Moral Hazard Pt 2 - Linchpin Salon Webinar
We held the second of our two Linchpin Salon panel debates on the subject on 31st May 2023. In the first one, we looked at moral hazard in banking and regulation; in this one we looked at whether incentives were effectively aligned to avoid moral hazard in sustainable investing. Aoifinn Devitt moderated the panel of:
Nick Spencer, Gordian Advice
Fabiola Schneider, Assistant Professor at Dublin University (DCU)
Stephen Barrie, Deputy Director of Ethics and Engagement, Church of England Pensions Board
Nawar Alsaadi, CEO, Kanata Advisors
Robert Eccles, Visiting Professor, Said Business School, Oxford University
Misalignments, mismatches and misunderstandings
The first point made was the mismatch in the investing horizons of asset owners, often one or more generations, and asset managers, rarely more than a few years. It is too easy for asset owners to be distracted by the sheer volume of reporting, but their role should be to challenge asset managers and to keep them to the long-term pathway. We also discussed how the risks of climate change tends to dominate ESG discussions, and equally important issues such as bio-diversity get crowded out.
Some of our panel thought that language and vocabulary was a major problem, and there was a need to standardise it so that we all knew what was meant by particular words. Others were more exercised by the difficulty of challenging orthodox views in this area: too much is treated like the holy scriptures as infallible. Several panellists made the point saying that we each lived in our own bubble and needed to be prepared to look at the problem from other angles.
Government needs to take ownership
There was a strong view, which echoed our first webinar, that governments and regulators need to take ownership of the problem. The private sector can do so much, but not everything, largely because of the danger of moral hazard. However, this brings issues such as politics and inter-generational unfairness into an already complex subject. We are making decisions for future generations.
We agreed that maximum leverage by asset managers and owners came at times of primary financing, and in particular corporate bonds. Taking a disinvestment stance in secondary markets such as listed equity markets can be effective, but more as a signal than because it puts real pressure on companies to change their behaviour. The panel thought that the incentives round green bonds in particular were perverse, as neither the issuer nor the investor has cause to report accurately on sustainability metrics.
The dangers of “greenwashing/greenhushing/greenrinsing” are well known nowadays, and we spent some time on the effectiveness of carbon offsets. These are needed to get to Net Zero, because by 2050 there will still be carbon emitters, but these are often misused. One panellist compared them to mediaeval indulgences, whereby the rich could pay the Church to assuage their consciences but carry on sinning.
One point made was that the magnitude and quality of the carbon offset are critical factors. It also depends on how companies use them. A reduction in carbon emissions does not count as an offset, nor does choosing a more carbon-friendly option such as reversing a decision to cut down a forest.
Shortcomings of ESG reporting
Others were worried about data quality, which led to a discussion on the shortcomings of ESG reporting. We noted that there are few sanctions for company officers who mis-report, and that ratings are often used to make relative comparisons within industries. This matters far less than the absolute numbers: for example, the panel did not believe that investing in the ‘best’ oil producer was a sustainable way forward.
We discussed what to do with companies who choose not to report, which often today means they get given an ‘average’ mark. One panellist mentioned that under the Transition Pathway Initiative they get treated as if they are doing nothing, which created a better incentive for them to report.
We noted that reporting was a necessary but not a sufficient condition for improvement. Too often data is collected but not used by asset owners to address transition risks. We need regulators to set targets. One panellist mentioned the difficulty of evaluating these risks in a financial framework. For example, what risk premium should an analyst put on an all-male board?
Another panellist made the point that what is measured today is often not what the end-consumer really cares about. The moral hazard here is more like a mutually assured delusion. For example, most people care about bio-diversity, but nobody has the agency individually to do something about it, and the tendency is to assume that somebody else will. In some cases the problem is not even acknowledged.
One panellist felt it unhelpful to demonise the failings of climate change reporting and disclosure. As standards fall into place, the rating agencies will devote more attention to analytics and less to data collection. It is up to regulators to force companies to provide data and governments to provide a lead. We noted that the European Union was trying, even if in an overly complex way, and thought that if other governments joined them, they could put real pressure on large global companies.
Net Zero Commitments and the role of Government
We ended up with a short discussion on Net Zero commitments. Some panellists thought that asset owners’ fiduciary duty included the precautionary principle and that more urgency was therefore needed. This chimed with the point made earlier about making decisions for future generations.
Plans need to be credible, to focus on the short-term, and to be practical. While the panel all favoured engagement, one panellist noted that disinvestment had the power to change the centre of gravity in this debate. We noted that a different transition path needs to be found for Emerging Markets, because the current direction of travel is likely to disadvantage them.
One conclusion from this debate, much as our previous one, is that governments and regulators need to own the problem and set out standards. The various agency problems make it difficult for private sector entities to align incentives in order to avoid moral hazard. This was not so very different a conclusion from our previous debate. But politicians are more sensitive to the impact on voters of a bank over-reaching itself than the long-term and complex problems posed by climate change.
European Financial Reporting and Governance website: https://www.efrag.org/About/Governance
The Aggregate Confusion Project: https://mitsloan.mit.edu/sustainability-initiative/aggregate-confusion-project
Recent articles by Bob Eccles