“Raj and his co‐author apply good judgement with a finely‐judged assessment of the issues to indict BP for its environmental record.  They also show how easy it is to confuse business‐as‐usual with the good management.  Corporations provide the basic ingredients for improving material well‐being.  But they also have responsibility to ensure their policies and procedures are consistent long‐term environmental quality.  This is a significant responsibility that requires anything but business‐as‐usual.”   

Prof Gordon Clark,  University of Oxford (in‐coming Director of the Smith School of Enterprise and the Environment)   

   “If you are a company director or investor, and you believe‐‐as I do‐‐that prevailing financial mindsets about risk have woefully let us down, this paper by Raj Thamotheram & Maxime Le Floc’h is for you.  It provides a fresh, comprehensive, and sensible way to think about ‘black swan’ eventualities.” 

Donald Hambrick, Smeal College of Business, The Pennsylvania State University    “Raj Thamotheram is a welcome voice in the corporate governance debates.  Rather than taking a simplistic, single‐lever approach to the subject, he paints a complex, though not complicated, picture of the problems and the potential solutions.  The BP Crisis as a “Preventable Surprise”: Lessons for Institutional Investors is a lovely example of Raj at his best.  It should be required reading for boards and institutional investors.” 

Roger Martin, Dean, Rotman School of Management, University of Toronto    “Raj provides a useful analysis of the implications of continuing BP governance dysfunction. This is an important piece in pointing out how the affected parties failed and the standards to which they should be held in the future. All of this information is critically important in anticipation of how the U.S. government will decide to administer the various criminal sanctions appropriate in this situation.” 

Robert Monks, Pioneering shareholder activist and corporate governance expert    “Impressive review of the possible responses;  tough and specific.  Highlights the differences between old and new ways of evaluating risk and deals with both prevention and resilience.”   

Charles Perrow, Emeritus Professor of Sociology, Yale University    “Your paper is very nicely written. I hope it gets the attention it merits, and generates a discernible impact.” 

Hersh Shefrin, Professor of Finance, Santa Clara University  

I n t e r n a t i o n a l J o u r n a lo f P e n s i o n M a n a g e m e n t

Volume 5Issue 1

Spring 2012

Table of Contents 1

Can the Pensions Sector Innovate?Keith Ambachtsheer 3

Benchmarking Retirement IncomeSystems around the World: WhichCountries Rank Highest and Why?David Knox 4

Pension Liability Measurement andIntergenerational Fairness: Two Case StudiesTheo Kocken 16

Incorporating Uncertainty into AccountingEstimates of Pension LiabilitiesUlrich Menzefricke andWally Smieliauskas 26

How Large Pension Funds OrganizeThemselves: Findings from a Unique19-Fund SurveyJody MacIntosh and Tom Scheibelhut 34

The Road Ahead: Rethinking the InvestmentPolicy RoadmapRanji Nagaswami 42

Really Investing for the Long-Term:A Case StudyAlex van der Velden and Otto van Buul 50

Thinking Strategically about ClimateChange: Risks and OpportunitiesDanyelle Guyatt, Jane Ambachtsheerand Elisabeth Bourqui 58

The BP Crisis as a “Preventable Surprise”:Lessons for Institutional InvestorsRaj Thamotheram and Maxime Le Floc’h 68

ICPM RESEARCH PROJECT UPDATE

ICPM Invests in InnovationStefan Lundbergh 78

I n n o v a t i o n i n t h e P e n s i o n s S e c t o r

a new way to think | pension management

Coverage of the 2010 Gulf of Mexico disasterdominatedAmerican news for months after the initial explosion.Now, less than two years on, it is history. Attention has shiftedto new corporate crises – Tepco’s nuclear explosion, NewsCorporation and MF Global’s ethical implosions, Carnival’sshipping disaster, and the latest phase of the “Great Recession.”But are we any better at identifying patterns that should triggerconcern? Or is there nothing to be learned from events likeBP’s oil spill?

A priori, one might expect significant investor interest in atleast this last question. Not only was the Gulf of Mexico spilla major cause of unexpected deviance in portfolio returns,BP was actively followed by environmental, social, andgovernance (ESG) investors, and this event is probably themost dramatic case of financial loss resulting from ESGperformance failures.

