BLI: Plato's look on sustainable and responsible investment

11 maart 2024

By Thierry Feltgen, Head of SRI Strategy & Stewardship Thierry Feltgen at Banque de Luxembourg Investments

Sometimes, 'the obvious' can be deceiving. It might seem apparent that by choosing virtuous and avoiding harmful companies, investors have the leverage to put the global economy on a superior path in terms of sustainability. Unfortunately, this convenient thesis falls apart upon closer inspection – in the same way as shadows on a cavern’s wall are just a projection of real objects and not reality as such.

In his allegory of the cave, Plato describes a group of people who are imprisoned in a cave. They have been chained to a wall, all their lives, unable to see each other and face a blank wall. On this wall, they see the projection of shadows of objects passing in front of a fire. The prisoners give names to the shadows and infer reality from the shapes they see.

While the shadows are the prisoner’s reality, they are not a fair representation of the actual reality. The shadows represent the fragment humans can normally perceive with their senses, while the effective objects under the sun represent the wisdom that can only be perceived through reason.

Relevance of the allegory for sustainable finance

The prisoners in the allegory fall for the fallacy that shadows are a full representation of reality – which seems to be a good analogy for the generally accepted perception of sustainable finance. In fact, many efforts that are made in sustainable finance support a positive narrative about the widespread effects of “virtuous investment”, which on closer inspection, unfortunately prove elusive in the real world. They are like Plato’s shadows.

The narrative is the following. Computing statistics about the positive and negative effects of the companies in investment portfolios provides guidance to investors in terms of how these portfolios may (or should) be optimised to reach a superior environmental or social status. Linked to this are measures of positive and negative impacts of investments – with overweighting positive impact issuers and avoiding as far as possible negative impact issuers being the logic consequence.

This narrative percolates in many instances.

Banks and investment managers produce colourful brochures for sustainable investment products holding investments with virtuous features implying that by investing in these products the investors may participate in the drive to make the world a better place.

It is however by no means limited to marketing departments of financial institutions – where some positive exaggeration might even be expected. Matters get tricky when regulatory requirements (European Commission, ESMA, Finance Authorities) encourage this narrative. As per regulation financial market participants are required to report this type of data in multiple reporting documents.

Since 2023, financial market participants are held to publish an annual “Principal Adverse Impact” statement with a series of key environmental and social statistics. Year after year, this report needs to be published and progress about the statistics commented. The casual observer might conclude that with improving statistics of financial portfolios, the world will be on the mend.

Finally, in their recent proposal reviewing the Technical Standards of the SFDR^[1] regulation, the ESA^[2] suggest the addition of a supplemental chapter in the legal documentation of investment products. Should the proposal be accepted, investment products will be required to declare, whether they aim to decrease the greenhouse gas emissions from their investments. There are three options:

• By investing in assets that are expected to lower their emissions of their activities.
• By engaging with investee companies to influence their business decisions to lower emissions or
• By selling investments in assets with high emissions to instead buy investments with lower emissions.

Reduction targets will visualise the ambition of the investment strategy.

If the regulator requests this kind of declaration, it should have a direct effect, shouldn’t it?

The inconvenient truth about this is that while it is always possible to calculate and manage a statistic, if it does not translate into in real-world effects, they are in vain. In essence, the first and last option that are proposed by the ESA fall into that category^[3].

Indeed, the impacts that are generated by companies bought in the secondary markets happen independently of the investors^[4]. This is because stock ownership changes – and consequently, the ownership of the company capital represented by the stock – in the secondary markets happen without the issuing company receiving any new capital. The company received the cash payment when it first issued the stocks. Hence, the transaction on the stock market is neutral for the activity of the company and any real-world effects it may have^[5].

The consequences are significant for investors seeking real-world impact: since company activities happen independently of investor activities on the secondary markets, it is not possible to attribute any (positive or negative) impact the investee company may have in the real economy to these investment streams.

In other words, investments on the secondary market do not provide any additionality: by investing in the impactful company, the investor does not allow the company to provide more positive impact. Conversely, divesting from a harmful company will not prevent it from doing harm.

The only effect of investing in virtuous companies while avoiding harmful companies resides in a possible alignment of values between the final investor and the investment portfolio: the positive glow of owning “good” companies. While this feels good, the real-world effects don’t go beyond this feeling.

One might take the position that while the real-world “investor impact” of investments in the secondary markets is elusive, the calculation and publication of non-financial portfolio statistics will not do any harm.

I strongly disagree.

The calculation of futile 'shadow-like'-statistics and the effectless optimisation of portfolio statistics are a time-consuming distraction from initiatives that do have a direct effect. In addition, in case said “portfolio optimisation” constraints which are based on ineffective metrics hinder proper portfolio management and diversification we face value destruction.

Worse still, the narrative that 'following virtuous portfolio optimisation will heal the world' points society into the wrong direction: if the diagnosis is wrong, the cure will be wrong too, and we risk missing the opportunity to put the world on an improving trajectory.

It is a nice dream to think that all you have to do to save the polar bear is to invest in “virtuous” companies. If it was that simple, the polar bear wouldn’t need saving in the first place. In fact, experience teaches us that if a story looks too good to be true, unfortunately it tends not to be.

