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Sell at haste, regret at leisure? Roger Cowe asks whether a culture shift could prompt investors to place greater value on long-term returns.
It used to be said that, in the City, ‘long term’ means after lunch. That was before the advent of high-frequency trading. Now, each millisecond counts so much that traders want their computers to be physically nearer to the stock exchange computers. In this case, ‘long term’ means the time it has taken to read this paragraph.
Millisecond trading is the culmination of what is, ironically, a long-term trend to ever shorter investment time horizons. For decades, investors have been moving from a ‘buy and hold’ approach to increasingly rapid buying and selling. On average, shares now change hands after just eight months. That’s not even long enough for the company to tell investors how well it is doing in the annual report. Progress towards sustainability inevitably suffers.
Take, for instance, private investment in unsustainable ‘drag’ fishing technology. This drove the Newfoundland cod population to near-extinction in the 1990s, when a longer-term perspective would have yielded greater returns for more investors over a longer period. Similarly, investors in fossil fuel companies can gain attractive short-term returns from high oil prices. The risks of carbon-intensive activities to the overall system (climate change, water depletion, forest degradation, conflict, financial crisis) may ultimately reduce the financial returns from investments, but often only over a long period.
In a sustainable world, investors would profit from patience. They would wait to reap the benefits of company spending on improved products, new ideas and leading technologies – because selling out early would mean losing out. The best way for companies to strengthen their business would be through investment in projects to cut emissions, support ecosystems and improve livelihoods. In fact, boards would be under pressure from investors if they failed to invest for the future...
As it is, investors (or those who manage their assets) focus on what will make a quick buck now, rather than what will pay off in 10 or 20 years. Executives of leading public companies admit (in anonymous surveys) that they try to meet expectations for the next quarter’s earnings, even if the company will be worse off in the long run.
There’s a problem here, and the UK Government recognises it. The Business Secretary, Vince Cable, has asked economist John Kay to head an enquiry into how the workings of the financial markets affect company performance. “It is especially urgent”, says Cable, “that we work out how the equity investment regime can be recalibrated to support the long-term interests of companies as well as underlying beneficiaries, such as pension fund members.”
Urgency acknowledged. So how can it be done?
A Forum for the Future project, ‘Overcoming the Barriers to Long-term Thinking in Financial Markets’, supported by the Friends Provident Foundation, has been looking into this whole issue of ‘how to think long term’. It proposes three essentials for a much healthier system. The first is that companies provide fund managers with much better strategic information on environmental, social and governance issues, and fund managers demand it. This goes hand-in-hand with companies placing a greater emphasis on the benefits of a longer-term strategy in communications with shareholders, mainstream investors and the media.
The second is to do with incentives. Current incentives can serve a fund manager’s bonus, calculated on the last quarter’s performance, for instance – even at the expense of the asset owners’ interests. To move away from this, fund managers must provide evidence that all investment incentives serve the long-term interests of asset owners.
And the third is that companies also tackle this problem of misplaced incentives, through greater transparency in how they judge and reward the performance of their board, CEO and staff. Asset owners should also demand this transparency, alongside information from fund managers on environmental, social and governance issues.
The Government has its role to play, intervening to correct the current market failures that encourage investors to seek short-term returns with long-term economic disadvantages. Part of that is creating incentives for investors to act for long-term gain, maybe through the tax system. The other is making sustainable business more attractive – by putting a proper price on carbon emissions, for example.
Looking beyond the barriers
Of course, it’s easier said than done.
The Forum project was forthright about existing barriers to long-term thinking. Companies say investor pressure forces them to prioritise short-term returns. Investors say short-term returns are what matter – despite evidence, from catastrophes like Deepwater Horizon, of the dire consequences that can stem at least in part from cutting corners. And incentives on both sides of the fence tend to encourage people to look at the next few months rather than decades.
“We’ve gone round the houses so many times” on this long-termism debate”, admits Alice Chapple, Forum’s Director of Sustainable Financial Markets. “Sometimes it seems it’s about the only thing around the City that is long term!” [See box 'On board for the better', below.]
But perhaps the largest barrier to long-term thinking is a cultural one, and this has to be part of the solution. The project report calls for a significant shift towards a culture which honours those who act in the company’s long-term interests – and vilifies those who are only concerned with this year’s earnings.
Once upon a time, after all, the prevailing boardroom value was to leave the company stronger than you found it. The short-term culture is a phenomenon of the last 50 years, and is notably less pronounced elsewhere in Europe. Change is clearly possible: the challenge is to shift the direction of change towards, not away from, more sustainable business values.
Already, prominent business leaders such as Paul Polman of Unilever and Ian Cheshire of Kingfisher have spoken out in favour. Earlier this year, Polman said: “We are moving our business model to the longer term. I tell our investors, if you don’t like that, to be honest, then I fully respect you but look at other alternatives.” Similarly, Cheshire has called for new economic objectives: “Instead of the goal of maximum linear growth in GDP, we should be thinking of maximum wellbeing for minimal planetary input.”
A tale of rust and resilience
Better the devil you know?
