02 May 2006

Cdn Banks & Tree Huggers

Investment Executive, James Langton, 2 May 2006

Tree huggers and the “greed is good” crowd are hardly natural allies, but with environmental worries on the rise, financial services firms are increasingly finding themselves at the centre of efforts to limit the human-inflicted damage being done to the planet.

The uneasy dance between the two groups involves many steps. Banks are facing pressure from both advocacy groups and institutional investors about the banks’ impact on the environment, both through their own activities and those of their large clients. Banks are also increasingly sensitive about damage to their reputations.

And they aren’t the only ones eager to be green. Some prominent investment managers are making environmental considerations an increasingly important part of their decision-making process, a move that may ultimately force the rest of the industry to share their concerns.

Banks, particularly in Canada, make good targets for organizations seeking to motivate social change. They are so large and diverse that they can’t help being touched by a vast array of issues, both directly and as financiers. As banks are generally eager to be seen as good corporate citizens, they often lead the way for the rest of corporate Canada on a multitude of issues.

BankTrack monitors financial institutions around the world in an effort to hold them accountable for their financing activities. Earlier this year, BankTrack and the World Wildlife Fund published a joint report indicating that there is a growing commitment to sustainable banking within the international banking sector, but more needs to be done. In particular, it highlighted the need for the sector to adopt more transparent financing policies.

TD Bank Financial Group got a more direct taste of environmental activism at its annual meeting in Vancouver, when the groups ForestEthics and Rainforest Action Network released a report accusing TD of having a poor record on social and environmental issues. The report was distributed to TD shareholders attending the meeting, and a representative questioned TD CEO Ed Clark about his bank’s environmental efforts during the question period.

Clark stridently defended the bank’s record, insisting that TD “believes passionately in the environment.” He said the bank’s efforts to improve its environmental practices are not a marketing ploy, but reflect a genuine belief that in the long run TD must pay attention to environmental issues. To that end, the bank has focused on funding grassroots environmental projects, a cause it has spent more than $40 million on since 1990.

In terms of its own impact of the environment, such as consumption of paper and power and other resources, Clark agreed that the bank could improve. “I wouldn’t give us an A-plus; we have a way to go,” he said.

A more contentious issue for Canada’s banks is their role in financing projects that generate environmental concerns. All the resources industries face such issues. The mining, forestry, energy and power sectors often generate controversy with both local populations that are affected by their efforts and advocacy groups. At the TD meeting, Clark argued that banks have different obligations when such projects are carried out in developed, democratic countries vs those destined for the developing world, in which environmental standards may be much lower and the local population may have much less of a voice.

Financial firms have recognized the dichotomy, in part through development of the “equator principles,” which are project-financing guidelines for the developing world that aim to promote responsible environmental stewardship and socially responsible development.

TD is the only one of the Big Five banks that hasn’t signed on to the principles. Many of the world’s biggest banks, including HSBC Group, Citigroup Inc., JP Morgan Chase and Mizuho Corporate Bank are signatories, as is Manulife Financial Corp.

Clark says TD hasn’t signed on simply because it doesn’t finance the sort of projects the guidelines are meant to cover. That said, the principles are being updated and Clark says TD will look at signing the revised version, due for release in the summer, as a matter of principle — even if it still doesn’t apply to TD’s business.

When it comes to clients operating in developed and democratic countries such as Canada, Clark argues that it is not appropriate for a lender to impose its values. As long as its clients are complying with local environmental standards, he suggests, a bank would be abusing its power as a lender to substitute its values for those of the local elected government by putting conditions on projects beyond those imposed by the government.

Even so, Clark notes that the bank is prepared to work with environmental groups to ensure that it is doing enough to make its clients understand any environmental concerns. In fact, TD made a similar pledge earlier this year in response to a shareholder proposal filed by Ethical Funds Co. of Vancouver. TD’s latest proxy notes that it received two proposals from Ethical Funds: one dealing with climate-change risk disclosure and the other with biodiversity protection policies in corporate finance. Both proposals, however, were withdrawn before being put to shareholders.

