Institutional Investors & Corporate Governance for sustainability Dr Raj Thamotheram Oxford University 18 th May 2012
What I really appreciated about today Creative/challenging/sophisticated Inter ‐ discplinary Examined most parts of the investment chain ESG conidered in an integrated manner Interaction of real world academics with reflective practitioners
And what would I love to see more of next time More focus on the hidden gorillas in the ecosystem – investment consultants, analysts, financial media Make use of the points of intellectual flux – behavioural finance More practitioners, including mainstream More challenging of “BAU” assumptions Focus on what’s really critical (vs what creates papers to publish) Think communication to the public Action reseach – organisational transformation/management of change /immunity to change
11 fatalities 17 injuries Latest BP cost estimate $40 billion 30% share price drop 1 ‐ year suspension of dividends
“The Dominant Narrative” – the BP example “an Act of God” Rick Perry , Governor of Texas “I left BP a long time ago, four years” Lord Browne "It's very dangerous to join up dots that may not be appropriate to join up" Tony Hayward
Warning signs prior to the disaster Azerbaijan Grangemouth Gas leak 2000 Gulf of Violations Mexico Of Clean Thunder Alaska Oil spill Water Act Horse Oil Accident Spill Charges for Texas Texas Manipulation Penalties Refinery Refinery Of gas From the Accident Accident market OSHA “ “ Source: Yahoofinance.com Up until April 19 (the day before the Deepwater Horizon explosion) , his [BP’s] performance was excellent. An investor close to BP quoted by The Financial Times, July 25th 2010
How much attention did “sell ‐ side” pay to safety? Before the oil spill, 6 occurrences every 100 pages = the vast majority of reports do not talk about these risks at all .
Behavioral finance expert: “analysts are biased” Unicredit: analysts claim that BP has a good operational momentum because of its “first ‐ mover advantage in cost cutting” (17 December 2009) 5 = buy or strong buy recommendations 4 = add, overweight, outperform and accumulate 3 = hold, perform, neutral 2 = reduce, underweight and underperform 1 = sell or strong sell Source: SHEFRIN Hersh, CERVELLATI Enrico Maria, “BP’s failure to debias: underscoring the importance of behavioral corporate finance”, 21 st February 2011
Are asset owners & “buy ‐ side” much better? Sadly, no! Only 60% of capital voted at BP’s 2010 AGM 57% of votes in favour of chair of safety committee! (Only leaving in 2012!) Even proxy voting agencies recommended abstain (ISS) or vote against (Glass Lewis) Source: BP plc, ISS ProxyExchange
Another Narrative
Another Narrative In the end it all comes down to…. We are all co ‐ creators of a dysfunctional system Investors are very important enablers (aka “shareholder value maximisation”) The stakeholders of investors are enablers of investors (Russian dolls) We can therefore consciously aim to create a better system Since neither worldview can be proven, let’s choose the latter
So what went wrong? Narrow Shareholder Weak concern Conception of risk value for negative fundamentalism externalities Outdated approach To safety Focus on riskier M&A and and dirtier O&G Outsourcing/SCM SYSTEM BP O&G SECTOR Ineffective Saviour CEO regulation Weak safety culture Regulatory Leadership & capture Governance failures Organisational Learning disabilities
Fukushima Driver Evidence? Lack of concern for Full costs for dismantling plants, managing nuclear waste and damage in case of negative externalities accident not “in the price” Narrow conception of Probabilistic thinking about a really severe earthquake excluded possibility of it risk + failure to consider consequences of earthquake AND tsunami + failure to consider how one accident could impact whole nuclear industry Regulatory capture “Tepco’s cosy links to watchdogs” (FT) + Lack of support from government for the Japanese nuclear industry regulator since nuclear was a non-negotiable matter of national energy independence Organisational Lack of learning from earlier near misses learning disabilities Leadership & Weak standards of governance (non independent board member) governance failures Shareholder value Focus on meeting investors’ expectations leading to a weak safety culture in fundamentalism practice Source: THAMOTHERM Raj, LE FLOC’H Maxime, “Nuclear meltdowns are bad for returns”, FTfm talking head, Financial Times , 2 nd May 2011 with additional research by Kazutaka Kuroda
News Corporation Driver Evidence? Lack of concern for Over-dominant role of politically motivated media barons ignored negative externalities in most countries & over long-term Weak ethical standards taken as a given Narrow conception of risk Cameron himself recognised risk from overly close lobbying relationships Sector was widely viewed as low ESG risk Regulatory capture NewsCorp promised end of Ofcom “as we know it” Organisational learning Repeated warning signs ignored disabilities Leadership & Over-dominant Chairmen, lack of independent directors, class B, governance failures Shareholder value Repeated examples of most investors and most analysts discounting fundamentalism ethical concerns & weak corporate governance
Global Financial Crisis Drivers Questions Lack of concern for Why didn’t regulators/investors worry more about mortgage market “growth”? negative externalities Capital adequacy? Narrow conception of Are current risk models ‘fit for purpose’ ? risk - crossed derivatives linking financial firms - quant VaR models which aren’t suited to high impact, low probability events Regulatory capture Why did regulators accept claims that banks had diversified risk through derivatives? Why are regulators/politicians so vulnerable to attempts at regulatory arbitrage? Organisational learning What happened to the lessons learned from Enron/Dotcom & 2008 crash? disabilities What can we learn from repeated trading debacles at UBS about risk management culture? Leadership & What does it say about the leadership/governance culture that it tolerates governance failures outsized remuneration package WHILST banks are still being bailed out? Shareholder value Why do most asset owners maintain benchmark exposure to a sector fundamentalism which has weak performance, has so much hidden risk & which operates so irresponsibly?
Investors: our 10 deadly mistakes Mistake Still true? Passively/actively encouraged banks to pursue suspect / risky products & strategies Passively/actively encouraged banks to over ‐ leverage on debt Judged future performance solely on past performance Approved pay designs which incentivised dangerous risk taking and “too big to fail” growth Failed to get sell side/credit rating agencies to analyse bank’s corporate governance and didn’t resource/listen to independents who did do such analysis Didn’t ensure boards were experienced enough and independent enough Relied on the (inadequate) risk models that banks used (VaR) and didn’t invest in risk management models which they needed Did not appreciate the systemic risks presented by the shadow banking system Maintained excessive exposure to a high ‐ risk sector because of cap weighted indices. Allowed banking lobby to set public policy agendas and capture regulators/politicians
But “Black Swans” are the visible tips of the iceberg Investors also enable wealth ‐ destruction below the waterline “[…] the destruction of shareholder value through legal means is pervasive, perhaps even a routine way of doing business. Indeed we assert that the amount of value destroyed by companies striving to hit earning targets exceeds the value lost in these high ‐ profile fraud cases.” Source: GRAHAM John, HARVEY Campbell & RAJGOPAL Shiva, “Value destruction and financial reporting decisions”, Financial Analysts Journal, Vol 62 No 6, 2006
Dealing with our “Inner Jack Welch” – academics too! “As long as the music is playing, you’ve got to get up and dance. We’re still dancing” Chuck Prince
Minor tweaks or fundamental changes?
The practical agenda 1. Better metrics 2. Better reporting 3. Better supply chain management 4. More respect for employees 5. Better leadership 6. Better regulation
The strategic agenda 1. More diversity in corporate purpose 2. CEOs enabled & held accountable for being authentic leaders 3. Boards are guardians of long ‐ term sustainable wealth creation 4. Courageous, ethical government and smarter regulation 5. Investing as if the long ‐ term matters 6. “Citizen investors” drive this agenda – transparency taps public pressure
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