The reality has been a surprising lack of attention from bothmainstream and ESG analysts and finance academics. Thedominant market narratives about this and other corporatecrises – a “black swan” event or “bad apples” – discourageinvestor learning, in particular about our role. This articleaddresses this blind spot on the basis that crises are often goodopportunities for learning and change. We show how this caseis emblematic of market dysfunction: indeed, the “silver lining”

in this heavily investigated crisis is that it exposes thesedysfunctional patterns rather well. And because, unlike theglobal financial crisis, it is relatively easy to distinguishbetween contested accounts of reality, the conclusions drawnhave wide relevance.

In arguing that this event is a “preventable surprise,” we adapta term (“predictable surprise”) used to describe an event thatcatches people off guard but which could have been anticipatedhad attention been paid to readily available warning signs(Bazermann and Watkins 2004). Of course, it is impossibleto prove which narrative is “true,” and the risks of hindsightbias are real. But dismissing these as random failures inevitablyleads to weak learning. In contrast, using the “preventablesurprise” analytical framework stimulates reflection on howseveral stakeholders have co-created this outcome and fostersthe desire for prevention.

“Preventable Surprises”:A Framework for UnderstandingCorporate Crises

This section summarizes the six causative drivers of this crisis.For more details on how these factors interacted and theirrelevance to other crises, please see the dedicated website.1

Raj Thamotheram is aninternationally recognizedthought leader on “investingas if the long term matters”and has held senior positionsat Universities SuperannuationScheme and AXA IM. MaximeLe Floc’h is an investmentanalyst at a large global fundmanager specializing inenvironmental, social, andgovernance issues. They arethe co-founders of PreventableSurprises.(http://preventablesurprises.com).

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Raj Thamotheram and Maxime Le Floc’h

Rotman International Journalof Pension Management

With high-impact, low-probability events increasing in frequency and impact,this article shows what investors can learn from BP’s Gulf of Mexico spill. Itidentifies six causative drivers, one of which is shareholder value maximization;shows why these events are “preventable surprises”; and describes howinvestors could choose to be enablers of sustainable capitalism rather thanof the dysfunctional markets experienced today. Arguing for a fundamentallydifferent mindset that includes, among other things, acknowledging theimportance of “sustainable cash flows” and “ESG beta,” the authors highlighta practical management agenda for long-horizon asset owners who have atwenty-first-century understanding of fiduciary duty.

Keywords: Investment Beliefs, Long-Term Investment, Organizational Learning, Pension Fund, Risk,Sustainable Cash Flows

The BP Cr is i s as a “Preventable Surpr i se”:Lessons for Inst i tut ional Investors

Volume 5 • Issue 1 • Spring 2012 • 10.3138/rijpm.5.1.6868

Regulatory Capture Creates ToothlessRegulatorsRegulators undoubtedly performed badly in this crisis,2 but toexpect awareness of this to result in corrective action is naïve.Regulatory failure was due largely to corporate capture ofregulators enacted through legal means, both donations andlobbying, and corporations have little incentive to change(Monks 2012).

The positive news is that institutional investors may be startingto see that good regulatory practice is in their clients’ interestand their own (Mackintosh 2011). This is obvious for highlydiversified investors, but it is also true for concentrated stockpickers, who are vulnerable to unpredictable consequencesof regulatory capture.

Organizational Learning Disabil it iesBP and many others (e.g., regulators) have failed to learn frompast experience and so avoided acknowledging that the companyhad a weak process-safety culture.3

Investors, too, have avoided learning. Given the major disruptionto dividend payment, the serious loss of asset value, the attemptedpartnership with a high-risk corporation, and the possibility thatthe company might have been completely wiped out or split up,this is worrying. It is also sadly predictable: while much wassaid about how investors should change after Enron and the dot-com bubble, the global financial crisis demonstrated that manysensible changes were never implemented.4 Once investorsconclude that an event is “in the price,” they move on.

A Narrow Conception of RiskThe Deepwater Horizon blowout occurred at a state-of-the-artplatform that used cutting-edge technology. But some hazards,particularly ESG, are frequently underestimated, and systemicrisk is often ignored. This leaves organizations vulnerableto high-impact low-probability events, which seem to bebecoming more frequent (Taleb, Goldstein, and Spitznagel2009). In this particular case, personal safety was consideredan adequate proxy for process safety, despite the BakerCommission’s highlighting the error in this thinking.

Both investors and companies tend to undervalue ESG risks:the “reasons” are many (too long-term to be material, too soft/difficult to integrate into models, or simply anti-fiduciary). Thisdysfunctional investment thinking – the result of worldviews,training, peer pressure, and incentives – means that risk isdefined in very narrow ways, with the focus on alpha (i.e.,short-term relative financial performance), and systemic riskis ignored. As a result, investors send a powerful message tocompanies, probably unintentionally, that increasing ESGand systemic risk is acceptable so long as short-term financialreturns are secure.

