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«Sustainable Investment Amsterdam, 31 August 2010 Commissioned by Duisenberg School of Finance and Holland Financial Centre Sustainable Investment ...»

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Legislation According to Renneboog et al. (2008b) the SRI industry has been able to grow, partly because of changes in regulation. Since 2000, several countries implemented bills in which the disclosure of social, environmental and ethical (SEE) information becomes compulsory. The first country to implement such regulation was the United Kingdom, which obligated trustees of occupational pension funds as from 2000 to state to what extent the selection of investments is influenced by SEE considerations.

Other countries followed. Today, most (Western) European countries have adopted SRI regulation, but there is no mandatory transparency law at European level. The European Parliament is working on increasing the transparency of institutional investors. Eurosif is trying to introduce an EU-wide Statement of Investment Principles (SIPs) for investments funds. By establishing this, pension fund trustees would be obliged to report on how they are taking Environmental, Social and Governance (ESG) risks into consideration (Eurosif, 2008).

As these products are at the heart of their corporate activities (their raison-d’être), it determines whether the financial institutions are in fact socially responsible themselves. In other words, one could argue it is CSR practiced by financial institutions.

In a sense, financial institutions play a ‘dual role’ as they also offer financial products that allow investors to invest socially responsible (e.g., green funds).

Both capital sources (project finance and funds) typically appear in different stages of the project life cycle (Biermans, Grand, Kerste, & Weda, 2009). This might result in differences in the impact of SRI on financial attractiveness, and offer an interesting venue for future research..

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Table 5 in Appendix A provides an overview of SRI regulation per (western) country.

Voluntary Standards In addition to regulation there is an increase in voluntarily adopted measures to enhance the disclosure of information about the nature of companies and/or projects. The argumentation for voluntary standards is is as follows. Many companies apply for loans to implement their projects and that Through the provision of financial products (e.g., loans, project finance and insurance), financial institutions can indirectly influence the sustainable developments by voluntarily adopting standards that limit their business to projects that are developed in a socially responsible manner and that reflect sound environmental management practices. This way, negative impacts on project-affected ecosystems and communities could be avoided where possible and, if these impacts are unavoidable, they should be reduced, mitigated and/or compensated for appropriately (Andrew, 2008; Papadopoulos, 2009; Richardson, 2007).

A well-known example in this regard is the development of the Equator Principles (EPs) in 2003 (Box 3). Other examples include the Global Reporting Initiative (GRI)18 and normative frameworks such and the Collevecchio Declaration. See Box 4 and Table 6 of Appendix A for more information on voluntary standards related to SRI.

Box 3 The Equator Principles Parties adopting the EP promise commitment to environmental assessment based on: (i) compliance with host country laws, regulations and permits applicable to the project; (ii) World Bank and IFC Specific Guidelines;

and (iii) the IFC Safeguard Policies and IFC Pollution Prevention and Abatement Guidelines for the relevant industry sector (Coulson, 2009).

More than 65 banks have adopted these principles and apply them to projects worldwide. These banks have become known as the Equator Principles Financial Institutions (EPFIs). Because banks can voluntarily apply these principles, there were some initial challenges with actual fulfillment of the requirements. Since 2006 there are stronger covenants to ensure compliance. There is however still a disclaimer included in the principles, preventing that banks are faced with punitive actions for not disclosing information. More generally, there are concerns about the enforceability of the principles with the current lack of legal recourse (Andrew, 2008;

Papadopoulos, 2009). Furthermore, critics point to failure to reach agreement on how one can evaluate the impact of Equator adoption on both bank and borrower performance, a lack of disclosure by banks, and evidence that banks subjected to the EPs still support investment in controversial project and activities (Coulson, 2009).

There has been debate on the economic incentives (as opposed to compliance incentives) for financial institutions for constituting and adopting the Equator Principles. Almaric (2005) argues that the effectiveness of the EPs – i.e., the likelihood of EPs contributing to sustainability objectives – is highly dependent on the economic drivers underlying the EPs. If EPs are a a strategy devised by high reputation risk banks to restore the level playing field with their less exposed competitors, and/or if they serve to counter critics of large development projects (e.g., large-scale dams), the likelihood of EPs contributing to sustainability objectives is small. Likewise, Wright & Rwabizambuga (2006, p. 90) offer evidence that “codes of conduct are primarily adopted by firms as signaling devices for demonstrating positive credentials, with the aim of strengthening The Global Reporting Initiative (GRI, www.globalreporting.org) was launched by the Coalition for Environmentally Responsible Economics (CERES) and UNEP in 1997. This “multistakeholder process” created an internationally applicable framework for reporting on sustainability issues (including a sectorspecific supplement for the financial sector (GRI, Financial Services Sector Supplement: Environmental Performance, Pilot Version 1.0, March 2005): reporting principles and specific indicators to guide sustainability reporting for companies and other organizations. The third generation of these guidelines, issued in 2006, are known as G-3. GRI has become the dominant standard for non-financial reporting (Richardson, 2007). KPMG (Kolk, van der Veen, Pinkse, & Fortanier, 2005, p. 20) states that 40 percent of respondents in their CSR reporting study noted that the GRI was determinative of the content of their company’s sustainability report. See also Willis (2003) and the GRI Register.



corporate reputation and organizational legitimacy more generally”. Scholtens & Dam (2007) reach a similar verdict: their analysis shows that CSR policies are rated significantly higher if FIs have adopted the EPs, and that adopters of the EPs tend to be bigger firms (i.e., banks that are in the spotlights).

