Looking ahead

The credit crisis has brought to light a whole range of systemic failures, including a range of corporate governance issues. What is your assessment of the situation? Do fund managers and asset owners have a role to play in addressing these systemic issues? What actions, if any, are you taking to address these issues and to reduce the risk that they will happen again? What actions do you believe asset owners can play in responding to these challenges?

Karina Litvack: There is no doubt that investors and asset owners have a key role to play in addressing the systemic failures that brought on this crisis, and that is because although regulatory reform is essential, it cannot solve all ills on its own. Scrutiny, challenge and constructive debate - the features of active ownership - are all necessary to complement a strong regulatory response. The tragedy is that several investors had, in fact, been calling for reform of inadequate governance practices over the last several years, but their voices were more often than not drowned out in the exuberance of the credit bubble, and their demands, particularly on commercially sensitive matters like pay, met with resistance because of competitive concerns. Investors need to engage much more forcefully, so as to overcome the combination of inertia and market failure that stands in the way of positive reform.

Steven Falci: Governance failures across the financial system were pervasive, ranging from financial institutions inadequately overseeing and understanding the risks embedded in complex financial instruments to money management organisations turning a blind eye to the risks of excessive leverage and cheap credit. A significant common thread running through these issues was a preponderance to focus on the short term at the expense of long term value. This led managers across financial institutions to ignore risks that might not come home to roost before booking illusory profits for the current year. Similarly, short term focus led some money managers to ignore significant risks while stretching for the next quarter's returns.

At KBC Asset Management, we have been managing environmental thematic strategies since 2000 with an explicit focus on long term drivers of return. These strategies are grounded in providing solutions to our biggest global sustainability challenges related to three long term trends; (1) the world's growing population and changing demographics, (2) the stress it is putting on the provision of vital resources of energy, food and water and (3) climate change and the imperative to reduce carbon emissions while meeting growing global energy demand.

These three trends point to the need for significant investment over at least the next 25 years in renewable energy, energy efficiency and water infrastructure and technology. While the drivers are long term, our environmental strategies team is keenly attuned to the full spectrum of portfolio risks including those related to company debt levels, access to finance and quality of earnings. The aim is to hold well managed, well governed companies that are best positioned benefit from long term secular drivers of growth.

There is now greater certainty around the political and technological response to climate change, with greater access to data and research on the risks and opportunities. How is this likely to impact the fund over the next one to two years, and three to five years?

Karina Litvack: Firstly, I would dispute that premise: there may be a great deal more certainty regarding the inevitability of the damage caused by climate change, and sustained progress in developing technological responses, but the political response remains woefully inadequate to the scale of the challenge, and characterised by chronic back-pedalling and special-interest carve-outs. It is true that the election of President Obama marks a turning point, and that several fiscal stimulus packages have had a distinctly green tinge. But the fact remains that industry and financiers still lack the visibility they need on policy action, or the certainty of a high carbon price, to ramp up investment to the levels that it could and should reach. Until that changes and there is real clarity and certainty about the next two to three decades' worth of policy-making, we are not going to see capital being mobilised to deliver technological solutions to climate change, nor will it play the part it could otherwise play in enabling the transformation we need in the global economy.

There are some remarkable parallels, but also some worrisome differences, between the current financial crisis and the climate crisis that awaits us if we fail to take serious, urgent action. On the one hand, like the credit overhang, the jury is out about the climate risks that are piling up and, in our view, the market is failing to price in this unconventional type of risk. On the other hand, a credit crisis is a cyclical thing, painful as this one might be, and what goes down does eventually come back up. In the case of climate damage, we are in uncharted territory and simply cannot say whether the atmosphere will recover the way the economy can after a boom-bust cycle. All we know is that the sooner we act, the better off we will be.

Steven Falci: The global consensus around the imperative to address impacts of climate change has galvanised the political response to climate change through out the globe. Governments are formulating and implementing long term regulatory measures including emissions reduction targets, renewable energy targets and tax credits and subsidies for renewable energy that buttress long term investments across the spectrum of clean technologies. Additionally, to both combat the recession and address the long term challenges presented by climate change, fiscal stimulus packages across the globe contain "green" components that direct a significant portion of government spending to environmental areas. HSBC estimates that approximately 15% of the US$3trn in fiscal stimulus spending is directed to green initiatives, which will support investment in grid infrastructure, rail transport, building energy efficiency, renewable energy and water and waste water infrastructure.