Short-Term Shareholder ValueFundamentalismEven though the National Commission on the BP DeepwaterHorizon and Offshore Drilling (2011) did not find explicitevidence that profit was deliberately put ahead of safety, itsreport states that pressure to cut corners was one main driverbehind BP’s weak safety culture, a finding common to manyof the reports about earlier BP accidents.5

In common with other sell-side research firms, Morgan Stanleyjustified their overweight/buy recommendation on BP, issuedjust one month before the accident, on the grounds that“management focus on costs and execution over the last18 months is undiminished” (Shefrin and Cervellati 2011).Because practices such as outsourcing and mergers andacquisitions often improve short-term profits and offer tradingopportunities, they find widespread support among investors,but there is little compensatory focus on the impact of thesetransactions on ESG-related risks.6

Many CEOs justify the pressure they apply internally to boostrevenue and cut costs in terms of the pressure they face frominvestors to achieve the “quarterly number” (Lacy 2010). Ofcourse, there is a blame game at work here: CEOs are far frombeing impotent victims (Fuller and Jensen 2002; Brochet,Loumioti, and Serafeim 2012). But management signals andincentives undeniably favor the short term over the long termalong the whole financial chain (WEF 2011).

Failures of LeadershipIn addition to organizational failure, there is also “executivefailure,” which leading specialist Charles Perrow (2011, 292)defines as executives’making “deliberate, knowing choices thatharm the organization and or its customers and environment.”It is easier to focus on the more neutral “corporate culture”agenda, but Perrow asserts that when the tone from the topis deeply pathological, it should be acknowledged as such.

Given how much investors value charismatic leadership and“savior CEOs,” it is not surprising that the usual corporategovernance structures and processes have largely been unableto contain damaging trends in risk appetite and incentivestructures. Investors often perceive CEOs as a, perhaps the,central element of a company’s performance. This is clearlyreductionist thinking, but the drive to appoint “savior CEOs”– who set expectations high, deliver share price growth, anddo so without worrying too much about wider or longer-term impacts – is largely undiminished, and this inevitablyencourages unbalanced leadership behaviors and priorities.

Weak Concern for Negative Externalit iesIf oil and gas executives had to internalize the full costs ofa major external spill – for example, if insurance to cover

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plausible worst-case scenarios were mandatory, or if “ecocide”7were a real legal risk – they would manage risky drillingprocesses very differently. Instead, the assumption is that whencatastrophes happen, government will socialize most of thecosts. This approach to negative externalities is worrying, giventhat, with “peak economic oil” approaching, the focus is on“frontier” reserves such as the Arctic, oil sands, and shale gas.The failure to internalize the costs of externalities also explainswhy these events should be seen not as cases of idiosyncraticrisk (which can be managed by good diversification) but,rather, as a symptoms of systemic risk (which must beaddressed at its roots).

Who picks up the tab for badly managed or badly pricedsystemic risk? In this and other cases of “hidden risk,” thepeople who are least responsible and least able to afford thepenalty – ordinary pension fund members and insurancecompany customers – take the hit. Negative externalities donot generally affect relative performance and are thereforeof little interest to the intermediaries. The net result is thatcompanies can indulge in activities that may end up beingenvironmentally or socially very costly, so long as theyare working to “best of class” standards, even if these areinadequate. Therefore, simply focusing on “ESG alpha”represents a serious misunderstanding of the sustainabilitychallenge: much greater weight should be put on “ESG beta.”

How Investors Can Help

Practical AgendaBetter Metrics: The Deepwater Horizon spill shows that manyexperienced mainstream (and even some ESG) analysts needto develop a better understanding of core ESG-related risks,especially in sectors where such risks are critical. Investorsneed to place more emphasis on lead indicators (e.g., fines,near misses) and rely less on lag indicators (e.g., fatalities,injuries) alone. More standardization would also allow realcomparisons between companies.8

Better Reporting: Companies that have taken the “bolt-on”route to sustainability, and this is probably the majority, needto take corrective action and make it clear to employees,subcontractors, and investors that meeting ESG standardswill be at the core of how the company operates. BP has, toits credit, learned and taken such action.

By demanding better external reporting, investors can drivebetter internal reporting. It is therefore important that investorsask for integrated reporting, since this will “improve informationfor stakeholders about the company’s performance and how itis being achieved” (Krzus 2010; emphasis added).

