co-edited by Nick Robins (HSBC Head of Climate Change Centre of Excellence) and Cary Krosinsky (Vice-President of Trucost), it is a collection of essays exploring the many facets of sustainability investing, how it can be applied to different classes (including carbon finance, real estate, fixed income, microfinance, social investing, private equity) and how it is gaining ground in emerging markets such as India and China – where ESG issues have traditionally been under-researched or under-reported.

Bringing together many leading voices in the industry, including Ivo Knoepfel and Gordon Hagard (OnValue), Valery Lucas-Leclin and Sarbjit Nahal (Société Générale), Emma Hunt and Rachel Whittaker (Mercer), Matthias Kopp (WWF) and Björn Tore Urdal (SAM), Steve Waygood (Aviva Investors), the mythical Tessa Tennant and many more, this book shows how sustainability investing is breaking new grounds and becoming increasingly relevant in all aspects of financial markets operations.  And although sustainable investing has come a long way, I would agree with the authors’ conclusion that there is still a “distance to be travelled” before we truly integrate sustainability risks and opportunities in all investment decisions, systematically and across all asset classes.

Encouraging nevertheless!

Happy holidays

PS: Looking back at the FT article on ESG labels this summer, it appears that “sustainable investment” has won the day in the terminology debate. We welcome this clarity of vision and purpose, and believe it will further contribute to the broad acceptance of this investment philosophy by the “mainstream”.

Just days after the collapse of Lehman Brothers, this was a powerful reminder of the need to make markets work for the long-term. Given the interdependence of financial markets and the real economy, the slideshow suggests that there is a pressing need to rethink the notion of “market efficiency” to ensure that all aspects of social, economical and environmental well-being are taken into account in investment decisions and that markets mechanisms are geared towards delivering value for the long run. Just how much regulations vs. volontary industry initiatives is needed remains an open question – and the focus of the debate.

In this slideshow “premiere”, the NSFM sheds some light on issues ranging from fiduciary duty to climate change and executive remuneration. You can watch the video of Raj addressing the conference delegates, and you should also take a look at the pdf document (nsfm_riaa-melbourne_september-24-20082) if you actually want to see the slides Raj is talking to.

I have been incredibly privileged to work with NSFM coordinators to put this slideshow presentation together and make a meaningful contribution to today’s discussions. Louise O’Halloran has also been a great source of inspiration throughout this process. In the spirit of Al Gore’s Inconvenient Truth and Louise’s Enlightened Self-Interest, individuals who share these beliefs are welcome to use the slideshow to deliver its message to other audiences. All they need to do is fill out a License to Present form on the NSFM website (link to come).

And of course, all your thoughts / comments / reactions are welcome!

Organised by Responsible Investment Association Australasia (RIAA) and my dear friend Louise O’Halloran, its Executive Director, it mobilised the “responsible investment” community at a time of unprecedented crisis in the financial markets – and produced some interesting and challenging thinking.

I’m a big fan of Donald MacDonald, Trustee of the BT Pension Scheme, who may not be “an economist or a financial or investment expert”, but who as “a pensioner and member nominated trustee of a large defined benefit pension scheme” understands the issues like no one else and who offers candid views on the mess we currently find ourselves in.

He reminds us that “one or two people in the RI movement, did, it is said, see the crisis looming, but I think we, as representatives of pension funds, foundations, insurers, asset managers and specialist advisors, have to ask ourselves this; why didn’t we see it coming, in a much more clear manner?

[...] So while we in the Responsible Investment community may express some self righteous indignation at the breakdown of trust and transparency in the financial sector, it does occur to me, that, as shareowners in that sector, as clients of hedge funds, auditors and accountants, as stock lenders, perhaps we, at the head of the investment chain, may have missed some of our own responsibilities in the stewardship and governance area.”

Whilst he rightly questions the RI industry and its ability to have foreseen the crisis (and helped prevent it), he also makes it clear that now is the time to provide leadership and to reaffirms the RI community’s commitment to investing “with a long-term horizon”.

The rest of his speech is worth a read because it offers some lessons from the current crisis. It also reminds us that our success will depend on our ability to develop holistic approaches to tackle interconnected challenges such as climate change, food security and eco-system balance. This is something we tend to lose sight of at a time of short-term panic-driven thinking.

Finally some timely contributions from the wide-ranging community of sustainability practitioners:

1/ A very interesting webinar on the potential credit cards default crisis, hosted by Innovest’s financial analysts Greg Larkin and Laura Nishikawa. In their own words: “Innovest, which was early with its call on sub-prime mortgages, has determined that what Wall Street and the Federal government are diagnosing as a mortgage problem is, in fact, a symptom of a deeper crisis of deteriorated consumer financial health”. The full report is available here (innovest_credit_cards).

2/ John Elkington, one of the most established thought leaders of the sustainability movement (and founder of UK SustainAbility think tank), offers a comprehensive picture of some of the fundamental issues that lie at the core of today’s crisis. Drawing on their scenario analysis “Raising our Game: Can we sustain Globalisation?”, they question whether democracy has shown its limits when it comes to our collective ability to respond and pre-empt crises (be it the credit crunch or climate change, the impeding “ecological credit crunch”). Their conclusion is worth quoting.

