What kind of businesses can drive fairness, equity and good environmental outcomes? Can capitalism deliver and what can government do? How do we measure outcomes and are we even asking the right questions, such as the cost of externalities?
In this fascinating dialogue with one of the world’s deep thinkers on environmental social governance frameworks for investment, ABC journalist David Speers teases out some powerful insights in the reality of investment in a rapidly changing world.
He’s talking to Colin Melvin, founder and managing director of Arkadiko Partners, who was part of the team that coined the term ESG (environmental social governance) and was involved in the development of the United Nations Principles for Responsible Investment.
The interview was a highlight of the annual conference Business Council of Co-operatives and Mutuals, which represents businesses owned by their members (instead of shareholders).
Melina Morrison, chief executive of the council which claims eight out of 10 Australians are members of a mutual or co-operative, said her members types of businesses are 25 per cent more resilient that others and now faced the opportunities to engage in the “global trend towards ever high ESG standards”.
The event, held last week at the Intercontinental Hotel in Sydney, was themed as “The Sustainability Edition” and included speakers such as professor Ross Garnaut who recently published his book Reset through Black Ink Press, Mary Delahunty head of impact for superannuation group HESTA which has nearly 900,000 members and $52 billion in assets, Jacki Johnson, advisor to Insurance Group Australia, Rohan Mead, group managing director and CEO of Australian Unity, Heidi Lee, CEO of Beyond Zero Emissions and Rohan Lund, group CEO of NRMA.
Following is a lightly edited version of the interview.
David Speers: Can we start with your role in coming up with the whole idea of ESG – can you tell us a bit about how it came about? Why did you think that the original concept was needed?
Colin Melvin: ESG was part of the dialogue around the United Nations’ Principles for Responsible Investment. I was involved in that project early on, in 2004, 2005, and I was part of the drafting group. I didn’t come up with the acronym just myself, but with a group of people.
We were considering what we should call all those things that might impact the long-term value of an investment decision, which we weren’t currently considering. That is, the value of the asset we were investing in.
We were looking around for different words, social, environmental, governance and so we came up with the ESG as a shorthand for saying everything that might impact the long-term value of the decision we’re not currently considering.’
Can capitalism help achieve fairness and equality?
DS. I have a quote from you, “Capitalism, as it has functioned through the ’80s, ’90s and early 2000s, was broken, that there’s much more demand for a longer-term trend towards getting back to greater fairness, equality, and opportunity”.
Many would agree with that, but you could also argue this is the role for government, to achieve that sort of fairness and equality itself. Why did you believe that private investors could drive this sort of change, or should drive this sort of change?
It’s not either/or. I think it’s both/and. You need both parties to be participating together and we should remember that government doesn’t legislate in a vacuum.
It’s also very difficult for national governments to control multinational corporations, or to rein them in. Investors can get involved in the setting of policy, or indeed could perhaps do more in that regard, just as companies do. So, we needed both.
Governments have a pretty mixed record, when it comes to actually driving change. There is a kind of natural short-termism baked into the electoral cycle as well, we must remember. If you’re going to seek re-election every three, four, or five years, you’re disinclined to be introducing new taxation, for example. And of course, on certain measures, it’s taxation that we very clearly need.
So, it seemed to us at the time, and it still seems to me now, that there’s a role for private actors, businesses and investors, to work together for common benefit, and to shift focus away from the transaction as the source of wealth creation towards the relationship. From the short-term to long-term. That’s the key to understanding, I think, the shift towards sustainability.
The purpose of business
DS: So how was that shift initially received? Were there many at the time that said, “Well, hang on. Businesses are about making money. That’s how the market works. We shouldn’t be about all these other things.”
CM: Well, it’s very clear that business requires to make money. It’s like oxygen for business, but it’s not the purpose of business to make money. That was clear to us at the time and I think it’s increasingly clear to a very large proportion of the business and investment community now.
You’re referring to the so-called Friedman doctrine. Milton Friedman famously said that “The purpose of business is to make to make money for its shareholders” even if he didn’t really believe it, in its concentrated, or stark, form at that time. It’s fairly clearly not the purpose of business. But business, and those of us who invest in business, understands that there’s a purpose behind it. The purpose is to provide solutions to needs.
DS: That’s a really interesting question. What is the purpose of business? Why does a business exist? Do you think the business owners or managers have the answer to that?
CM: There’s a very interesting and active dialogue around two things at the moment. One is corporate purpose and the purpose of investment companies, and the other is impact. And both of these kind of work together. I think a lot of businesses haven’t fully articulated their why yet.
Why does the business exist? And when I was running the stewardship service at Hermes Investment Management, that was one of the key questions we would ask the chair or the chief executive of the companies that our clients invested in, was “What’s the purpose of the business?” It really elicited very interesting responses. And you could often get some insights into the quality of management and direction of the firm through that sort of dialogue.