Better Leadership: Focusing on technical safety solutions isimportant, but it is not enough – corporate culture needs tochange, and this happens from the top down. Thus leadersmust be held accountable for ensuring that short-term financialpriorities do not impede an effective safety culture. Like otherESG issues, safety is best addressed when integrated withinnormal operations as a business-line concern.

To support this change, investors need to develop a moresophisticated understanding of “good management” and basetheir investment and governance judgments on this revisedmodel, as indeed a few investors did with respect to BP.9They also need to go beyond the CEO, CFO, and Chairmanto engage – and thus empower – key directors such as theChair of the Risk Committee and senior executives such asthe Group HR Director. And when things go seriously wrong,investors should act promptly. It is worrying that it tookinvestors nearly two years to make clear that they wanteda new Chair for BP’s safety committee.

Better Supply-Chain Management:Much greater emphasisis needed to embed a strong safety culture among contractors.Companies should show contractors that safety matters bymaking it a key criterion in the selection, performanceappraisal, and remuneration of suppliers.

Investors should also engage in better supply-chain managementin their own sphere of control by rewarding sell-side sectoranalysts, credit-rating agencies, and specialist researchorganizations for taking explicit account of ESG factors thatare material today or likely to be become so in the time frameunder consideration (i.e., for assessing the sustainability ofcash flows).

More Respect for Employees: To err is human, but to explainincidents in terms of human error, blaming middle managersand front-line employees, is particularly counterproductive.Instead, the goal should be to create a genuine learningorganization that is able to identify, analyze, and remedy safetyhazards. Collecting information on “near misses” is critical,so a culture that enables employees to raise safety concernswithout fear of retaliation is essential. This means an internalombudsman process, with a fallback external whistle-blowingsystem (O’Toole and Bennis 2009). Both must be independentfrom management and allow anonymized testimonies.

Here again, investors have a vital role to play in encouragingboards to push this through, despite executive resistance:boards need to know what they don’t know but should know.

Better Regulation: As Justice Louis Brandeis of the UnitedStates Supreme Court said, “Sunlight is the best disinfectant.”Investors should encourage investee companies to implement

the International Corporate Governance Network (ICGN)Code on Bribery and Corruption, adapting it so that “legalizedbribery” of the kind that is prevalent in the United States andother developed markets (Friedman 2011) is clearly targetedby the core policy. Investors could also support resolutionssuch as those from the Centre for Political Accountability toensure disclosure of political donations and lobbying activity.

Strategic AgendaThis practical agenda may be common sense, but it is unlikelyto become common practice without a fundamental shift ininvestor strategic priorities. A useful analogy here comesfrom the safety industry itself: the understanding of safety hasevolved from a focus on technical, engineering changes to afocus on corporate culture. A parallel change is now urgentlyneeded in financial market thinking, and investors have a corerole to play here. But first we must consider the wider context.

More Diversity in Corporate Purpose: Today’s corporatepurpose, dominated by “maximizing shareholder value,” ismonocultural and lacks resiliency. More diversity is neededto tackle the many pressing challenges we face today. Thismeans that other corporate purposes – for example, delightingcustomers, focusing on innovation to cope with coming eco-resource scarcities, and generating significant employmentto prevent civil unrest – should be celebrated. Tentative stepshave been made in this direction (e.g., enlightened shareholdervalue in the United Kingdom, the “B Corporations” inthe United States), but progress needs to be much fasterand deeper.

CEOs Held Accountable for Being Authentic Leaders:In recent decades, CEOs have been wrongly directed andincentivized by boards and investors (Sachs 2011). There isan urgent need for investors and boards to make clear to CEOsthat they expect healthy corporations and serious attention tothe “ingredients” for this type of sustainable growth, namelyemployee and customer satisfaction, eco-efficiency, and othermaterial ESG performance.

Boards as Guardians of Long-Term Wealth Creation:A transformation of board governance is needed to makedirectors effective guardians of the long-term focus of thecompany. This is quite different from the box-ticking or “checksand balances” role that boards play today. This transformationinvolves improving directors’ ability to partner with andchallenge management, which means greater resources,including skills and time, than is the norm today.

Confident Use of Smarter Regulation: Policy debates shouldmove away from the binary choice of free markets versusstate control to a more pragmatic approach focused on howto combine the two to achieve the desired goal. To prevent

corporate influence, regulators should be fully independentfrom the companies they regulate, which also means havingadequate resources and staffing to enforce regulations andstrong support from governments (Murphy 2011).

