August 21, 2012
In 2011, the California Public Employees' Retirement System (CalPERS) adopted a "total fund" approach to sustainable investment, through which it committed to integrate the analysis of its portfolio companies' environmental, social, and governance (ESG) performance into all of its investment strategies. Like other pension funds or foundations, CalPERS has long-term liabilities and a fiduciary duty to its members, which, for CalPERS, is set out in California's constitution. By taking a wider perspective and by incorporating ESG criteria into its investment-decision process, CalPERS believes it can increase the financial performance of its portfolio and better achieve the long-term, risk-adjusted returns on which its members rely. For CalPERS' portfolio companies, this means their ESG performance is under greater scrutiny. For example, the pension fund will pay particular attention to a company's governance structure because poor governance often translates into poor decision-making and a decline in shareholder value. In another example, CalPERS will closely monitor emerging-market companies to ensure no infringement of social and human rights principles. CalPERS, with its focus on ESG integration, is not alone among mainstream investors—even in today's relentlessly short-term-focused economy. As evidenced by the growing number of UN Principles for Responsible Investment (UN PRI) signatories, asset owners and investment managers are embracing sustainable investing. As of June 2012, the 1,100 UN PRI signatories collectively represented US$32 trillion of asset under management, or 25 percent of the world's total financial assets. Two key drivers are leading this trend:
- Demand from asset owners is rising. Globally, asset owners, including pension funds and insurance companies, are leading the way by adopting ESG integration strategies for their entire portfolios. Altogether, asset owners hold US$65 trillion, or about 35 percent of the world's financial assets.
- ESG indicators are seen as increasingly material. When a growing percentage of a company's market value can be attributed to intangible assets, mainstream investors are increasingly looking at the ESG performance as a way to improve their financial performance. According to the International Integrated Reporting Council (IIRC), this has increased from 17 percent to 80 percent in between 1975 and 2010 for S&P 500 companies. This means there is a need for a wider set of indicators to help investors identify potential risks and opportunities.
Implications for Listed Companies
For listed companies, long-term investors constitute a more attractive investor base. While short-term investors have exacerbated what Dominic Barton of McKinsey describes as "quarterly capitalism," long-term investors allow companies to reconnect their investment strategies with the real needs of their business. There are three main reasons why long-term investors are valuable to companies:
- Establish the foundation for sustainability: While mainstream investors generally analyze financial performance on a quarterly basis, it takes more than a quarter for companies to harvest the benefits of their sustainability efforts. Furthermore, implementing a successful sustainability strategy includes building future markets and preparing for future resource constraints. Both require near-term costs that can be adequately assessed only with a long-time perspective.
- Align investment and business cycles: Similarly, R&D, capital investment programs, or even advertising necessitate a time horizon longer than a quarter. As IBM's former CEO, Sam Palmisano, once told McKinsey's Barton: "I can easily make my numbers by cutting SG&A [selling, general, and administrative] or R&D, but then we wouldn't get innovations as we need."
- Reduce costly share turnover: By holding shares over a longer period of time, long-term investors reduce share turnover that is costly for companies.
How to Attract Long-Term Investors
At BSR, we see real opportunities for listed-companies to attract long-term investors by enhancing and communicating their ESG performance. What follows are four recommendations for listed-companies to further integrate sustainability into their business and improve their ESG communication to investors. 1. Avoid the "quarterly capitalism" culture. Harvard Business School research shows that firms focusing more on the short term have (not surprisingly) a more short-term-oriented investor base. Therefore, by avoiding sending short-term messages to investors, companies have a better chance to attract investors with a longer-term perspective. This can be done in two ways:
- Avoid the default practice of quarterly-earnings guidance. Pressured by financial markets, companies commonly issue quarterly earnings guidance—a default practice that diverts their attention from long-term strategies. After observing such distortions, Unilever CEO Paul Polman announced in November 2010 that his company would stop giving quarterly earning guidance to focus on the development of a more sustainable business model. In doing so, the company has signaled to the market the types of investors it wishes to own its shares. Coca-Cola and Ford have adopted similar policies.
