Q Finance: The Ultimate Resource

Viewpoint: Finance Teaching After the Global Financial Crisis by Jayanth R. Varma Jayanth R. Varma holds a doctorate in management from the Indian Institute of Management, Ahmedabad, and is a professor of finance and accounting at the same Institute. During the last 25 years as an academic he has worked mainly in the field of financial markets and their regulation. He has served on the board of the Securities and Exchange Board of India, on several government committees concerned with risk management and financial sector reforms, and also on the boards of a couple of Indian banks.

OVERVIEW

I argue that we must rethink the way finance is taught because the global financial crisis has revealed deep-seated problems with older, oversimplified models that used to be popular in the classroom. I believe that newer and more nuanced models became well established in finance theory in the last couple of decades, and the crisis has not done anything to discredit these models.

Finance teaching must therefore start shifting toward these more modern and sophisticated models so that our students are better able to cope with the post-crisis world.

RISK MEASURES MUST BE MULTIDIMENSIONAL AND FORWARD LOOKING

The capital asset pricing model (CAPM) was developed half a century ago, but it remains the workhorse model in the classroom even today. The CAPM is popular because it is simple and easy to use: there is only one source of risk (market risk or beta), and there is a practical way to measure this risk.

Modern finance theory, on the other hand, has moved on to multifactor models where the measure of risk is multidimensional: † size: small-cap stocks are riskier than large-cap stocks; † value: value stocks differ systematically from growth stocks; † momentum: prices trends cannot be ignored; † liquidity: illiquid assets are more risky.

Today, although no serious finance journal would publish a paper that relied exclusively on the CAPM to measure risk, many finance MBAs probably believe that the CAPM is the best way to measure risk.

The CAPM makes the simplifying assumption that all investors have identical beliefs about the probability distribution of future stock prices—investors are assumed to agree on the means and the variances of the returns. While the modern models in finance theory assume that probabilities are subjective and are estimated using optimal Bayesian methods, classroom practice is

dominated by classical statistics. Students therefore easily fall into the trap of believing that means, variances, and betas are objective facts to be revealed by statistical estimation from historical data instead of being subjective judgments about the future.

Finance professors like to joke that accounting is about the past, while finance is about the future. However, when it comes to risk measurement, we have allowed students to uncritically imbibe a backward-looking methodology that failed so disastrously in the crisis—VaR models based purely on recent past data led to catastrophic underestimates of the true risk.

I think that finance teachers must now bring modern risk models to the classroom in a much bigger way.

PRICES MAY NOT BE RIGHT, BUT THERE IS STILL NO FREE LUNCH

The efficient markets hypothesis (EMH) has two important components, and the global financial crisis has led to diametrically opposite conclusions regarding these two: † There is no free lunch—or it is not possible to beat the market in risk-adjusted terms.

If something is too good to be true, it probably is not true. The global financial crisis has strengthened this claim. All those apparently low-risk, high-return investments turned out to be high risk. † Prices are “right” in the sense that they reflect fundamentals. The global financial crisis has weakened this claim. Many prices were clearly not right.

Limits to arbitrage imply that prices are not always “right,” but limits to arbitrage also tell us that the prices are wrong for a reason.

The no free lunch argument remains true: there are anomalies, but no easily exploitable anomalies.

What appears like a free lunch is just the reward for a hidden tail risk. The unhedgeability of this risk (possibly a liquidity risk) means that the apparent free lunch can be exploited only by those who can back their bets with a nearly infinite pool of liquidity and capital. Pre-crisis, the “too big to fail”

(TBTF) banks with implicit sovereign support might have thought that they had infinitely deep pockets, but the crisis blew the illusion away.

Finance courses need to teach more about the limits to arbitrage, with proper attention paid to transaction costs, leverage, and collateral requirements. The important stream of recent literature linking funding liquidity and market liquidity needs to be part of the core courses in financial markets.

MARKET MICROSTRUCTURE HAS MACRO-CONSEQUENCES

The study of market microstructure has become one of the most exciting fields in finance, and a vast literature of elegant models has emerged. In finance teaching, however, market microstructure is covered only in specialized courses, if at all. The dominant thinking seems to be that microstructure is important only to securities brokers and dealers who are focused on extremely short-term movements in prices. It was thought that the weird phenomena that take place at the short time scales relevant to market microstructure wash out over longer time periods and become irrelevant for mainstream finance.

The global financial crisis and subsequent events like the flash crash of May 2010 in the United States have taught us that this is not so. Quite often, market microstructure has macro-consequences and, perhaps, a financial crisis is simply market microstructure writ large.

Over the short time intervals of microstructure events (a few minutes), sharp and rapid price declines (market meltdowns) and the converse (“meltups”) happen all the time.

For example, any sell order large enough to sweep through the whole or a major fraction of the bid side of the order book would cause

“The chief business of the American people is business.” Calvin Coolidge

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a steep decline in prices within seconds (if not milliseconds). It might take several minutes for enough latent orders to enter the order book and reverse this meltdown.

Conversely, a large buy order can send the price shooting upwards in the space of a few seconds or even milliseconds. These highfrequency price movements are several times the range that would be expected from a Gaussian distribution.

Although fat tails are very common in high-frequency price data, microstructure theorists do not regard these markets as dysfunctional or irrational. On the contrary, the self-correcting ability of the market restores equilibrium over the space of several minutes or hours. Taking into account the various frictions (search and information costs, transaction costs, and leverage restrictions), we should probably consider a market which experiences (and then quickly recovers from) such microstructure meltdowns or meltups to be an efficient market.

During the crisis, booms and busts happened at a macro-scale (over time frames of several months instead of minutes), but it is possible that the phenomenon differed from microstructure events only in their scale and duration. A financial crisis may simply be a market microstructure event that has gone macro. Perhaps the complexities of “microstructure noise” persist at longer time scales as well, and the market is in a perpetual state of chaotic movement toward an ever-changing equilibrium instead of being in a continuous state of equilibrium.

The hypothesis that financial crisis is simply market microstructure writ large implies that markets are messier and more complex than the ideal friction-free market that is typically taught in finance courses.

On the flip side, it means that we have the theoretical tools and techniques (of microstructure theory) to study crises.

ECONOMETRICS MUST BE GROUNDED IN FINANCIAL HISTORY

The global financial crisis and its aftermath evoked parallels with: † the Great Depression of the 1930s; † the panic of 1907; † the sovereign defaults of the 1890s and 1930s; † the financial (and sovereign debt) crises of the 1830s and 1870s.

From a long historical perspective, the financial crisis does not appear to be an aberration at all. On the contrary, it is the socalled Great Moderation of the late 1990s and early 2000s that appears to be an aberration.

For example, Haldane (2009) provides the data given in Table 1 for macroeconomic volatility in the United Kingdom.

Table 1. Volatility of UK macroeconomic variables during the Great Moderation compared with 150-year average Variable

Volatility,

Volatility,

1998–2007

1857–2007

GDP growth

0.6%

2.7%

Earnings growth

0.5%

6.4%

Inflation

0.9%

5.9%

Unemployment

0.6%

3.4%

Source: Adapted from Haldane (2009), Annex Table 1.

A key mistake prior to the crisis was the assumption that the Great Moderation was a permanent structural change in the world economy that implied a permanently reduced volatility. The crisis has taught us that the statistical processes that we observe during any particular period should be viewed as just one of several possible regimes. There is always a nontrivial probability of shifting to a different regime.

The “new normal” in this sense is that there is no unique and stable “normal.”

I see financial history as providing powerful inputs into the econometric procedures that we use. Since high-quality data do not usually go back more than a few decades, we do not have the option of fitting econometric models directly to centuries of data. Yet it is not sensible to limit the estimation process to only the limited sample duration that is available. Students should be encouraged to favor robust models that are qualitatively consistent with decades, if not centuries, of historical experience.

Students taking advanced courses should be exposed to powerful econometric techniques like Markov switching models, but much simpler approaches may also be sufficient. Haldane’s table reproduced above involves only a simple tabulation of means and standard deviations for different sample periods, but it provides very valuable information. This means that a significant amount of financial history should be a part of the finance curriculum.

THE NORMAL DISTRIBUTION IS COMMON IN NATURE BUT RARE IN FINANCE

The Gaussian (normal) distribution is found everywhere in nature, but nowhere in finance. Theoreticians and practitioners use various tricks to correct for nonnormality—for example, the smile in a Black– Scholes option pricing model accounts for the fat tails of asset prices. Finance teaching tends to underemphasize this, and students tend to think of the Gaussian distribution as the default assumption in finance.

