Five Questions about SRI – Weekly Expert Interview with Colin Melvin, Chief Executive Officer, Hermes Equity Ownership Services, London, United Kingdom – November 25, 2011

Each week Emerging Markets ESG publishes an interview entitled, “Five Questions about SRI.”  The interview features a practitioner’s insights about SRI in emerging markets and through Emerging Markets ESG shares this expertise with a wide global audience.  The goals of Five Questions about SRI are fourfold:

  • To reflect on what SRI in emerging markets means to practitioners;
  • To collect a catalogue of examples of SRI in practice in emerging markets;
  • To raise awareness about SRI in emerging markets; and
  • To enable SRI practitioners in emerging markets to network with peers around the world.

This week’s interview is with Colin Melvin, Chief Executive Officer, Hermes Equity Ownership Services, London, United Kingdom.

Hermes Equity Ownership Services (HEOS) is a pioneering advisory service which enables its clients to be responsible investors and owners of companies.  It helps institutional share owners around the world to meet their fiduciary responsibilities and become active owners of public and private companies. HEOS’ team of engagement and voting specialists monitors its clients’ investments in companies and intervenes where necessary with the aim of improving performance. HEOS’ activities are based on the premise that companies with informed and involved shareholders are more likely to effectively manage risk and achieve superior long-term performance than those without.
Owned by BT Pension Scheme, the UK’s largest pension fund, HEOS has a strong commonality of interests with the global coalition of investors it represents. Hermes and BTPS have extensive experience of implementing the United Nations’ Principles for Responsible Investment (UNPRI). HEOS’ Chief Executive, Colin Melvin, chaired the committee that drew up the original principles. This insight enables EOS to help clients who wish to become signatories or have already achieved signatory status to meet the challenges of the PRI.  Colin joined Hermes in 2002 and became CEO of HEOS in 2005. He is an associate member of the Chartered Financial Analysts Institute and the UK Society of Investment Professionals. He holds an MA from Aberdeen University and an MPhil from Cambridge University, both in History, and a Diploma in Investment Analysis from Stirling University. He is an Associate of the Centre for Corporate Governance Research of the University of Birmingham and a Commissioner on the UK Governments Commission on Ownership. Colin is a non-executive director of Aedas Europe, an architectural firm.

Emerging Markets ESG:  How would you define socially responsible investment (SRI)?

Colin MelvinSocially Responsible Investment (SRI) describes preferring or avoiding investment in certain entities, including shares in public companies, because of concerns about their behaviours or products, which may impact long-term financial performance. SRI can also refer to the practice of investors interacting or engaging with the entities in which they invest, including public companies, with the intention of altering their behaviours and products.

SRI is now commonly shortened to Responsible Investment (RI), which is the preferred term of the hugely successful and influential UN Principles for Responsible Investment. 

Some investors, including the BT Pension Scheme, which owns Hermes EOS, prefer the term ‘sustainable investment’, as this recognises that long-term investors, such as pension funds, are part of society and have a strong, self-interested contribution to make to sustainable economic development. By investing sustainably and behaving as responsible asset owners, funds can increase returns and reduce risk within their portfolios.

Emerging Markets ESG:  What distinguishes SRI from mainstream investment? 

Colin Melvin:   Over the past decade many mainstream investors have started integrating environmental, social and governance (ESG) factors into their investment analysis and decision-making. This has developed from an understanding that ESG issues can affect long-term investment performance. Some investors have also become concerned about the reputational risk of holding shares in certain companies or sectors. A key component of this mainstreaming of responsible investment has been the rise of engagement or ‘stewardship’, whereby the investor behaves as a responsible asset owner.

Hermes EOS enables its clients to be responsible asset-owners, engaging with companies and using investor influence to promote beneficial change. Our engagement dialogue is focused on improving the ways in which companies are run over the longer term. For example, when engaging with companies in construction and the extractive industries across the emerging markets we promote a culture that seeks continual improvements in health and safety rather than a focus on policies and procedures.

A key factor in successful engagement is our understanding of local practices and ability to tailor our work accordingly. HEOS’ Emerging Markets Team comprises individuals who often speak the local language, have a sound appreciation of the cultural nuances, have formed credible relationships with company management and have a track record of producing beneficial corporate change.

Emerging Markets ESG:  Which extra-financial theme – environmental, social or governance – is the most challenging for emerging market companies to manage?