Financial institutions are reluctant to disclose information about the processing and assessing of project finance because it would infringe client confidentiality. Whether the adoption of the principles actually leads to more socially and environmentally responsible projects, would be worth further investigation, ideally using data about the projects and their characteristics and data about CSR performance on a project basis. Additionally, future research on this subject could also focus on analyzing differences in financial performance between banks applying the principles and banks that do not. (Andrew, 2008; Papadopoulos, 2009; Scholtens & Dam, 2007, p. 1322). Some of the sparse empirical work on this topic is done by Scholten & Dam.

Scholtens & Dam (2007) find (indirect) evidence that signing up to the Equator Principles (EP) is associated with higher costs, similar to previous reasoning by Wright & Rwabizambuga (2006). They also conclude that “[t]he combination of observing larger banks adopting the EP and observing lower operational profits for these banks suggests that adopting the EP[s] is not window dressing but exhibits some real costs” (Scholtens & Dam, 2007, p. 1322). For larger banks, according to the authors, the benefits of signing up to the EPs outweigh the costs. Their logic is that “[s]everal event studies showed that shareholders did not react negatively to signing up, which implies that shareholders expect that adhering to the Equator Principles will not significantly affect shareholder value”. This could either imply that project finance is merely a small part of their total business, or that there is no (direct) tradeoff between banks’ CSR and their stock returns.

Note also that FIs benefit from the CSR reporting initiatives by companies (either voluntarily or compliance-based) in the sense that it helps them comply with their sustainability (reporting) requirements, such as the EPs, more easily. As funding (and other financial products, such as insurance) is at the core of FIs’ activities, the increased importance of CSR and CSR reporting for companies (see section 2.4) implies that voluntary SRI codes of conduct are becoming continually more relevant.

3.2.3 Salient Information The third reason for incorporating sustainability information is that it provides more information about a company, information that can be salient. E.g., sound social and environmental performance might signal high managerial quality, which translates into favourable financial performance (Renneboog, Ter Horst, & Zhang, 2008a; Renneboog et al., 2008b).19 Vice versa, firms may use CSR disclosures as one of the informational signals upon which stakeholders base their assessments of corporate reputation under conditions of incomplete information. For instance, high CSR reputation ratings may improve relations with bankers and investors and thus facilitate their access to capital (Fombrun & Shanley, 1990; Orlitzky et al., 2003; Spicer, 1978).

Renneboog et al. (2008a; 2008b) consider this signalling function as an argument for their ‘outperforming SRI hypothesis’ (see paragraph 3.3.5).

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3.3 Performance of Sustainable Funds The performance of SRI funds in comparison with conventional funds has been the subject of many empirical studies and many econometric methodologies.20 This section will discuss their key conclusions as well as identify shortcomings.First, theory on differences in performance between sustainable and conventional funds is covered in paragraph 3.3.1. The remainder of this paragraph discusses a series of Mutual Fund Studies aimed at identifying the performance of SRI funds. After a general overview in paragraph 3.3.2, paragraph 3.3.3 to 3.3.5 discuss the impact of regional differences and short run versus long run results, respectively the use of more sophisticated econometric models.

3.3.1 Underlying Theory Renneboog et al. (2007) suggest that there are three hypotheses regarding the relationship

between SRI screening and SRI fund performance:

1. SRI funds underperform compared to conventional funds;

2. SRI funds outperform conventional funds;

3. SRI portfolios have different risk exposures than conventional funds.

The first two hypotheses are about risk-adjusted returns (sometimes referred to as ‘alphas’), while the last hypothesis is about the risk exposures (betas) of SRI portfolios.

The first hypothesis states that SRI screens imply a constraint on the investment universe (the exclusion of ‘sin stocks’) and therefore impose a limit on diversification possibilities. According to this hypothesis SRI funds should underperform conventional funds.

The first hypothesis correlates with the efficiency of optimizing risks and returns, i.e., whether it is possible to exclude or include stocks without loss of efficiency. Geczy et al. (2005, p. 3) argue that SRI constraints can impose diversification costs, “in the sense that the constrained investors are less able to balance optimally their portfolios’ exposures to factor-related risks and to eliminate risks that, on average, investors are not compensated to bear”. They conclude that SRI constraints impose large costs on investors who rely heavily on individual funds’ track records to predict future performance. See also Barnett et al. (2006), Bello (2005), Galema et al. (2008), Hoepner et al. (2009) and Renneboog et al. (2007; 2008b) for further reading on the diversification cost of investing in SRI funds.

The second hypothesis is that SRI portfolios outperform their conventional peers as information

on corporate governance and environmental performance is underpriced by the stock markets:

SRI screening generates value-relevant non-public information that helps fund managers to select securities and consequently generate better risk-adjusted returns than conventional mutual funds.

The second hypothesis thus implies that the screening process for SRI funds generates information which is normally not available for investors. This extra information can result in a See Renneboog et al. (2007) for an overview of the latter, including Mean-Variance Analysis (meanvariance optimization, generalized Jensen’s alpha, generalized Sharpe ratio), Performance Evaluation Methodologies (Capital Asset Pricing Model, multifactor models, conditional strategies, seemingly unrelated assets), market-timing ability and return-based style analysis.



better selection and hence generate better risk-adjusted returns. The underlying arguments are that sound social and environmental performance indicates good managerial quality which results in a higher financial performance. Also, screening based on social and environmental criteria reduces the potential costs during corporate social crises or environmental disasters. The implications for SRI is a subject for future research. (Renneboog et al., 2008b).

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