I think that finance teaching should include more discussion of fat-tailed distributions as well as copulas and other tools for dealing with non-Gaussian data. Similarly, courses on stochastic calculus should not be focused only on the mathematics of Wiener processes, but must also cover Le´vy processes, which have non-Gaussian increments.

FINANCE MUST DRAW FROM OTHER DISCIPLINES

Insights from psychology in the form of behavioral finance are now an integral part of the standard finance curriculum, but it is necessary to seek inputs from other disciplines as well. Neuroscience tells us a lot about the cognitive capability of the human mind as well as the nature of risk and time preferences. The sociology of finance asks us to look at markets as complex sociotechnical systems that overcome some of the limitations of bounded rationality. Network theory provides powerful theoretical tools to understand highly interconnected financial markets and institutions. Finance students should be exposed to all these important perspectives.

Some of these ideas would surely lead to changes in finance theory itself. But even before this happens, finance teachers can prepare their students for a post-crisis world by discussing the more robust models that already exist in the literature.

MORE INFO Books: Easley, David, and Jon Kleinberg. Networks, Crowds, and Markets: Reasoning About a Highly Connected World. New York: Cambridge University Press, 2010.

Glimcher, Paul W. Foundations of Neuroeconomic Analysis. New York: Oxford University Press, 2011.

Reinhart, Carmen M., and Kenneth S. Rogoff. This Time is Different: Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press, 2009.

Articles: Haldane , Andrew G. “Why banks failed the stress test.” Bank of England, February 13, 2009.

Online at: tinyurl.com/aztdqc [PDF].

MacKenzie, Donald. “The credit crisis as a problem in the sociology of knowledge.” American Journal of Sociology 116:6 (May 2011): 1778–1841. Online at: tinyurl.com/pfglcl2

“Economics is as much a study in fantasy and aspiration as in hard numbers–maybe more so.” Theodore Roszak

INTRODUCTION David Bresch has headed the sustainability unit at Swiss Re since 2008. His previous roles there include head of university and risk research relations, head of atmospheric perils group, and chief modeler for natural catastrophe risk assessment. He has been member of the deal teams for many innovative risk transfer transactions, like cat bonds and weather index solutions. He has been a member of the official Swiss delegation to the UNFCCC climate negotiations in Copenhagen (2009), Cancun (2010), Durban (2011), and Doha (2012). He is a member of the adaptation board of the global network for climate solutions of the Earth Institute at Columbia University, a steering committee member of ProClim, and a member of the advisory board of the INSEAD energy club. He holds a PhD in physics from the Swiss Federal Institute of Technology (ETH) and lectures on the economics of climate adaptation there.

How does Swiss Re approach sustainability? Is it very different as a concept for a reinsurer, given that by definition what you manufacture is a technical insurance solution, not a tangible widget that takes a set number of carbon units to produce?

The key point to grasp is that for every reinsurer, the nature of the game has to be long-term. You have to take a long-term view of risk, since this is fundamental to the idea of insuring insurers and large corporates against specific risks for moderately long periods. Much of what stood against sustainability—and which the whole sustainability effort was partly aimed at redressing—was the myopic dash after short-term profits regardless, for example, of long-term environmental damage caused in the pursuit of those profits. Since Swiss Re was founded 150 years ago, we’ve worked together to find smarter ways to manage risk sustainably, so that people all over the world can turn pioneering ideas into reality or get back on track when things go wrong.

Risk for us comes in two flavors, both of which have to do with “sustainability” in that they are about sustainable growth over time. First, there is the emergence of new technologies and the risks associated with managing new technologies, which for us means assessing how to provide cover for these new technologies and their inherent risks. The second is more directly associated with climate change and has to do with development in hazard-prone areas, such as coastal plains. This is where a lot of our focus is and our aim here is to make societies and communities more resilient by providing them with naturalcatastrophe cover.

“Resilience” differs from “sustainability,” but they imply each other. A “fragile” society will not be very sustainable. However, in helping societies to be more resilient you must look closely at their exposure to environmental risk. I imagine this also means looking at what they must do to mitigate risk?

Absolutely. We must have a sustainable business, since we are engaged and committed for the long term. So we have to make sure that we do not engage in transactions that we would later regret.

We use our in-depth knowledge of risk and our capacity to model a wide range of environmental risks to evaluate specific opportunities to see if they fit within acceptable parameters, or, if they don’t, what would be needed to bring the risk within acceptable parameters. It is often not helpful simply to refuse a proposal. The better approach is to engage in a conversation with the client to see what we would require to be changed for the risk to be insurable. Take a ouse that is on the edge of a crumbling cliff, for example. That is not an insurable proposition as it stands, but a serious consideration would want to look at whether the cliff top could be stabilized, or the cliff supported, perhaps for other reasons such as coastal defense that would justify the cost. To explore these kinds of issues we formed the Economics of Climate Adaptation working group in 2008 with a view to forming partnering relationships with communities, cities, and regions There are large numbers of cities or regions that would be in a better position if they could get some of the risk volatility out of their balance sheets, with much of that volatility coming from the stresses that follow “acts of God.”

The best example of this is the Caribbean Catastrophe Risk Insurance Facility (CCRIF). The CCRIF is a risk-pooling facility owned, operated, and registered in the Caribbean for Caribbean governments.

It is designed to limit the financial impact of catastrophic hurricanes and earthquakes to Caribbean governments by quickly providing short-term liquidity when a policy is triggered. It is the world’s first and, to date, only regional fund utilizing parametric insurance, thus giving Caribbean governments the unique opportunity to purchase earthquake and hurricane catastrophe coverage with lowest-possible pricing. The CCRIF represents a paradigm shift in the way governments treat risk. The facility was developed through funding from the Japanese Government, and was capitalized through contributions to a multi-donor Trust Fund by the Canadian Government, the European Union, the World Bank, the governments of the United Kingdom and France, the Caribbean Development Bank, and the governments of Ireland and Bermuda, as well as through membership fees paid by participating governments.

Sixteen governments are currently members of the CCRIF, namely: Anguilla, Antigua and Barbuda, Bahamas, Barbados, Belize, Bermuda, Cayman Islands, Dominica, Grenada, Haiti, Jamaica, St Kitts and Nevis, St Lucia, St Vincent and the Grenadines, Trinidad and Tobago, and the Turks and Caicos Islands. In 2007, the CCRIF paid out almost US$1 million to the Dominican and St Lucian governments after the November 29 earthquake in the eastern Caribbean; in 2008, the CCRIF paid

“Unsustainable situations usually go on longer than most economists think possible. But they always end, and when they do, it’s often painful.” Paul R. Krugman

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Viewpoint: The Role of Insurance in Bringing Resilience to Societies Challenged by Global Warming by David Bresch

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out US$6.3 million to the Turks and Caicos Islands after Hurricane Ike made a direct hit on Grand Turk; and in 2010, the CCRIF made a payment of US$7.75 million to the government of Haiti after the January 12 earthquake. Swiss Re provides the reinsurance for the fund and was instrumental in its establishment.

We got together with the World Bank and others to look at how we could combine to help Caribbean communities deal in a better way with hurricanes and earthquakes in a forward-looking manner, instead of having the world community provide aid after the event. The key here was to find ways of structuring the finances of these countries so that they would be able to get fast access to relief money and to provide an insurance mechanism that would make funds available to all the affected governments rapidly. The mechanism we came up with means that the scale of the payout is precisely calibrated to the intensity of the disaster.

What this shows is that even if the world does move into a more unstable, more volatile phase, if global warming takes hold it will still e possible to model potential events and to plan for them in a coherent fashion.

However, we have to engage and develop the dialogue with various regions, cities, and communities because if matters are left to local insurers, they very often simply do not have the capacity to deal with the scale of what is being envisaged. We also find that there are a great many public infrastructure exposures that are not being insured, and these too represent opportunities.

We have a similar example to the Caribbean fund that we can point to, namely the Mexico catastrophe bond. This has a similar logic behind it, in that if there is a large earthquake or hurricane, then the bond pays out. This is not reinsured by us, but it was brought to the capital markets and was very well received by investors. It might seem odd that investors would want to take on the risk of insuring against catastrophes, but you have to remember that the risk is well-rewarded and that it is not correlated with any other risk in the investor’s portfolio, so it adds considerably to their diversification.

