What’s preventing palm oil investors from going green?

Part two in a five-part series on the attitudes of palm oil financiers towards company sustainability. Read the first, third, fourth and fifth installments.

Evidence suggests that environmental, social and governance (ESG) risk assessment — a method for grading companies on metrics like climate footprint and fair labor policy — is becoming steadily more widely accepted and demanded in the financial sector. However, though many investors want to implement more extensive ESG methods,[36] there remain an array of obstacles that prevent them from doing so:

1. Internal organizational constraints

Individual investment managers might be aware of environmental issues, but they find it difficult to influence investment decisions at a firm-wide level, especially in mainstream investment institutions.[37] This is because these institutions rarely have a central ESG issues department accessible to all fund managers within the firm. As a result, ESG analysts often report their findings only to the firm’s socially responsible investment (SRI) fund divisions, rather than the Asian fund management divisions that control the palm oil portfolio.[38]

“Analysts may be barred from talking to fund managers of their own financial institutions because of ‘Chinese walls’,” noted Eric Wakker, of sustainability consultancy Aidenvironment. “They can only ‘throw their assessments over the wall’ and hope someone reads it.”[39] Due to these constraints, ESG specialists often find themselves not just advocating for sustainability principles towards external clients, but also engaging within their own companies to improve their companies’ performance.[40]

2. Lack of research, data and expertise

Sustainable investing is a relatively new field, and experts agree that a lack of knowledge about sustainable investing remains a major problem for financiers. The palm oil sector, in particular, is “both definitionally and metrically challenged,” said Iain Henderson, of the UN Environment Program Finance Initiative. For instance, there remains no universal agreement over the meaning of terms such as “zero deforestation” and “degraded land,” which are crucial for designing ESG metrics.[41]

Not enough research is being done into the modeling and prototypes necessary to quantify ESG risk. Regarding ESG issues, “many banks are still in the research phase — they just don’t know how to do this kind of evaluation yet,” Cary Krosinsky, independent sustainability advisor, told Mongabay. “Efforts are not being focused enough on the crucial areas of climate change and agriculture.”[42] As a result, passive investors interested in applying ESG metrics are stymied by “a lack of essential tools, such as robust and publicly available exclusion screens, white lists, blacklists and benchmark ratings.” Many investors are forced to defer to the lists produced by a few prominent funds, such as the Norwegian sovereign wealth fund’s list of excluded companies.[43]

Many companies simply do not disclose the data necessary to subject them to meaningful ESG evaluations. “Disclosure is particularly poor in the land use sector for publicly listed companies,” Henderson said,[44] citing research led by the SRI mutual fund firm Calvert Investments, which found that just 6% of publicly listed companies worldwide reported their raw materials use.[45] Banks themselves are sometimes complicit in this lack of transparency; for example, loans to small companies are still extremely opaque, and often involve the use of multiple shell companies.[46]

Finally, institutions willing to implement ESG methods often find they lack the necessary expertise and institutional capacity to do so. Many lack the expertise to understand the complex issues surrounding specific industries, including — crucially — palm oil.[47] In terms of manpower, the typically small- to medium-sized teams that run investment funds also find themselves underequipped to deal with ESG issues that are growing increasingly more complex.[48]

3. Lack of proven materiality

Perhaps the most fundamental challenge facing sustainable investing is that there is still not enough evidence to prove that unsustainable investing has a negative impact on corporate value. This makes it tough for investors to justify incorporating ESG principles at scale in mainstream portfolios, especially when these principles conflict with conventional models projecting high returns.[49]

“For investors, the risk of ‘little environmental impact’ has always been secondary to the risk of low returns,“ remarked Krosinsky, the sustainability advisor. “It is not accidental that due diligence on risk of return is a highly standardized method with large brand names such as Moody’s on the front lines, while due diligence of environmental impact remains a scattered approach led by companies you have probably never heard of.”[50] Hence, in the absence of “sticks” in the form of externally imposed regulations and penalties, investors naturally gravitate toward the “carrots” of investing in unsustainable, but profitable, companies.

This is not to say that companies’ unsustainable practices do not have a negative impact on their returns. Rather, it is more likely that the assessment methods currently used by banks are not sophisticated enough to detect these negative effects. Some NGOs are stepping in to help fill the gap — Chain Reaction Research, for example, has developed a method to measure a company’s financial risk by calculating the amount of contested land it owns.[51]

4. Short-termism and lack of incentives for environmental performance

The problem of proving materiality is closely linked to short-termism, which is a structural issue associated with present financial markets. Short-termism refers to the tendency for fund managers to consider investments in terms of short-term returns, rather than long-term value. This can manifest in several forms, including decreasing CEO tenure, short-term benchmarks for measuring the performance and compensation of fund managers, and the definition of risk as volatility around an index, rather than long-term absolute risk to capital.[52][53] Short-termism is linked to the problem of proving materiality because if fund managers have incentives to evaluate an investment’s value solely in the short term, they are likely to miss or care less about the negative impacts on value caused by unsustainable practices, which mostly only become apparent in the long term.