The gradual adoption of ESG
DS: So in the years since the concept of ESG was formed, has it been well understood, or has it become confused? Have some picked and chosen amongst the three elements? Do they get that they need to work together as a whole?
CM: It has been a little confused. At its best you can see the rise in interest in ESG, and sustainability, and investment, as a clear potential of momentum for change and I think that’s the best way to look at it, really. However, within that, you do see the acronym ESG attached to pretty much anything.
You can see paragraphs, purpose statements, mission statements and so on, full of ESG. And the more I see it within a single sentence or paragraph, the more doubtful I am that it actually means anything at all. Wherever you see ESG, it’s worth asking yourself, “Does this mean impact? Does it mean stewardship? Does it mean improving the quality of investment decision making or business strategy?” And if it doesn’t mean those things, what does it mean? That’s really worth considering, because we are in danger, within the investment community, of setting something up separate from investment, which is responsible investment, which, of course, is a mistake.
The whole point of the UN Principles for Responsible Investment was to change the way investment itself works, not to create something else. It’s the responsibility of business and the responsibility of investment, which then is seen to drive performance in the longer run.
DS: Can we pick apart the ESG here, because there may be some advantage for mutuals in the areas that are perhaps often neglected. But at the risk of focusing on E, where I guess there has been overwhelming focus, what are your thoughts? We have this fascinating, and slightly weird, debate in Australia when it comes to climate change in particular, where a lot of business- certainly all the main business groups, Business Council of Australia and so on, the farming lobby, are all in support of greater action, whether it’s setting the target of net zero emissions by 2050 or having a properly regulated mechanism to get there.
The government, by contrast, isn’t yet at either of those goals. Within that dynamic, do you think business is doing enough to pressure the government? Many listed companies are going out on their own and setting targets and doing things. But should they be pressing the government harder?
CM: Yes. I think so. I think we need more robust engagement with government to get the right regulation, to get the right outcome. I don’t think the government can hold out for much longer. It is swimming against the tide. But as we discussed earlier, there is a natural disinclination by legislators to bring in the regulation we need properly to address these issues. They just don’t think long-term enough. The electoral cycle is naturally short-term, so it requires robust engagement by business, and by investors, to get governments to do the right thing.
We should also recognise the lobbying that goes on by the companies themselves. Although the leaders of many companies are now starting to say the right things, their colleagues are still spending shareholder money, investor money, lobbying to reduce regulation, and this is happening globally. That needs to change. It’s a kind of lazy assumption that, because the leadership are saying the right thing, everything’s fine in the background. It’s not fine in the background. There’s a toxic relationship between business and government, which leads to lobbying money, which leads to the wrong sort of regulation almost by default, through industry bodies. And that really does need to be addressed.’
DS: On the S, then, in ESG– last year, we also saw, amidst the pandemic, the Black Lives Matter movement in the United States, and I think around the world, to varying degrees – this campaign for tackling racial inequality.
Many businesses are trying to grapple with diversity and inclusion. Is this what we’re talking about and how important is tackling that S in the equation here, when it comes to ESG?
CM: It is massively important. And I think we’re going to see more attention to this as the world recovers from the pandemic. You mentioned diversity, and the Black Lives Matter movement. This, of course, is not just a single event, but a series of events. It’s part of that mega trend that we discussed earlier, towards greater fairness in society, which cuts across pandemics and other crises.
The trend is towards business attending to the needs of people, and towards taking a more relational approach. In terms of diversity, it’s essential for business success. Diverse teams are more creative, they reflect more clearly the interests of the stakeholders and the business. It’s just now becoming obvious that this is the right thing to do. I would encourage all of CMEs to consider very carefully the social aspects of business, not as something altruistic, or pure in its own form, but as key to business success in the future.’
DS: And then the G. Just tell us, is this really about bringing it all together, the glue to actually deliver what we’re talking about here?’
CM: Good governance is behind it all, really. Good corporate governance is the quality of the direction and control of the business and we’ve had guidelines on this globally for decades. If you look at the World Bank, the International Corporate Governance Network, they’ve got fairly clear guidance, which applies internationally.
Virtually every developed market now has local corporate governance codes and guidelines, which are policed by investors. So it is, as you say, what brings it together. Behind every company that’s got a significant strategic, social, or environmental risk, or a problem, or an opportunity they haven’t yet grasped, there’s a governance issue somewhere. And so good governance supports good business success.
Investing for impact. Stewardship.
DS: What is the difference between impact investing, stewardship and ESG?’
CM: All these definitions are still in flux, they’re part of a dynamic conversation within the investment industry. Impact investing was very niche until quite recently; it was, effectively, a kind of venture capital. You were allocating new capital with the intention of doing something additional – intentionality plus additionality, and you would maybe take less of a return as a result. You’d feel good, because you’d done something good in the world – there’s nothing wrong with that, and that’s a very valuable thing, but it’s quite niche, quite small-scale venture capital.
