Corporate Responsibility, Social Investing & the Trustee

Kellie A. McElhaney

June 7 & 8 , 2007

PUBLIC PENSION INVESTMENT MANAGEMENT PROGRAM

Outline

• Context of Corporate Social Responsibility

• Overview of Social Investing

• Rationale for Social Investing

• The CALPERS Effect

Context of Corporate Social Responsibility (CSR)

Corporate Social Responsibility: Has it gone mainstream?

YES!

I think you can run a good business, but also solve big problems.

Typically profits are made by businesses that are doing things that ultimately have real societal benefits.

- Jeffrey Immelt, Chairman & CEO, GE

GE Thinks So

Defining Strategic Corporate Responsibility

• A corporate strategy that is integrated with (1) core business objectives & (2) core competencies to create financial and social/environmental returns, and is embedded in day to day business operations.

Strategic Corporate Responsibility

CR strategy must fit two things:

1. Core business objectives (e.g., sell financial products & services)

2. Core competencies (e.g., high quality, comprehensive financial products & services)

Global Citizenship/ CSR/ Sustainability

How many companies view “it”:

• Employee Engagement

• Community Engagement

• Corporate Philanthropy

• Government & Public Relations

• Governance & Ethics

• Corporate Environmental Footprint

• Socially & Environmentally Sound Product Design & Production

“Deeper business purpose, great products, customer satisfaction, employee happiness, social and environmental responsibility— these are the keys to maximizing long-term profits.” John Mackey, CEO Whole Foods

“People want to know your values and ethics demonstrated by how you treat employees, the community in which you operate, and many other things that are important to them.”Howard Schultz, Chairman Starbucks

“I believe that businesses today need to ensure that corporate social responsibility is a strategic component of their own planning and reporting.” John Chambers, CEO Cisco

Overview of Social Investing

Brief History of SRI

• SRI Defined: SRI is an investment process that considers the social and environmental consequences of investments, both positive and negative, within the context of rigorous financial analysis. This approach integrates these concerns into investment decisions

• Long history of ethical/moral based investments from religious beliefs

• Modern SRI industry stems from series of social, environmental, civil rights, women’s rights & anti-war movements in the 60’s

• Broadened to include management and labor issues, and anti-nuclear sentiment in the 70’s

• Social investing attracted a considerably larger group of American investors due in the 80’s, in large part due to concerns about the racist system of Apartheid in South Africa and divestiture from companies active in South Africa

• Evolved into negative screening of “sin” stocks

• Positive screening, shareholder advocacy & community investment are the latest additions to the SRI arena

SRI Methodologies

• Practice of including or excluding publicly traded securities from investment portfolios or mutual funds, based on social and/or environmental criteria

Shareholder Advocacy

• Describes the action that many socially aware investors take in their role as owner of corporate America. These efforts include engagement with companies on issues of concern and voting proxy resolutions

Community Investing

• Financing that generates resources and opportunities for economically disadvantaged people in urban and rural communities in the U.S. and abroad, that are underserved by traditional financial institution

Screening

+ or -

SRI Screens (+ and -)

• Major SRI Screens– Alcohol– Environmental Stewardship– Defense/Firearms/Military– Gambling– Human Rights/Labor Relations/Workplace Conditions– Tobacco

• Minor SRI Screens– Abortion/Contraceptives– Adult Entertainment– Animal Testing– Community Investment– Corporate Governance– Nuclear– Religious values/principles– Renewable/Alternative Energy

Most Common Screens

$2.3 Tril in SRI assets

1% annual fee = a $24 Bil market.

Source: Social Investment Annual Report, 2004

Significant SRI Market in the U.S.

Source: National Underwriter

YTD One Year 3 Year 5 year 10 year Inception

KLD 400 -0.18 9.2% 8.0% 5.6% 8.3% 11.9%

S&P 500 0.64 11.8% 10.1% 6.3% 8.2% 11.3%

As of 3/31/07

Source: www.kld.com

SRI outperforms the S&P 500

Tier Firm AUM Mutual Funds Negative Screens Positive Screens Shareholder Resolutions

A

Calvert Group $ 8.5BX X X X

Kinder, Lyndenberg & Domini $ 1.3BX X X X

Walden Asset Management $ 3.8BX X X X

Trillium Asset Management $ 0.7BX X X X

B

Mellon Financial $500 BX X X

Neuberger Berman $56.1BX X X

Kayne Anderson $ 8.6BX X X

1838 $ 5.0BX X

Roxbury Capital Management $ 4.0BX X

Harris Bretall $ 2.7BX X

Nelson Capital Management $ 0.7BX X

C

Large cap banks and brokersState Street, etc. Generally providing SRI services through outside manager referral program or through purchase of social funds

Source: Wells Fargo Project 2003 / Trust & Estates

The Players

Does Social Investing Matter?