Another strong argument in favor of investing in catastrophe bonds for many investors is that this is an investment that is a good thing in and of itself. It does good in the world by helping to make a particular area or region more resilient and better able to recover should disaster strike. Many investors want to secure some ethical dimension for at least a portion of their investment and they can therefore justify the investment on two grounds: on the probable returns, and on the fact that this is

an investment that does good. This is well beyond aid, in that investors are not just giving away money. They are entitled to a share of the profits if things go well and they have the satisfaction of knowing that the fund they are creating will do good if things go badly.

Since catastrophe bonds address the capital markets, what role is there for Swiss Re in this side of the sustainability initiative?

There are a lot of technical issues that have to be overcome in the structuring of a catastrophe bond. Above all, you need it to be supported by a really good modeling system. We do all our disaster modeling inhouse and employ some 30 scientists for this purpose. We are very transparent in how we go about building these models and we make them available for studies on the economics of climate change, so that institutions, both academic and financial, can understand the economic risks associated with global warming and the additional risks of further economic development.

Obviously, catastrophe bonds are a very good innovation in that they bring the capital markets into play and they broaden the capital base of the insurance industry very substantially. However, structuring a catastrophe bond so that it is transparent to all the stakeholders, so that everyone knows what the bond’s purpose is when it is triggered, and what their liability is, is critical. We see a very strong role for Swiss Re in structuring these bonds properly, so that they can be renewed and replenished.

The deeper understanding of risk is at the core of what we do.

When you have models of the comprehensive risk landscape, you can start to assess the nature of the risk and how you can reduce and manage it. From a community’s point of view, they can pinpoint specific actions, such as the impact of building a dam, or how zoning and building restrictions on certain kinds of land might reduce risk. Higher standards in building or flood-proofing could be called for. The Netherlands is an extremely good example of how a whole country has dealt with natural-disaster threats in a very resilient, long-term fashion.

Is your initiative in the direction of sustainability wholly dependent on the realities of climate change?

There is a tremendous body of evidence pointing to climate change being both a fact and man-made, Even if all emissions could be stopped today, the climate will continue to alter in the coming decades. This means

we need to reduce emissions as quickly as possible and deal with the impact of climate change by making our societies more resilient. We employ a scenario approach to imagine how various futures might look.

When you look at the economics of climate adaptation, then you start figuring out what would constitute the basket of measures that societies need to undertake in order to increase, strengthen, or at least maintain their resilience against possible future challenges. Above all, we need to transform our energy and transportation systems. In doing this we encounter some of those technological challenges I mentioned. There are risks, for example, in moving from traditional electric grids to smart grids. It is a huge step to take and one that comes with a lot of opportunities and some risks, and we are willing to take on some of those risks in order to enable the change to happen.

There are lots of opportunities, but you need a deep understanding of the driving forces and you have to dig through the complexity to provide viable solutions. Our approach is to collaborate very strongly with the various stakeholders, since no one organization can provide a solution in isolation any more.

The global society should do the utmost to avoid the unmanageable—that is, global greenhouse gas emissions need to be drastically reduced. Only if this is achieved, can the insurance sector help to manage the unavoidable—that is, the increase in risk associated with a changing climate. If matters are well organized, it is possible to manage risk at a reasonable cost, with the aim to keep societies resilient and robust.

The challenge for some of these societies, particularly low-lying islands, for example, is that if catastrophes happen too often, the people become desperate and lose trust in institutions and society. The social fabric starts to unravel, so you need to address these matters with quite some urgency. As a single actor we can by no means provide resilience single handedly; but we do play a role in helping communities to strengthen their resilience.

MORE INFO

See Also: Climate Change and Insurance (pp. 149–150) The Impact of Climate Change on Business (pp. 875–877) Viewpoint: Leveraging Influence to Impact Climate-Change Policy (pp. 696–697)

“Like other branches of the study of society, economics remains culturally parochial, and its underlying concepts based on a few centuries of Western experience.” John Gray

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Viewpoint: A Single Currency for Asia?

by Amitendu Palit INTRODUCTION Amitendu Palit is an economist specializing in comparative studies of China and India, international trade and investment, political economy, and public policy. Currently he is a senior research fellow of the Institute of South Asian Studies at the National University of Singapore. He has a decade’s experience handing macroeconomic policy issues at India’s Ministry of Finance. His latest book is China–India Economics: Challenges, Competition and Collaboration (Routledge, 2012) and his forthcoming book is on the Trans-Pacific Partnership (TPP) and its implications for China and India. His work has been published in peer-reviewed academic journals and he writes regularly for India’s Financial Express, China Daily, and The Business Times.

BACKGROUND

Asia’s efforts to move toward a common regional currency appear to have stalled.

Although the Asian financial crisis of 1997 created the tempo for greater monetary policy and exchange rate coordination in the region, large heterogeneities in economic structures, policies, and institutions among regional economies have prevented decisive moves to a common currency. Asia lacks appropriate institutions for adopting common monetary policies and moving to a single currency. The problems faced by the euro have further diminished the prospects for a single currency in the region.

The key challenges facing implementation of a single currency for Asia are: † the Asian financial crisis of 1997, the need for greater policy coordination, the Chiang Mai Initiative, and the Asian Currency Unit (ACU); † ASEAN’s centrality in a common Asian currency and its lack of enabling conditions; † the difference in exchange rate arrangements in the region; † the question as to whether Asia could even contemplate a single currency, when the euro faces crisis despite covering a more homogeneous economic region.

One of the consequences of the prolonged economic contraction and financial downturn in Europe is the skepticism it has engendered about the prospects of a unified regional currency in Asia. There was a time when Asia was seriously considering the prospect of adopting a common currency.

But the troubles of the euro have made the South East Asian economies wary of currency unification. South East Asia, or more specifically the ASEAN group of economies, is central to moves toward a single Asian currency. The lack of enthusiasm of the ASEAN on a common legal tender for the region underscores the

erosion in credibility that the concept of a single regional currency has suffered following the European crisis.

THE 1997 ASIAN FINANCIAL CRISIS AND THE BIRTH OF THE CHIANG MAI INITIATIVE

The beginnings of a common currency in Asia can be traced to the Asian financial crisis of 1997. The crisis drove home the importance of greater policy coordination among the regional economies, particularly the large economies of North East, South East and South Asia. These regions comprise several large economies such as Japan, South Korea, China, Taiwan, Hong Kong, Singapore, Malaysia, Indonesia, Thailand, and India. Most of these countries were affected by the crisis of 1997, though not in equal measure. Economies like China and India suffered relatively less because of their limited integration with the global financial system. Nonetheless, the urgency of policy coordination was realized by all the economies notwithstanding the difference in the degree of the difficulty they encountered.

A major driver of greater policy and institutional coordination among the regional economies was their disappointment with the policy responses of the IMF during the crisis. The crisis highlighted the importance of the region being self-sufficient in warding off contagion-type situations precipitated by speculative attacks on national currencies. This realization gave birth to the Chiang Mai Initiative (CMI).

The CMI created a pool of reserve currency and extended bilateral credit swaps to participating members. The reserve pool and the swaps are intended to help regional central banks to maintain the stability of their currencies in the event of speculative attacks. The CMI has 13 participating economies, which include the 10 ASEAN members (Brunei, Cambodia, Laos, Malay-

sia, Myanmar, Indonesia, the Philippines, Singapore, Thailand, and Vietnam), China (including the Hong Kong Monetary Authority), Japan, and South Korea. It has been decided that the current corpus of the CMI should be doubled, from US$120 billion to US$240 billion.

The move on the CMI was accompanied by the first steps for forming an Asian currency unit (ACU) in the middle of the last decade. Following the interest expressed by China, Japan, and South Korea in greater coordination of their currencies at the annual meeting of the Asian Development Bank in May 2006, the idea of an ACU was formally floated.

The ACU is statistically conceptualized as a basket of currencies reflecting the movements of various national currencies against a numeraire currency. This was expected to be a precursor to an eventual common currency in Asia. However, the move to a common currency has been sluggish for several reasons. Many of these relate to typical features of the region and its economies.

IS ASIA READY?

On paper, a common currency has several benefits for Asia. These include more seamless integration of trade and capital flows within the region. This follows from avoiding costs of invoicing products and services in different currencies when they cross borders. Apart from cutting transaction costs of paperwork and procedures, a single currency also helps traders to avoid the risks of exchange rate fluctuations.

These risks often force traders to hedge against fluctuations by entering into futures contracts. More predictability and less uncertainty are clear benefits of a common currency. Given that the region has extensive intraregional trade, a common currency should ideally be a welcome option.

