Assignment Title: Responsible Investment

Ethics, Corporate Governance and Socially

Student Name:

Paul Baptist

Student Number:

03025077

Module Number:

MN 0486

Due Date:

16/05/11

Date Submitted:

16/05/11

Word Count of Report:

3121

Contents
Page A2 B1 C Comply or Explain Environmental Reporting Socially Responsible Investment References Appendix 1: British Airways Environmental Disclosures Appendix 2: Barchester Best of Green Life Fund Appendix 3: British Airways Contents Page Appendix 4: SRI Fund Selections 3 5 7 10

Part A, Requirement 2 2

Comply or explain is an approach to corporate governance that was created in response to corporate scandals in the 1980s and 1990s. The concept was first introduced as part of the Cadbury Code as a set of best practices to follow rather than a set of rules that must be adhered to. The code, now known as the UK Corporate Governance Code, has been updated and developed several times over the last 20 years and is now considered to be an international benchmark for corporate governance practices (Arcot et. al 2010). The essence of comply or explain dictates companies should either comply with the best practices of the code or give explanation for noncompliance. The main advantage of comply or explain is the flexibility it allows companies in the way they meet the requirements of their governing code. If a company does not comply with the code they are able to explain noncompliance in their annual report. An example of this can be found in Tescos UK 2010 annual report where, due to two unexpected resignations, they did not comply with a provision requiring at least half of the board being made up of non-executive directors. The flexibility of comply or explain allowed Tesco to explain the situation without incurring penalties. This is in contrast to the rules-based approach in the United States where noncompliance with the provisions set out in the SarbanesOxley Act can lead to penalties. Studies show another consequence of a rulesbased system for companies is the increased costs associated with ensuring compliance is met (Zhang, 2007; Ahmed et. al 2010). An example from the US is Kroger who state in their annual report that they hire an outside auditor to ensure that their compliance is adequate. It is also argued companies incur opportunity costs as resources are used to comply with the rules instead of focussing on business activities (Solomon & Byron-Law, 2004). Unlike a rules-based system which tends to set minimum requirements to comply with, the flexibility of comply or explain allows a governance code to set more demanding standards. The approach encourages companies to adopt the spirit of the code whereas a more statutory regime such as the US encourages a box-ticking approach. This is reflected in Tescos annual report where it states Tesco PLC is committed to the highest standards of corporate governance, while Kroger simply state their disclosure controls and procedures were effective. Comply or explain also recognises that in some circumstances it may not be practical for a company to achieve good governance. Factors such as a companys size and ownership structure can affect the way in which they are able to comply with a governance code. Comply or explain allows a company to maintain good governance without having to meet all the provisions of a code. In contrast, the US employ a one size fits all approach where companies face a financial burden of complying or in some cases simply delist from the US stock exchanges (Hansen et. al 2009). Another benefit with regard to flexibility is the ease in which the UK Corporate Governance Code can be changed (MacNeil and Li, 2006). Due to its selfregulatory status the code is not required to go through the same legislation process as company or securities law, allowing changes to be made within a shorter period of time. 3

A disadvantage of comply or explain occurs when companies provide poor explanations when not complying with the code. Arcot et. al (2010) found companies departed from best practices without giving informative explanations. As there is no formal authority that monitors the quality of the explanations it is left to the market to decide whether these explanations are appropriate. This method of monitoring can work when shareholders take action. For example, at a Tesco general meeting in 2009 47% of shareholders failed to back the remuneration report. However, a study by MacNeil and Li (2006) found that shareholders were likely to tolerate noncompliance if a company performed well financially. When looking at whether a company complies within the comply or explain approach it is interesting to look at Arcot et. als (2010) definition of complying. They consider apply or explain to be a more accurate definition as applying the provisions set out by the code or explaining noncompliance are in essence both ways of complying. By this definition Tesco would be fully compliant as they appear to have applied to the provisions and have given an explanation when noncompliant. With regard to complying with the spirit of the code Tesco appear to be committed to this as well, disclosing that below board level there is a strong culture of good governance and high ethical standards. In comparison, Kroger offer little reference to their corporate governance policy in the annual report but ultimately comply with their system by ticking all the boxes. In conclusion, comply or explain is the most appropriate system for corporate governance at present. The flexibility in which companies can comply with the system is a big advantage over the rules-based approach. It encourages companies to aspire to higher standards of corporate governance rather than just meeting the minimum requirements. However, in order for the system to be more successful it is important that companies embrace the spirit of code instead of using it as a method to avoid complying. As there is no formal system monitoring comply or explain it is also important that shareholders become more active in ensuring that the company is being governed correctly, and are prepared to act if they are not content with the companys disclosures. If these actions are taken by companies and shareholders alike, the comply or explain approach would work more effectively and would diminish the need to adopt a different approach.

