The bottom line comes full circle

Triple bottom line was a great concept. But as investors clamour to include ESG (environmental, social and governance) factors in their decision-making, a new era of harmonized reporting—effectively, a single, integrated bottom line—is nigh
By John Greenwood

Under chair Mary Jo White, the SEC moved closer to expanding ESG disclosure regulations

“History will judge today’s effort as pivotal,” said U.S. president Barack Obama, as he and Xi Jingping, the president of China, ratified the Paris climate accord in early September. If the comments sounded auspicious, they are. That the leaders of the world’s two biggest economies and greenhouse gas emitters opted to set aside their many geopolitical differences in the name of the environment is an object lesson in the sea change that is taking place in the thinking around global warming, an issue that only a few years ago was still being dismissed by many as a fringe concern.

Four days later, in a less-heralded moment, Norges Bank, which oversees Norway’s US$900-billion sovereign wealth fund, Government Pension Fund Global, announced it had liquidated the fund’s entire US$550-million investment in Duke Energy Co., based in Charlotte, N.C., and several Duke subsidiaries. The reason: risk of “severe environmental damage” related to its ownership of coal-fired power plants in its home state.

The long-term impact of the Obama-Xi announcements could be profound for all energy producers and consumers, society and the planet. Yet the action against Duke by the world’s largest sovereign fund—which at the end of 2015 owned shares in more than 9,000 firms, totaling 1.3% of the value of all public company equity worldwide—signals a related but more immediate and significant sea change for listed companies and their boards, management and shareholders.

The change isn’t about Duke, specifically. Neither is it merely about Norway’s sovereign fund nor, for that matter, is it only about coal, climate change or the environment. Rather, it concerns a spectrum of non-financial factors and indicators—spanning environmental, social and governance (ESG) issues—and the extent to which they are being integrated into the core of investment decision-making. “It’s now mainstream investors pushing this forward,” says Alice Korngold, a New York-based strategy, sustainability and governance consultant to corporations, non-governmental organizations and non-profits.

Naturally, this shift puts a brighter spotlight on the way companies operate and incorporate such issues into their strategy and planning. But equally critical is the significance it places on the accuracy and effectiveness of how they report on and account for them in their financial statements, earnings releases, proxy circulars and annual reports. So much so, that earlier this year in a report called “Exploring ESG,” Blackrock Inc.—merely the world’s largest asset manager—declared: “ESG issues of relevance to business performance should be integrated into fundamental company communications, publication and disclosures.”

To the extent that companies don’t get their ESG reporting right in other words they’re relying on others—third-party ratings firms, proxy advisers, media and investors themselves—to interpret their actions and tell their story, with their access to capital and investor support hanging in the balance.

Besides withholding investments from companies with coal, climate and other environmental risk exposures, Norway’s Government Pension Fund Global considers companies off-limits if they violate its ethical rules on human rights—with emphasis on electronics and textile manufacturing—or if they’re engaged in the tobacco industry and or make certain weapons. In one sense, despite the difference in scale, its approach has much in common with “ethical” or “socially responsible” investment funds that have been around for some time. What’s changed in the market today, however, is that while traditional ethical funds have typically been niche players catering to individuals and special interests, it’s now the biggest institutional investors—including pension funds, mutual funds, insurance funds and hedge funds—that are holding companies to account.

In Canada, a recent survey of 24 institutional investors representing more than $1.7 trillion in assets under management by SimpleLogic Inc. and R.R. Donnelley found that 65% of those investors often or always consider environmental and social issues when making investments.

Asked about governance, the third leg of the ESG stool, and it was nearly a clean sweep—95% said they bore those issues in mind often or always (see chart for a further breakdown).

Globally, the results are similar. In 2015, the CFA Institute surveyed members who are portfolio managers and research analysts, and it found 73% take ESG issues into account in their investment analysis and decision-making. Governance issues ranked highest, followed by environmental and then social. When respondents were asked why they took ESG issues into consideration, “to help manage investment risks,” was their top reply.

This last answer underscores another significant change in the mainstreaming of ESG issues. Whereas the civil society groups and greens that were the original driving forces behind ESG did so mainly in the name of social or environmental good, it’s now a bottom-line concern. Echoing the Blackrock report above, SimpleLogic’s president Catherine Gordon explains that we’ve moved from a process of sorting out “bad” companies from “good” to where there’s a growing consensus that “social, environmental and governance aspects are fundamental to a company’s performance.”

On one side of that ledger, as noted, are risks that threaten a company’s profitability and share price, either directly or indirectly. These metrics vary from company to company and industry to industry. In a straightforward example, if you’re an oil company, you have to accept that you’ll be facing additional costs in the form of carbon taxes and perhaps even legislated caps on the amount of greenhouse gasses your operations are allowed to produce; the prospect of spills or other environmental damage ups the risk factor. Likewise, if you’re a clothing retailer or, say, a smartphone maker, you must now accept the risk that your suppliers in developing countries may be caught abusing their employees, causing damage to your reputation.

On the other hand, company action on ESG isn’t only about mitigating the downside. It’s also about achieving better bottom-line results. In recent years, for example, data has shown that in terms of profitability and share price, companies with strong governance—independence, diversity and renewal on boards, for instance—outperform those that don’t. Boards and management that incorporate into their strategy the optimal use of resources, environmental protection, strong relations with communities and securing social license to operate do likewise. “They need to be able to see the big picture; and that’s really about leadership,” says Korngold.

