Jon Lukomnik is one of the pioneers of modern corporate governance. He cofounded the International Corporate Governance Network (ICGN) and GovernanceMetrics International (now part of MSCI), and served as interim chair of the Council of Institutional Investors’ executive committee. He serves as executive director of the IRRC Institute, which funds corporate governance, sustainability and capital market research. A three-time recipient of the NACD’s Directorship 100 award, he has also been honored by the ICGN, Ethisphere, Global Proxy Watch and others. Jon is a member of the Standing Advisory Group of the PCAOB, and his new book, What They Do With Your Money: How the Financial System Fails Us and How To Fix It, co-authored with Stephen Davis and David Pitt-Watson has been widely praised.
Christopher P. Skroupa: Jon, you recently identified two developments at the nexus of investing and sustainability, one of which you dubbed ESG 2.0 and the other systems level investing. Can you explain how they differ from old-style SRI or impact investing?
Jon Lukomnik: Let’s take systems investing first, because it’s a phenomenally important investment paradigm that is only now being understood. Under modern portfolio theory, the biggest determinant of the return on your investments is “the market.” But despite the fact that the market’s return determines more than 90% of the variability of your portfolio—much more than which stocks or bonds or other securities you select—modern portfolio theory says it’s exogenous to your investments. In other words, if you just use portfolio theory, you think you can’t affect the overall market and just have to agree to be buffeted by its cross-currents.
In the real world, we know that’s not true. For example, “Risk on/Risk off” markets are caused by investors moving their money. More narrowly, CalPERS changed the market return of the Philippines equity market by getting the laws there that affect foreign investors changed. In fact, Steve Lydenberg, Bill Burckart and Jessica Ziegler of The Investment Integration Project recently issued a great report showing how 50 major institutional investors deliberately try to influence the financial, environmental and social systems so that their investments can thrive.
ESG 2.0 is more of an implementation tool. Think of it as the sustainability equivalent of “smart beta” investing, which uses quantitative strategies to gain exposure to specific risk factors (which really ought be called risk/opportunity factors). That has been made possible because of improvements in both measurement and computing technology.
Similarly, ESG 2.0 quantitatively specifies certain ESG risk exposures. So, for example, both the New York State Common Retirement Fund and CalSTRS have put billions of dollars into low-carbon exposure stock index funds, designed to minimize their exposure to carbon risk while maintaining similar exposure to the other risk factors in broad-based stock indices. Others have chosen to gain exposure to high quality governance and accounting companies.
Skroupa: You are developing a bit of a reputation as a futurist. Most recently, you’ve been thinking about how modern technology will change sustainability and governance investing and disclosure. What changes do you see on the horizon?
Lukomnik: You could write a book on this, but let’s just look at two examples.
First, let’s look at big data and machine learning: I’m on the advisory board of TruValue Labs, a San Francisco company that’s using big data and machine learning to provide real-time sustainability information to investors. Certainly, sustainability is an important investing factor long-term, but it turns out that you can understand trends in the sustainability profiles of companies earlier when you aggregate what customers, suppliers, NGOs, regulators and the companies themselves are saying, and then use artificial intelligence to parse it rather than waiting for quarterly or annual reports.
Second, let’s talk about drones, data visualization, and augmented reality: Our conceptualization of reporting is still dominated by the idea that reports should be laid out as if they were physical pieces of paper. Even when reports are in electronic form, they’re usually “flat” PDFs or web pages. At best, companies and NGOs are now using videos. A few of those videos are interactive.
But imagine a future in which greenhouse gas emission reports are actually video images from drones in various facilities, aggregated and augmented by data feeds and instantaneous computations, to give you realtime information available to anyone, anywhere in the world. You could click through trends over time, or zoom in to a particular geographic region or a particular pollutant. Or you could look at water basins that way. Or inspect supply chain facilities. Augmented reality could show you the current state versus peers, or versus goals.
Skroupa: What hasn’t changed, but is under-appreciated, as fundamental factors that affect governance and sustainability?
Lukomnik: The day after the presidential election, I was in Denver at an SRI conference. The 700 attendees were understandably concerned about what happens to the regulatory environment under a new president. But here’s what hasn’t changed: About 80% of the stock of large capitalization public companies are held by institutional investors.
Why is that important? Simple. In our capitalistic system, increased capital means increased power. Institutional investors today consider the job of monitoring corporate governance and sustainability issues as tools to seek value and manage risk. For example, in the governance space we have seen a remarkable spread of proxy access bylaws in just three years, the wholesale removal of classified boards, and the adoption of voting.
In the “E and S” of ESG, more than 90% of the largest companies in the world report through GRI, 1,614 financial services firms have signed the Principles for Responsible Investing and 9,146 companies have signed the UN’s Global Compact. None of that occurred because of obligations in law or regulation. Simply put, sustainability is now rooted in business and investing strategy. Big institutional shareholders and companies simply do not wait around for the law to force them to do what they recognize is in their financial interest. That’s not going to change. If anything, we see an uptick in the number of environmental and social proxy resolutions being filed at U.S. companies since the election.
Skroupa: What will be early indications of how the Trump Administration will affect sustainable investing?
Lukomnik: The big question around Washington is which Donald Trump will show up as President: The populist reformer who called CEO pay a “disgrace” and railed about Wall Street “getting away with murder”? Or will it be the Republican standard bearer who has big business boosters licking their lips as they await their first banquet in eight years?
An important early indicator may be how the Trump Administration deals with executive compensation. Two regulations would seem to be in the cross-hairs of the transition committee. The first is say-on-pay, the advisory vote by share owners on executive compensation. The second is the pending pay ratio rule, which would compare a CEO’s pay to an average worker.
In terms of environmental disclosure, advocates had hoped that current SEC Chair Mary Jo White’s disclosure reform project would lead toward mandatory disclosure of various sustainability metrics.
How the Trump Administration deals with those three issues will be interesting. My bet is that say-on-pay is already so well ingrained into the marketplace that it will remain no matter what the incoming administration does, but the pay ratio rule is at risk. And sustainability disclosures will get a boost from Michael Bloomberg and former SEC Chair Mary Schapiro’s financial sustainability board global project to harmonize environmental disclosures through stock exchanges rather than anything that happens at the SEC.
Finally, it seems clear that the one unifying theme of President-elect Trump’s philosophy is job creation. So, if environmental advocates can convince the administration that there are more green jobs to be created from moving toward the Paris Accord than will be lost (which is true), that could go a long way towards winning over incoming policy makers and making the administration more favorable to efforts to aggressively limit climate change.
Christopher P. Skroupa is the founder and CEO of Skytop Strategies, a global organizer of conferences.