Part B, Requirement 1 British Airways environmental disclosures can be found in appendix 1. The relevance of environmental reporting in the decision making of investors has been widely researched. Some studies (Belkaoui, 1980; Derwall et. al, 2005; Aerts et. al, 2008) indicate that environmental disclosures can be useful to investors while other studies (Teoh & Shui, 1990; Deegan & Rankin, 1997; Milne & Chan, 1999) suggest it is of little or no use. The aim of this section is to discuss if environmental reporting can affect the decision making process of fund managers, and the overall impact this will have on the investment decision. As the primary objective of a fund manager is to generate a return on investment the first reason environmental reporting may affect a managers decision is if disclosures were shown to affect the performance of a company. A meta-analysis of previous research carried out by Orlitzky et. al (2003) concluded a positive correlation existed between social reporting and financial performance. Based on these findings a fund manager would look to invest in companies with high quality disclosures as they are likely to perform better. However, Milne & Chan (1999) suggest investors are only likely to use environmental disclosures if the information provided will have a significant impact on the future cash flows of a company. As an example, an oil spill would affect future cash flows as a company would have to rectify the situation and could also lose custom because of negative publicity. Studies from Hamilton (1995) and Klassen & McLaughlin (1996) support this theory, finding companies reporting bad environmental information experienced significant negative returns on their market value. Another reason environmental reporting could affect a fund managers decision is if the clientele providing the investment to the fund had socially responsible requirements. For example, the ethical fund Barchester Best of Green Life Fund state they will not invest in a company if they have been convicted of a serious pollution offence by the Environment Agency (appendix 2). As British Airways business involves pollution the fund manager would need to look at the companys environmental disclosures to ensure the requirements of the fund had been met. Having to adhere to certain criteria places restrictions on the companies a manager can invest in, strengthening the statement of Derwall et. al (2005) who assert the mainstream finance community believe incorporating environmental criteria into investment decisions comes at the cost of portfolio performance. Fund managers who agree with this statement, and have no 5

requirements from their clients, will be less likely to consider companies with environmental disclosures in their decision making as it will lead to lower returns. However, fund managers who do need to meet their clients requirements are starting to put pressure on companies to disclose better information so that they can make more informed decisions. In 2010, a coalition of global investors from 13 countries, managing over US$2.1 trillion of assets, called for better corporate reporting on environmental, social and corporate governance activities (www.unpri.org). A factor affecting a fund managers decision to use environmental reporting is the usefulness of information that companies are disclosing within their annual reports. Milne & Chan (1999) argue the majority of social disclosures are too narrative and therefore being dismissed by investors. However, Milne & Chan go on to say if social information could be quantified and incorporated into the financial statements it would have an impact on investors decision making. From the British Airways 2010 annual report (pp.38) it can be seen that the company has attempted to quantify their environmental reporting, albeit not in the financial statements. Factors such as carbon emissions, recycling and noise pollution have all been given figures so that they can be analysed and to reveal how the company is performing. Craswell & Taylor (1992) argue companies like to report good news and are less likely to disclose negative environmental information if they believe it would do them harm. This is reflected in the same part of the British Airways report in that they have disclosed the environmental factors they are improving but not mentioned any factors that are worsening. When companies do disclose negative information it tends to be mixed in with positive information, leading Aerts et. al (2008) to assert investors reading this information collectively fail to find it useful. Aerts et. al add investors who do separate the information may find the disclosures useful. Deegan & Gordons (1996) study shows disclosure of positive environmental information will increase when a company is part of an environmental sensitive industry. The decision to use environmental disclosures may also be affected by the time constraints in which fund managers operate. If investment decisions need to be made within a short time frame the manager may only look at what is deemed to be important thereby excluding environmental reporting. Deegan & Rankins (1997) study asking stockbrokers and analysts to rate the relative importance (1 being unimportant and 5 being highly important) of information in decision making found profit (4.56), net assets (4.69) and cash flow disclosures (4.50) were all rated more important than environmental performance (2.81) in the decision making process. A reason for this occurring maybe explained by the study of OLoughlin & Thamotheram (2006) who question the terminology generally associated with environmental information, suggesting investors may overlook the information entirely due to it being labelled as non-financial. Although British Airways do not label their environmental information as nonfinancial, there is a clear separation in the annual report of financial statements and the our business section which entails the environmental reporting (appendix 3). 6

