Democracy as an ESG issue: Promoting strong democratic institutions
Tuesday, November 3, 2020
Tuesday, November 3, 2020
A deep dive of sustainability topics with Ethic's lead data scientist
Democracy as an ESG issue: Promoting strong democratic institutions

You could be forgiven if you looked at the news in 2020 and, at least once or twice, felt distinctly discouraged about the state of global affairs. Aside from the obvious tragedy of an ongoing pandemic, this past year we’ve witnessed an outbreak of religious violence buoyed by a far-right nationalist agenda in India; escalating attacks on media, academic, and religious freedoms in Hungary; a constitutional crisis regarding judicial independence in Poland; and ongoing protests elsewhere such as Chile, Belarus, and Hong Kong. Here in the United States, we’ve experienced civil unrest and increased political polarization that is unlikely to abate as we near a general election.

No matter your political leanings, the erosion of civil liberties appears to be a trend that warrants attention: the Varieties of Democracy Institute at the University of Gothenburg has noted that, for the first time in almost 20 years, autocratic regimes are now in the majority. Meanwhile, in major democracies, a creeping autocratization has been characterized by government attacks on civil society, freedom of speech, independent media and even elections themselves.

As an advisor, you might feel that tackling such overwhelmingly global issues lies far beyond your purview. Sure, you might vote for—and even donate to—political candidates that you feel best represent your interests and those of your community. But what about when your clients approach you and expressly ask you how they can use their portfolios to support democracy and human rights around the world?

Why it matters

At Ethic, we believe strong democratic institutions are of fundamental importance in promoting the material wellbeing of people around the globe. Although not always perfect, democracies offer some well-documented benefits to their citizens. There is evidence that links improved democratic institutions and civil liberties with reductions in inequality, increases in government spending on public programs, growth in secondary school enrollment, as well as a wide range of improved health outcomes. In addition to these material benefits, the ideal of civic participation is simply a value held by many investors around the world, likely in part because greater levels of democracy are linked with greater stock market returns.

We’re committed to helping our clients understand how democratic institutions can be undermined by corporate actions. Here’s our primer on how the companies you invest in might be supporting, or stymying, the integrity of global democracies:  

Climate Change

Climate change is one of those sustainability topics that intersects and overlaps with numerous other issues, and democracy is no exception. After all, our very survival as a species is predicated upon the existence of safe and habitable living conditions, which are likely to be increasingly threatened by climate change. Rising global temperatures are already exacerbating existing inequalities, but could also “impair the productive capacity of the economy and undermine its ability to generate employment, income, and opportunity.”

Earlier this year, a panel of national security, military and intelligence experts released a report concluding that, in the event that global warming is not slowed considerably, the world will experience destabilizing changes that significantly threaten security environments, infrastructure, and institutions. The same report contended that, in areas that are already feeling the most severe effects of extreme weather, competition over access to water, food, and other economic resources is likely to intensify, pushing already-fragile states to the brink of conflict.

As we have seen this year, amid catastrophic wildfires and a historic hurricane season, the United States is certainly not immune to the damaging effects of climate change. Extreme weather events and their aftermaths are expected to destabilize existing security infrastructure and the very institutions on which international security relations depend, while also exacerbating existing divisions within society and providing a fertile breeding ground for anti-democratic, isolationist views.  

The business sector, of course, has an outsized role to play in combating climate change. Companies can lead the way when it comes to embracing greener technologies, identifying new ways to limit emissions throughout their own business operations and supply chains, and embracing climate-friendly legislation. And this is no longer solely a moral pursuit—as we’ve written previously, the financial risks presented by climate change are very real and stand to affect companies across diverse industries.

Corporate Governance

As many came to realize in the wake of the 2007-08 financial crisis, corporate governance shortcomings at major companies can have profound and lasting effects on the overall health of the global financial system. Crucially, the burden of the last recession fell largely on the shoulders of those least able to bear it: millions of lower and middle-class families, whose household finances were affected by the excessive risk-taking of a privileged few. In the United States alone, it’s estimated that some 8.8 million jobs in the United States were erased as a result of the crisis, representing an estimated $19.2 trillion in lost household wealth.

One of the many legacies of this crisis was an enduring distrust for public and financial institutions. In October 2008, the month after the shocking collapse of Lehman Brothers, global dissatisfaction with the functioning of democracy jumped by around 6.5 percentage points—and has deteriorated ever since. Some have argued that the financial crisis, and the deep inequality it exposed, is among the factors that has fueled a growing wave of populism in Western nations.