There are currently few roles in the financial industry whose compensation is tied to environmental performance. “Environmental performance is an incentive for managers of carbon markets, and only a couple of CEOs have linked their remuneration to environmental performance,” Gabriel Thoumi, sustainability analyst and faculty at the University of Maryland’s Robert H. Smith School of Business, told Mongabay. “But I don’t know of any portfolio managers who have linked their remuneration directly to environmental performance criteria, such as energy intensity or exposure to deforestation risk.”[54]

Within the general analyst community, buy-side analysts are more likely to take ESG assessments seriously, because their compensation is closely tied to how their investment recommendations perform. However, it is difficult to tell how and how much buy-side analysts assess environmental risk, as they do not publish their reports.[55] In comparison, sustainability is rarely a concern for sell-side analysts, especially at Asian banks.[56] This is because sell-side analysts’ compensation is linked more closely to the speed at which they can obtain new financial information, as well as their ability to market their firm’s services to clients.

5. Additional issues specific to palm oil

Other than the issues outlined above, there are some additional reasons that make assessing the ESG impact of palm oil investments difficult for many investors.

•         Palm oil constitutes only a small part of the direct investment portfolio for North American and European funds, which have the most active SRI policies. For these funds, direct investments in palm oil may constitute less than 1% of assets under management.[57] In comparison, over 80% of the funds directly invested in the palm oil sector are controlled by only about 20 fund managers, most of them probably based in Asia. It is unclear what ESG methods these managers use, if any.[58]

“For this reason, sustainability efforts in Europe originally focused on encouraging buyers to demand the RSPO’s certified sustainable palm oil [CSPO],” Asia Research & Engagement’s Benjamin McCarron said. “European investors have a much larger exposure to fast-moving consumer goods retailers in their home market than to [palm oil] producers listed in Southeast Asia.”[59]

In reality, however, funds in the Western world are probably much more exposed to palm oil than these figures suggest, because many of them track indices containing palm oil or palm oil-linked companies.[60] A 2012 study by the Worldwide Fund for Nature, an NGO, concluded that due to “the pervasive nature of the commodity and globally interconnected supply chains,” the “majority” of global portfolios will be exposed to palm oil.[61]

•         Western funds are separated from palm oil companies by geographical and language barriers. 90% of palm oil growers by total market capitalization are listed in Southeast Asia, specifically Singapore, Malaysia and Indonesia. For Western investors, this geographical remoteness accentuates cultural and language barriers and limits access to companies’ management.[62]
•         Southeast Asian banks have to follow implicit government policy. Palm oil revenues continue to be a cornerstone of economic development policy in Malaysia and Indonesia.[63] As a result, banks based in these countries may find it difficult to restrict capital from palm oil companies, or challenge the sustainability of their operations.[64]

Citations:

[36] Palm Oil Investor Review, pp. 21-25.

[37] Palm Oil Investor Review, p21.

[38] Ibid.

[39] Eric Wakker (personal communication, November 7 2015).

[40] Gabriel Thoumi (personal communication, October 20 2015).

[41] Iain Henderson (personal communication, October 29 2015).

[42] Cary Krosinsky (personal communication, July 30, 2015).

[43] Palm Oil Investor Review, p22.

[44] Iain Henderson (personal communication, October 29 2015).

[45] Calvert Investments, Fauna & Flora International, and Crowell Moring, “Global Financial Indices and Natural Capital Policies Assessment: Q3 2014 Baseline Analysis,” 2014, p4, http://www.calvert.com/NRC/literature/documents/Global%20Financial%20Indices%20and%20Natural%20Capital%20Policies%20Assessment%20Q3%202014%20Baseline%20Analysis%20Final.pdf.

[46] Cary Krosinsky (personal communication, July 30, 2015).

[47] Palm Oil Investor Review, p22.

[48] Ibid., p21.

[49] Iain Henderson (personal communication, October 29 2015).

[50] Todd Cort and Cary Krosinsky, “Green Finance Environmental Impact Hard to Measure.”

[51] Eric Wakker (personal communication, December 4 2015).

[52] Ben Caldecott and Jeremy McDaniels, “Financial Dynamics of the Environment: Risks, Impacts, and Barriers to Resilience,” UNEP Inquiry Working Paper, 2014, pp. 6-7. http://apps.unep.org/publications/pmtdocuments/Financial_Dynamics_of_the_Environment_Risks_Impacts_and_Barriers_to_Resilience.pdf

[53] Iain Henderson (personal communication, October 29 2015).

[54] Gabriel Thoumi (personal communication, October 20 2015).

[55] Eric Wakker (personal communication, November 7 2015).

[56] Ibid.

[57] Iain Henderson (personal communication, October 29 2015).

[58] Palm Oil Investor Review, p19.

[59] Benjamin McCarron (personal communication, October 23 2015).

[60] Benjamin McCarron (personal communication, October 23 2015).

[61] Palm Oil Investor Review, p8.

[62] Ibid.

[63] Will Greene, “Palm Oil in Indonesia and Malaysia: A Controversial Industry,” Tigermine Ventures, May 13 2013. http://www.tigermine.com/2013/05/13/palm-oil-malaysia-indonesia-controversy/

[64] Gabriel Thoumi (personal communication, October 20 2015).