What makes a sustainable company?

Published by Net Impact Amsterdam on

Guest post written by:
Andres van der Linden
ESG and Impact Officer at Triple Jump BV

Net Impact Amsterdam
‘Thinking Out Loud’ Blog Series

In summary…

  • This article is aimed at financial, sustainable, responsible, ESG and impact investing practitioners (however you want to call it!).
  • The financial system is extremely effective at allocating capital, based on a clear understanding of a company’s financial performance. 
  • A similar robust system does not yet exist from an ethical point of view and this deficiency has resulted in serious social and environmental problems. 
  • Mainstream responsible investment is a step in the right direction, but it currently lacks clarity of purpose and relevant and reliable data. 
  • There are four steps that need to be taken to get to “sustainable capitalism”: 
    1. Companies are obliged to published comprehensive impact statements.
    2. Investment managers distinguish the difference between ESG and impact.
    3. Institutional asset owners require real-world impact funds.
    4. Our personal values are reflected in our portfolios.

It’s time for the financial system to do better

Our planet is warming, global inequality is rising, and we are facing mass extinction. Many would argue that the unrestrained capitalism of the 20th century is to blame for these and many other problems, with businesses fueling a culture of mass consumption, exploitation, and self-interest. But we cannot forget that this same system has also raised living standards around the world, lifted millions out of poverty, and enabled ongoing technological innovations that make our lives easier every day. Its impacts, both negative and positive, have been made more acute by the growth of its circulatory system. The financial system channels capital between companies and projects with great effectiveness, in part because it has come up with answers to the question titling this article.

What exactly constitutes a “good” company is complex and open to multiple interpretations.

What makes the financial system so well-suited to answering this question is the system’s clear and unambiguous purpose: financial return. Should I buy XYZ stock? If it earns me money, then yes. If it loses me money, then no. Furthermore, the system is able to answer this core question – what makes a company “good” – thanks to reliable, relevant and publicly-available information. New information, found in a company’s annual report for example, is immediately captured by and reflected in the system’s answers. This forces accountability on decision makers and ensures that companies always choose the people and processes that best serve the pursuit of profit and the circulation of capital.

An unambiguous system drives towards ever greater efficiency. But because it fails to capture more ambiguous externalities, the current capital-first system is creating environmental and societal issues. A comprehensive system does not yet exist to answer the question “What is an ethically good company?” The volume and quality of data available to answer this question is negligible compared to that with which we can form a financial opinion of a company. We have made good strides in the Responsible Investment (RI) movement in the past few decades, but in order to become a truly sustainable society we need to build an enhanced capitalist system where ethics sits alongside money at the center. A system of “sustainable capitalism”.

An emergence of responsible investing

Introducing ethics into finance is not a new idea, but it remained a largely niche strategy until the 2000s, with the advent of Responsible Investment (RI) as a mainstream strategy. By 2018, the US Forum for Sustainable and Responsible Investment (US SIF) estimated that nearly USD 12 trillion fell under some sort of sustainable investing strategy (ref 1). The increased popularity has been paralleled by the use of Environmental, Social, and Governance (ESG) ratings, which attempt to quantify non-financial metrics for use by investors. The growing adoption of ESG and RI by mainstream finance represents an important step in the right direction. However, there are two problems in today’s RI industry that prevent accelerated change to a more sustainable world.

The first problem is that RI has not one, but two objectives: pursuing sustainable development and proving financial materiality (i.e. linking ESG with financial outperformance).

The first problem is that RI has not one, but two objectives: pursuing sustainable development and proving financial materiality (i.e. linking ESG with financial outperformance). These two unreconciled, sometimes opposing, objectives lead to a lack of clarity in what an ethically good company is supposed to be.

Initially, RI was defined by negative screening strategies (e.g. excluding coal producers – or even further back, based on South African apartheid), where sustainability had primacy, but this was applicable only to a minority of assets. To help grow the RI market, research providers started offering ESG ratings for all types of companies and sought foremost to prove that a financial analyst armed with their ratings could select financially superior companies. This successfully boosted RI’s popularity, but also made it a tool more for capitalism than for sustainable development, the latter often at risk of being seen as incidental or secondary. It is true that even an indirect consideration of ESG factors still creates positive impact. However, using it as a means to an end results in a distorted view of how ethical a company truly is. Does an “A” rating mean XYZ is a good company? Or does it leave out sustainability topics that are too short term to be material, but are critical for a sustainable society? Or does it mean XYZ has all the right tools to show the raters exactly what they’re looking for (glossy sustainability reports)?

If we are to effectively allocate capital in pursuit of positive societal impact, then RI needs to treat sustainability with equal importance as financial returns, with both having their own explicit objectives and methodology. The stated missions of two of the largest ESG rating providers today are “to measure a company’s resilience to long-term, financially relevant ESG risks (ref 2)” and “to help investors identify and understand financially material ESG risks at the security and portfolio level (ref 3)”. To be sure, players such as these have been hugely important to the RI movement. However, that their own mission statements centralize only financial materiality speaks volumes about where the current priorities still lie.

Their own mission statements focus only financial materiality, which speaks volumes to where the financial system’s current priorities still lie.