Empowered Citizen Investors: Since vested interests will resistchange, public pressure will be needed to drive this agenda.The public will need to acknowledge its responsibility as theend client of the financial industry, rather than just seeing itselfas the victim. NGOs have a critical role to play in this regard.

Adapting Investor Beliefs and Practices: Last but not least,investors need to reinvent their investment beliefs and align theirpractices with these beliefs, an agenda we discuss further below.

Better Investing: How to Make ChangeHappen

As demonstrated above, investors play a significant enablingrole vis-à-vis all six aspects of the practical agenda, either aspart of the problem or as part of the solution. The issue is notone of investors’ becoming “political” but, rather, of whichform of capitalism investors want to encourage. Do investorswant to be enablers of a healthier, more sustainable, moreresilient form of capitalism? Or do they want to continue todrive the crony capitalism and dysfunctional markets thatwe see today? (Martin 2011).

Many experienced investment professionals (several of themassociated with the Rotman ICPM) have written convincinglyabout the changes needed in investment policy and practices.10Impressive as this intellectual leadership has been, it has notyet delivered much change in investor behavior. Perhaps onereason for this is that the necessary organizational developmentagenda has not had the attention it needs. It is here, therefore,that we focus.

Prepare Intellectually to Meet Our Clients’Needs in Tomorrow’s WorldRemembering how different today is from the world just 20years ago, we need to invest in thinking outside the box toanticipate how things may be in 2030. A proven approach isto use scenarios based on credible macro trend research. Withgood-enough scenarios, we can then choose a “no regrets”investment strategy that customers in 2030 would judge tobe professional.

Novel thinking will highlight how we systematically underestimateESG risks today and how material a failing this is. There isconvincing evidence that corporations forgo economic wealthcreation to meet analysts’ expectations and that what happened atBP is just the tip of the iceberg. The conclusion of experienced

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economists is damning: “the destruction of shareholder valuethrough legal means is pervasive, perhaps even a routine wayof doing business. Indeed we assert that the amount of valuedestroyed by companies striving to hit earning targets exceedsthe value lost in these high-profile fraud cases” (Graham, Harvey,and Rajgopal 2006, 1).

Make Our High-Level Investment Choices onthe Basis of the World That Is EmergingTo date, most ESG effort has been at the stock level, andcomparatively little effort has gone into considering howinvestment beliefs, asset allocation, and portfolio constructionshould change. This imbalance should be corrected.

Institutional investors who have a long horizon shouldacknowledge that they routinely risk poor portfolio performancethrough weak attention to the drivers of long-term sustainabilityrisk / return, not least because these factors are generallyabsent from the models used by the mainstream. This weaknessis typically not monitored, thanks to the prevalent use ofmeasurement tools that do not take these factors into account(e.g., relative benchmarks and cap-weighted indices). Thesefalse intellectual “security blankets” should be discardedor replaced.

For example, although most of a fund’s ability to meet its long-term liabilities is due to beta, most funds spend the vast bulk oftheir resources – financial resources but also, more importantly,management time – on alpha. The responsible investment (RI)world mirrors this imbalance, with most effort directed atcapturing “ESG alpha.” This is not to say that “ESG alpha”does not exist, only that it is harder to deliver in practice thanin theory – much like alpha in general. Similarly, there is amuch greater payoff from improving “ESG beta” (e.g., safetyin the oil and gas sector as a whole) than is widely realized.This is a collective agency challenge that diversified assetowners are badly positioned to deal with today. Yet this couldbe relatively easily addressed with leadership intent. Successfullearning experiments such as Pharma Futures and the InvestorGroup on Climate Change have shown that sector and thematicengagement can be done effectively and efficiently.

Align Our Investment Business with OurLong-Term StrategyWe need to develop business processes and systems that deliverthese disruptive changes. At a minimum, this means movingaway from business as usual where there is good evidence thatthese norms are part of the problem (e.g., relative performanceand cap-weighted indices). We should also change incentives,both at the organizational level (i.e., the mandates thatasset owners give) and at the individual level (i.e., the wayindividual analysts are rewarded). And how risk is definedneeds fundamental review.