This idea of impact investment has come right into the mainstream now. People investing in public markets, buying shares from someone else, are starting to say the impact of the company, whose shares they’d bought, is somehow their impact. But that doesn’t seem right, because there’s no new money going into this. You’ve just bought the shares from someone else.
So, there isn’t really an impact unless you’ve done something as a result of your ownership, it would seem. And that’s where stewardship comes in. Stewardship is the quality of the ownership of the asset, and then how you behave as an owner, how you use your shareholder rights, and the responsibilities attached to that, and so on. Impact has shifted from venture capital to the mainstream, but it’s somewhat confused. The major impact in public markets is through the quality of ownership of the firm. And in many cases, it’s not very good quality ownership. It needs to improve. And then you’ve got the whole debate around ESG itself, and the integration of ESG into investment decision making, which is another feature here.
DS On the shift to the mainstream of all of this, we should talk about Larry Fink. Of course, very well known, and perhaps arguably the world’s most powerful investor. And the letter that he writes to CEOs each year – the latest came out just a few weeks back, in which – I thought he made an interesting point.
Many might have suspected during the pandemic that issues particularly around climate change, would have dropped down the order of importance. But it seems quite the opposite. He is really stressing once again, in fact, more so, the importance of tackling this, amongst ESG issues.
And he makes the point that there’s been a whopping 96 per cent increase in sustainable investing since 2019. Do you share the view that the pandemic has only emphasised, I guess accelerated, the trend here of ESG?
CM: I think there has been some acceleration, but remember, this is a long-term trend. It’s a mega trend. My own career and involvement in this goes back 27 years, way before it became fashionable, and has covered several crises, of which the pandemic is the most recent. But the trend has continued. After the global financial crisis in 2008, you might have thought, “Well, that’s the end of it. People will retreat to short-term money,” but, in fact, the opposite happened. There was a growth of stewardship and interest in sustainable investment very markedly after the crisis. Right now, what we’re seeing, I think, is a deep understanding of our interdependence.
If you atomise societies and economies, if you force people apart, it’s very clear that they need each other in order to create wealth. And I think that’s behind part of what we’ve seen. But the bigger point here, really, is that this mega trend towards sustainability, this shift towards greater fairness in our economies and societies, this understanding that we are interdependent, and that wealth arises through the quality of the relationships we have and generate as businesspeople, as investors, not through our skill in buying and selling things from each other. We need to do that but doing a turn on the transaction is not how you create wealth in the longer run.
Measuring ESG value
DS: Larry Fink also made the point in this year’s letter about the need for companies to detail how they’re going to achieve what they say they’re going to achieve. He says, “We expect you to disclose how this plan is incorporated into your long-term strategy and reviewed by your board of directors.” I guess that brings us into this conversation around how to measure, what standards should be agreed upon, how to report these issues. How is the process going in this space of actually measuring progress?
CM: There is a lot of effort going into this. There are groups of investors and companies looking at impact measurement, but it’s all very much in its infancy. I do, though, get a little concerned when people say, “Show me the data”.
The data is the problem, because it’s often only to the extent we haven’t properly focused on the right measures and requirements yet. If you think about a business, and assessing the value of a business, we are yet to the point where we can properly understand what are called, or termed, externalised costs.
This notion of a business externalising costs onto the environment, which may need to be picked up, or the business will be forced to pick up the costs through consumer preference changing, or regulation. That isn’t part of the dialogue around the accounting for business success at the moment and those are the kinds of things that need to change. So, a simple search for data and reporting doesn’t really get you there. It’s an easy thing to complain about, but I think there’s a more fundamental point here, which is actually assessing and valuing the contribution of business, which goes beyond the financial contribution in the short term.
DS: There are some voluntary standards there, but do we need more unified global standards?
CM: There are some attempts to do this, at least within the European context. You might be aware that there’s new disclosures coming into force on the 10th of March which are going to require investors to make clear the aims of their investment products, as to whether they’re sustainable or not, the kinds of businesses they’re investing in, what their intentions are, and so on.
So that’s an attempt to standardise the labelling of investment products in relation to sustainability. I think we’re going to see more and more of these types of efforts, but fundamentally, it comes down to human behaviour, the leadership, and the quality of leadership of our firms and our investing institutions, and an understanding of how we create value in the longer run.’
The development of global Environmental, social and governance standards (ESG)
Currently, ESG reporting is reflected in the many voluntary standards that have emerged, but the range of initiatives is confusing for both investors and companies trying to develop meaningful reports and assessments. Some ESG reporting standards offer competing alternatives, while others complement each other.