The second problem is the absence of standardized ‘outcome’ (i.e. impact) data, which is due to a lack of corporate disclosure. ESG data today generally relate to a company’s environmental and societal preparedness (e.g. the presence of an environmental policy and program) rather than its actual environmental and social impact (e.g. carbon footprint data). This is not to say that the former is not useful. Preparedness is an insightful, forward-looking dimension. But it is insufficient for directing capital to companies that actually achieve real-world impact and for holding companies accountable if they do not. If we want to pursue carbon neutrality, for example, then analysts need access to relevant and reliable data, namely the current and historic carbon footprint of a company. If we want to pursue gender equality, analysts need to know how many women are employed and what the pay gap is. Environmental and human resource policies are a first step but relying on them alone is not enough to effect lasting change. It would be comparable to a portfolio manager picking stocks based on investment policies, without using financial statements.

Charting the way forward

This is the current state of the industry: the financial system continues to fuel a world economy that aids and abets societal and environmental harm. RI, while representing a positive start, is frustrated by having two competing objectives and a lack of relevant corporate disclosure. What can we do to overcome these challenges, leverage the efficiency of the financial system, and achieve sustainability? How do we get to “sustainable capitalism”? 

Step 1: Companies are obliged to published comprehensive impact statements

In sustainable capitalism, the foremost difference will be in what companies publicly disclose. This will also address the second of the aforementioned problems: non-outcomes information. We already see positive initiatives, such as the Carbon Disclosure Project and the Environmental Disclosure Scheme. In sustainable capitalism, all these disparate initiatives will be captured in an obligatory ‘impact statement’, which will include all the relevant social and environmental inputs and byproduct outputs determined by a company’s sub-sector. The selection of indicators will be standardized for all publicly listed companies and based on a universally accepted development framework (e.g. the UN SDGs). To make this work, governments will need to cooperate to develop, endorse, and enforce reporting. To alleviate the extra reporting burden on companies, governments could initially offer subsidies or roll out reporting requirements in stages (e.g. first on SDG 13, Climate Action). Governments should also assist the growth of facilitative industries like impact auditing, which will ensure that data are consistent, comparable, and reliable.

Step 2: Financial institutions distinguish the difference between ESG and impact 

Armed with this newly available impact data, investment managers will be able to differentiate themselves to their clients by offering portfolios that deliver both financial and environmental and social impact results. Contrary to how existing ESG data (i.e. preparedness data) is currently handled, impact will be a distinct and quantitative goal in itself, alongside financial return. While financial analysts will work towards the latter, a separate team of impact analysts will pursue the former. This will address the first of the abovementioned ESG problems – competing objectives that create unclarity in purpose. Both groups will make use of financial, ESG, and impact data. But while the financial analyst will use the information to build an image of how financially viable a company is, the impact analyst will use the same data to assess how the company contributes to or hinders impact goals – how ethically viable it is. 

These two separate analyses, each targeting distinct objectives, will be equally weighted by a portfolio manager as they decide if the company is investment-worthy or not. This decision will be done considering the portfolio’s current financial and impact performance. If an energy company in their portfolio is poised to generate an excess of clean energy, then this could free up bandwidth to pursue more profitable companies that may be more carbon intensive. If a newly published impact statement reveals that the energy company produced coal instead, the analyst who forecasted these energy figures can then be held accountable. In such a system of sustainable capitalism, impact, alongside financial performance, can be actively managed. 

Step 3: Institutional asset owners require real-world impact funds

With investment managers now providing insight into the impact performance of investments, asset owners will be able to package and pass on this information to their retail clients. Something similar is already happening in the impact investing world. Impact fund managers already report real-world impact to investors, but this industry is only focused only on privately held assets, constituting just under 2% of the total RI market (ref 4). In sustainable capitalism, standardized impact metrics will cover all assets. The result will be a vastly broader offering of returns that stakeholders can expect from their investments. A pension fund, for example, could promise that its beneficiaries’ money will have a net carbon footprint of zero or create 10,000 quality jobs for low-income people over 20 years. We may even come to expect that funds that do not offer such “returns”, or that do not achieve their promised impact, will be unpopular, as retailers increasingly expect transparency on the impact of their money.

Step 4: Our personal values are reflected in our portfolios

So, what makes a good company? In a system of sustainable capitalism, with the help of impact analysts, every one of us will be able answer that question for all companies. These opinions, combined with perspectives on financial viability, will feed into our investment decisions. No longer will we base these decisions solely on the financial track record, but instead on the asset manager’s ability to deliver net positive impact on our chosen areas of interest.

In today’s world, many of us surrender to banks the aggregate power of our savings and, unwittingly or not, turn a blind eye to the potential harm we may be facilitating. But in order to drive the change towards a sustainable global society, each one of us must shape our economic behavior to reflect realities beyond the black-and-white system of mainstream finance. By giving environmental and societal impact an equal weight in asset allocation, we will be able to make investment choices that offer far more interesting, textured, and meaningful returns.

About the author: Andres van der Linden

Underpinning my education and career is the mission to prove that it is possible for finance to work positively for society and the environment. From 2013-2017, I provided research and advisory services to institutional investors to aid them in integrating sustainability into their investments policies and decisions. I am currently working at an impact fund manager, Triple Jump, as part of a dedicated ESG and Impact team, with a focus on microfinance, SME finance, and access-to-energy solutions.

References
  1. C. Taylor, ’Green is good. Is Wall Street’s new motto sustainable?’, Reuters (accessed 10 February 2020).
  2. ESG Ratings, MSCI (accessed 14 February 2020). 
  3. ESG Research and Ratings, Sustainalytics (accessed 14 February 2020).
  4. Sizing the Impact Investing Market, GIIN (accessed 14 February 2020); Global Sustainable Investments Rise 34 Percent to $30.7 Trillion, Bloomberg (accessed 14 February 2020).