Sustainable & responsible finance

ESG investing

ESG factors used to pursue financial goals — non-financial = financial in long run

Impact investing

Pursues social value, lower returns on average

Fiduciary duty

Act in members' best interests; financially material ESG is OK; values only under member-preference + no significant detriment.

Traditional RI

Exclusionary screening (sin industries, low diversity, high pay ratios) — box-ticking. Best-in-class.

Disadvantages of Traditional RI

Only one or few factors (halo effects), easy to manipulate, quantitative not qualitative, ignores strategic context, may exclude entire industries even when not material.

Modern RI

Integrate ESG with financial factors, Net benefit test, external advisory

Governance mechanisms

Shareholder rights, Ownership control, Board

Low correlations between ESG ratings

Scope, Measurement, Weighting

Two greenwashing views

Always harmful (misleads, crowds out, delays decarbonisation)

Transitional (markets still learning, over-regulation deters participation)

3 Discipline mechanisms

1. Internal (purpose)
2. External (activism and stewardship)
3. Institutionalisation (stewardship codes)

Company Purpose

- Defines why the company exists (comparative advantage)
- Useful purpose lets the firm say no to actions that don't align.
- EG: Sainsburys: "Great food at a fair price"

Errors of omission (Kodak)

Kodak: Invented digital camera, internal studies predicted disruption, didn't commercialise, bankrupt

Why are omissions hard to detect

- No visible wrongdoing: no fraud, no scandal, no extraction (reputational/legal/market mechanisms don't fire)
- Hard to punish: law and incentive systems prohibit bad acts but don't easily mandate brave ones.
- Incentive-driven: failure aligns with current incentives.

Shareholder activism

- External monitors when internal incentives fail.
- Often misunderstood as pie-splitting.
- Why it works: portfolio concentration, pay-performance sensitivity, resources to redesign.
- Three key features: concentration, incentives, resources.
- When does it destroy value? When the activist forces lacks expertise/break long-term stakeholder commitments.

Stewardship

the exercise of ownership rights to internalise the long-run externalities of investment decisions, when exit or market prices alone cannot do so

Why is stewardship rational?

- Some investment externalities are LR + not fully priced.
- Exit isn't always feasible (index funds can't sell; shareholder VALUE ≠ shareholder RETURN; diversified owners face general-equilibrium effects).
- Ownership creates influence that markets alone cannot.

Two types of engagement

- Specialised: Bottom-up, tailored to the firm, hedge funds, usually private meetings
- Generalised: Top-down, one issue across many companies, index funds, usually voting/campaigns

3 Buyback concerns

- Distributional: benefits shareholders, not workers.
- Investment: crowds out R&D/capex.
- Managerial: short-termism, EPS gaming.

Buyback effect on stock price

Long run prices rise more than short term

Types of mergers

- horizontal: same industry (buying competitors)
- vertical: Supply chain integration
- conglomerate: different industries, diversification

Synergy =

Value of merged firm - sum of parts

Concept: Principle of Comparative Advantage

A firm should focus on social activities where it can deliver more value than other firms by leveraging its core capabilities.

Why is the evidence that Environmental and Social investing improves financial performance considered 'conditional'?

Outcomes depend on specific economic channels, the accuracy of measurement, and the institutional context.

When examining large-scale academic studies on E&S performance, why does correlation not necessarily imply causation?

High performance could be caused by profits, social actions, or a third variable like high-quality management.

effect of a rigid labour market on relationship between social responsibility and financial performance?

Responsibility tends to pay relatively less in countries with more rigid labour institutions.

Define Principle of Multiplication

An activity is responsible if every £1 spent by the firm generates more than £1 of benefit to the stakeholder.

Example: Coca-Cola's 'Project Last Mile' leverages the firm's expertise in logistics to deliver medicines. Which principle does this demonstrate?

The Principle of Comparative Advantage.

Define Principle of Materiality

A firm should prioritise stakeholders that are material to its specific business model and long-term cash flow.

What is the likely outcome if a manager ignores the Principle of Materiality?

The firm's attention and resources are spread too thinly across too many stakeholders.

What occurs when a firm fails to apply the Principle of Multiplication to its social investments?

Short-term private costs dominate the long-term social benefits, leading to value destruction.

How does a responsible business differ from one that purely maximises long-term shareholder value?

It explicitly considers externalities to all stakeholders rather than focusing solely on profits.

The view that ESG should focus purely on financial materiality and risk management is known as the _____ view.

politically neutral

Why is the 'politically neutral' view of ESG often contested?

Because ESG decisions inevitably reflect social values and create winners and losers in the market.

What are the three ways to correct a firm's failure to 'grow the pie'?

Internal discipline (purpose), external discipline (activism), and institutionalisation (stewardship codes).

Why might a CEO choose to invest even when it does not 'grow the pie'?

may have private incentives to engage in 'empire-building'.