A limitation to some of the studies reviewed is that opinions on environmental reporting may have changed in the time period since they were first conducted. A limitation to the studies monitoring decision-making behaviour on the stock market is pointed out by Booth, Moores & McNamara (1987) who question the confidence to which these decisions can be attributed to the disclosures of environmental information. To conclude, Milne & Chan (1999) argue that as investors are only concerned with risk and return they will only consider information that is useful to their decision making. With some studies (Hamilton, 1995; Klassen & McLaughlin, 1996; Orlitzky et. al, 2003) showing environmental reporting can have an impact on both the cash flows and market value of a company, investors should be incorporating environmental disclosures into their decision making. Further to this, fund managers specifically need to meet the investment criteria of their clients and are therefore forced to take account of environmental disclosures.

Part C A socially responsible investment is any investment which a single investor believes to be socially responsible to their individual values and principles. Authors definition of SRI At present there are many different definitions for socially responsible or ethical investments. The aim of this section is to review the literature on socially responsible investing (SRI) and discuss the problems and difficulties as to why a single agreed definition has not yet been determined. The SRI funds selected by the author to fit into the authors definition can be found in appendix 4. Renneboog et. al (2008) assert SRI can be traced back to the early traditions of Christianity, Judaism and Islam. Examples within these religions such as ethical use of money, restrictions on investments and avoidance of certain industries are all examples of SRI. Up until the 20th century the driving force behind SRI was based on religious traditions. However, the driving force behind more modern SRI now includes the personal values and principles of individual investors. This evolved from political issues in the 1960s where Martin Luther King organised protests and boycotting, most notably the Montgomery Bus Boycott, of specific corporations. However, Heese (2005) argues it was the global coverage of the racist apartheid system operated in South Africa during the 1970s and 1980s that propelled SRI into the mainstream investment arena. The media coverage made people more aware of the consequences of their investments, and as a result generated a desire among investors to invest more ethically. This led investors to exert pressure on companies to withdraw business from South Africa and to urge mutual funds not to include South African companies. These efforts 7

were largely successful as companies diverted business away from South Africa and eventually contributed to the devolution of the apartheid system. The SRI discussed so far has involved negative screening; the process of avoiding investments in companies based on social, environmental or ethical (SEE) criteria. For example, the Standard Life Ethical Life (SLEL) fund will avoid investing in companies that manufacture tobacco products. In the modern era, investors also use positive screening where they search for the best companies that fulfil certain SEE requirements. Using the SLEL fund as another example, they look to invest in companies who make a positive contribution to the environment. The screening process, both positive and negative, raises difficulties among investors in trying to agree what SRI is. With regard to the positive screening example, a logging company could provide a positive contribution to the environment by planting two trees for every one tree that is chopped down. One investor may see this as an ethically sustainable investment whereas another investor may argue it is unethical in the short-term. This type of problem also applies to negative screening. An investor wanting to avoid investing in a company associated with tobacco may choose the SLEL fund, where they avoid investing in companies who manufacture tobacco products. The investor may see this as SRI but another investor may argue the fund could still invest in retailers of tobacco products, and is therefore not SRI. From the screening process it can be seen that people can have different views to what SRI is and what it is not. This may be caused by cultural differences between societies, such as religion or traditions. It may also be caused by individual circumstances. For example, someone may have suffered the loss of a family member as a consequence of alcohol and would therefore have a stronger cause to avoid investing in a company associated with alcohol. A further problem arising from the screening process is the different investment criteria used by funds to select their investments. Table 1 shows a summary of the funds and investment criteria that were selected to fit within the authors definition of SRI. As can be seen from the pollution screening, the criterion for investment varies greatly between the three funds. Given the criteria below, a company receiving a small pollution conviction would be excluded from Standard Lifes investment, but it is debatable whether they would be excluded from the other two funds. Schlegelmilch (1997) argues commercial actors within the SRI industry may actually be against the outcome of an agreed definition of SRI as the current ambiguous definition allows companies such as the funds below to diversify from one another, thus creating market segmentation. Standard Life Ethical Life Fund Equal Opportuni ty (Positive) Companies with good policies on equal opportunities and diversity Marlborough Ethical Fund Equal opportunities practice and procedures Rathbone Ethical Bond Fund Human rights standards