There’s still the question of whether long-term considerations can really be compatible with investors’ financial concern for current share value. Even if companies and fund managers do understand about sustainability, and know what’s good for the company’s long-term business, there is a strong argument that investors benefit from short time horizons, from a purely financial point of view. If short-term performance is poor, there is after all no guarantee that things will get better, so it could be safer for an investor to sell in haste rather than regret at leisure.
If this is the case, companies will only be able to take long-term decisions if there is less immediate pressure from the City. This takes us into deeper waters, raising all manner of corporate governance concerns about shareholder rights.
Indeed, to some, the conventional share ownership model is at the heart of the problem:
“In my view”, says Bevis Watts, Head of Business Banking at Triodos Bank, “a more sustainable economy won’t happen with existing ownership structures that only value profits. We need ownership structures and new corporate bodies that value social cohesion and environmental impacts.”
One encouraging sign, says Watts, is the emergence of new ownership forms such as community land trusts [see ‘Can community ownership combat cuts?’]. Watts also calls for more localism – and sees an opportunity in the current crunch. Local organisations can step in where the public sector is retreating, switching the focus to quality rather than profits and growth.
But however successful new models may become, they won’t cure the current system – and nor will they be quick to replace it. So we are forced to remember that financial markets, unlike ethical banks, are essentially amoral. Their job is to allocate capital where it can be used most efficiently. If they are doing that, and the outcome fails to match what society needs, it’s not a failure of the City. It’s a wider problem of market failure – and that’s a job for government to fix.
Does that mean the City’s off the hook? No, says Steve Waygood, Head of Sustainability Research and Engagement at the insurance company Aviva:
“If it’s in the interests of the economy to be long-term but investors are not appropriately incentivised, then investors should engage with government to correct that market failure.” Ultimately, investors need a sustainable economy, too.
Vision for a sustainable economy
Aviva commissioned a separate Forum project, 'Sustainable Economy in 2040: a roadmap for capital markets', which asked what a sustainable economy would look like in 2040, and described the environmental limits and social conditions such an economy would meet.
In the vision, the economy measures wealth by more than just GDP. The whole system is geared towards building resilience in natural and human systems. Headline-grabbing investments are in biodiversity and solutions for greater resource efficiency. It goes without saying that the more transparent, the better. Fair terms for global trade are de rigueur, perverse subsidies are eliminated, and sustainable behaviour is incentivised.
Aviva will be using the 2040 Framework to see if sector guidelines for investment are “stringent enough – and how we might need to change them”, according to Steve Waygood, Head of Sustainability. It will also help the group to pinpoint where external catalysts might be needed, such as tax changes and other government action.
What will it take to increase investment in sustainable activities? Engagement, for one, says Alice Chapple.
There’s no shortage of capital for innovative solutions and sustainable activities – if it can be shifted away from unsustainable ones. Global oil and gas exploration attracts significantly more investment than the development of clean technologies. Obesity drugs get more than drugs to beat malaria – which kills a million people every year.
At present, however, investors see no reason to make this shift. Why would they? Investors are paid to achieve high short-term returns, so it’s not surprising that they aim to do so. The resulting risks to the overall system (climate change, water depletion, forest degradation, conflict, financial crisis) may ultimately reduce the financial returns from investments, but often only over a long period and the impacts are uncertain.
So how can we create the change that’s needed? At Forum for the Future, we’re asking just that. It’s all part of our five-year strategy to ramp up the pace of change towards sustainability by transforming some of the key systems that underpin our lives, including finance. We are engaging with companies, financial institutions, NGOs and government, and support them in seizing opportunities to do things differently.
It’s a huge challenge, and so we’ve divided it into three themes. The first looks at incentives within the finance system. We want to unpick the reasons why investors account poorly for future risks, and why they fail to value the assets that matter to our long-term prosperity, such as a stable climate, biodiversity and strong communities. We’re working at a practical level both with companies and with investors, to highlight reasons for short-term thinking and pilot new approaches. The result, we hope, will be more economic activities designed to deliver lasting wealth rather than simply a short-term share price hike.
The second theme looks at ways to enable funds to flow to sustainable activities. This requires innovation, such as new types of financial mechanism. One example is our work on forest-backed bonds, which explores how ecosystems services – the largely unvalued benefits which we get from forests in terms of carbon sequestration, biodiversity, landscape value, social and cultural value, flood protection, subsistence livelihood support and so on – may be used to augment the value of a bond.
Another important part of the picture will be innovation by companies to develop new business models to address sustainability challenges. GlaxoSmithKline’s adoption of tiered pricing on drugs is a case in point. The pharmaceutical company is selling life-saving medication at a much lower price in developing countries than in developed countries, while still meeting overall return targets for investors in the business.
And finally, we want to inject some new thinking into the system. We’ll identify and support new players from others sectors, who are bringing in new technologies, such as mobile phone banking, or new financing approaches, like peer-to-peer lending and time banking. Existing businesses will be pushed towards better practice by this new pressure on their markets, and the range of financial service providers will increase, improving the resilience of the system.
Alice Chapple is Director of Sustainable Financial Markets at Forum for the Future.
Roger Cowe is a consultant on corporate sustainability and an Associate Director of Context Group.
Photo credits: Samxmeg / istock; digicamchic / istock; : alaincouillaud / istock