In addition, investors should review how they engage with publicpolicy debates and with their mainstream research providers(sell-side and credit-rating agencies). Much more could bedone to ensure that analysis of material ESG performance isbrought into the mainstream research notes, and thus intoconsensus estimates. Until this happens, the possibilities forasset owners and the buy side to make decisions that allocatecapital sustainably are much constrained. There is thus acritical need to reinvent the Enhanced Analytics Initiative(EAI), taking account of the fact that members of Principlesof Responsible Investment (PRI) now account for 10–15% ofthe global investment market.11 One lesson from the failureof the original EAI is that without much greater support fromasset owners, the free-rider challenge will not be addressed,and senior management within buy-side firms and researchproviders will have little reason to engage.12

On the active stewardship agenda, major gains could be madefrom a relatively small change in business models, with in-house ESG staff and engagement overlay providers becomingcatalysts for collaboration. Rather than everyone having whatare often superficial discussions with the same few large-capcompanies, the focus should be on collaborating (to widencoverage) and specializing (to develop expertise). The rationalefor greater collaboration flows from a customer-centric mindset– beneficiaries are not in competition with one another for abetter retirement life.

These changes need to be client driven, and the best time to useclient influence is when an asset owner selects a fund manageror re-commits to an internal manager. Thus, much depends onowners (and their consultants) giving ESG issues more profilein mandates and in reporting and appraisal. For example, activemandates could disincentivize high trading, since activeownership and ESG analysis have less value as churn increases.In addition, asset owners who believe in better stewardshipcould select investment managers with a stronger culture formanaging conflicts of interests. The ICGN Model Mandateinitiative is a welcome step forward (Kropp 2011), but mandatoryreporting by asset owners is needed for this “voluntary” initiativeto have traction.

Adopt a Governance Framework That HasRealistic Chances of DeliveringInvestors have spent much effort on the corporate governanceof investee companies. This should now be balanced byequivalent attention to their own corporate governance policiesand practices.

If a fund is too small to have trustees who operate as profes-sionally as a good board of directors would, or too “cash poor”to afford the in-house professionals that mitigate the agencyrisks that are inevitable when using external agencies, these are

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powerful reasons for questioning whether the fund should existas a separate entity: in most cases, its best option would be tomerge with related funds.13 Of course, agency issues withinsuch funds often prevent rational action, and thus governmentinvolvement is needed. Some governments have shownleadership in this regard (e.g., the industry “super” funds inAustralia), while others (e.g., the United States, the UnitedKingdom) have not.

More immediately, asset owners could do more to ensurebetter management of conflicts of interest by their ownmanagers, and this would have positive knock-on effectsdown the investment supply chain. For example, ownerscould make clear their preference for fund managers thathave an independent chairman (especially important whenthe manager is part of a larger financial house) and candocument effective ombudsman and whistle-blowing systems(non-use or low use would be a worrying indicator).

Commit to the Battles We Are ReallyCommitted to WinningToo much of what has happened in the ESG space to date hasbeen about process and, at worst, box-ticking. The challengetoday is to be clear about what we intend to change and thendo what is needed to get there. Easy to say, this is harder to doin practice, given the competing priorities and many obstacles.Investors can improve our chances of success bya. Obsessing less about “CYA risk.” It is not in our members’interests for pension funds to compete with other funds onmetrics that have little real value (e.g., quarterly or evenyearly relative performance).

b. Making these new commitments just as explicit as thetraditional financial targets, and treating them as equallycentral to the appraisal and remuneration process forsenior executives.

c. Involving “tough friends” who will challenge business asusual. For example, it is often said that pension funds donot know how to lobby, but it is clear, at least from theFinancial Transaction Tax, that many funds know how toblock changes they do not like. Involving stakeholders inreviewing how funds influence policy, both directly andthrough their trade bodies, will be critical to addressing“ESG beta” issues. These tough friends need to be outsiders,given the levels of self-censorship that are endemic today.

d. Moving away from “box-ticking” company engagementto focus on sector and thematic projects: individualcompanies often face serious constraints on what theycan do because of first-mover disadvantage, but “bestin class” is not adequate. Some of the issues currentlycreating the greatest market dysfunction are lack ofrotation of auditors (with related conflicts of interest,given their consulting activities) and incentive structuresthat focus on bonus but are silent about malus. These and

other fundamental issues need sustained, collaborativeattention, and doing many company-specific engagements,because this activity is easy to document and report, is nolonger good enough.

Make Sure We Do “What It Says on the Tin”Integrity with respect to implementation is critical at thistime when key stakeholders have little trust in financialorganizations. If we say that we believe ESG factors areimportant, then we have a duty to ensure that ESG isprogressively integrated as a normal part of doing all ourbusiness, and on a time scale that counts.