The early moves toward the ARU involved China, Japan, South Korea, and the 10 ASEAN economies. This is the ASEAN þ 3 grouping that spans across South East Asia and North East Asia. How feasible is it for the group to work toward a common currency?

The ASEAN is the most cohesive regional grouping in Asia. But it is different from the European Union in several respects.

The most important difference, perhaps, is the lack of regional institutions with the capacity to serve as overarching regulators.

The ASEAN secretariat is hardly equivalent

“In the end we beat them with Levi 501 jeans. Seventy-two years of Communist indoctrination and propaganda was drowned out by a three-ounce Sony Walkman.” P. J. O’Rourke

notion of a common currency. One of the main reasons for the unwillingness is the heterogeneity among the economies.

There are considerable differences within the ASEAN economies in the degree of economic development and in their economic structures. The relative differences increase if the pool is enlarged to include China, Japan, South Korea, India, Australia, and New Zealand. Apart from the obvious differences in economic features and the nature of economic institutions, there are noticeable differences in the economic policy management systems as well.

One of the best examples of the heterogeneity in the region in the context of a single currency is the difference between the exchange rate systems of the various economies. While most economies follow the floating exchange rate system, there are variations in the nature of the float. Many prefer the “managed” float where, despite allowing the exchange rates of national currencies to be market-determined, central banks intervene at periodic intervals to influence the values of the currencies through their sales and purchases. The interventions are usually influenced by the desire to control large appreciations of currencies, which can erode the competitiveness of a country’s goods and services.

Indonesia, Malaysia, Thailand, and India are examples of managed floats, while Japan and South Korea have more free floats, in contrast to the “peg” arrangements of China and Vietnam. In several countries of South East Asia, such as Cambodia, Myanmar, Indonesia, and Vietnam, the US dollar is unquestionably accepted as the legal tender. With such wide differences in exchange rate regimes and monetary policy frameworks, moving to a common currency through convergence of institutions and systems is seemingly difficult.

THE EFFECTS OF THE EURO CRISIS

The prospects for a common Asian currency have received a considerable setback after the problems experienced by the euro. The financial crisis in the Eurozone— particularly the difficulties suffered by relatively smaller euro economies like Greece, Portugal, and Ireland—has raised serious doubts over the effectiveness of currency integration in facilitating greater integration of trade and investment within a region. If the Eurozone and the euro,

with the Eurozone’s much greater institutional, systemic, social, and political similarities than the ASEAN þ 3, could not avoid a financial catastrophe, then the possibility of any such arrangement in Asia is far less likely.

Indeed, common currencies can probably work only if member countries have a lot in common. There is no denying that noncommonalities among the ASEAN þ 3, and among the even greater Asian region that includes India, Australia, and New Zealand, are too much to even contemplate formal and common exchange management structures. Apart from economic dissimilarities, matters are further complicated by delicate political and strategic dynamics. The China–Japan–South Korea grouping, for example, harbors considerable political volatility. The Eurozone was free from such pressures. Even then, the members’ economies are finding it difficult to stick to the euro.

The euro crisis also reveals the importance of institutional support in times of trouble. The European Central Bank has tried its best to support the affected countries. But probably that is not enough.

It will be unwise of Asia to contemplate a common currency unless the regional institutions are strong enough to sustain multiple bailouts. This will require the growth of contingency measures far larger than the current Chiang Mai corpus.

FINAL THOUGHTS

The outbreak of the global financial crisis and the troubles faced by the euro initially raised hopes for the emergence of a common currency in Asia and its gradual growth as a global reserve currency.

However, Asia does not appear to be ready for currency integration. Several limitations are hampering a regional currency union, including the large economic, social, and institutional heterogeneities in the region. Countries seem unprepared to converge on common exchange rate management systems and monetary policy frameworks. The region also lacks strong institutions for coordinating monetary and exchange rate policies. The failure of several Eurozone economies to manage their monetary and fiscal health, despite operating in a far more homogeneous region than Asia, has made the already remote possibility of a single Asian currency even more distant.

“What breaks capitalism, all that will ever break capitalism, is capitalists.” Raymond Williams

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to the European Commission. More importantly, ASEAN does not have the equivalent of a European Central Bank. Individual ASEAN members continue to retain sovereignty over their monetary policies. Such sovereignty must be sacrificed if the move to a common currency is to be made.

Progress on a common currency is inseparable from progress on regional integration. The conditions for moving to a common currency must take shape within the ASEAN, which is the most visible structure of a regional bloc in Asia. If ASEAN cannot produce the enabling conditions for a common currency, it is difficult to perceive how the ASEAN þ 3 can do so.

This appears all the more difficult given that South Korea, Japan, and China are unlikely to agree easily on various aspects of convergence of their monetary policies and exchange rate management.

The EU experience shows that some members can retain their individual currencies. Those EU members outside the Eurozone, such as the United Kingdom, Denmark, Switzerland, and Sweden, have different currencies. Can Asia adopt such a system? Reproducing the current EU structure with similar features would require creating a “eurozone” within Asia. More specifically, in the context of the ASEAN þ 3, either the ASEAN or a subgroup within ASEAN needs to replicate the “eurozone” by giving up sovereignties on monetary and exchange rate policies and establishing a supranational regulator to manage the group collectively. Such a scenario appears distant within the ASEAN. The milestones that have been mentioned to achieve the ASEAN Economic Community (AEC) by 2015 do not include steps for moving to a single currency. The plan proposes the establishment of a regional economic zone enabling free flows of goods, services, capital, investment, and labor. But it refrains from proposing more ambitious plans of monetary policy convergence or establishing a regional regulator for managing monetary policy and moving toward a common currency. Indeed, it does not even propose the establishment of a parallel currency on the lines of the ACU. Similarly, the idea of a common currency does not find mention in other regional economic integration initiatives, such as the one being pursued by the East Asia Summit.

It appears that ASEAN and the Asian region are not yet ready to embrace the

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Viewpoint: Principles for Responsible Investment— Looking Beyond the Financial Metrics by James Gifford INTRODUCTION James Gifford is executive director of the PRI initiative and has been guiding the initiative since its inception in 2003. He worked with UNEP FI and the UN Global Compact, leading the PRI drafting process, and after the launch of the PRI secretariat in 2006 became its first executive director. He has a PhD from the Faculty of Economics and Business at the University of Sydney on the effectiveness of shareholder engagement in improving corporate environmental, social, and corporate governance performance, and a background in IT and environmental protection. In 2010 Gifford was named by the World Economic Forum as one of 200 Young Global Leaders.

What were the origins of the United Nations-backed Principles for Responsible Investment (PRI) initiative?

The PRI initiative is a network of international investors that work together to put the six Principles for Responsible Investment into practice. The PRI came out of two UN agencies: the UN Environment Programme Finance Initiative (UNEP FI) and the UN Global Compact (UNGC). UNEP FI works with banks, insurance companies, and asset managers on environmental, social, and corporate governance (ESG) issues, while the Global Compact encourages organizations to sign up to a set of 10 principles. The Global Compact is the United Nations’ key initiative on corporate responsibility. In late 2003 we started thinking about ways to enable the UN to work more closely with the investment sector, and pension funds in particular, to deliver a more sustainable economy.

Our team at UNEP FI proposed the development of a set of principles focused on what it would take to create a business case for mainstream pension funds and asset managers to engage with sustainability issues via ESG integration and active ownership.

In 2005, the UN Secretary-General Kofi Annan wrote to 20 of the world’s largest pension funds, inviting them to UN headquarters in New York to commit to developing a set of responsible investment principles. The drafting process took place over 11 days of meetings with investors and experts, and the initial six principles were launched with some fanfare at the New York Stock Exchange in April 2006. Within a year of the launch, about 50 investor organizations had signed up.

Today there are more than 1,100 signatories, representing about US$32 trillion of assets under management, or about 15% of total global capital. Interest in becoming a signatory extends beyond the United States

and Europe. We have tremendous support, for example, in Brazil, where more than half the total funds under management in that country have signed up. In Korea the National Pension Service, the fourth largest pension fund in the world, is a signatory, and they are showing real leadership in Asia. Similarly, in South Africa, GEPF, the government employees pension fund, has been a champion in that market. Australia is also very strong, with our signatories managing half of the funds under management in that country, including the majority of its superannuation funds. China, India, the Middle East, and Spanish-speaking Latin America, however, are in early stages of awareness of these issues.

