Global sustainable, responsible and impact (SRI) investments have been growing rapidly over the years, but became a major focus for investors since the 2008 crisis. MAHINAZ EL-AASSER anticipates that sustainable investing will grow in the coming years taking into consideration the policy development happening in the markets relevant to corporate environmental, social and governance (ESG) disclosure.
Investors have been considering revising the stocks they are acquiring in order to avoid getting hammered again. The market has shown a growth of 61% in almost two years; from US$13.3 trillion at the start of 2012 to US$21.4 trillion at the beginning of 2014. The main focus in the market is in Europe, Canada and the US, dominating almost 99% of global sustainable investing assets.
Table 1: Proportion of SRI relative to total managed assets |
||
|
2012 |
2014 |
Europe |
49% |
58.8% |
Canada |
20.2% |
31.3 |
US |
11.2% |
17.9% |
Australia |
12.5% |
16.6% |
Asia |
0.6% |
0.8% |
Global |
21.5% |
30.2% |
Source: Global Sustainable Investment Review |
With such concentration in the developed markets, we find that on the other hand the Islamic finance industry is mainly focused in the GCC and Asian markets, where the latter dominates almost more than 50% of global Islamic financial assets. The industry that is currently estimated to exceed US$2 trillion globally has set solid grounds in developing and emerging countries, mainly fostered by the base of the Muslim population already there. With the current global downturn, Islamic finance might face one of its toughest times with its core markets slowing down, expecting to reach significantly less growth rates than the previous decades.
The two markets, sustainable investments and Islamic finance, seem to be different in terms of market focus, prospect growth rates, and even market share of global assets. Despite such discrepancies, there is, however, huge overlap between the two industries such as: taking care of social aspects which is reflected in community development programs in ESG and in Zakat in Islamic finance; exclusion of sectors that cause social harm; promoting better environmental, social and governance aspects in business as reflected in Maqasid Al Shariah in Islamic finance; and many more overlying facets. Recently, an incident occurred that could be a case study of a possible integration of the two growing and complementing industries. Volkswagen, which mockingly has repeated the word ‘environment’ in its 2014 sustainability report 355 times, is currently facing relevant accusations from the US Environmental Protection Agency of devising a software installed in its diesel vehicles, known as the ‘defeat device’, that cheated on emission tests. The software switches the engine to a low-emission mode when being tested, and once the cars are on the road the mode is switched off leading to higher emissions that allowed almost 40 times the legal limit of nitrogen oxide (N2O).
On the corporate level, the scandal affected Volkswagen’s stocks, which plummeted by more than 40% since the announcement of the news. Moreover, with the heavy reliance on the car industry, Germany might face a significant monetary damage besides the potential threat on the ‘Made in Germany’ image that always reflected high quality and trust. The company has set aside GBP6.5 billion (US$9.89 billion) to cover the expected costs of such a fallout, which might scale up with the prospected car buybacks and other problems that could occur such as the violation of the green guide of the Federal Trade Commission. In addition to this, the level of expected pollution and its effect on people’s health is undeniable.
Now that we know the scandal details and its aftermath, it’s time for a question: Does this pose a threat on the ESG industry? Could have ethical and/or religious filters helped to avoid such a problem? Volkswagen, the company that was ranked as one of the highest performing companies in its industry, has been removed from positive and responsible indexes worldwide. But is it enough? The scandal showed a massive problem of reliance on companies’ self-reporting. Once a piece of information is available, complete transparency is assumed and the company passes on one of the screening aspects. Several companies look at sustainability as a selling edge for them, though what’s behind the scenes might be contradicting to what is being reported leading to problems of asymmetric information.
It is, however, interesting to note that as per the internal research of IdealRatings, Volkswagen has been considered as non-compliant for Islamic finance investors, and as such was also non-compliant for ESG investors even before its latest problem appeared on the scene. Volkswagen has both excessive interest-bearing investments and interest-bearing debts, approximately 146.93% and 144.86% of market cap respectively. This should have clearly removed Volkswagen from any ESG and/or Shariah compliant-based investment universe, if and only if the ESG methodology had such filters like interest-bearing debt, which Islamic finance investors use.
The bottom line is sustainability should not be an ad hoc process; it should be fully integrated in the company’s business. To truly implement this, four focus points are highly recommended. First, a third-party assurance should be a must on companies providing sustainability reports, just like the independent auditing assurance done on financial aspects. Moreover, since all employees respond to their paychecks, it is highly recommended to tie the company’s sustainability goals with the employees’ incentive plans. A prominent example is Intel’s greenhouse gas emissions that were 35% reduced by 2012 when it applied this method. The latter recommendation is on the way of implementation globally though with a minimal percentage; as per IdealRatings statistics almost 70% of global listed companies do not tie their executives’ compensations. By making sustainability goals everyone’s job, more effective performance can be guaranteed. Another recommendation which is really important is to incorporate filters like interest-bearing debt to market capitalization as a way to measure management effectiveness as in the case of Volkswagen.
Mahinaz El-Aasser is a senior research analyst at IdealRatings. She can be contacted at [email protected].