Given the power investment consultants have as “gatekeepers,”one of the most leveraged things asset owners can do isencourage consultancy firms to ensure that their “front line”consultants really integrate ESG analysis in the recommendationsand so look for fund managers who do the same. Fund managerswho have a “silo” approach to ESG functions – where ESGstaff have little say in decisions made by the traditionalinvestment professionals, not unlike the way safety expertswere treated within BP before the spill – would thus get auseful wake-up signal.

Emphasize and Implement Deep Learning inOur OrganizationsGiven the breadth and depth of the changes needed, we cannotexpect to get things fully right at the outset. Rather, we haveto create a culture in which learning from errors is the norm.Investors should make lessons-learned exercises a routine partof doing business by building this step into all major projectsand processes, remembering that learning is not the same asauditing. And boards should hold management accountablefor implementing lessons learned.

For example, asset owners could routinely inquire what theirinvestment managers have learned when stock or sectorperformance deviates sharply from what was expected, andwhether ESG factors were relevant. To make such learningblame free, this should happen as a routine agenda item.

Sharing the learning with other investors (or at least withtheir clients, in the case of commercial fund managers) wouldimprove practices in the industry. Pension funds that rememberthat they are not in competition with each other could showan even higher degree of collaboration. And as “learning bydoing” becomes the mark of excellence – something that isnow understood by “Main Street” – those investors who arecommitted to this approach will gain credibility for havingbeen early adopters.

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Our Common Cause

We have argued here that there needs to be a significant changein the mindset of long-horizon asset owners, matched by seriousoperational changes to discharge their fiduciary duty in thetwenty-first century well.14

Much is known about the technical investment changes thatare needed. What we know much less about is how to achievefundamental organizational change in this sector. For example,is it better to focus on the mindset changes first, or to takedisruptive action to trigger these worldview changes?

We have focused on forward-looking investment players, whoare the minority, perhaps 10% of the market. However wellinformed and well governed they may be, these players willtend not to do as much as they could because the benefits oftheir actions will be widely shared, while the costs will not.To avoid this “tragedy of the commons,” action is needed bygovernments and other stakeholders to move the 90%.

To do what they need to do, financial regulators could learnmuch from airline regulators, who spend considerable time andmoney to understand the causes of plane crashes (Lo 2010).It is because airline regulators have done a much better job ofavoiding corporate capture that they have been better able toprotect the public interest.

Similarly, civil society – campaigning NGOs, unions, thinktanks, and financial / specialist media – also have an importantrole to play in animating this change, as we have seen withNews Corporation and American Internet privacy laws.

But it is not good enough just to pick on easy-to-blame corporate“sinners”: civil society’s role in co-creating this dysfunctionalsystem should also be actively understood.

How much did the financial media help to create the conditionsfor Lord Browne and Tony Hayward to operate as they did?How many of the environmental NGOs and unions most heavilyengaged with the Gulf of Mexico crisis have changed how theirown investments are made? And how many of these NGOshave sought to encourage their major high donors to do thesame, and likewise for union-nominated trustees?

Taking this systemic perspective is far from depressing. Onthe contrary, it shows how different actors can collaborate toco-create a different system. Clearly, investors play a big role,currently more as enablers of the problem than as enablers ofthe solution. That can and must change.

T h e B P C r i s i s a s a “ P r e v e n t a b l e S u r p r i s e ” : L e s s o n s f o r I n s t i t u t i o n a l I n v e s t o r s

75Volume 5 • Issue 1 • Spring 2012

Endnotes

1. In addition to in-depth investigations by the New York Times, theWallStreet Journal, and PBS, there have been several books on the event andsome official reports. The three that take the most systemic approach areFreudenburg and Gramling (2010), National Commission on the BPDeepwater Horizon and Offshore Drilling (2011), and the NationalAcademies report (National Academy of Engineering and NationalResearch Council 2011). All, however focus on the interface betweenthe oil and gas sector and public policy; surprisingly, none has muchto say about what role investors played, or could have played. Seehttp://preventablesurprises.com/ for further details.

2. The regulatory failure is analyzed in detail in chapter 4 of NationalCommission on the BP Deepwater Horizon and Offshore Drilling (2011).

