Future of the Environment

How coming clean on environmental impact helps companies grow

An engineer works under solar panels at a solar plant near Santiago, Chile, May 2017

The results are clear: transparency on sustainability drives a company's share price up Image: Reuters/Ivan Alvarado

Jeffrey McDermott
Global Co-Head, Investment Banking, Nomura
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Future of the Environment

This article is part of: World Economic Forum Annual Meeting

Over the past 75 years, free-market investor capitalism has lifted tens of millions of Americans out of poverty and, combined with democracy and the rule of law, enabled us to enjoy an unprecedented increase in prosperity and quality of life. Today, we face a historic challenge in climate change, as evidenced by the loss of life and massive destruction of property and infrastructure by Hurricanes Harvey, Irma and Maria. Investor capitalism can help us surmount this as well.

A growing number of institutional investors believe climate change is a serious risk to global prosperity. So do the individuals and asset allocators who give institutional investors their money to invest. In contrast to the 2008 financial crisis, which arose abruptly, the climate crisis is a gathering storm, playing out over decades, with impacts that are irreversible, severe and global.

The largest pension funds and institutional equity investors own a large swath of the equity market and have systemic risk exposure to severe climate change. Compelling executives to disclose their environmental footprint in an industry-standardized, consistent manner can lower this systemic risk without any adverse impacts.

While there are many sustainability reporting frameworks, the Sustainability Accounting Standards Board (SASB) is specifically designed to support investor decision-making with comparable, quantified reporting inside Securities and Exchange Commission filings. Recognizing that sustainability is an international issue, SASB has recently teamed with the Climate Disclosure Standards Board (CDSB) to align with the G20 Task Force on Climate-related Financial Disclosures' (TCFD) recommendations. By insisting that boards and corporate executives disclose SASB/CDSB-standardized metrics, investors can drive a wave of sustainability reporting, and thereby change the US CO2 emissions trajectory, and show the world the power of our free-market system.

Studies show that companies that take steps to operate more sustainably outperform their peers in terms of shareholder return. In a recent study from the Henley Business School, researchers examined the relationship between carbon emission disclosures and financial performance for UK companies. They found that the mere act of disclosure results in improved share price performance, and that there is “a significant positive relation between corporate carbon disclosure and corporate financial performance”.

In another study, Harvard researchers examined the future financial impact of material and immaterial sustainability investments. Using SASB’s framework for materiality, they were able to determine that firms with strong ratings on material sustainability issues outperform their peers with inferior ratings. Specifically, they found that top performers achieved an estimated annualized alpha of positive 4.83%, while firms that made no investments had an estimated annualized alpha of negative 2.20%.

In October, Boston Consulting Group released a report that agreed – “investors rewarded top performers in specific ESG topics with valuation multiples that were 3% to 19% higher… than median performers”. In addition, they found that top performers had margins that were up to 12.4% higher. It is irrelevant whether this is due to correlation (executive teams that understand the need for sustainable business operations are better managers overall), or causation (because of their superior sustainability efforts, these executives are creating brand value and customer allegiance that enables them to financially outperform); there is credible evidence that sustainability disclosure can help investors make better decisions.

The potential benefits are huge. CO2 emissions can be significantly reduced if boards and executives commit to sustainability. If every relevant business that could embrace climate change initiatives and report on sustainability progress actually did so, the result would be a reduction in CO2 emissions of approximately 10 billion tons by 2030, or about half the gap between the “business as usual” projection of 61 billion tons and the COP 21 two-degree scenario goal of 42 billion tons. When boards and executives disclose information such as total energy consumed, renewable energy utilized and manufacturing waste recycled, management teams of industry rivals will strive to improve their metrics in order to compete. The cost of measurement and disclosure is trivial compared with the behavioural change that will be triggered by this information.

Disclosure cures

Investors are dissatisfied with the status quo. Existing corporate sustainability reporting and disclosure efforts are intentionally obscure and provide information that is essentially useless to discerning investors. Although 75% of SASB’s climate-related disclosure topics are mentioned in SEC filings, they are not being reported in a useful way. A total of 82% of the S&P 500 issued sustainability reports in 2016. However, of those that reported, 76% failed to disclose any metrics and 53% used bland, boilerplate language offering no insight. Most of the 24% that did disclose metrics provided data that was not comparable across businesses within the same industry. Platitudinous reporting will never lead to progress.

Large pension-asset allocators should query their equity managers on how they assess sustainability in selecting equity investments. Is sustainability merely a phrase on their website or a quantified, analytical process proven by transparent, standardized metrics? Equity managers should make their voices heard.

The Task Force for Climate Financial Disclosure, chaired by Michael Bloomberg, has a much more ambitious agenda. It is proposing that companies report the changing environment’s potential impact on them, using future scenario analysis and other methodologies, which have yet to be agreed upon. While worthy, this route may take three to five years for standards to emerge and consensus to be achieved. We are proposing that companies disclose their impact on the environment today, and that this can be done to a high standard with existing SASB/CDPB tools, beginning in 2018.

If investor capitalism doesn't do it, it won't get done. By acting together, investor capitalists can motivate boards and management teams to provide sustainability disclosure. After that, let the market decide. Once it is measured, it can be managed. There is an old expression in the securities markets: “disclosure cures”. Perhaps this will never be truer than with respect to sustainability disclosure and climate change.

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Related topics:
Future of the EnvironmentClimate Change
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