Disclosure standards and frameworks provide the foundation of this as they facilitate the disclosure of comparable, consistent, and reliable ESG information. Using this information, data providers and rating agencies can build tools, analytics, and resources for the capital markets.
Co-operative and Mutual Enterprises and ESG
DS: Let’s look at the context for co-operative and mutual enterprises. CMEs here in Australia operate across a whole range of industries: banking, agriculture, motoring clubs, health care insurance, and so on. They’re values based, they’re purpose-driven mutuals.
They now have the option to potentially include investment partners. What do you believe are some of the opportunities, and, indeed, the challenges for mutuals and co-operatives?
CM: The opportunities for mutuals, I think, relate to the corporate structure and ownership structure itself. One of the challenges you have in publicly owned firms is the requirement for short-term results and returns. The tyranny of the market, and the still kind of lazy expectation that you’re going to keep on improving earnings on an improving trend, and that dialogue you have with the owners of the business, who aren’t really owners at all, but rather asset managers focused on short-term results. That’s still fundamentally the case, although, hopefully, it’s starting to change.
Mutuals don’t have that problem. They have a very clear alignment of interest between the owner and the business. A coincidence of interests. And I think that gives them an advantage in the shift towards a more relational perspective on business and investment. I think that’s a very good starting point, and it enables these businesses to take a longer-term perspective, and genuinely to reflect the interests of their owners.
Measuring Mutual Value
DS: Coming back to the question around setting standards, developing standards, and having some uniformity here, is there a risk that they won’t fully incorporate the mutual business model that we’ve been discussing? Should mutuals, do you think, work more closely together to try and help the investment community understand what their distinct purpose is?
CM: Yes, I think so. We need a variety of corporate forms and ownership. I think it’s very healthy to have that. I was part of the Ownership Commission set up by the UK government some years ago, and that looked at different corporate forms, including the mutual form, and, indeed, proposed that the government introduced policy which encouraged different forms of ownership of companies.
I think the mutual sector has got a lot to offer. The style of ownership lends itself to a longer-term perspective, so there’s a great connection between the interests of the owners and the interests of the business overall, and that’s not there in the same way in public markets. I think it’s actually very well set up to think more relationally, and more long-term, than transactionally.
This next piece is a breakout
DS: There is, in fact, some work under way here. BCCM and Monash University have developed a methodology for measuring the value that mutuals and co-ops can generate. They’ve called it the mutual value measurement. Is this the sort of front foot approach of trying to define and measure that value, that should be put forward to investors?
CM: Yes, that sounds like a great initiative, I think it would be good to see that. We should also make the point that governments are in a position to introduce policy which can support mutuals and the mutual structure, and I think it would be sensible to do that.
The future of ESG
DS: Looking at the trends, then, at the moment. I mean, where do you envisage ESG, and investing more generally, to be at in the next decade? If we look at coming out of this pandemic, and the sort of things that Larry Fink and others are saying, what do you see in the future?
CM: I spend a lot of time in my work as a consultant with asset management firms globally. Through my business, Arkadiko Partners and for one of our larger clients, which is one of the top 10 asset management firms by asset size, in the past year, we did a survey of their key prospects and clients. They selected 10 of their prospects and clients that they deemed to be most advanced in sustainable investment and we went to talk to them. We interviewed them all to find out what they thought was going to happen.
Rather than us making it up, or gazing in the crystal ball, we thought, “Let’s go and talk to the people whose money it is we’d be investing.” The key takeaway from that was that the sustainability of the investment management firm, not the strategy or product, but the firm itself, was a key consideration in the pension funds hiring the investment manager. It was no longer enough just to offer the right product or service, which of course has been the case for decades in investment. But you, as an investment management firm in yourself, should behave sustainably. That’s fascinating, because that is that shift from the transaction to the relationship as the source of wealth creation. These big pension funds are looking to build a relationship with an asset management firm which shares a purpose and a set of sustainability traits and behaviours, with that shared purpose leading to a longer-term relationship, which leads to the creation of value.
I think that’s the shift. It’s away from the transactional to the relational. It’s from the short- to the long-term in business relationships.
DS: At the end of the day, does it work, ESG investment? I mean, I know it’s not all about the money, we have discussed that. But what do the results actually show for the bottom line?
CM: It is about the money in the sense that profit is oxygen for business, and investment needs to find a return. The point is that in the longer-term, the creation of value or wealth is the same as the creation of wellbeing. It is, in the end, human flourishing and that’s what you’ll see rewarded.
Now, is that happening in terms of the returns to sustainable investment products at the moment? Yes. They’ve been performing very well. Now, you might say, “Well, they’re just carbon-related effects, oil price is depressed,” and so on. I think it’s more than that. And we’re going to see this coming through more strongly going forward, I suspect.
So, if there is a mega trend towards sustainability, if this is the way that business and investment are going, then I would think that’s the trend to follow.