3. It is important to note the distinction between process safety and personalsafety. As noted by the Baker Panel, created to investigate the 2005 TexasCity Refinery explosion, “The Panel believes that relying exclusively orpredominantly on lagging indicators to assess process safety performanceis ill-advised…. BP’s reliance on lagging, after-the-fact indicators ofprocess safety performance rather than leading, predictive measures …impaired BP’s ability to measure, monitor and detect deteriorating ordegraded process safety conditions and performance … This failure touse a set of effective performance metrics that includes leading indicatorsincreased the likelihood that the organization would identify the need forimprovements or additional controls only after something had gone wrong”(Baker et al. 2007, 194). Worryingly, the highly respected US NationalAcademies concludes that even after this accident, “Overall, neither thecompanies involved nor the regulatory community has made effectiveuse of … lessons learned in the Gulf of Mexico and worldwide to adjustpractices and standards appropriately” (National Academy of Engineeringand National Research Council 2011, 4).

4. See EAMA (2003) and Plender (2003) on how post-ENRON/post-dot-comrecommendations have been largely ignored. Neither source could bedismissed as radical or poorly informed.

5. The Baker Panel, commissioned by BP itself, concluded that “while thePanel did not develop or identify sufficient information to concludewhether BP ever intentionally withheld resources on any safety-relatedon any assets or projects for budgetary or cost reasons, the Panel believesthat the company did not always ensure that adequate resources wereallocated to support or sustain a high level of process safety performance”(Baker et al. 2007, 59).

6. Our own research, covering about 350 reports on BP from the mainsell-side analysts and credit research agencies over the period from theTexas City Refinery explosion in 2005 to the end of the Gulf of Mexicooil spill in July 2010, shows that the coverage of ESG issues related toaccidents occurring at BP’s operations is very low. We screened thereports for keywords related to these issues, such as safety, accident,Baker, OSHA, and spill, and found that the average occurrence of thesekeywords is 6 per 100 pages. Since most of the reports are 20 pages longat most, this means that most reports do not deal with these issues at all.We also found that there is not a wide difference between analysts andthat the low level of coverage is consistent over all periods examined.

7. Ecocide has been defined as the destruction of, damage to, or loss ofecosystem(s) of a given territory, whether by human agency or by othercauses, to such an extent that peaceful enjoyment by the inhabitants ofthat territory has been severely diminished. For further details seehttp://www.eradicatingecocide.com/.

8. Organizations working on “better metrics” include the European Federationof Financial Analysts Societies (EFFAS), which has proposed sector-specific Key (ESG) Performance Indicators (for details see DVFA andEFFAS 2010), and the Global Reporting Initiative (GRI), which is themost widely supported sustainability reporting framework to date, withmore than 1,300 companies taking part. GRI has initiated sector-specificreporting guidelines; for details of the Oil and Gas guidelines seehttps://www.globalreporting.org/reporting/sector-guidance/oil-and-gas/Pages/development-of-the-oil-and-gas-supplement.aspx. Attemptingto bring much-needed coherence to these and other reporting initiativesis the International Integrated Reporting Council (IIRC).

9. Bank Sarasin excluded BP from its sustainability fund (which is also thedefault option for its high net worth clients), while Sarasin & Partnersunderweighted the stock in its UK Equities fund (personal communicationwith Sarasin employees, April 2011). Among specialist ESG researchagencies, we have found only one – GMI – that red-flagged BP aheadof the crisis.

10. For a selection of key articles and books seehttp://preventablesurprises.com/resources/evidence/.

11. The members of UN PRI collectively manage assets of US$30 trillion(PRI presentation, December 2011). Figures for total global AUM varyenormously, from US$80 trillion to US$212 trillion. Thus, a conservativeestimate often used by PRI spokespeople is that the project accounts forbetween 10% and 15% of global AUM.

12. The importance of the sell side is documented in Thamotheram (2008).

13. One major reason for market dysfunctionality is that the traditional“industrial structure” of the pension industry is itself dysfunctional.Small asset owners are easily captured by powerful agents, includingfund managers, investment bankers, consultants, and lawyers. This isespecially still the case in the United Kingdom and the United States.It is possible, however, to create a far more functional industry in whichpension funds are clear about their mission and have the mandate andcapability to achieve it, and these changes are beginning to happen inCanada, the Netherlands, Scandinavia, and Australia. For further detailssee Ambachtsheer (2011).

14. Most pension funds, insurance companies, and sovereign wealth fundswould qualify as long-horizon investors, as would many foundationsand family offices.

76 Volume 5 • Issue 1 • Spring 2012

Rotman International Journalof Pension Management

Volume 5 • Issue 1Spring 2012

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