Don’t get me wrong I strongly believe that the world and its economy need to change course. However, let’s not waste energy and time playing an ineffective reallocation game. Nice stories and statistics will not do the trick. Actions that have effects in the real world will.

Let’s leave the cave

In Plato’s allegory, the prisoners are freed and are allowed to leave the cave, but the brightness of the sun makes them wish to return to the cave.

In the case of sustainable finance, the formerly described narrative of investing in virtuous companies while avoiding harmful companies is very comfortable, easy to grasp and too simplistic. Getting out of the cave means leaving the comfort zone of assumed and agreed certainties behind and devise strategies that effectively do have a positive effect on the real world within a reasonable time frame.

The good news is: there are indeed strategies that generate positive real-world effects.

The bad news: they are much less simple and more long-term to implement than simply reallocating a portfolio.

The 'shadows-analogy' implies that investing or divesting on an individual base generally does not have any measurable effects on the real world. Then what does?

To identify the channels allowing to influence company strategies – and have an effect on the real world – it helps to realise that equity ownership represents a co-ownership of a company. Being the owner of a company, you may voice your opinion on how it should be managed – formally in company general meetings or informally by entering into dialogue with the company. This boils down to the simple fact that while company management runs a company, the owner has a say on how it should be run.

Investors who wish to voice their expectations have four distinct channels at their disposal – with increasing levels of effect.

• Individual dialogue with companies,
• Individual voting at general meetings,
• Collective dialogue with companies,
• Collectively coordinated voting at general meetings – possibly combined with individual motions.

Since most investors are small compared to publicly listed companies, entering into individual dialogue with companies will not help a lot changing these companies from the inside. The weight of individual investors is simply too low. However, the dialogue with companies on specific sustainability topics will help investors to better understand the analysed companies and decide for their own sake whether the company manages its relevant risks (be it financial or non-financial) well.

Individual voting at general meetings of companies largely falls into the same category: the weight of individual investors (even that of big asset managers, the likes of Black Rock) is just too small to skew the vote in a certain direction. However, with proxy voting services enabling time- and cost-efficient voting campaigns, the rate of investor participation at general meetings is increasing. The mass-effect will not fail to take hold – especially with regulation pushing the investment community in the direction of a more and more responsible and sustainable mindset.

In case real and urgent change is intended, the most promising strategies consist in collective interaction with companies where investors forge alliances to induce companies to change in a certain direction.

The diplomatic option is to enter into dialogue with companies through collaborative engagement campaigns. The outline of such a campaign takes the following form. A lead manager identifies a relevant topic for a company, structures a project in which the facts (e.g., significant water pollution of a plant owned by the company) as well as the request to the company (letter to the board asking for an explanation for the reasons for the identified issue / request to install a sewage treatment plant) are exposed. The project, together with any supporting documentation, is posted on collaborative engagement platforms (e.g., the one offered by UN PRI), inviting other investors to join the campaign.

The beauty of this approach is that while a single asset manager representing say € 50 bn may not have enough weight to be heard, the combined weight of 15 such asset managers may create enough pressure to open the path for proper dialogue – of course depending on the size of the targeted company.

In case this non-formal dialogue does not lead to satisfactory results, there is the possibility to escalate by coordinating the voting power of the collaborative alliance to make its point. Possible strategies may be to vote against the directors responsible for identified harmful practices. Informing company management of the collaborative vote and exposing the background of the action will provide it with more impact.

The pinnacle of investor intervention is the submission of special motions at the annual meetings supporting their change project within the company.

It is true that the democratic process at general meeting may not necessarily lead to the hoped changes. Many investors still do not care about positive change – more often than not short-term financial considerations prevail. However, if the objective is to generate impact and to change the way our economy is run, there is currently no better way.

You might object that these strategies are not simple and that they are hugely time-consuming with limited effects on reality.

The answer is simple: There is no reason why it should be easy – especially if 'easy' solutions are ineffective. Unlike the management of statistics, engagement and voting strategies enable investors to interfere with real-world processes, which is needed to change the economy 'from within'. And finally, while engagement and voting have a limited effect on reality, they are largely superior to strategies that have no effect.

To return to Plato’s allegory: we can stay in the cave and continue to compute ineffective statistics bearing no link to the real world and wonder why nothing changes or leave the cave and work on strategies that foster the change we need.

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^{[1] Sustainable Finance Disclosure Regulation}

^{[2] European Supervisory Authorities: EBA, EIOPA et ESMA)}

^{[3] In case an overwhelming majority of investment managers apply 'decarbonisation targets' as a consequence of this regulation, there might be an effect on the stock price of concerned companies – which in turn might trigger a change in company behaviour. This effect may be labelled as the “federating effect of regulation” – which is highly indirect and so far, not researched.}

^{[4] For a detailed discussion of this effect, please refer to my former article 'SRI deconstructed – and reconstructed'}

^{[5] There is one instance where the company is not indifferent: if many investors are interested in the company, its stock price performs better. The company is less at risk of being taken over and in the event of a new capital issue, the additional public offering will have more prospects of success. In addition, share price performance will matter to shareholder value-oriented management. This effect is however not direct and may only materialise over the very long term.}