This report looks at the definitions, motivations and purposes of responsible investment. With over 1,000 organisations now signatories to the Principles of Responsible Investment, it seems sensible in terms of sheer numbers to discuss its definitions. While there are a number of definitions, the key differentiator of responsible investment is the long-term, broad-based value creation. Three broad motivations are also identified – service to society, enhanced returns, and economic imperative – serving a common aim to reward sustainable business models. It then goes on to review the moral case for responsible investment in greater depth than usual, shedding light on the relationship between the financial case, the ethical case and legal risks. With discussion of planetary boundaries, this report also touches on the economic case for responsible investment. Furthermore, the report explores the environmental and social factors that underpin the financial case for responsible investment. The literature review of this topic critically assesses the state of the literature and identifies crucial gaps in knowledge. Finally, the report offers opportunities for collective action and research by responsible investors. It identifies the actions that would substantially advance the practice of responsible investment, and the subsequent research studies that would inform it:

1. Scale up capital allocation to the green economy.
2. Underpin this commitment with research on the economic impact of environmental risks over the next two to three decades.
3. Tactical opportunities to support ESG integration.

The literature review by Farzad Saidi, reviews a range of responsible investment literature and concludes that a filter function could be constructed to identify firms with superior ESG performance. The fact that this has not been modelled to date in the existing literature could explain the mixed nature of the current empirical evidence. The filter would allow groups of firms to be assembled into profitable responsible investment funds. There exist a myriad of papers documenting correlations between ESG factors and sound corporate practices but these do not establish the direction of the relationship, and therefore the underlying causal mechanisms. In the majority of papers reviewed, ESG practices refer to doing good at the firm level and not to proactive innovation in response to sustainability risks and mega trends. Despite many limitations it was possible to collect studies that show robust causal evidence in favour of the case for responsible investment. However, the literature did not identify managerial agency problems that may attenuate the effect and thus justifies the need for future research.

Financial short-termism is widely cited by business leaders as one of the principal barriers to stronger ESG practices by companies. Research found that companies forego investment opportunities with positive long-term net present value in order to satisfy the market’s short-term performance expectations. In contrast, one of the opportunities to support ESG integration is promoting long-termism through investment mandate design.

Modern portfolio theory (MPT) stems from the idea that markets are efficient: that all the information relevant to investors is reflected in the price of an equity or bond in real time. There is mounting evidence that the efficient market hypothesis is empirically false or at best a truism. The fact that ESG issues and risks are generally not included in the price of equities or bonds presents risks and opportunities for investors.

As a whole, the report offers a tour of the main drivers and debates in responsible investment, with recommendations on future actions and research.

1. The mutual dependence of financial and non-financial value lies at the heart of responsible investment. Responsible investment is clearly intended to satisfy the financial requirements and expectations of beneficiaries while avoiding causing harm to the financial system, economy, environment and society.
2. The separation of ethics from fiduciary duty assumes that the overriding interest of savers is to make the most money possible, regardless of the social and environmental consequences – a view that has never been verified through robust empirical research.
3. There are many good reasons for transitioning from business as usual investment to responsible investment. It can be done without sacrifice to financial performance, with reduction in real risk and in better alignment with the inclusive goals of beneficiaries.
4. The economic implications of environmental issues such as climate change, resource scarcity, biodiversity loss and deforestation, and of social challenges such as poverty and human rights are increasingly being recognised. The investor might judge that factoring companies’ sustainability exposure into their index weighting, rather than basing it purely on their current market capitalisation, is likely to deliver better returns.
5. Value of responsible investment? Three forms of value creation are financial value from both capital allocation and engagement; and non-financial value.
6. Through the review of literature there are three gaps that are identified that, if closed, could explain the mispricing of sustainability risks. They are: market short-termism, varying sensitivity to sustainability issues across asset classes, and the role of critical mass in influencing investor behaviour.
7. Environmental and social, rather than governance, factors appear to add value, not just through lower firm-level risk but also through lower cost of capital, with roughly similar findings holding for firm value.
8. Collective action (A) that would advance the practice of responsible investment - Scale up capital allocation to the green economy: The ILG is well placed to tackle these issues by exploring options that would enable institutional investors to scale up their allocation to green infrastructure, including the development of mechanisms for targeting opportunities in emerging markets.
9. Collective action (B) that would advance the practice of responsible investment - Underpin this commitment with research on the economic impact of environmental risks: To support the case for shifting capital into the low carbon, sustainable economy, targeted research is needed on the exposure of investment assets to environmental risks in order to determine which risks can be addressed through investment strategies, and which require policy action to protect returns.
10. Collective action (C) that would advance the practice of responsible investment - Tactical opportunities to support ESG integration: Develop methods of consistently reporting the ESG impacts of investment; promote long-termism through investment mandate; and contribute to shared understanding of fiduciary duty globally.