3 ways for institutional investors to fight corruption

Wind turbines used to generate electricity are seen at a wind farm in Guazhou, 950km (590 miles) northwest of Lanzhou, Gansu Province September 15, 2013. China is pumping investment into wind power, which is more cost-competitive than solar energy and partly able to compete with coal and gas. China is the world's biggest producer of CO2 emissions, but is also the world's leading generator of renewable electricity. Environmental issues will be under the spotlight during a working group of the Intergovernmental Panel on Climate Change, which will meet in Stockholm from September 23-26. REUTERS/Carlos Barria  (CHINA - Tags: ENERGY BUSINESS ENVIRONMENT) - RTX13UEQ

Clean investing has market value Image: REUTERS/Carlos Barria

Carlos Santiso
Director for Digital Innovation in Government, Development Bank of Latin America
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Institutional Investors

Institutional investors have a pivotal role to play in the global fight against corruption. Through their investment policies, they help set corporate standards, create incentives for businesses and influence the market valuation of companies. In the United States, the Securities and Exchange Commission is increasing its disclosure requirements for firms regarding their compliance with environmental, social and governance standards. Customers – especially millennials – are demanding greater ethical and environmental responsibility from businesses.

Responsible investing means not only green investing; it means investing in ways that do not reward fraud, bribery and other underhand practices. Institutional investors and their asset managers are asking for better sustainability disclosure of listed companies, and using that disclosure as a determinant of a company’s long-term value. They have launched a voluntary initiative with six principles for responsible investing. There are currently more than 1,500 signatories from over 50 countries, representing US$60 trillion in assets.

However, while these initiatives have made progress in mainstreaming environmental and social standards into corporate practices, they have done less in terms of integrating corruption concerns. But nowadays, companies that engage in corruption are more likely to get caught and fined, and suffer media condemnation.

3 incentives to foster clean investing

There are three promising financial mechanisms that can change the incentives of firms, especially those operating in developing countries.

First, credit agencies need to integrate corruption as a core determinant of sovereign risk. There has been progress on this front, as the level of corruption can affect a country’s willingness to pay back its debts. A study by Union Investment, an asset management company, shows that sovereign defaults are often associated with corruption. Moody’s assessment of a country’s institutional strength is based 25% on the credibility of public policies and 75% on governance risk, including corruption risk.

There is evidence that greater transparency in government lowers risk premiums and borrowing costs. Depken (2007) shows that corruption affects credit-worthiness through its impact on the size of the formal sector and the capacity to raise taxes. One standard deviation decrease in corruption improves sovereign credit ratings by almost a full rating category. That’s annual savings of roughly US$10,000 for every US$1 million of debt.

Corruption affects borrowing costs directly but also indirectly, through its corrosive impact on the rule of law. Adequately gauging the impact of corruption on sovereign risk therefore has an intrinsic value for rating agencies, as it improves the predictive power of their ratings: their core business.

Second, philanthropic foundations need to make corruption a key concern of their investment policies. Philanthropic institutions finance their granting activities from the interest on their endowments. The endowments of US private foundations alone represent a staggering US$650 billion. Asset managers often manage these funds with the sole objective of maximizing endowment returns, with some exceptions regarding objectionable industries.

However, the investment strategies of these endowments are not always consistent with the mission of the foundations. The Council of Foundations, analysing the investment policies of 186 US foundations, representing US$40 billion in assets in 2014, found that only a minority of them make an explicit link between their investment policies and their mission statement.

Mainstreaming corruption concerns in endowments’ investment policies would go a long way to create the sort of market incentives that would alter the behaviour of the companies in which they invest – or disinvest.

In 2015, Darren Walker, the president of the Ford Foundation, initiated a reform of its endowment investment policy to better align it with its core mission, the global fight against inequality. “I no longer find it defensible,” says Walker, “to say that our investment strategy is only to maximize the value of our endowment … There is growing evidence that it is possible to find impact-investing opportunities that deliver financial and social, double bottom-line returns.” The foundation grants approximately US$500 million annually; its endowment exceeds US$12 billion.

Pressure has grown on philanthropies to unlock their endowments for mission-related investments, now allowed by recent changes in US tax laws. This is not only a matter of their fiduciary responsibility, but also to foster transparency and integrity through the investments they make.

Third, sovereign wealth funds need to integrate corruption risk in their investment strategies, too. Traditionally, these investment policies are oriented towards maximizing shareholder value. However, sovereign wealth funds are publicly financed funds and, therefore, there is a strong case for ensuring that their investment policies are aligned with government priorities and society values. At the minimum, they should avoid inconsistency.

A good practice is the Norwegian sovereign wealth fund, with a market value of US$870 billion. Its Ethics Council recommends the exclusion or observation of companies, including disinvesting, based on the firms’ adherence to environmental, social and increasingly governance standards, in particular for high-risk extractive industries. This represents an innovative mechanism to integrate corruption concerns in investments decisions.

For sovereign wealth funds, clean investing is a matter of policy coherence. For Norway, the fight against corruption is a cornerstone of its foreign aid. But governments have to make the case to their taxpayers that they are not sacrificing returns for principles. There is evidence to suggest that ethical investments are, at least, as profitable as ethics-blind investments. The International Forum of Sovereign Wealth Funds has an important role in facilitating this debate.

Author: Carlos Santiso heads the Institutional Capacity of the State Division of the Inter-American Development Bank. He is grateful to the Rockefeller Foundation, as this article was written while a resident fellow at its Bellagio Center in September 2016. The opinions expressed in this work are those of the author and do not necessarily reflect the views of the Inter-American Development Bank, its Board of Directors, or the countries they represent.

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