Sustainability has a range of meanings.

How should investors relate to the PRI initiative?

Responsible investment today is very different from the earlier movement of ethical investing and it is not focused on restricting the range of potential investments based on absolute criteria. The PRI started from the premise of engaging mainstream investors and investment processes. Telling investors they should restrict themselves to an approved list was never going to resonate with fund managers whose priorities are to achieve their benchmark returns. If we wanted to engage mainstream investors on ESG issues, it had to be entirely aligned with their fiduciary duties and, therefore, had to focus on the business case.

The PRI initiative takes a twofold approach. First, we encourage investors to look at ESG issues from a risk and opportunity perspective. The world is changing very fast. There are hugely important megatrends going on around environmental shifts, societal developments, and changes in regulatory frameworks and governance; all of these present challenges for investors and fund managers.

Traditional fund managers have measured

success in terms of a very narrow and short-term set of metrics, and it is clear that there are real risks with that approach.

Mainstream investment is increasingly embracing the view that you need a much broader understanding of future value drivers and that traditional narrow financial metrics simply represent the tip of the iceberg, and a deeper analysis of ESG issues can help to work out what might be under the water.

Investors should therefore look at a broad range of ESG issues when evaluating and valuing companies. This does not mean that you need some kind of exclusion filter, but rather that you should look at issues such as a company’s environmental performance and its relationship with its community, and how these may affect its future business. To understand the potential impact of ESG issues on shareholder value you only have to look at examples like Lonmin in South Africa, with its labor issues, which have led to a dramatic destruction of shareholder value. Similarly, it was relatively well known in the industry that BP’s US division was not managing safety issues as well as its peers prior to Macondo. Massey Energy in the United States also had a poor safety record that led to a dramatic loss of shareholder value.

It is a relatively straightforward argument to make to investors that the companies that are going to prosper over the long term are those that manage ESG issues better than their peers. We encourage our signatories to consider these issues deeply when they make investment decisions. For example, when you assess two mining companies with similar fundamentals, a review of their respective ESG performance can help to reveal which one may offer the better long-term prospect and lower risk.

“I don’t invest in anything I don’t understand—it makes more sense to buy TV stations than oil wells.” Oprah Winfrey

Where does shareholder and investor stewardship fit into this?

The Principles themselves (see panel) were originally designed to provide a framework around which to build an active community of investors sharing best practices and, ultimately, pooling resources and influence to seek improvements in the ESG performance of investee companies. It was felt that this community would only develop, and the initiative would only fulfill its potential, if the Principles were backed by a dedicated secretariat tasked to promote them, build the community, and coordinate investor collaboration. As soon as the Principles were launched, a secretariat was established and got to work, with the strong support of the UN partner agencies.

Stewardship is the second pillar of mainstream responsible investment, and active ownership is reflected in Principle 2.

The PRI urge investors to take their stewardship responsibilities seriously.

They are part owners, after all, and that comes with responsibilities. If not, who will hold management to account? If capitalism is to function and flourish, it needs responsibility and accountability across the whole agency chain, from company employees right through to the owners of companies and their customers and beneficiaries. It requires monitoring and the necessary information flows to make stewardship possible. When responsible investors look carefully at the behavior of the companies they are holding in their portfolios, they will press companies that are not managing their ESG risks appropriately to do so. Investors need to engage the companies they hold in dialog, and they need to vote at annual general meetings in an informed way. They also need to vote against management when they feel that the company is on the wrong track, and they need to encourage management generally to be more long-term in its thinking. We do a lot of work with our signatories to encourage the companies in their portfolios to be world-class in their approach to ESG issues.

Transparency is another principle enshrined in the PRI. It goes hand-inhand with stewardship, and investors should ensure that they are getting sufficient information from management to have a clear and appropriate view of the business.

How does the PRI initiative ensure that its signatories are accountable?

The PRI has an annual reporting and assessment process that is mandatory for all investor signatories to complete. We have compiled good statistics on what our signatories are doing with respect to implementing responsible investment, and it is fair to say that there has been increased activity with respect to responsible investment.

The PRI clearinghouse remains one of the most important strategic priorities for the initiative. Its role is to stimulate collaboration among large investors with companies on their ESG performance. Using a private online forum, investors post proposals for collaboration with peers to seek changes in company behavior, public policies, or systemic conditions, or they simply discuss issues of concern. The clearinghouse lowers the barriers of entry to active ownership and offers leverage to single institutions that may have a “good point” that others may not have identified. The tool, starting as a simple online bulletin board, has become an active hub of investor collaboration hosted on a searchable IT platform and supported by a number of dedicated staff. The PRI secretariat also works with signatories to come up with new ideas for collaboration and ensures that they are framed in ways that are likely to gain as much support as possible from peers.

The clearinghouse is one of the most active areas of signatory participation, and more than 350 signatories have joined in collaborations.

How well do companies respond to shareholder concerns?

There are generally a number of dialogs taking place, and sometimes the companies respond well to shareholder concerns and sometimes they don’t. In the United States it is common practice for investors to file shareholder resolutions when they feel they are not getting the response they need from companies or the attention of their boards. In other countries shareholder resolutions tend to be seen as very confrontational.

Disclosure on ESG issues, which is at the heart of Principle 3, is key to much of what we do, so naturally there is an emphasis on encouraging companies (via their owners) to improve ESG disclosure. Principle 6 focuses on disclosure from the investor side, and encourages signatories to communicate with clients, customers, and beneficiaries about ESG issues and their approaches to PRI implementation. This includes determining the impact the PRI make on their

investment processes and, ultimately, investee companies.

A lot of the work done in the clearinghouse revolves around finding ways to encourage companies to produce systematic disclosures about their business operations that are compliant with recognized frameworks, such as the Global Reporting Initiative or the Global Compact’s Communication on Progress.

One of the successes of the PRI is that we have been able to bring investors together globally to address collective action issues. Before the PRI, there was no global forum capable of bringing investors together to address these problems across a full range of ESG issues. As well as engaging with corporations and industry sectors, our signatories engage with governments on specific issues. Investors can encourage and lobby for appropriate policies, and they can drive voluntary initiatives within the corporate and investment sectors.

The Extractive Industries Transparency Initiative, for example, is an initiative that has been driven both by the UK and other governments, investors, and Transparency International, the world’s leading nongovernmental anticorruption agency. This leverages the power of investors to push governments to sign up to the UN Global Compact and to implement reporting requirements that encourage greater transparency on issues such as facilitation payments and royalty payments.

What our reporting and analysis shows beyond doubt is that the companies that create the most value are those that deliver on these wider objectives. There is a very strong connection between creating financial value for shareholders and creating products and services that people want, make their lives better, and are aligned with what society wants. That alignment between financial prosperity and the interests of society as a whole converges over the longer term. If you take a pension or superannuation fund, its obligations to its members extend over a two- to four-decade time frame, so it has a natural interest in wanting to be part of a long-term productive enterprise that is delivering value to society. This is at the heart of the culture that the PRI initiative is trying to generate: encouraging investors to invest in productive enterprises that deliver real value to society is the classic win–win over the long term.

Appendix: the UN Principles for Responsible Investment (PRI)

As institutional investors, we have a duty to act in the best long-term interests of our

“If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.” Warren Buffett

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What is becoming clearer to investors is that ESG issues can have very material consequences, and investors have not traditionally paid attention to these issues, which could drive, or destroy, value for shareholders in the future.

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beneficiaries. In this fiduciary role, we believe that environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios (to varying degrees across companies, sectors, regions, asset classes and through time). We also recognize that applying these Principles may better align investors with broader objectives of society. Therefore, where consistent with our fiduciary responsibilities, we commit to the following: Principle 1. We will incorporate ESG issues into investment analysis and decisionmaking processes.

Possible actions: † Address ESG issues in investment policy statements. † Support development of ESG-related tools, metrics, and analyses. † Assess the capabilities of internal investment managers to incorporate ESG issues. † Assess the capabilities of external investment managers to incorporate ESG issues. † Ask investment service providers (such as financial analysts, consultants, brokers, research firms, or rating companies) to integrate ESG factors into evolving research and analysis. † Encourage academic and other research on this theme. † Advocate ESG training for investment professionals.

Principle 2. We will be active owners and incorporate ESG issues into our ownership policies and practices.

