New SRI Research Strikes Balance Between Ethics and Economics

New SRI Research Strikes Balance Between Ethics and Economics

Socially responsible investing (SRI) is far from monolithic, encompassing a wide diversity of approaches spanning the political spectrum and the palette of investment strategies. Inevitably, mainstream financial institutions taking up SRI strategies similarly diverge significantly in their approaches. These differences can be telling. Take, for example, the report released earlier this year by UBS Investment Bank, the first such work by the firm's SRI research team that formed in December 2004 with the assignment of analysts Julie Hudson and Shirley Knott.

As with the recent Goldman Sachs SRI report on the energy sector, the UBS report (Why Try to Quantify the Unquantifiable?) takes a hard-nosed approach to quantifying corporate social responsibility (CSR) issues. However, UBS takes a decidedly different approach from GS. The GS report focuses on "new legacy assets," or oil and gas reserves now coming on line that will fuel the industry for the next several decades. One could argue that petroleum, an energy source closely associated with global warming, represents a misplaced focus from a sustainability perspective.

The UBS team strikes an interesting balance by acknowledging the inherently ethical implications of corporate actions while simultaneously noting that social and environmental impacts invariably create financial consequences on what UBS calls enterprise value. Mss. Hudson and Knott utilize a "stakeholder balance sheet" to quantify costs when potential corporate social liabilities crystallize into actual liabilities. The authors define corporate social liabilities as the "potential obligation to make good any adverse environmental, social, or economic effects of corporate activity."

Specifically, they look at the cost of internalizing that which companies formerly externalized. For example, companies may damage the environment without having to pay for it upfront; some companies recognize this and choose to minimize the damage while other companies may eventually face costly lawsuits requiring them to clean up their pollution.

"If a firm or industry 'externalizes' costs, the affected stakeholder is very rarely given the opportunity to agree the transfer of costs, and so the 'price' (perhaps very small in the eyes of the firm but very large in the eyes of other stakeholders) is not negotiated at the time when costs are externalized," write Mss. Hudson and Knott. "The danger to firms is that, if the balance of power between stakeholders changes, the price of the exchange may be renegotiated at a future date, and sometimes, but not always, in a court of law."

The UBS report sets out a framework for quantifying corporate social liabilities, first identifying issues that may give rise to such potential liabilities, such as climate change, electronic waste management, human rights risks, and bribery and corruption, among others. The UBS framework next ranks potential corporate social liabilities in terms of likelihood of crystallization, then assesses potential scale, and finally estimates potential impact on enterprise value. While Goldman Sachs applies its analytical template only to the energy sector, UBS applies its framework across nine sectors: basic materials, consumer, energy, financials, healthcare, industrials, technology, telecommunications, and utilities.

The UBS team additionally applies to its analysis the discipline of industrial economics, which addresses asymmetries between economic actors. For example, global corporations have the power to demand production deadlines that have the effect of stripping supplier factory workers of their power to maintain basic labor rights. In other words, corporations externalize the negative impact of time constraints onto the health of their supplier workers.

One potentially controversial aspect of the UBS approach is the quantification of social and environmental liabilities, in that it essentially puts a price tag on human suffering and ecological destruction.

"Putting an absolute monetary value on a clean environment, or an organization's indirect economic impacts, the quality of life, or life itself, may be regarded as unethical or nonsensical," write Mss. Hudson and Knott. "In our opinion, putting a price on something 'priceless' when the aim is to facilitate a mutually beneficial, orderly, and equitable reallocation of resources (or to prevent expropriation) need be neither unethical nor nonsensical."

If the purpose of quantifying adverse social and environmental impacts is rectification, then the effort is ethically (and economically) justified, the UBS team argues. In other words, pricing corporate social liabilities creates benefits not only for people and the earth but also for companies, as markets ultimately require internalization of externalities and asymmetrical power relationships are often equalized. Recognizing the financial implications of these realities incentivizes the identification of mutually beneficial solutions.

Both the Goldman Sachs and the UBS reports suggest that SRI pays. The difference is that while GS recommends best-in-class oil and gas companies with exposure to petroleum reserves, UBS suggests assessing companies' movement toward social and environmental justice.