We believe that this governmental support for addressing climate change reinforces the long term secular drivers of growth to investment across KBC Asset Management's Environmental Strategies. For example, the need to meet growing global demand for energy while reducing carbon emissions has led governments to set aggressive targets to add renewable forms of energy to the energy mix - increasing them substantially from current levels to targets of 20% in both the EU and the US by 2020. This, and other regulatory measures, points to the need for significant investment in renewables over the next 10 years that we believe provides strong support for returns in our Alternative Energy, Climate Change and Environmental Solutions Strategies over the next three to five years. Over the next one to two years, we expect tariffs, subsidies and green stimulus programmes to positively impact returns in our environmental thematic portfolios.

We are seeing a move in the investment marketplace towards integrating responsible investment principles beyond listed equity, to a wide range of asset classes including bonds, property, infrastructure and private equity. Do you believe RI principles suit the wider range of asset classes? And if so, which asset classes are most susceptible to RI risks and opportunities, and why?

Karina Litvack: In 2007, F&C launched its ethical bond fund, investing in UK corporate bonds and using the same strict ethical screening criteria applied in our Stewardship range of equity funds.
Ethical investment had its origins in equities because it was the obvious route for individuals or institutions to influence corporate behaviour through the supply and demand dynamics of shares.

Bond investing does not confer the rights of ownership, so the scope for engagement via share-voting is absent. However, access to funding is critical, particularly in the present market, while the corporate credit market is considerably more concentrated than in the case with equities. This confers a degree of influence to bond investors that has not been properly exercised in the past, and certainly can and should be. Dialogue with issuers on broader issues of governance and sustainable business practice is beginning to spread to the credit markets, and is likely to continue.
Meanwhile, as investors become increasingly sensitised to the importance of ethics, good governance and sustainability, they are demanding more choice, and a growing number of fund managers are responding to that need by providing products that address diverse risk profiles.

We do believe that investors should be able to make the same socially responsible decision when investing in different asset classes, whether it is equity, bonds, property or private equity. With this in mind I believe the range of non-equity ethical funds is set to grow.

We've got to ask it, does SRI add value, and how?

Karina Litvack: I don't think it's particularly constructive to argue that ethical investment is systematically going to outperform. However, what I think is entirely fair to argue is that ethical investment can perform at least competitively, if not better, against non-ethically screened funds.

In addition to that, what ethical funds deliver is a type of performance that is not factored in the numbers: that is getting companies to do their business in a better, cleaner, safer way, which is equally important. This is something that is increasingly valued by investors and that works to the benefit of the business - a business that respects the environment and respects people is going to be a more successful business, with more loyal employees, customers and local communities.

What we do know is that our investors do value what we do. They look very closely at the way our ethical funds are managed and how stocks are selected. They are interested in the way active investor dialogue is conducted and want to see evidence that we are effective in getting companies to improve their behaviour.

Steven Falci: As with any successful investment discipline, sustainable and responsible investing can add value if it is properly integrated as part of a pension funds overall investment strategy. Our experience has been that allocating money to environmental thematic strategies has added value over the last five years and continues to provide exposure to new sources of alpha with long term secular drivers of growth. Exercising ownership rights in ways that address material issues and improve corporate governance can maximise shareowner value over the long run, by owning better governed, better managed companies. Integrating material environmental, social and governance (ESG) factors into individual portfolios can reduce risk and potentially add value if asset managers understand the effect of individual ESG factors across sectors, industries and companies.

Similarly, just as plan sponsors have sought to identify superior asset managers historically, that quest now includes evaluating managers' ability to understand sustainability trends and integrate ESG insights. First, investing in solutions to sustainability challenges requires identifying managers with the requisite specialist skills to understand the environmental challenges, emerging technological solutions and financial strength of the company to identify which stocks are best positioned to be among the long term winners. Secondly, evaluating individual managers with broader mandates requires understanding the risk and return implications of ESG factors in the context of their specific investment discipline and how they are integrating ESG factors into their respective processes.