Possible actions: † Develop and disclose an active ownership policy consistent with the Principles. † Exercise voting rights or monitor compliance with voting policy (if outsourced). † Develop an engagement capability (either directly or through outsourcing). † Participate in the development of policy, regulation, and standard-setting (such as promoting and protecting shareholder rights). † File shareholder resolutions consistent with long-term ESG considerations. † Engage with companies on ESG issues. † Participate in collaborative engagement initiatives.

† Ask investment managers to undertake and report on ESG-related engagement.

Principle 3. We will seek appropriate disclosure on ESG issues by the entities in which we invest.

Possible actions: † Ask for standardized reporting on ESG issues (using tools such as the Global Reporting Initiative). † Ask for ESG issues to be integrated within annual financial reports. † Ask for information from companies regarding adoption of/adherence to relevant norms, standards, codes of conduct, or international initiatives (such as the UN Global Compact). † Support shareholder initiatives and resolutions promoting ESG disclosure.

Principle 4. We will promote acceptance and implementation of the Principles within the investment industry.

Possible actions: † Include Principles-related requirements in requests for proposals (RFPs). † Align investment mandates, monitoring procedures, performance indicators, and incentive structures accordingly (for example, ensure that investment management processes reflect long-term time horizons when appropriate). † Communicate ESG expectations to investment service providers. † Revisit relationships with service providers that fail to meet ESG expectations. † Support the development of tools for benchmarking ESG integration.

† Support regulatory or policy developments that enable implementation of the Principles.

Principle 5. We will work together to enhance our effectiveness in implementing the Principles.

Possible actions: † Support/participate in networks and information platforms to share tools, pool resources, and make use of investor reporting as a source of learning. † Collectively address relevant emerging issues. † Develop or support appropriate collaborative initiatives.

Principle 6. We will each report on our activities and progress toward implementing the Principles.

Possible actions: † Disclose how ESG issues are integrated within investment practices. † Disclose active ownership activities (voting, engagement, and/or policy dialog). † Disclose what is required from service providers in relation to the Principles. † Communicate with beneficiaries about ESG issues and the Principles. † Report on progress and/or achievements relating to the Principles using a “comply or explain” approach. † Seek to determine the impact of the Principles. † Make use of reporting to raise awareness among a broader group of stakeholders.

MORE INFO Websites: Extractive Industries Transparency Initiative (EITI): eiti.org Principles for Responsible Investment (PRI): www.unpri.org Transparency International: www.transparency.org United Nations Environment Programme Finance Initiative (UNEP FI): www.unepfi.org United Nations Global Compact (UNGC): www.unglobalcompact.org United Nations Global Compact “Progress & Disclosure” section—includes page on the annual Communication on Progress (COP) reporting: www.unglobalcompact.org/COP/ See Also: Ethical Funds and Socially Responsible Investment: An Overview (pp. 481–483) Viewpoint: Green Investing—Looking beyond the Financial Metrics (pp. 492–493) Viewpoint: Outperformance through Ethical Lending (pp. 546–548)

“Those who invest only to get rich will fail. Those who invest to help others will probably succeed.” Art Fry

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Viewpoint: The Companies Bill, 2012, and its Impact on the Future of Corporate Social Responsibility in India by Sudhir Singh Dungarpur INTRODUCTION Sudhir Singh Dungarpur is partner and head of the development sector practice at KPMG in India. He has over 18 years’ global experience working in both start-ups and large multinational corporations in the areas of technology, education, and consulting. Sudhir’s strength lies in developing new businesses and he has successfully built new divisions and businesses in highly competitive environments. Building strong relationships and networks, a clear control on market dynamics, and creating the best teams has ensured that Sudhir has delivered consistent results in growth, revenue, operational performance, and profitability.

BACKGROUND TO THE INDIA COMPANIES BILL, 2012

The peril of socio-economic inequality has become an urgent priority in India, especially over the last decade. Inequalities vary from region to region, between rural and urban populations, between social and ethnic groups, and most obviously between the rich and the poor. It is in recognition of these challenges that the Indian government has repeatedly articulated its commitment towards “inclusive growth.” There has also been a widespread recognition that critical to the push towards “inclusive growth” is the participation of a wide range of stakeholders in designing, financing, implementing, and evaluating development interventions.

With the Companies Bill, 2012, passed in the Lok Sabha in December 2012, discussions on its impact on corporate India have been gathering steam. The Companies Bill states that companies with a specified net worth, or turnover, or net profit during any financial year shall constitute a Corporate Social Responsibility Committee of the board of the company, and, accordingly decide the strategy and spend on corporate social responsibility (CSR) activities.

In this article, I outline the opportunities for CSR in India and the priorities on which companies should focus in the new regulatory regime. Companies should view this as an opportunity to expand their scope and reach towards society at large, by transforming themselves into model corporate citizens. This may very well be achieved through a strategic approach towards CSR and by incorporating rigorous standards of effectiveness in the projects funded as part of its CSR interventions.

CORPORATES AND INCLUSIVE GROWTH

India ranked a lowly 134 out of 187 countries in the UN Human Development Index 2011, with 30% of its population

estimated to be living below the poverty line. Over the last decade therefore addressing socio-economic inequality has become an urgent priority in India. In its endeavor to counter this inequality among citizens of the country, the Indian government has initiated various social-sector schemes in education, public health, food security, and livelihood support in order to reach out to the poorest of the poor and facilitate their socio-economic development. At the same time, there has been a widespread recognition that critical to the push towards “inclusive growth” is the participation of a wide range of stakeholders in designing, financing, implementing, and evaluating development interventions.

The society looks at the corporation as a social organ for wealth creation. Peter F. Drucker had in the 1950s eloquently said that “even the most private of business enterprise is an organ of society and serves a social function . . . the very nature of the modern business enterprise imposes responsibilities on the manager . . . it can no longer be based on the assumptions that the self-interest of the owner of property will lead to public good, or that the selfinterest and public good can be kept apart and be considered to have nothing to do with the other.”

There is a growing consensus that companies are expected to contribute to the welfare of the society in which they operate and wherefrom they draw their resources to generate profits. To meet its goal of inclusive growth, the Indian government has mandated CSR for all companies, including the private sector, through a statutory provision in the Companies Bill, 2012. This is a significant step by the government, given that in most developed economies there are hardly any jurisdictions mandating an allocation towards CSR. By and large, it is a voluntary initiative by the corporate sector. And while in countries

like Denmark, Sweden, and France reporting on CSR practices is mandatory, investing in CSR is not.

INDIA’S COMPANIES BILL, 2012 AND THE EMPHASIS ON CSR

Section 135 of the Companies Bill, 2012 mandates that companies having net worth of INR 500 crore (circa US$100million) or more, or turnover of INR 1000 crore (circa US$200million) or more, or a net profit of INR 5 crore (circa US$1million) or more during any financial year shall constitute a Corporate Social Responsibility Committee of the board constituted of three or more directors, out of which at least one director shall be an independent director. This section also directs the committee to: † formulate a CSR policy; † allocate funds; † monitor the progress of the CSR activities.

The Companies Bill, 2012, further directs companies to ensure the expenditure of at least 2% of the average net profit made during the three financial years immediately preceding the current year, or to specify the reasons for not spending the amount as part of the board’s report to the financial statement.

The Bill therefore attempts to make CSR a sustained and systematic activity by: † mandating the presence of an independent director, thereby encouraging companies to bring in people with specific social-sector expertise and an objective outlook;

“Leaders are almost like midwives of ideas. They really understand what is going on. You know when you come to them with an idea, they aren’t going to just say, ‘Well, that’s nice, and maybe we can use that.’” Warren Bennis