- Align compensation structures with long-term, sustainable performance. According to both Generation Investment Management's David Blood and McKinsey's Barton, most compensation structures disproportionately emphasize short-term performance and fail to hold managers accountable for the long-term impacts of their actions. Too often, executive compensation is structured to reward a leader for making it to the top and not for what he or she has actually done for the company. To foster greater alignment between executives' concerns and long-term performance, companies should anchor compensation structures to the fundamental drivers of long-term value creation.
At Danone, executives' bonuses are based on economic, societal, and managerial objectives. While economic and managerial criteria are similar to other organizations, societal objectives consist of two parts: On the environmental front, executives are evaluated on the reduction of the carbon footprint of the activity they are responsible for; on the social front, they are evaluated based on the rate of work injuries, as well as on the number of training hours and the development of employee talent.
2. Integrate ESG into the business model. Whether companies have the ability to generate the sustainable growth long-term investors look for depends on their ability to think about ESG as an integral part of their business model and strategy. This can be accomplished in two ways:
- Integrate sustainability into corporate strategy with C-level and board support. For many companies, corporate and sustainability strategies are independent from each other. Integrating them requires developing a strategic vision for delivering sustainable value to all stakeholders. Because such strategic redefinition might impact a company's core business model, it requires involvement from top management. Clear governance and accountability structures are also necessary. Royal Dutch Shell and HP are among the companies that have dedicated board committees to manage sustainability issues.
- Integrate ESG into core products and services. Increasingly, long-term value creation is determined by a company's ability to build new modes of collaboration and new ways of thinking into the development and delivery of products and services. Nike, through its Considered Design approach, aims to reduce its environmental footprint by designing fully closed-loop products. These products are developed with the fewest possible materials and are designed for easy disassembly, allowing them to be recycled into new products or safely returned to nature at the end of their life.
3. Identify and communicate issues that are material to investors. While an increasing number of companies publish CSR reports, they usually fail to effectively communicate to investors on the issues that have the greatest potential impact on their business. This can be improved in two ways:
- Implement a materiality-assessment process. One way companies can demonstrate the quality of their management and risk systems and articulate a broader understanding about the global context in which their companies operate is to identify and communicate their most material ESG risks. Companies should understand which ESG issues have the most material impact on their business and be able to communicate to investors how those issues will impact long-term financial performance.
- Focus the discussion on issues that matter to investors. Companies should also recognize that different investors prioritize different issues. They should understand which issues their investors care most about, and tailor their communications accordingly. For example, when talking to pension funds, investor relations officers should take time to talk about the governance performance of their company and articulate how strong governance allows the company to nurture long-term value creation.
4. Improve ESG communications channels. A challenge for many companies is explaining the benefits of their sustainable business strategies to shareholders. On the one hand, while investors constitute a single audience, most companies use separate channels to communicate about their financials and ESG performance. On the other hand, most investors rely on third-party rating agencies to analyze companies' ESG disclosures and do not ask companies for ESG information. By directly communicating on ESG, companies can explain to investors how their sustainability strategies translate into long-term financial performance. This can be done in a few ways:
- Incorporate ESG into the investor relations team mandate. To foster better ESG communication, companies should encourage their investor relations team to gain knowledge about the company's most material ESG issues, and learn how they are being addressed. CSR teams should also look for ways to join investor relations in ESG conversations with investors. For example, Intel organizes an annual SRI/ESG "road trip." Investor relations should also be encouraged to actively court long-term investors rather than answering only current investors' inquiries.
- Adopt integrated reporting. Integrated reporting links a company's financial and nonfinancial performances into a unique report. It also provides a framework for companies to consider sustainability as an integral part of their business strategy.
- Monitor the quality of ESG information supplied to investors. Since most investors rely on third-party rating agencies to analyze companies' ESG disclosure, companies should also evaluate the amount and quality of information they supply to the market.
While financial markets globally have undergone substantial stress and change, an increasing number of mainstream investors see ESG integration as a way to improve their long-term financial performance. This trend offers companies opportunities to reduce their shareholder turnover, better align their investment strategy with the real needs of their business, and lay the foundation for a sustainable future. We have outlined four recommendations for listed companies to enhance and communicate their ESG performances. Concurrently, we continue to look for opportunities to advance the ESG dialogue and to reduce the remaining barriers to ESG integration into mainstream investments. For more detailed information on this topic, read our new paper on "Trends in ESG Integration in Investments," or contact Laura Gitman.
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