This is not a tie-dyed, patchouli-oiled, bleeding-heart post about why institutional investors should try to “do good” or focus on quadruple bottom lines. No, friends, this post here is for the icy-veined finance professionals who are, to put it mildly, allergic to any and all talk of incorporating extra-financial risks into their investment decision-making. To these consummate professional financiers, I have an important message: The extra-financial risks that you consider a distraction are being transformed into something few in the finance community thought they ever would be: financial risks.
That’s right; the ‘extra-financial’ is increasingly just ‘financial’. Take as an example the interesting work of the GRESB Foundation, which is made up of some of the world’s largest institutional investors (i.e., not hippies). This group has developed a new Global Real Estate Sustainability Benchmark which is all about pricing the long-term environmental risks to their real estate investments. It’s quite cool. Here’s a blurb:
“The Global Real Estate Sustainability Benchmark is a science-based benchmark to measure the environmental performance of property portfolios, based on an annual survey produced by the GRESB Foundation. This industry-led initiative has the goal to enhance shareholder value by increasing transparency in environmental and social practices in the property sector. …The information provided by the GRESB Foundation can assist institutional investors in their investment decisions, and offers a unique tool for direct engagement on environmental and social performance with property funds. For managers of property companies and funds, benchmarking their current sustainability practices at the portfolio level offers the opportunity to compare, set goals and improve performance.”
I think that’s fascinating. But, even more importantly, the GRESB offers investors an opportunity to boost their financial returns. How? Well, including ESG factors in investments has now been shown to bump investment returns: a recent study by Allianz shows that environmental factors can improve performance of portfolios by 1.6% over a five year time horizon. And the GRESB report backs this up:
“…the general evidence indeed shows positive financial effects associated with better environmental performance. For example, commercial buildings with energy efficiency ratings command significantly higher rents, better occupancy rates, and higher prices than otherwise comparable conventional buildings. On the other hand, lower levels of energy efficiency and sustainability have been associated with an increased risk of obsolescence.”
In other words, investors should ignore the environment at their own peril. In fact, the GRESB report suggests that if you’re on a pension fund board and you’re not considering these factors in your investment strategy, you may be breaking your fiduciary duty to maximize financial returns. How’s that for turning the tables!
The nerd in me (which if I’m honest is most of me) wonders whether we should be surprised by the financialization of these extra-financial criteria. After all, we’re living in an increasingly financialized world; from individuals’ sub-prime mortgages being packaged and sold around the world and bureaucrats investing public money in black swan hedge funds via sovereign wealth funds, it seems all levels of society are participating in global financial markets in new and remarkable ways. In this world, then, is it really a surprise that “extra-financial risks” are becoming obsolete? That the financial community is coming up with mechanisms for pricing risks that were, here-to-fore, un-priceable? No, it’s not really surprising at all. We’ve been heading there for a while now.
And, given where we are today, I think that this a very positive development. Why? Two reasons. First, the investors may end up creating more efficient investment portfolios that take their Sharpe ratios to new levels. Second, there are some obvious benefits to society from having institutional investors pricing long-term risks, such as climate change (for the economists in the room, this is what finding market solutions to externalities is all about). But the societal benefits are for another post; I promised to keep this one devoid of hippy finance.