• Some social factors have been consistently associated with superior returns– Environment – Corporate governance– Employee relations

• Orlitsky (2003) most significant study showing positive correlation

• Other positives:– Greater transparency/ disclosure– CSR driver to engage companies– Educating consumers– Challenges assumptions– Changing corporate behavior

• Violated human-trafficking laws on U.S. bases in Iraq via 3 major contractors employing 1000s of workers.

• Provided substandard living conditions to laborers.• Used deceptive hiring practices.• Paid fees to job brokers to lure workers into Iraq.• Failed to provide mandatory "awareness training" on U.S. bases concerning human

trafficking.

– KLD Report 2007

Company Price Shares Mkt value Return Contrib Stock Sel

HAL 29.63 1.3mm $38mm -19.25 -0.09 -0.14

Halliburton

Stock Specific Attribution

•Philanthropy •Negative screens only

•One SRI mutual fund

•Outsourced SRI research

•Positive and negative screens

•Broad product offering w/ SMAs

•Simple KLD shareholder advocacy

•All products focused on SRI

•Internal SRI research

•Aggressive Shareholder advocacy

•SRI Core to business and brand

D: Least Integrated

C BA: Most

Integrated

The SRI Spectrum

Rationale for Social Investing

Started A Long Time Ago

• John Wesley – Christian Ethics– The world is corrupt.

• “Enemy-occupied territory – that’s what the world is.” - C.S. Lewis, Mere Christianity

– We act of our own free will.• “By their deeds you shall know them.” – Matthew 7:16

– Money is important. For, let the world be as corrupt as it will, is gold or silver to blame? "The love of money," we know, "is the root of all evil;" but not the thing itself. The fault does not lie in the money, but in them that use it. It may be used ill: and what may not? But it may likewise be used well…We ought to gain all we can gain but ...

Don’t hurt yourself, physically or mentally. Don’t hurt your neighbor. Compete fairly.

Having, First, gained all you can, and, secondly saved all you can, then "give all you can."

Lydenberg’s Modest Proposal

• The goal: Harness market forces to encourage better corporate behavior

• “How do you direct corporations to the public interest? We need new vocabulary to do that, new data. And I think [socially responsible investment] can bring great value to that. We can bring fresh perspectives to risk, intangible assets, and wealth creation.”

Steven Lydenberg’s To-Do List

• Build consensus that better corporate behavior is desirable.

• Create data sources so people can be better-informed about corporate social responsibility.

• Build institutions that will make society more sophisticated about corporate social responsibility.

• Engage market forces to encourage better corporate behavior.

Albert Hirschman – The Playbook

The Problem is Easy to StateBut Hard to Answer

An organization is engaged in behavior we don’t like. What should we do?

Economic strategies

Moral and ethical strategies.

Option #1 - Exit

• This is the classical economic response

– Only option when voice is impossible

– Abandons opportunity for change

• Biggest risk: reinvestment

Option #2 - Voice

• ‘Political’ response

– Only option when exit is impossible.

– Requires investment of time, energy, money

• Biggest risk: entrapment

Loyalty

A rational judgment to try voice instead of exit.

Loyalty is based on…

• The likelihood of positive change

• The quality of the alternatives

A Version of Stakeholder Theory: At the Center…

CONTROLGROUP(MGMT)

Stakeholder theory can be viewed as a constellation of ‘Hirschman relationships’ between a Control Group and a variety of groups...

Commercial Relationships

CUSTOMERS

CONTROLGROUP(MGMT)"There is only one boss. The customer.

And he can fire everybody in the company from the chairman on down, simply by spending his money somewhere else."

- Sam Walton

Commercial Relationships

CUSTOMERS

SHAREHOLDERS

EMPLOYEES

SUPPLIERS

CONTROLGROUP(MGMT)

In the 80s and early 90s it was popular to say that if you took care of these groups, you didn’t need to worry about much else.

Are There Others?

A McKinsey & Co. study leaked to the press by walmartwatch.com found that up to 8% of shoppers had stopped patronizing the chain because of its reputation.

[CEO Lee] Scott wondered,

“If we had known ten years ago what we know now, what would we have done differently that might have kept us out of some of these issues or would have enhanced our reputation?”