IMPLICATIONS FOR COMPANIES

The new CSR model has moved away from simple social concerns to a model in which generating value for both the society and for the companies go hand in hand. Currently, barring a few notable exceptions, CSR largely comprises voluntary initiatives by companies. One has to recognize that companies have to worry about their bottom line and, therefore, they may not see this as an obligation. The Companies Bill provides an opportunity for companies to develop social businesses and to integrate responsible business activities by making use of 2% of their profits. However, in establishing a sustainable CSR architecture, there are many issues that need to be considered. Three critical ones are set out below. † Identifying Opportunities for Investing in Strategic CSR: In the emerging regulatory regime, companies must make the transition from voluntary, sporadic, CSR activities to a strategic CSR roadmap. The Companies Bill identifies a number of areas (mostly on the lines of the Millennium Development Goals (MDGs) and supporting local projects and contributions to relief funds) from which companies can choose. At the same time, companies must ensure that CSR is strategic—that the CSR activities selected are aligned with the corporation’s core competencies and businesses. This will require professionals, internal and external, who can design programs that have a longterm vision, are mutually beneficial for the company and the local community in which it operates, and are in tune with the country’s priority for inclusive growth. † Delivery Mechanisms for CSR: Broadly, companies can be guided by the provisions in the bill, which allow CSR spending as per the priorities that are in line with the MDGs. At the same time, companies also need to determine how CSR is best done. Is CSR to be undertaken through activities managed directly by the company (employee engagement or a corporate foundation), or through supporting non-government organizations (NGOs), and promising development interventions? The Companies Bill propels macro-level CSR

to become a core business function that is central to the corporation’s overall strategy and success. At the micro level, companies will need to formulate a robust governance structure for their CSR programs. † Making Visible Impact by Doing “Good”: It is clear that companies that take up CSR activities will do so with a dual objective—that of doing good to the society at large, while at the same time gaining visibility for the impact it achieves. Critical to this is the ability to monitor and measure outputs and outcomes of development projects. As for any business investment, monitoring the accountability and performance of CSR activities is the key. For example when building a classroom in a village school, one should assess whether the investment has translated into an increase in enrolment and an improvement in learning. Also, without a robust monitoring system it will be difficult to ascertain where further investments are needed, whether there is value for money, and value-creation for the communities supported, and, most importantly whether the 2% hard-earned contribution is leading to the larger inclusive development agenda of the nation.

IMPACT MEASUREMENT: NEW PARADIGMS

Today, those investing in India’s development sector are under increasing pressure to demonstrate the social impact created through their activities, in a language easily understood by different groups of stakeholders. This applies to companies as they seek to create value through their CSR activities, while seeking to report the impact they create accurately. All around us, we are constantly seeing traditional social-impact methodologies being challenged, as greater emphasis is placed by decision-makers on showing value-for-money and understanding "return on spend" in monetary terms.

For companies, this implies measuring and reporting “return on investment,” an idiom that appeals to the judgment of corporate boardrooms. In this context, the impact-measurement tools used must be innovative, combining rigor with smart reporting. I believe that the important characteristics of an impact-measurement tool should be the following: † a tool that monetizes social, environmental, and financial outcomes of a development-sector project or program, organization, or even a policy, through a combination of Return on Investment (ROI), Cost-Benefit

Analysis (CBA), Opportunity Cost Analysis, and so on; † a participatory tool, and it uses financial proxies to uncover the value of all outcomes, including those that do not have direct market values, and which are often left out of traditional impact assessments; † a tool that goes beyond a quantitative indicator and gives a narrative—of how a project, program, organization, or policy creates and destroys values in the course of implementing a development project.

Further, it must explore the processes and mechanisms by which it attempts to create an impact, thereby yielding lessons for both internal and external stakeholders.

Using impact-measurement tools that bring together the characteristics outlined above requires commitment towards measurement and reporting. Companies must recognize the benefits that accrue from the use of a robust and comprehensive measurement framework. Some of these are as follows: † Gaining a clear understanding of the wider impact: Impact measurement can help understand and account for the wider impact of the work being done as a result of the CSR spend by the company. It further fine-tunes understanding of the potential and actual impacts. † Clear communication of impact: Impact measurement can help to communicate to the stakeholders the value created by time and money invested in the development of interventions in a consistent, robust, and rigorous way (this may be to board members, shareholders, funders, or beneficiaries).

It will show others how valuable the interventions are. † Refinements and improvements: Impact measurement can reveal potential refinements and improvements to enable the company to take informed decisions and support better design, planning, and implementation. † Informed decision-making: An impact measurement analysis can provide a strong basis for internal and external stakeholders to make decisions regarding funding, thus assisting them to recognize impact in a language that they understand. † Stronger partnerships with stakeholders: Impact measurement can help to develop a strong ongoing relationship and dialogue with stakeholders, particularly beneficiaries. Using impact measurement shows beneficiaries that their needs and concerns are being addressed.

“I am I plus my surroundings, and, if I do not preserve the latter, I do not preserve myself.” Jose Ortega y Gasset

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† formulating a comprehensive CSR policy as a strategic engagement, and not an episodic charitable activity; † encouraging companies not only to allocate funds for CSR, but also to monitor (and evaluate) progress and outcomes.

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† Profile raising: Using impact measurement can provide a differentiator for an organization trying to raise itself above its competitors. † Risk management: All of the above factors ultimately support good riskmanagement practices.

CONCLUSION

It is advisable that companies view this new regulatory regime not as a constraint, but as an opportunity to expand their scope and reach by transforming themselves into model corporate citizens. This can be achieved through a strategic approach towards CSR and by incorporating rigorous standards of effectiveness in the projects funded as part of its CSR interventions.

Evaluating CSR programs using rigorous impact-measurement tools can bring a lot of value to companies. It provides a solid foundation with which to communicate simply and effectively CSR results to the board and to other stakeholders. Ultimately, to be ahead in the game, companies must not only engage in strategic CSR, but they must also demonstrate how their investments are creating sustainable value for the society at large.

MORE INFO Book: Drucker, Peter F. The Practice of Management. New York: Harper, 1954.

Websites: India Companies Bill, 2012: www.mca.gov.in/Ministry/pdf/The_Companies_Bill_2012.pdf UN Human Development Index: hdr.undp.org/en/statistics/hdi/ UN Millennium Development Goals: www.un.org/millenniumgoals/ See Also: CSR: More than PR, Pursuing Competitive Advantage in the Long Run (pp. 664–666) Viewpoint: The CFO and the Sustainable Corporation (pp. 719–720) Viewpoint: Embedding CSR and Sustainability in Corporate Culture: The Boots Experience (pp. 671–672) Viewpoint: The Growth of Sustainability Reporting (pp. 680–681) India (pp. 1505–1507)

“Capitalism is at its liberating best in a noncapitalist environment. The crypto-businessman is the true revolutionary in a Communist country.” Eric Hoffer

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Viewpoint: Leveraging Influence to Impact Climate-Change Policy by Mark Kenber INTRODUCTION Mark Kenber is CEO of international NGO The Climate Group. He has worked on climate change for fifteen years and is an expert on international climate policy. Before becoming CEO, he was The Climate Group’s deputy CEO (2010) and international policy director (2004–10). Mark advised former UK Prime Minister Tony Blair in the joint policy initiative Breaking the Climate Deadlock. He is also a carbon markets expert and cofounded the Voluntary Carbon Standard (VCS), now the most popular kitemark for the US$400 million voluntary market. He continues to be involved as deputy chair of the VCS Association. Prior to joining The Climate Group, Mark worked for WWF and Fundacion Natura, Ecuador’s largest environmental organization. Mark currently sits on the Climate Change Advisory Council at Zurich Insurance (since 2009), BP’s targetneutral Assurance and Advisory Panel (since 2007), the Climate Policy Editorial Advisory Board (since 2005), and the Institutional Investors Group on Climate Change Steering Committee (since 2005). Mark has a degree in economics and an MPhil in development studies.

The Climate Group’s mission is to use its ability to influence positive action on climate change wherever it sees the opportunity. How did this initiative begin?

In mid-2003 Michael Northrop, Program Director at Rockefeller Brothers Fund, was concerned that the United States had pulled out of Kyoto. He wanted to ensure that not everyone in the United States got tarred with the same brush, and to show that there was real concern in the United States about the potential adverse impacts of climate change.

However, he also saw clearly that for US companies to participate positively in actions to alleviate climate change, the fundamental thrust had to switch from one that viewed climate-change initiatives as a cost burden on companies to one that saw it as an opportunity. As a result, The Climate Group was launched in April 2004 with the simple mission to change the perception of climate change from burden-sharing to opportunity.

The key to doing this was—and continues to be—our ability to demonstrate in project after project that specific climate-change initiatives bring real benefits to the participating parties. One of our earliest initiatives was the C40 Network, a network of 40 of the world’s most populous cities, all committed to pushing through initiatives to lower their carbon footprint as cities and to look at ways of making their cities run more efficiently by utilizing and disseminating best practice between themselves.

The C40 Network became independent and now runs its own affairs, but it all began when Ken Livingston was the Mayor of London, about the time of the G8 meeting in 2005. We worked with the office of the Mayor of London to produce an initial C20 group of global cities, but it grew very rapidly

from there. Now, despite the name, which has stuck, the C40 Network has around 60 city members that exchange best practice and support each other. That is a pretty fair indication of the kind of project that The Climate Group has been active in promoting.