In the proxy, TD acknowledges the risks associated with climate change for energy-intensive industries it finances and, ultimately, the bank itself. It promises to develop risk-management policies in that area and, if they are deemed material, to disclose them in its financial statements. It also agrees to disclose its responses to the carbon disclosure project, an initiative of institutional investors to assess the business implications of climate change by requesting disclosure from the world’s large companies.

On the biodiversity issue, TD has pledged to meet with interested parties to consider appropriate policy actions, and to report its progress in its 2006 corporate responsibility report.

While TD was the one in the spotlight, all of the banks must be more sensitive to the environmental impacts of their activities — not because of ethics or public relations but for financial reasons. They can’t ignore the fact that environmental issues carry risks.

Demonstrating indifference to the issues can pose a risk to banks’ reputations and, under new capital adequacy guidelines, operational risks must be accounted and provisioned for accordingly. Moreover, environmental issues can become credit risk considerations, particularly as governments ramp up efforts to ensure companies bear a greater cost for the polluting they do.

The Office of the Superintendent of Financial Institutions does not have any guidelines that specifically address banks’ environmental policies. It does, however, give financial institutions general guidance concerning reputational risk, noting that “improving the effectiveness of reputation risk-management practices should be a priority for all financial institutions.”

Banks aren’t the only financial firms that are seeing their fortunes intersect with the interests of environmentalists. It’s also becoming a key issue for some asset managers. At the end of March, the Canada Pension Plan Investment Board announced it has signed the enhanced analytics initiative, an effort originated by European fund managers that aims to encourage a broader approach to investment research. The CPPIB, which manages about $92.5 billion, is the first Canadian firm to join the EAI.

Firms that sign on pledge to allocate at least 5% of their annual brokerage commissions to research organizations that analyse the so-called “extra-financial factors” that may affect the long-term value of a company. Factors include regulatory, political, governance and environmental risks. To win the business, analysts will have to provide insight into possible fallout from areas such as pollution, global warming and other risks in a company’s supply chain.

So far, no Canadian brokerage firms qualify for EAI commissions. In January, eight of 31 firms evaluated were deemed eligible to earn the commissions in the first half of 2006: Goldman Sachs, JP Morgan, UBS Investment Research, West LB, DrKW, Bernstein Research, CLSA and CM-CIC Securities.

For the money managers, the purpose of the initiative is improving returns. “Our membership in the EAI provides us increased access to data on the material impact of environmental, social and governance factors that will ultimately help us maximize investment returns and minimize investment risk over the long term,” says Don Raymond, CPPIB vice president of public market investments.

So far, equity analysts have proved fairly resistant to such change. A study by the United Nations environment program finance initiative found that the analysts it interviewed “are typically uninformed on many environmental, social and governance issues, and cynical about their materiality. Many are unconvinced that their clients would value environmental, social and governance-focused research, and doubtful that their companies would reward them sufficiently for doing it.”

The fact that asset managers are allocating brokerage commissions for such analysis should go a long way to reducing some of that cynicism. If institutional investors truly believe green issues impact long-term returns, they can only reasonably expect to prove it to brokerage houses by talking with their wallets.

Moreover, the fact that large pension funds are explicitly calling for research that spells out environmental and other non-financial risks is pushing against a legal tradition of excluding such considerations from investment decision-making. In that tradition, pension managers that are mindful of their fiduciary duties can only consider financial factors in making their investment decisions. Trying to “do the right thing” at the expense of returns could earn a lawsuit from plan members.

Yet the line between financial and non-financial factors is becoming increasingly blurred as governments seek to ensure that companies pay more of the cost of their pollution. The imposition of carbon-emission limits and the establishment of markets to trade such permits is putting a price on what were once intangibles. In late April, EU carbon permits were setting new price records as governments in the region mused over the possibility of cutting the number of permits issued after 2007. No longer is pollution just a bad PR risk for companies; it can also impact the bottom line.

Governments are pushing companies that generate pollution to bear the costs, and mainstream institutional investors are demanding more insight into environmental impact. As a result, the banks are growing increasingly sensitive to their own ecological footprints, and the financial services industry’s heartless capitalists may find themselves sharing common ground with the pro-green movement.