Colin MelvinWe have found that the level of awareness and management of ESG issues varies across the emerging markets. Furthermore, as the proportion of foreign shareholdings increases in these markets, many companies are facing a steep learning curve in understanding the nature and extent of their investors’ interest in ESG matters. We consider that environmental, social and governance risks can all be difficult for emerging markets companies to manage and that a company’s ability to manage such risks can be affected by its ownership structure and the dominance of a controlling shareholder.

For instance at state owned companies, management are often appointed for three year fixed-term contracts. This approach can prevent their remuneration structures being linked to the companies’ long-term strategic goals or the mitigation of ESG risks. Also some of the most successful companies from the region are family controlled, which can present its own unique challenges for companies and investors. Planning the succession for a founder CEO can be tricky – as this may necessitate addressing sensitivities, which the family does not wish to consider, leading to a rushed decision.  Although we generally accept family members being appointed we do look for leadership to be earned with the successor being the best person for the job and for a genuine review of a wider pool of directors.

Also in a family context, the founder is often the decision maker, which means that non-executives may struggle in providing challenge and oversight on ESG risks because of inadequate information.

More positively, companies in the emerging markets are increasingly understanding investor interest in social risks and their business materiality, rather interpreting this as an encouragement towards corporate philanthropy. More companies are also beginning to discuss issues related to water, carbon and waste management. Yet often because of the lack of local legal and regulatory structure in certain countries on environmental matters – investors are more likely to advocate international best practices, requiring companies to become educated on their benefits.

Emerging Markets ESG:  Which extra-financial theme – environmental, social or governance – is the most challenging for investors in emerging markets to analyze?

Colin Melvin:   Shareholder engagement with companies on governance and public policy is particularly important in those markets were shareholder rights are relatively poor. However, inadequate transparency and disclosure can be found across all ESG matters within the emerging markets and extends to disclosure in the voting process with the notable exceptions of South Africa and Brazil. For this reason, public policy engagement forms an integral part of our approach to responsible ownership on our clients’ behalf. We engage with regulators and industry bodies to encourage improvements to listing guidelines and transparency requirements. We have also used indirect channels, such as the training of journalists on ESG in Egypt and India. In the emerging markets having an independent local assessment of company disclosures can be helpful to our analysis.

Each year we undertake over 500 company engagements worldwide on issues such as:

–          Governance, including board composition and executive remuneration

–          Social, ethical and environmental factors which may pose material risks or opportunities

–          Business strategy, including capital allocation, M&A and capital structure

Our approach is pragmatic and specific to each of the emerging markets, taking into account individual company circumstances. We escalate the intensity of our engagement over time depending on the nature of the challenges companies face and the attitude of the board towards our intervention. In emerging markets we regularly travel to meet with company management and also undertake site visits were relevant to build our first hand knowledge of companies. Our engagement is not restricted to companies listed in the emerging markets exchanges and we actively engage with multi-national companies who have operations in these regions.

While we are robust in our dealings with companies, the aim is to deliver value to clients, not to seek headlines through campaigns. Using the media to advance engagements, risks undermining the trust between a company and its owners. We aim to be honest and open with companies about the nature of our discussions and will normally seek to keep such discussions private. Not only has this proved the most effective way to bring about change, it also acts as a protection to our clients, so that their position will not be misrepresented in the press.

Emerging Markets ESG:  The global economy and global financial markets are in a period of fundamental realignment.  Several financial institutions predict that current “emerging” markets will dominate global finance and trade by 2050.  What role do emerging markets play in HEOS’ current activities and long-term strategy?

Colin MelvinCurrent trends suggest that long-term shareholders will continue to increase their exposure to companies listed in emerging markets. Additionally, many emerging markets companies have ambitions to secure a greater proportion of foreign capital or are seeking a secondary listing in developed markets. Such companies are therefore under pressure to comply with codes of good governance and international best practice. There have also been recent initiatives in certain markets, including Malaysia, to consider the implementation of a stewardship code to guide shareholders in their interactions with companies. This is a positive step and we actively encourage domestic shareholders to work with policy makers and exercise their ownership rights and responsibilities.

HEOS has had engagements with many companies in the emerging markets. In our experience, successful engagement comes from applying the right level of resource and local understanding in challenging and supporting companies This requires persistence and determination to influence the company at the highest level so that sustainable changes are made in the interest of minority shareholders. HEOS has therefore allocated a standalone team to oversee this area – engaging with some of the emerging markets’ largest companies.