An unhappy customer may choose to complain and exchange their goods for a refund, while another may simply never return. This same dilemma also applies to ethically-minded investors.
Divesting from companies that break ethical rules is often the most convenient option for investors and can sometimes even bring about a quick reputational boost. However, once investors sell out they can no longer apply the required pressure to company boards to drive change. Instead, they could be replaced by less conscientious shareholders who are more than happy to look the other way. And as Hirschman observed, while exiting may be more convenient and conscious soothing, it tends to entrench the status quo.
So how can investors engage with companies to improve their practices?
Using engagement as a force for change
Engagement may sound like the latest industry buzzword, but its origins add more depth to the story. It can be traced back to the roots of consumer law, which positioned shareholders as the primary regulators of corporate behaviour. Modern investors should approach their responsibilities in the same spirit.
Investors have a moral duty to act when and where they have the power to enforce generally accepted standards. This can often mean staying put to engage and establish a dialogue and exerting pressure where necessary. In turn, this can help to protect long-term shareholder value. While divestment is the simpler solution in many cases, the real question investors need to be asking is what is more likely to bring about long-term change?
How investors can drive change
Equity investors have a wide variety of tools at their disposal. They have the power to fire a company’s leadership at AGMs and can use this power to vote against strategies they disagree with. Investors can also vote against auditors if they are concerned the company’s reports and accounts are not being properly scrutinised or do not truthfully represent the financial and reputational risk it faces.
Importantly shareholders can work together to bolster their influence. This type of collaborative engagement is particularly important when it comes to addressing the behaviour of powerful fossil fuel companies that might be used to resisting pressure from environmental campaigns.
This could include the inability to correctly price the impact of climate change or the depletion of natural resources such as iron ore or fresh water.
One way institutions can ensure managers are taking responsibility for driving change is to build engagement plans into yearly objectives. This helps set the scene for potential sanctions should the engagement plan fail to deliver.
It is also important to note and recognise the limits of what engagement can truly achieve in the face of specific market failures. This could include the inability to correctly price the impact of climate change or the depletion of natural resources such as iron ore or fresh water. This is primarily the responsibility of governments; however, the investment industry also has a role to play through engagement and market reform efforts.
What investors should do if they fail to see change
Despite the impact engagement can have, not every investor will have the influence to make a company change its behaviours, and sometimes firms will refuse to improve their business practices no matter how strongly investors protest. There is no denying that sometimes engagement can fail and there will come a time when the best option for an investor is to walk away.
Investors must set goals and timeframes to measure the effectiveness of their engagement. If those goals cannot be met despite persistence and a concerted effort, then it may be time for investors to use the exit – if the mandate agreed with the client provides for such an approach.
Investors should be bold enough to use their voices to bring about positive change. Through engaging in dialogue and bringing ESG to the forefront of corporate discussion, investors can help to accelerate meaningful action.
More news on the fund industry in Paperjam’s Alfi supplement.