New Metrics

The Next 5 Challenges to Sustainable Investing

Socially Responsible Investing (SRI) is a growing force in markets across the world. According to the US SIF Foundation, the responsible investing market in the US increased 486 percent while the broader US market of professionally managed assets grew 376 percent between 1995 and 2012. SRI investments are generally demand-side driven. More and more investors are looking for vehicles that are aligned with their values and priorities. In 2014, the total Assets Under Management (AUM) of the 1,278 signatories of the UN Principles for Responsible Investment (PRI), which include asset owners, investment managers and professional service partners, totaled $45 trillion. The SRI niche is not going away.

By Malaika Thorne | Published 10 years ago | About a 7 minute read

These investors want to send signals to the market economy regarding the way they want to get things done. For example, the California Public Employees' Retirement System (CalPERS) actively encourages corporations to improve environmental responsibility, examine executive compensation, and include more women and people of color in their boards. Investment beliefs adopted by the CalPERS board affect its organizational culture, and in turn, the organization has intensified its own focus on sustainability. To be a sustainable, prosperous organization, CalPERS’ long-term liabilities must also be sustainable, because some of them will be on their books for nearly 100 years.

But there are other ways that investors are sending signals to financial markets.

Approaches to Measuring and Reporting ESG

Institutional asset managers, including those from public retirement funds, college endowments and alternative investment vehicles, are explicitly incorporating Environmental, Social and Corporate Governance (ESG) factors into investment analysis and decisions. Evaluations based on ESG are different than Impact Investing, although there is some overlap. While impact investments are intentionally organized to generate a specific social or environmental result and a financial gain while measuring its impact, the ESG framework promotes six principles that seek to systematize the investors’ role as a change agent. ESG screening allows them to choose investments based on specific criteria, which can vary according to investor values.

There are no dominant frameworks yet for assessing the value of ESG factors. Some investment professionals rely entirely on financial analysis coupled with positive, negative or hybrid screens. Positive screens allow investors to preferentially invest in sectors, industries or companies based on their activities, products, performance or policies. Negative screens exclude investments based on the areas that fail to meet the general or specific sustainability and ethical concerns of investors, such as a human rights violation record or holdings in tobacco manufacturers. Alternatively, other funds may be thematic whereby investments are selected based on company exposure to themes like water scarcity or climate change.

The Sustainability Accounting Standards Board (SASB) classifies sustainability issues using a refined ESG structure to bridge the gap between traditionally reported information and information that is not usually reported and that may erode financial value. It provides sector- and industry-specific guidance for public companies in the US to disclose and quantify the potential impacts most likely to dampen a company’s ability to create long-term value. SASB seeks to identify the sustainability challenges different industries face by first verifying that there is intense interest in a specific issue, and then quantifying the potential financial impacts from managing or ignoring the issue.

The SASB approach is quite different from the Value Driver Model (VDM), developed by the UN PRI Initiative — a network of international investors — in collaboration with Global Compact LEAD, a subset of the United Nations Global Compact. Sustainable investment analysts such as Viara Nedeva Thompson (MIT Sloan MBA ’08) already incorporate VDM into their financial analysis to select investments. The model is as a voluntary framework that companies and investors employ to communicate the value, in monetary terms, of ESG initiatives to their stakeholders.

It proposes three ways sustainability initiatives can contribute to shareholder value: growth, productivity and risk management. These measures assure relevance to investors' interests.

Return on Capital Employed

This model links sustainability to key business metrics:

Sustainability-Advantaged Growth (S/G) measures a company’s revenue and growth from sustainability-advantaged products (defined in comparison to their own preceding and/or competitors' products). Examples of growth enabled by these products include access to new customer segments, market share gains due to new energy or resource efficient products, or innovations such as compostable packaging.

Sustainability-Driven Productivity (S/P) measures the total financial impact of all sustainability-related initiatives on a company’s cost structure in a given time period. Examples include waste and energy savings due to operational changes or productivity improvements from changes in HR policies.

Sustainability-Related Risk Management (S/R) measures performance over time of the critical metrics that a company believes pose a meaningful risk to their regulatory constraints, reputation (such as supply chain management practices) and revenues from diminishing access to non-renewable resources.

Over time, other metrics may be added to the framework.

Challenges to the ESG Framework

Although sustainable investment professionals around the world continue to evolve the overall ESG framework to effectively allocate value, they face several challenges:

Defining sustainability. The definition of sustainability varies from sector to sector, from company to investor to country and from citizen to citizen. Sustainability must be defined in a way that links action to the mega-trends of planet health, resource availability, and standard of living for human beings, and incorporate externalities in a way that motivates investors and corporations to act quickly.
Framing sustainability value. Investors disagree on the metrics to report ESG-related value. Is profitability enough? While some institutional investors insist that sustainability cannot be considered entirely financial, others embrace the idea of quantifying it in financial terms and using that as a lever to create change. Translating sustainability value into financial value is difficult and there is no standard for it yet. Some industries have already started adopting various approaches to sustainability that buck the impulse to create an apples-to-apples comparisons across companies and products.
Identifying the right levers. Not all cause-and-effect relationships are linear. While a company may decide to invest in a sector or a project based on ESG factors or on the issues it has identified as highly important within a sector, some issues cannot be mitigated by one strategy alone. System dynamics and systems thinking demonstrate the limits of the mental models adopted by managers and investors seeking sustainability, and expose the underlying relationships that create systemic change over time.
Investment horizon. ESG risks and opportunities for publicly traded companies can occur over periods beyond the quarterly financial performance reporting time frame. Investment activities that demonstrate value creation over a 10- or 20-year time frame are not favored by investors. A mid-term or long-term investment horizon can prevent the short-term movement of stock prices from interfering with ESG analysis, but while sustainability and financial goals can be aligned over the long term, they can also work against each other in the short term.
Data quality and access. Calculating ESG is not straightforward. There are variations in the methodologies used and how they are applied. Reporting is not yet robust, as opposed to externally audited SEC filings. Analysts that incorporate ESG into their recommendations must understand the practices that go into reporting, such as consistent data collection and timely updates.

Resources for Effectively Utilizing ESG Factors

Sustainable investment beliefs about risk or uncertainty go beyond volatility. Climate change risks, for example, challenge companies to reconsider the non-renewable assets — such as coal and oil reserves — sitting on their balance sheets. Value-driven investors are asking companies to think about scenarios where those assets become useless in the long run.

A related risk for companies is under-reporting and underestimating sustainability-related risks. While investors using SASB and the Value Driver Model rely on often self-reported metrics, corporations can utilize innovative and rigorous approaches to value creation that reduce their risk and favorably report their progress to investors. For example, corporations can intelligently identify the facilities and campuses best suited for increased production (i.e. those that are least resource-intensive). Forward-looking companies can also quantify and reduce their supply chain risks to identify improvements that may lower production costs and improve their reputation. Lastly, a firm understanding of the complex, interconnected nature of the risks companies and investors face will help them make firmer investment decisions while lessening their business risks. Finally, linking an ESG framework with these resources may provide sustainability management system that is robust enough to align information with effective and practical action.