Source: Fortune magazine, 7/31/2006

Social/Environmental Relationships

ENVIRONMENT

LOCALCOMMUNITY

GOVERNMENT CUSTOMERS

SHAREHOLDERS

EMPLOYEES

SUPPLIERS

CONTROLGROUP(MGMT)

Community Speaks: Hercules Chooses Exit

The Hercules [California] City Council voted unanimously Tuesday night to take the unprecedented step of using eminent domain to prevent Wal-Mart from building a big-box store on a 17-acre lot near the city's waterfront. The vote caused most of the 300 people who had packed Hercules City Hall for the meeting to break out in cheers and applause...

During a 90-minute public comment period that preceded the vote, nearly everyone who spoke urged the council to fight Wal-Mart. "Throw the bums out," Hercules resident Steve Kirby said at the podium of Wal-Mart. "Wal-Mart will never understand what we want."

Another resident, Anita Roger-Fields, expressed concern for small businesses in the city, saying they could be driven out of business by the discount store. “(Wal-Mart is) the worst thing that could happen to our community.”

Source: San Francisco Chronicle, 5/24/2006

Governments Speak

“Now, Wal-Mart finds itself under attack for what critics see as its miserly approach to employee health care, which they say is forcing too many of its workers and their families into state insurance programs or making them rely on charity care by hospitals.

“A survey by Georgia officials found that more than 10,000 children of Wal-Mart employees were in the state's health program for children at an annual cost of nearly $10 million to taxpayers. A North Carolina hospital found that 31 percent of 1,900 patients who described themselves as Wal-Mart employees were on Medicaid, while an additional 16 percent had no insurance at all.”

Source: New York Times, 11/1/2004

The Environment Speaks

“As we look at our responsibility as one of the world's largest companies, it just became obvious that sustainability was an issue that was going to be more important than it was, let's say, last year, and the years before. I had embraced this idea that the world's climate is changing and that man played a part in that, and that Wal-Mart can play a part in reducing man's impact. We recognized that Wal-Mart had such a footprint in this world, and that we had a corresponding part to play in sustainability.

“On a personal level, as you become a grandparent -- I have a granddaughter -- you just also become more thoughtful about what will the world look like that she inherits. So I think it was a confluence of both the personal side and the business imperatives that at least drew me to be interested in it.”

Source: Grist Interview with Lee Scott, 4/12/2006

The CalPERS Effect

Constructing the CalPERS Focus List

• Quantitative Screen– Stock Performance– Capital Efficiency– Corporate Governance

• Qualitative Review– Overall financial performance– Valuation– Strategic plans– Management and board member relations– Compensation Practices– Other miscellaneous shareowner issues (including takeover defense)

• Engagement Process – Since Exit is Impossible, Try Voice– “CalPERS considers the engagement process to be a crucial component of the overall

Focus List Process. CalPERS makes a persistent effort to meet with the management and directors to discuss performance and governance issues. CalPERS will focus on reforming the company's governance practices with an emphasis on accountability, transparency, independence, and discipline.”

Source: CalPERS

Short-Term Impact

• Barber finds a “small, but reliably positive” +0.25% effect on announcement date.

• “My best estimate, based on conservative short-term market reactions, indicates CalPERS activism has resulted in total wealth creation of $3.1 billion between 1992 and 2005.”

Long-Term Impact

0

10

20

30

40

50

60

70

80

90

100

1 Day 2 Weeks 1 Month 6 Months 1 Year 2 Years 3 Years 4 Years 5 Years

$ B

illio

ns

Source: Barber (2006)

Issues Facing the Future of SRI

• Individual vs Institutional Customer Needs and Focus– Fear of violation of fiduciary responsibility major barrier to

institutional investors – drives SRI dilution.• Marketing Messages

– Does true SRI beat the market? Quarterly earnings and returns on social responsibility have different timing cycles.

– Is a true socially responsible return on investment higher then the market return?

• What are the most effective methodologies?– Does screening really change the cost of capital and drive change in

company practices? Shareholder advocacy? – How do you reach companies removed from direct customer contact?

• Definition and Measurement of Social Responsibility– Can standardized systems be developed?– How should investors compare apples and oranges?

Offering SRI aligns profit with positive social change

BenefitsSignificant marketMinimal expenseIdeals alignmentImproved morale

Positive PREarly Mover Advantage

•Even if you question efficacy of SRI, LOHAS consumers and institutions starting to demand it.

If people want to invest that way, that’s their business. In most cases such investing is

neither helpful nor harmful.

Milton Friedman

The market can only reflect information that is available.

Robert Monks, 2003

CSR is not about how you spend the money you make. CSR is about how you

make the money you spend.

Slave Laborers

Questions?

Kellie A. McElhaneykmack@haas.berkeley.edu

Questins