In common contemporary parlance, it means replacing short-term thinking with long-termism. In that sense, the rise of ESG tracks the growing backlash against companies having a single-minded focus on quarterly financial results to the point that they’ll take steps to boost those results even—in some cases—when the company’s longer-term survival is put into doubt.

AT THIS POINT, SOME might be saying what’s the big deal? Many companies have reported on their “corporate social responsibility” and “sustainability” efforts for years. According to a recent tally, 81% of all S&P 500 firms now issue sustainability reports. And many of the world’s stock markets require listed companies to make disclosures around such issues as climate change and board diversity.

Well, the big deal is that because ESG disclosure is mostly voluntary, no two companies’ reports are the same. Even worse, relatively few firms appreciate or demonstrate the material impact of their specific ESG efforts on the bottom line. Instead most present whatever they choose, whether or not it’s relevant. What this means is that most investors either don’t read their reports at all, or treat them as secondary sources at best.

So where do investors go for information? According to the survey by SimpleLogic and R.R. Donnelley cited above, 75% of institutional investors get their ESG information on companies from third parties—primarily MCSI ESG Research, Institutional Shareholder Services (ISS) and Sustainalytics. The next best source is their own in-house research.

It’s not that there are no models or voluntary standards for companies to follow. If anything, there are too many. The Blackrock report lists more than half a dozen groups that provide competing templates. There’s Principles for Responsible Investment (PRI), supported by the United Nations; CDP (formerly the Carbon Disclosure Project), an NGO that gathers company-provided data on environmental risks; the Global Reporting Initiative (GRI), an organization that helps businesses and governments understand various sustainability issues; Sustainable Stock Exchanges, a group formed to help member exchanges improve ESG transparency, and the list goes on.

Blackrock sums up the concern from an investor standpoint: “There is a need for comprehensive, standardized, and comparable data to accurately measure how companies are managing relevant ESG issues…. [I]f an investor wants to compare the financial performance of, for example, the telecom companies in Singapore, the U.S. and Spain, they can rely on… widely understood international accounting standards. This is not the case if they want to compare the carbon dependency, employee turnover levels or the number of independent directors of those companies. Accordingly, it is necessary to coordinate and consolidate a standardized ESG factor reporting framework.”

On the flip side, anyone who has followed the field for more than a few years will recognize how far some of these reporting models have come—and the extent to which most groups that are involved recognize the need for greater standardization.

One key area of research that’s helping knit things together is in the area of materiality. In other words, determining which ESG indicators can be shown to directly affect bottom-line results, for better or worse. These vary from sector to sector, of course. Related research is also beginning to demonstrate that when material ESG factors are isolated and identified, their impact on performance is clear. According to “Corporate Sustainability: First Evidence on Materiality,” a 2015 working paper published by three academics associated with Harvard Business School, “firms with good performance on material sustainability issues significantly outperform firms with poor performance on these issues, suggesting that investments in sustainability issues are shareholder-value enhancing.”

One authority who isn’t concerned about the current proliferation of reporting standards is Michael Jantzi, chief executive of Sustainalytics. Now based in Amsterdam, Jantzi’s original firm launched in Toronto in 1992. Today, it is one the world’s largest ESG and corporate governance research firms, with 300 employees, a raft of corporate clients and ESG data distribution deals with the likes of Bloomberg and Morningstar.

Jantzi likens the situation to financial accounting, where there are several competing standards, including U.S. GAAP and several different versions of International Financial Reporting Standards. Investors and regulators seem to have no problem with this arrangement, he says, because they know that whatever the system, they can get the disclosure they want. “We’ve got these different frameworks but three-quarters of them are looking at the same thing,” says Jantzi. “I don’t think there is really a big problem.”

What’s more, there is a growing push toward common standards. “I think you are going to see over the next six to 12 months a very serious push by mainstream players, like credit rating agencies, to incorporate [ESG factors] into their ratings,” he says. “Once you see that starting to happen, the game is going to shift in a major way. I really believe we are on the shaft of that hockey stick and you are going to see some major shifts to show that these issues are becoming ingrained in corporate decision-making in a much more significant way.”

Two U.S. organizations not discussed thus far will be critical to watch in this regard—the Sustainability Accounting Standards Board (SASB) and the U.S. Securities and Exchange Commission (SEC). A non-profit founded in 2011, the SASB’s mission is to develop and disseminate sustainability accounting standards that help public corporations disclose material information to investors. Thus far, it has developed sustainability accounting standards for over 80 industries in 10 sectors. “They’ve even provided guidelines on how to integrate it with your Form 10K [and other mandatory SEC filings],” says Gordon. Until now, however, she notes, “this is without regulations.”

Enter the SEC and its current chair Mary Jo White. Earlier this year, it published a massive “Concept Release,” the intention of which is to revisit and upgrade disclosure effectiveness in multiple areas—including ESG. The period for comment on that release recently closed and it will be some time before White announces the SEC’s next steps. But many observers believe the establishment of well-defined, mandatory guidelines for ESG reporting, mirroring much of the SASB’s work to date, could be in the cards. And if it happens in the U.S., it’s a good bet Canada won’t be far behind.

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