As South Africa continues to feel the effects of several high profile corporate governance scandals, the proposal by the Financial Sector Conduct Authority (FSCA) to make it compulsory for pension funds to report on how they implement ESG (environmental, social and governance) provisions in their investment approach, could be a game changer.
The proposal by the FSCA, if legislated, will require the country’s pension funds to show how they apply ESG factors to assets they intend to buy; how regularly they measure the compliance of their assets to their sustainability criteria; and to report on how these provisions are being met in both financial statements and annual trustee reports.
More often than not, South African institutional investors and their fund managers do not ask the right questions, or consider the risks associated with ESG factors. This, as a number of case studies from the UCT Graduate School of Business (GSB) have highlighted, has contributed to the demise of some high profile companies in recent times.
The collapse of micro lender African Bank Investments Limited in 2014 under a weight of bad debt is a case in point. It demonstrated what happens when good corporate governance and responsible investing is not prioritised. The board and the investors failed to address the predatory nature of the lending practices the bank resorted to, in order to boost profits. Neither investors, nor the board, questioned how these practices would, in the end, jeopardise the lives of African Bank clients. Investors with a keen eye on sustainability and ethical principles would have very likely noticed early on, that the unsecured lending business would not be viable.
The demise of manufacturing and engineering firm First Tech in 2013 (the first-ever investment-grade corporate bond default in SA – involving between R800m and R3.5bn of investor fund fraud) similarly highlighted the need for better monitoring to prevent corporate governance failures. A GSB study revealed that some of the major issues of concern at First Tech included an over-complex corporate and financial structure, a ghost board of directors in no position to ask the right questions, a lack of independent and reputable auditors, and a ticking-the-box attitude towards codes of corporate governance. Financial groups exposed to First Tech included SA’s major banks, insurers and asset managers. All ignored the red flags.
The Lonmin saga, the object of another GSB case study, also left some investors asking themselves how they had failed to spot the brewing tensions between management of the company and the miners. Before the Marikana tragedy, Lonmin was a darling of the stock market, widely viewed as a sustainable and socially responsible company to invest in. It was included, for example, in the original JSE Sustainable Reporting Index, showing, with hindsight, how low the hurdle for inclusion on these matters was.
South African funds managers are, by and large, signatories to the United Nations-supported Principles for Responsible Investment (PRI) Initiative, an international network of investors that seeks to understand the implications of sustainability for investors and supports signatories to incorporate these issues into their investment decision-making and ownership practices. Yet, many appear to be turning a blind eye to corporate governance red flags that, at best, are contrary to the principles they are pledged to and, at worst, threaten the very sustainability of their investments.
Arguably, one of the major shortcomings of business is that it is motivated by short-term profit, and therefore investment decisions seem to be made without taking longer-term views. ESG matters, by their very nature, should compel business to take a longer term view. Yet in SA, and indeed across the continent, ESG is for the most part regarded as a compliance issue and not recognised as a value-adding activity, despite growing evidence to the contrary.
Approached in the right spirit, ESG can drive inclusive socio-economic growth, and by extension, catalyse private sector development as a recent GSB case study on Old Mutual demonstrates. For the past several years, the financial services giant has placed a growing emphasis on ESG - and is setting the bar in this regard.
In 2015, Old Mutual launched its positive futures plan, which aimed to “contribute to positive futures” by addressing sustainability issues relevant to its business and the markets in which it operated, along with the Old Mutual World ESG Index Fund with around R2 billion committed by institutional investors.
Jon Duncan, head of responsible investment (RI) at Old Mutual, saw the new fund as a significant milestone for Old Mutual, as it provided the evidence that new sustainability-themed product innovations could attract capital and at the same time provide investors with competitive risk-adjusted returns.
According to Duncan, who was interviewed for the case study, responsible investing practices can play a key role in creating shareholder value in three ways: by boosting businesses’ ability to deliver appropriate risk-adjusted returns by giving them deeper insight into risk; by improving their ability to attract and retain clients; and, by improving their ability to innovate in terms of both product and process.
Africa is heading in the right direction, but needs to face important challenges in terms of walking the talk. According to the latest African Investing for impact Barometer, as of the end of July 2017, around US $428.29bn of investment assets in the Sub-Saharan regions of East, West and Southern Africa were declared to be allocated to investment strategies which seek to generate social or environmental impact whilst generating investment returns. Our estimation is that this represents almost half of the total assets under management! The Barometer, which is published annually by the Bertha Centre for Social Innovation and Entrepreneurship at the GSB, reveals however that despite this promising account, the majority of investors surveyed are not good at communicating what they are actually doing and how much it has changed the way their organisations assess companies. In addition, they are still not able to demonstrate the positive impact on society of their investment decisions.
The First Tech, Lonmin, African Bank and recently Steinhoff debacles are cruel proofs that a lot still needs to be done to match good intentions with full blown implementation.
In Europe, SRI fund markets are already well established and responsible investment regulation has been passed in many countries. The European Commission recently released an ambitious Sustainable Finance action plan that stresses the necessity to inquire further into an investor’s preference towards ESG and to see more in-depth disclosure coming from institutional investors and their fund managers regarding their actual ESG achievements.
It is to be hoped that stronger regulations in South Africa, could help to shift short-sighted and deeply ingrained views around ESG factors, as they did in Europe. For Africa, a continent that needs billions annually to meet the United Nations' sustainable development goals, but with limited resources to do so, the role of ESG will be crucial in terms of catalysing additional capital flows.