Our aim is always to find interaction points where a combination of our own network of members and interested parties, and our combined skills can have the biggest impact in promoting action on climate change.

The C40 Network was a very impressive initiative. What were the others?

We created the Verified Carbon Standard (VCS). This too, is now a fully independent organization on whose board I sit. VCS was founded to provide a robust quality-assurance standard that various projects could use to quantify greenhouse gas (GHG) emissions. The program is still evolving to meet the needs of the market, but its mission is to provide a trusted, robust, and userfriendly way of bringing quality assurance to voluntary carbon markets. It aims to pioneer innovative rules and tools that open up new avenues for carbon crediting and that will allow businesses, not-for-profit organizations, and government entities to engage in very specific, measurable climate action.

The aim too, is to share knowledge and to encourage the uptake of best practice in carbon markets, so that markets develop along coherent and compatible lines, even as top-down regulations are being developed.

Another major project of ours, one that is still very much in play, is the light-emitting diodes (LED) street-lighting scheme. The LED street-lighting campaign started when we realized that while consumers were taking up LED lighting and enjoying very substantial

“Conservation is business too.” Gaston Vizcarra

savings, as well as lowering the overall carbon footprint of their homes, this was simply not the case in many public spaces. Street lighting, which can be very successfully addressed with LED lighting, was simply being ignored and the opportunity was not being adopted. So we formed a working party to look at the barriers to take-up and to look at how we could overcome such barriers as there were out there. The opportunities were huge, and ranged from Sydney, to Central Park in New York, to Calcutta. We looked to see if we could come up with a model that would enable 15 pilot projects in 12 major cities to be scaled up their take-up.

The first problem any city fathers face is that initially it costs more, since the upfront costs for LED lighting are higher than for a sodium bulb, for example. But what we sought to impress upon city authorities was that you get the costs back over two to three years, and you make very substantial savings on your power usage, and you enjoy a significant lowering of your carbon footprint. Another problem that we faced, straight away, was that the quality of a light bulb has for decades now been measured by the amount of electricity it consumes. So we expect a 40W bulb to be dimmer (that is, of a lower quality) than a 100W bulb. Moreover, if you measure yellow light instead of white light, more often than not the instruments that you are using are not suited to giving you an accurate view of the quality of the light output of the yellow LED. The way in which we addressed this issue in Calcutta, for example, was first to have a pilot scheme of 150 LED street lights and then to do surveys of the views of women and children who were using an LED-lit park. What emerged was that they felt significantly safer with the LED lighting. That was very interesting.

One still meets global-warming skeptics out there, including some scientists. They are headed in a diametrically opposed direction to your initiatives. What do you say to them?

We are aware that a “rubbishing-climatechange” lobby exists. I have been in debates with exponents of this view over the years, but in reality theirs is not a serious voice. The overwhelming scientific and anecdotal evidence points to the fact that climate change is happening and happening because of our industrialization. What we try to emphasize, however, is that irrespective of whether you are a believer or a skeptic on climate change, the opportunities that come from shifting to a more carbon-conscious framework have a positive internal rate of return, with or without climate change. A lot of the things that have been done, such as the LED-lighting initiative are good in and of themselves. The LED bulbs simply produce a better quality of light and are more power-efficient. A shopkeeper in Calcutta, for example, told us that switching from the old sodium lights to LEDs made his products look fresher to potential purchasers, so he sold more! The fact is that there is a whole range of things that it is absolutely important to do, including transitioning from an oil-based economy, even if the whole climate-change issue was proved to have been misconceived. A lot of what we do concerning low-carbon solutions have very positive immediate returns, create profits by doing things more efficiently, and lead to a better life. The climatechange argument is not necessary to make this worthwhile. There are other projects, of course—such as carbon capture and storage— that cost a huge amount of money to implement and you need to have a broad consensus on the importance of introducing fairly dramatic measures to combat climate change if you are going to get these projects to happen. Our role, however, is not to argue with the skeptics. We focus on categorizing the many opportunities that do exist.

What we have seen, without a shadow of doubt, is that if you look at climate-related

insurance claims in the 1980s and compare them to recent levels of claims, it is clear that climate-related claims have gone up six-fold in three decades. Then there is the drought effect in many countries that has been predicted as one of the consequences of global warming. Drought cost 1% of US GDP through 2012, and those sorts of things are pretty consistent with what the theory of global warming says we should expect. The overall pattern is very conformant with what the Intergovernmental Panel on Climate Change’s (IPCC) climatechange model says should happen.

However, if you just take it down to common sense and look at it from the positive side, every additional dollar invested in clean energy can generate three dollars in future fuel savings by 2050, so there are a lot of areas where carbon reduction makes real economic sense, whatever your views on climate change. A householder with a well-insulated house, for example, has a more comfortable house and one that costs less to heat, and in a world where energy bills are going up year on year, that matters. There are numerous examples of this at city and at state level. If you live in Beijing, for example, and have to put up with particulate matter that is 40 times higher than the World Health Organization recommends it is palpably clear that there would be strong collateral benefits to reducing the city’s level of carbon pollution.

How do you go about giving structure to your work when it is so project-based?

We split our work into two parts. The first part involves the strategic communications dimension. This looks at the way you can change the mindset of political and business decision-makers on issues such as giving leadership on low-carbon initiatives, on renewables, and on investment programs.

Already it is clear that companies that take a leadership position on green strategies are more successful than their peers. A study by the Harvard Business Review showed this quite clearly. We now have just over 40 corporate members of The Climate Group and 60 state and regional members. We also work with a number of cities and we have other institutional partners, ranging from The World Bank to the European Climate Community. There is a whole range of organizations that we work with to identify blockages and barriers to low-carbon initiatives and to see where there are significant low-carbon opportunities that are not being taken up. Then, the second part of our work kicks in and we form a project that helps to overcome those barriers and blockages.

For example, it is clear that there are significant barriers still in the way of a wider

take-up of electric vehicles. So we are looking into the feasibility of fleet-goods owners forming a procurement alliance to bring down the cost of electric vehicles to their members. Another factor here is looking at predictable short routes, so there is no anxiety about power running down and no range anxiety. The fleet charges up at the depot, so there are no refueling issues associated with the absence of recharging stations for electric vehicles. The aim is to choose the battles that we fight fairly carefully and to bring our network of partners together to help identify opportunities and problems. It is a very pragmatic approach and has real successes to point show.

What else are you working on now that holds out significant promise?

We are currently looking at the policy barriers to using IT to accelerate and scale-up energy efficiency and clean energy. We are looking, for example, at the way cities and corporates procure their energy solutions and at the way they use IT to run sustainable-energy partnerships. Right now we are pretty wellknown in the climate-change space and in the subset of the corporate community that is already well-engaged with sustainability issues. However, the challenge is to build recognition beyond this space. That is true not just for us, but for many climate-change organizations who are looking at how to resonate outside their established niche. Our solution is to seek continuously to partner with organizations that are not yet part of the climate-change space. There actually is a tremendous willingness by people who are not committed climate-change activists to get involved. The Climate Group hosts Climate Week NYC every year, which is a series of events, and in 2012 it was astonishing to see how many sectors and communities—from farmers’ organizations to veterans’ groups, to bankers and electricity companies—were involved. They were motivated by a very wide spectrum of reasons, and it is very encouraging to see just how much energy and willingness there is out there, waiting to be tapped.

MORE INFO Websites: The Climate Group: www.theclimategroup.org Verified Carbon Standard (VCS): www.v-c-s.org See Also: Climate Change and Insurance (pp. 149–150) The Impact of Climate Change on Business (pp. 875–877)

“Study how a society uses its land, and you can come to pretty reliable conclusions as to what its future will be.”

Ernst Friedrich Schumacher

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Best Practice Governance and Ethics

Calcutta is now negotiating a loan to scaleup its project from 150 LED bulbs to 15,000 bulbs, and Sydney has committed itself to full LED street lighting. To summarize this project, our undertaking of pilot studies allowed city authorities to see in a tangible way the realities and the benefits of LED lighting. This now has some momentum of its own, so we are not planning and do not intend to do any more pilot studies. What we do now is to help a few states to prepare their tenders for LED street lighting, but we feel quite confident that we have done our bit in terms of demonstrating and catalyzing the potential out there.

Published 29 August 2013 The one-stop finance resource, fully revised to include 70 new articles covering reputation, management, developments in ESG, asset-liability management, and corporate auditing. Ideal for finance practitioners, corporate strategists, planners and investors.

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