Although the underlying causes of the crisis were myriad and complex, numerous studies have pointed to the role of weak corporate governance structures in creating ideal conditions for a market collapse. Shortcomings identified include “board independence issues, weak systems of  management control, focus on short-term performance goals (and related executive  compensation packages), weak code of ethics, and opaque disclosure.” In addition, a separate study of subprime lenders underscored the vital role that board member experience and expertise plays when it comes to adequately evaluating and circumventing financial risks. Even Lehman Brothers’ former chief risk officer, whose concerns were reportedly dismissed by upper management at the firm, reflected that her experience at the firm has underscored the importance of good governance: “Leadership is about doing the right thing, and no one should go unchallenged when they are about to make a questionable decision. This culture of checks and balances is still lacking in many organizations.”

At Ethic, we look to companies that prize independence, accountability, experience and diversity at the board level. We also seek to identify those that are implementing policies to protect internal whistleblowers, as well as embracing ethical accounting and audit practices—an issue that came squarely into regulators’ crosshairs following the dramatic fall of Enron Corporation almost twenty years ago. It stands to reason that organizations with robust oversight measures, and an emphasis on strong governance, are arguably better positioned to effectively respond to emerging business and regulatory trends, and drive long-term value creation.

Political Lobbying

In the United States, we are no stranger to the influence that corporations wield in our democracy. In 2010, a landmark Supreme Court decision— Citizens United v. Federal Election Commission—expanded the rights of corporations to engage in political speech and campaign spending. And spend they have: in 2019, firms collectively spent more than $3.4 billion on lobbying activities, marking the highest level since the aforementioned decision was handed down.

However, although the U.S. Constitution outlines the right “to petition the Government for a redress of grievances,” the most vulnerable in society tend not to enjoy as much lobbying support as citizens and groups with money and resources. In fact, excessive corporate political influence can have negative societal impacts. For example, lobbying against the American Clean Energy and Security Act, a 2009 U.S. climate policy reform bill, is estimated to have created $60 billion in social costs that could otherwise have been avoided.

Shareholders seeking to gain a greater understanding of the business risks associated with corporate political activity are increasingly using proxy votes to demand greater transparency regarding corporate political spending and lobbying. The subsequent corporate disclosures gleaned can serve to highlight any discrepancies between a company’s public stance on a key issue and their support for political groups that serve to undermine that very cause. They might, of course, simply signal a firm’s tacit commitment to preserving the status quo, suggesting that leadership is not prepared to navigate emerging challenges.

Financial System Stability

Similar to poor governance, inadequate risk management practices can destabilize the financial system which, in turn, can threaten democratic institutions. When Lehman Brothers crumbled, it was in large part due to a systemic pattern of irresponsible lending that had seen the U.S. housing market propped up by non-traditional financial instruments such as collateralized debt obligations. As property prices tumbled, and securities that were tied to the inflated housing market became effectively worthless, it sent ripples through the global economy and led to a devastating fallout that disproportionately affected many of the world’s poorest communities.

Another major risk facing financial institutions is the threat of money laundering: something that has recently made headlines after a revealing investigation underscored the role that banks play in facilitating the flow of illicit money. Money laundering—the process through which criminals and terrorists conceal the origins of their funds in order to make it appear legitimate—is a crime that makes other crimes possible. And the crimes perpetrated by the aforementioned individuals pose a direct threat to economic stability, with the potential to “accelerate economic inequality, drain public funds, undermine democracy, and destabilize nations.” Not only does money laundering empower terrorists, autocrats and kleptocrats at home and abroad, but it often involves funds that might otherwise have been invested in vital infrastructure. In fact, one anti-poverty group estimated that as many as 3.6 million deaths could be prevented each year in the world’s poorest countries were it not for illicit deals concerning natural resources, the use of phantom firms, money laundering and illegal tax evasion activities.

Parting Thoughts

As American civil rights activist Bayard Rustin once said, "If we desire a society that is democratic, then democracy must become a means as well as an end. If we desire a society in which men are brothers, then we must act towards one another with brotherhood. If we can build such a society, then we would have achieved the ultimate goal of human freedom."

Democracy has the potential to foster a more empowered society that provides all its citizens with equal rights and protections …but we mustn’t take it for granted. We the People—yes, that includes advisors and their clients—have a role to play when it comes to preserving civil liberties, ensuring fair and free elections, and protecting checks and balances. Your investment portfolios are just one place to start.

Sources and footnotes
Contributors

Travis Korte is the Data Science Lead at Ethic. Previously, Travis organized civic-minded technologists at Hack for LA and advised a wide range of clients on data science, data policy, and quantitative methods. You can follow him on Twitter at @traviskorte.