California’s Investment Ethics Go Global

What standards should be used in making global investment decisions?

January 1, 2001

What standards should be used in making global investment decisions?

Who in the world could be against ethical investing?

Like low-impact hiking or organic gardening, ethical investing seems to offer a better way — in this case, the promise that justice will be considered as a motive together with profit in making decisions for portfolio allocation.

However, defining the term "ethical" turns out to be more difficult than one might expect. Standards change over time. In the early 20th century, for example, many progressive countries ratified labor conventions protecting women workers.

Decades later, these same conventions were denounced as codified forms of gender inequality.

And emphasizing the "ethical" can be a perfect disguise. Everybody knows that the naked pursuit of self-interest provokes outrage.

The same is not so true for the pursuit of self-interest once it is clad as a "campaign for a better world." In fact, a coat of ethical armor can make self-interest so appealing that it fools even those who wear it.

This brings us to a new — and powerful — attempt to inject ethics into investing.

The protagonist in this story is the California Public Employees' Retirement System (Calpers).

Calpers is not just any pension fund. It is one of the largest such entities in the world, with nearly $150 billion in assets (about as much as the two largest private pension funds combined). It owns shares in numerous companies.

So what has Calpers been up to lately? It had consultants develop investment rules based on a "scientific" system of classifying countries.

Calpers' new rating system has both developing country officials and some advocates for socially responsible investing concerned.

By ruling out whole countries as investment destinations, Calpers' policy effectively denies those countries the capital they need to raise their productivity.

If other investors follow Calpers' lead, some countries could find themselves attracting significantly less investment. This would likely reduce employment — and generally retard the process of economic development.

How does the Calpers system work? It scores each country on three broad features of its economy and four characteristics of its capital markets.

In the past, Calpers has focused on using its weight in financial markets to ensure a solid investment environment.

Because of that, one might have expected the company to ask that extra weight be placed on issues such as the fairness of financial markets and laws in each country.


But that is not the case. In practice, it is the country-wide — more than the market-specific — considerations that make countries unacceptable.

And among country-wide considerations, the category of "Productive Labor Practices" is highly correlated with eventual score. This category measures such things as the ratification of the International Labor Organization's core labor conventions (the United States itself has ratified only two of the eight), local labor law, "institutional capacity" — and "effectiveness of implementation."

It is the final two among these — the least well defined of them — that tend to separate the permissible from the non-permissible countries.

The average score of the "permissible countries" on labor practices is 2.6 (on a scale of 1 to 3). The non-permissible countries manage to score only 1.3.

The final classification of countries into the permissible and non-permissible sets could be approximated with high accuracy with the following rule: "Any country with GDP per capita (corrected for purchasing power parity) below $7,000 per year is not permissible."

For all practical purposes, the system can thus be summarized as "Calpers does not invest in really poor countries." Is this a coincidence?

Perhaps, but the AFL-CIO has been very active in promoting Calpers' investment code — and is enthusiastic about the result. And while the Calpers Trustees may not directly object to competition from very low-wage workers, their investment policy essentially targets the countries where such workers live.

In any case, the net effect of Calpers' policy is to withhold investment from countries with 84% of the total population of potentially eligible countries. Ethical investment in this case is a fancy name for discrimination against poor countries.

Denying them investment capital can only delay the time that they catch up to more developed economies.

This is not to say that ethical judgments always should be excluded from portfolio allocation decisions. There are some very corrupt and poorly ruled regimes and firms out there that might well be susceptible to external financial pressure.

Boycotts and economic pressures surely hastened the end of apartheid in South Africa.

But the evidence from the current Calpers experience underlines the dangers of trying to fine-tune ethical judgments.

Absent compelling evidence of egregious human rights violations (widespread poverty and ignorance are not such evidence), firms in every country should be free to compete for international markets and for investment dollars.

Ruling out investments in entire countries is simply too crude a tool to be effective.