Communit y (Positive) Tobacco (Negative)

Companies who are strongly involved in the community Manufacture tobacco products

Attitudes to communities in which they operate Companies that manufacture or retail tobacco as a major activity Activities which are felt to harm society more than they benefit it

Demonstrate longterm giving programmes to the community Manufacturers or wholesalers of tobacco products Companies convicted for serious or persistent pollution offences

Pollution (Negative)

Environmental pollution, convicted of a pollution offence, o-zone depleting chemicals, pesticides

Table 1 Summary of Screening Criteria for Investments by Fund Renneborg et. al (2008) question how far screening should be applied to companies in terms of their subsidiaries and suppliers. Opinions can be divided as to whether a company is still SRI if one of their suppliers is not. It can also be questioned if a supplier is still SRI if they are supplying a non-SRI company. An investor could argue a paper company should be excluded as the paper it produces could end up in the production of cigarettes. When attempting to define SRI, the regulation regarding the investment criteria must be taken into account. Eurosif assert that if a subset from negative screening were to be made a legal obligation then that subset would no longer constitute SRI. As an example, if the manufacturing of tobacco products was made illegal, the three selected funds could no longer attest to meeting the tobacco SRI of the investor. Sandberg et. al (2009) argue one factor that may have impeded a definition being agreed is the various terms that have been used interchangeably with SRI, stating such examples: ethical, social, environmental, responsible, sustainable, values-based, corporate governance. An example of this can be found in the EIRIS summary of Marlborough Ethical Fund where they display their ethical investment overview on the same page that lists their SRI website. Sandberg et. al question how an agreed definition can be made if the actual term itself has not already been agreed. To conclude, being socially responsible has a different meaning from one investor to the next, leading the author to believe that there will never be an agreed definition. As investors have different values and principles regarding SEE criteria the author suggests that a single thorough definition can not be created without compromising the values or principles of another investor. People having different values and principles also raises the question of who has the right to decide what SRI is (Umlas, 2008). With these points in mind the author argues that the definition stated earlier, although simple, is applicable to all investors. 9

The author further argues that it is better to have someone investing in what they deem to be socially responsible rather than investing in something they deem to be non-socially responsible at all.

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Orlitzky, M., Schimdt, F.L. and Rynes, S.L. 2003. Corporate social and financial performance: a meta-analysis, Organization Studies, 24 (3), pp.403441. Unpri (2010) Available at: http://www.unpri.org. (Accessed 07 May 2011) Renneboog, L.D.R. Ter Horst, J.R. & Zhang, C. (2008) Socially responsible investments: Institutional aspects, performance, and investor behavior, Journal of Banking & Finance, 32 (9), pp.17231742. Sandberg, J. Juravle, C. Hedesstrm, T.M. & Hamilton, I. (2009) The Heterogeneity of Socially Responsible Investment, Journal of Business Ethics, 87 (4), pp.519-533. Schlegelmilch, B. B. (1997) The Relative Importance of Ethical and Environmental Screening: Implications for the Marketing of Ethical Investment Funds, International Journal of Bank Marketing 15 (1), pp.4853. Solomon, D. Bryan-Low, C. (2004) Companies complain about cost of corporategovernance rules, Wall Street Journal, Feb 10. Teoh, H. Y. & Shui, G. Y. (1990) Attitudes towards corporate social responsibility and perceived importance of social responsibility information characteristics in a decision context, Journal of Business Ethics, 9 (1), pp.7177. Umlas, E. (2008) The Global Expansion of SRI: Facing Challenges, Meeting Potential Development & Change, 39 (6), pp.1019-1036. Zhang, I. X. (2007) Economic Consequences of the Sarbanes-Oxley Act of 2002, Journal of Accounting and Economics, 44 (1-2),pp.74-115.

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