Environmental Investing
Posted 8th January 2001
by Tricia Hylton, Website

Socially responsible investment (SRI) is the integration of social and environmental values into the financial decision making process. It involves applying a set of agreed upon Œscreens¹ to investment options to assess their environmental or social merits. The more commonly used social and environmental screens are: Environmental performance, community relations, employee relations, diversity, ATP (alcohol, tobacco, and pornography), corporate governance, operations in countries with repressive regimes, military production and nuclear power. Currently, Canada has 14 mutual funds, and five labour sponsored venture capital funds that apply some or all of these screens.

These funds control approximately $4.9 billion dollars in investment capital. In addition, an undisclosed sum of screened assets is privately controlled by discretionary money and pension fund managers. Although a comparatively small proportion of the investment industry, SRI in Canada is growing rapidly and cannot be ignored. Since the first screened investment fund was introduced in the early 1980s, SRI has been plagued by one pervasive criticism from the mainstream investment industry: You cannot invest responsibly and be financially profitable. These critics cite the screening process as the main culprit. Social and environmental screens, they say, knock out too many companies and thus reduce the number of investment options available to construct a portfolio. This reduces opportunities for diversification and increases the systematic risk associated with any investment portfolio. Recent studies conducted in the United States and the United Kingdom, however, have conclusively proven these critics to be completely wrong. The Social Investment Organization (SIO) has reviewed over 40 empirical studies on the issue of screening and financial performance, the majority of which conclude that screened portfolios perform as well as non-screened portfolios. Moreover, with proper portfolio management, screened portfolios pose no additional risk or volatility.

Of even greater interest is research showing a direct link between progressive environmental management and improved financial performance. That is, corporations with progressive environmental policies and practices will financially outperform those corporations lacking similar policies and practices. This is very good news for environmentalists. Corporations have traditionally resisted adopting progressive environmental policies because of the belief that there is an inherent and fixed cost involved in improving environmental standards. Compliance with regulations when and where possible is thought to be enough. Short of being forced by government regulations to innovate and to implement new and improved environmental management systems, corporations are normally not motivated to do so. The SIO has reviewed six recent studies on the issue of environmental screening and financial performance. Of the six papers reviewed, four found a direct and positive correlation, one found no correlation at all, and only one found a negative correlation between environmental screening and financial performance.

The results of these studies can be summarised as follows. First, corporations which limit their negative environmental impact will experience higher levels of input utilization, greater production yields and overall improved product quality, which all lead to increased profits. Second, the perception of the financial markets and the general public that a corporation is a good environmental citizen will have a positive impact on stock market activity, pushing up share prices. Third, poor environmental management is a form of economic waste, which is inevitably paid for by the customer or by society as a whole. Good environmental management, however, is a proxy for good overall management which leads to higher profits. Fourth, improved environmental management and performance will reduce the risk of adverse environmental disasters. Companies will be rewarded for this risk reduction with a lower cost of capital which leads to higher share prices, and greater shareholder wealth. In the study where a negative correlation was found between environmental screening and financial performance, the author was very reluctant to fault the screening process for the negative correlation.

She qualified her findings by stating that if the study had been conducted over a different time period, the results of the study could potentially have been very different. In her view, the negative correlation between environmental screening and financial performance was a factor of the cyclical nature of financial markets rather than a direct result of environmental screening. Canadian evidence of the effects of environmental screening can be assessed by looking at the performance of Canada¹s only family of mutual funds dedicated to environmental investing ­ the Clean Environment Fund, a family of four individual funds. Each is composed of corporations that use new technologies that redesign processes, alter techniques, preserve, recycle and reduce raw material consumption, increase efficiency, and reduce pollution. Clean Environment believes that companies that implement these policies will increase substantially their profitability and competitive position. Named Canada¹s top performing balanced fund in 1996 with assets over $20 million dollars, the Clean Environment Balanced Fund returned 30.7 percent rate of return to its unitholders, outpacing all other balanced funds, which averaged a 17.5 percent rate of return. This fund has provided an average investment return of 15.5 percent over its five year history. In real terms, this means that if an investor contributed $10,000 into the fund in June 1991, without making any additional contributions, the value of the investment would have amounted to $20,525 by December 31, 1996 ­ a significant return by any standard.

The Clean Environment Equity Fund offers a similar financial performance. As of January 1997, this fund earned an average one year rate of return of 32.1 percent compared to the TSE 300 25.5 percent rate of return over the same time period. Over its five year history, the fund has averaged a 17.5 percent annual compound rate of return, which has outperformed the TSE 300¹s five year rate of return of 14 percent, and the five year average of all Canadian equity funds at 13.1 percent return. The fund has continued to provide stellar returns as it was again named one of Canada¹s top 40 equity funds in October 1997. The ramifications of this research are far reaching. The mainstream investment industry and corporations must begin to reconcile with empirical evidence conclusively showing that poor environmental management will result in economic waste, loss profits, depressed share price and trading volume, and lower shareholder returns. It also has implications for portfolio managers and trustees. In failing to acknowledge the performance of screened portfolios, are they fulfilling their fiduciary responsibility of maximising portfolio return? More intensive research needs to occur in Canada to assess the financial performance of screened portfolios. But if preliminary research is any indication, the results in Canada will substantiate that results of research already conducted in the US and the UK: environmental and social investing is financially profitable. In New Zealand the leading ethical investment organisation is Prometheus Ethical Finance". ...

Tricia Hylton is the Director of SRI Research and Membership Services at the SIO. The SIO is a national non-profit organization dedicated to advancing socially responsible investment (SRI) and corporate social responsibility (CSR). .