“We desperately hope we are wrong, but our analysis is that the current meltdown is not yet the sort of crisis that will force our leaders to the point where [...] they (and we) break frame, do the completely unexpected—and invest in the future as if our futures depended on it. Meanwhile, there is a growing (if unwelcome) opportunity to learn and spread the relevant lessons from the still-evolving credit crunch, both in terms of how to develop and run our economies in ways that are financially sustainable and, longer term, in ways that are also socially and environmentally sustainable.” John Elkington & Mark Lee, SustainAbility.

3/ At the same time on the other side of the pond, Mindy Lubber, President of Ceres, “a leading U.S. coalition of investors, environmental groups and other public interest organizations working with companies to address sustainability challenges such as global climate change”, speaks about the problems of short-termism in the markets, lack of board accountability and excessive CEO remuneration on the Harvard Business School blog.

4/ Finally some blue-sky thinking is coming out of SoCap08 in San Francisco. The Social Capital Markets Conference 2008 is buzzing with blogging excitement. Taking a helicopter view, sessions focused on how capital can be deployed in a way that serves the investor’s values and the social good,  and whether social values can drive more effective investments. We certainly look forward to finding out more about the outcomes of the conference in the coming days.

After a marathon weekend to rescue the banking system from complete meltdown, the various headlines of today’s FT seem to point to some convergence of thinking (finally). Here are some of the highlights:

“There was a strong sense that a serious regulatory backlash was coming and that the best the sector could do was to get ahead of the game and promise to clean up its own act”. According to an article in today’s FT, this was the dominating perception amongst finance practitioners attending the Institute for International Finance’s dinner in Washington last night.

Josef Ackermann, Deutsche Bank chief executive and Chairman of the Institute, unequivocally stressed that “we want to be one of the frontrunners in improving our industry before we get asked by the regulators and governments to do so”.

Meanwhile, also in today’s FT, George Soros offers a detailed plan to recapitalise the banking system using the US$ 700bn bail-out package agreed by Congress. He also warns that “time if of the essence” and that “only by promptly announcing a comprehensive set of measures and executing them vigorously can the situation be brought under control”.

Clive Crook, in his article, puts forward an idea promoted by Pr. Avinash Persaud, Chairman of Intelligence Capital Limited and a member of the Network for Sustainable Financial Markets, to introduce “contra-cyclical capital requirements” which would “force banks to build up capital faster when their lending is expanding most rapidly.. [effectively] taxing the expansion of credit and building a bigger cushion for any bust”.

Finally, the FTfm dedicated a section to global pensions and published an article highlighting the fact that 3/4 of UK pension funds had a responsible investment strategy (according to a survey conducted by the UK Social Investment Forum). In the case of Barclays UK Retirement Fund, this strategy may have paid off; the emphasis on good governance has helped the fund win important mandates, according to its fund manager Mark Hyde Marrison (watch the video here).

Similarly the UK Environment Agency (a pension fund with £1.5bn AUM) has also announced that “it would only hire UNPRI signatories for future mandates”. This anecdotal evidence is encouraging because it suggests that the principles that underscore sustainability investing can have a material impact, not only on investment returns, but also on asset managers’ ability to attract new clients.

Whilst this starts to provide a systemic approach to the industry, we have yet to hear more concerted voices from the responsible investment community on other industry-wide issues that require collaborative efforts with a view to improve financial market mechanisms for the long-run.

Yesterday we pointed to the fact that there was relatively little analysis and self-criticism coming out of the ESG/SRI community or the broader financial community with regard to the current crisis. So it was refreshing to see an article from the WBCSD President Bjorn Stigson, in today’s FT Sustainable Business section, on the parallels between the climate change negotiations and the financial crisis.

Stigson sees the current financial crisis “as the result of unsustainable business models in the finance sector.” In his opinion, “the finance industry has lagged behind in addressing sustainability issues” and “the current financial crisis is shedding light on the flaws of the current business models in the finance sector and the enormous extend to which public trust has been damaged”.

He goes on to say that “to regain this trust, the finance industry will need to revisit its role in society and deliver updated business models that consider current societal expectations of open and transparents businesses that demonstrably deliver value to society”.

Whilst some of this rings true, it fails to capture the complexity of the finance industry and financial services. Do fund managers share the same responsibility as hedge funds, investment bankers, traders, mortgage lenders or credit rating agencies? As Hendrik du Troit, CEO of Investec Asset Management, pointed out recently in the FT “the attack on Wall Street is indiscriminate”. Yet he also admits that “we’ve been part of pushing banks to make more profits instead of making sure they were building more stable businesses.”

So there is a need for a little more soul searching in the industry. And this also present a significant opportunity for the SRI/ESG community to assess the robustness of their research model and investment philosophy. Surely there are some lessons to be learned for all of us involved.