Sustainability is a dreadful word. It originated as business’ answer to the global policy push to sustainable development - leaving future generations with the same or better opportunities as past ones.
But this morphed into ‘corporate sustainability’, was abused to mean ‘sustainability of the corporate’, then petered out into a morass of acronyms and general suspicion of do-gooders wanting to take the oomph out of capitalism.
So, let’s ignore the word and focus instead on what it offers and why. Quite a few interesting strands of investment theory, corporate governance and industrial history come together, with sometimes surprising results. In recent years, the financial community has sidestepped the S-word by introducing ‘ESG’ — the Environmental, Social and Governance or ‘non-financial’ performance factors of a firm. And investors are becoming increasingly impressed by these factors, and their revealed impact on financial performance.
Firms need healthy markets
The value of good corporate governance is relatively well understood. You wouldn’t want to invest in a company that gave you little comfort that it would spend your money wisely and accountably. The company may destroy value, in the parlance. In this case, your cash.
But what if the company was risking or destroying value elsewhere? What if it were running down social or environmental capital? What if it were relying on those ‘externalities’ to underwrite its own business model?
That might not concern the company’s shareholders if they had only that single identity. But they don’t. They may hold shares in other companies that may in turn depend on social and environmental capital. As individuals or institutions, they may see their taxes being spent to protect or restore social and environmental capital. As individuals, they may themselves benefit from that capital, or acknowledge that their families depend on it, and will do so for generations.
BP’s 2010 Deepwater Horizon disaster in the Gulf of Mexico is an extreme example of an all too frequent case. Incalculable social and environmental harm has been ‘rounded down’ to BP’s US$20 billion compensation fund, its US$3.2 billion clean-up costs, and its US$60 billion loss of equity. Could an investor have predicted such losses? Perhaps not. But they could have known that BP oil refineries had accumulated 760 ‘egregious wilful citations’ from the US health and safety authority in the three years prior. Quite a lot. In case you think otherwise, the rest of the US oil industry, together, had only one. ESG analysts identified this gap and advised investors to sell.1
In fact, with a little thought, most companies realise that they themselves depend on the health of the economies, societies and ecologies in which they operate. People don’t buy much in broke, anarchist desolation, however good a backdrop for Mad Max 5 it may be. In the long run, if you rely on cheap social and environmental externalities, you run down your own markets.
Firms that support healthy markets do better
Investors are taking a closer look at such risks. Repeated analyses are showing that a company that manages its social and environmental issues well, outperforms the market, all else being equal. So across portfolios, funds that take these factors into account outperform their peers.2
Institutional investors are very comfortable with this. They take a portfolio-wide view: if a company creates no real value by ‘winning’ only at the expense of another, there is no net gain to their portfolios. Accordingly, they are demanding more information on firms ESG performance.3
Governments are also comfortable with this. They take a similar economy-wide view: if a company ‘wins’ only by not paying for a public or environmental good, society has to pick up the tab. Accordingly, they are reviewing corporations law to clarify that directors should take social and environmental issues into account in their decisions.4 As well, most legislation since 1992 has had ‘sustainable development’ in its objectives clause, so that those who partner with or supply to a government entity may have to show that they are supporting that objective
Employees are also comfortable with this. As well as employees, they are investors, citizens and consumers. Ideally, they could align the interests of these split personas. If they’re too far out of whack, it’s awkward – the famed BBQ test might be failed. Accordingly, companies that transfer costs to others – notably tobacco companies – have to pay far more than market rates for people to work for them.
Objections have been overcome
Among each of these stakeholders, there have been strong voices reacting to what they see as ‘the imposition of irrelevant responsibilities’. It hasn’t been the shrill calls of external do-gooders that have silenced these doubts, rather it’s the business case being repeatedly proven. By better managing social and environmental issues, risks are being avoided and opportunities are being taken.
Some investors relied on financial theory to argue that imposing any ESG constraint would limit the investment universe, and so necessarily reduce returns. Cannier investors were happy to limit their investment universe by preferring good managers. Investors that incorporate ESG factors well also see lower risk for the same returns.5
Some directors (or those claiming to speak on their behalf) claimed it was their legal duty to maximise the profitability of the firm, so that considering ESG factors may breach that duty. Lawyers quickly replied that, in fact, their duty was to the best interests of the company as a whole, and that included future shareholders. Further, while directors should use their business judgment to determine what to do about social and environmental issues, ignoring them may be extremely poor risk management, possibly in breach of their duties
Some conservative think tanks spent energy in the 1990s attempting to influence public policy against the consideration of social and environmental issues by corporates. They have been singularly unsuccessful since, as noted above, it is the free market that has decided to incorporate ESG factors, not governments.
Some employees have felt constrained from engaging on social and environmental issues or have actively rejected the notion as a distraction from their core business, which is hard enough already. But, once they’ve seen that management will support sensible initiatives, employees at all levels have been among the strongest advocates of social and environmental engagement. With tacit or explicit approval, they can sensibly apply their firm’s resources to relevant social and environmental issues, to benefit the firm, the issue and their own professional development.
Curiously, CEOs have been among the quickest employees to accept the value of ESG efforts. Their responsibility includes looking beyond the horizon to the emerging business environment, and they can see how social and environmental issues are constraining their firms and providing it with opportunities. Compared with middle managers, they are more likely to be good systems thinkers – to see how one thing leads to another – and have the freedom to consider and act on those second-, third- and fourth-order effects over a longer time frame.
First published in the Governance Industry of Australia's Keeping Good Companies, May 2012
Read part two of the article here.
- Morris J and Pell, MB, 2010, 'Renegade Refiner: OSHA says BP has "systemic safety problem", www.iwatchnews.org/2010/05/17/2672/renegade-refiner-osha-says-bp-has-%E2%80%9Csystemic-safety-problem%E2%80%9D [4 April 2012]. That statistic rang alarm bells among some ESG-led investors, but not enough. Similarly, the ESG research firm Invest expressed concern about AAA investments laid over 'ninja' (no income, no job, no asset) loads, nine months before the emperor's clothes came off in September 2008
- Morningstar, Australian fund performance over one, three, five and seven years to 30 June 2011
- Through the principles of Responsible Investment, the Equator Principles, the Carbon Disclosure Project, the Water Disclosure, the Enhanced Analytics Initiative, and myriad other investor-led calls for disclosure
- In the UK, this is now a positive obligation under the Companies Act
- Superannuation funds are a special case here. Their trustees recognise that they're investing for their beneficiaries over ten to 40 year time frames, and that superannuation contributions are mandated by society through the voice of its legislature. It makes sense then that superannuation fund investments take into account the longer-term social and environmental investments