Responsible investors: who they are and what they want

Their interest in a broad range of corporate policies and practices – including environmental, social and governance (ESG) – means that they are well-informed about the strategic directions, business models, and corporate cultures of their holdings. Corporations seeking to attract well-informed, long-term investors should therefore want to seek them out, and attract and retain them.

So what types of ESG initiatives do they expect corporate managers to create, monitor, and report on, and will companies whose managers invest in such initiatives be rewarded in the marketplace? These are the kinds of questions this paper seeks to answer.

Responsible investment models

Lydenberg identifies four distinct approaches investors typically use to frame responsible investment:

• norms and standards;
• ratings and rankings;
• integration with stock valuation;
• alignment of business models and societal goals.

In practice, according to the author, these four models are not always clearly distinguishable (norms and standards are implicit in ratings and rankings, while business models have implications for stock valuation), but each differs in its primary emphasis and is likely to lead corporate managers towards different approaches to their ESG plans, policies, practices, and communications, to emphasise different strategies and tactics. In addition, managers’ understanding of these different investment approaches can lead them to formulate and target their communications differently.

Corporate approaches to ESG

To clarify how corporations’ approaches to environmental, social and governance (ESG) issues can correspond to responsible investors’ models, the author outlines several different approaches that corporate managers adopt as they implement ESG programmes:

Enriching stakeholder relations

Managers who believe that investing in their stakeholders – including employees, consumers, communities, suppliers and regulators, and the environment – will strengthen their company and help generate longterm financial rewards by addressing the full range of ESG issues for each stakeholder group.

This approach covers the broadest range of issues and stakeholders, but runs the risk of spreading corporate resources thin or giving equal weight to issues of varying importance. It can also fail to place sufficient emphasis on disparities between companies’ underlying business models and social goals. This approach is likely to be attractive to investors who favour the norms/standards or ratings/rankings approaches to ESG.

Developing shared value business models

Managers here focus on the core business model of the company, as opposed to stakeholder relations. The author says this approach presents opportunities to create shared value by applying business models that are both profitable for the corporation and address an unmet social or environmental need. The challenges of developing profitable business models that accomplish this goal, however, can be substantial and often involve highrisk undertakings.

For example, creating a network of small entrepreneurs in developing markets to sell consumer products, typically distributed in mass quantities through major outlets, involves a substantial commitment of corporate resources.

This approach finds particular favour with impact investors who look to the development of business models aligned with unmet societal needs and those incorporating social and environmental considerations into fundamental stock valuation.

Addressing industry-specific materiality KPIs

Managers here recognise that their ESG reputations will not be helped unless those ESG issues most material to their success are addressed. That means identifying the issues that have the most relevance to their specific industry pose the greatest sustainability challenges or which offer the greatest opportunities - and then focusing on them.

For example, pharmaceutical companies are likely to focus on such issues as product safety and long-term affordability; fossil fuel companies are likely to focus on climate change and alternative energy; and information technology companies are likely to focus on privacy, censorship and the digital divide, where in some regions of the developing world access to technology is currently underserved. This approach is particularly well suited to investors who seek to integrate ESG factors into stock valuations. This approach, however, can appear to give weight to ESG considerations only when they relate to the over or undervaluing of company stocks at a given moment in the markets.

Lydenberg notes that these three approaches need not be mutually exclusive, but they cannot all be given equal weight. An emphasis on stakeholders can spill over into core business models and vice versa, but when making strategic management decisions, one or the other is likely to predominate. Industry-specific sustainability issues can encompass both stakeholder issues and business model challenges, but will not be all-encompassing.

The clearer companies are about which model predominates, the easier it will be for them to communicate effectively with responsible investors and to identify those investors most likely to be aligned with their approach.

Four types of corporate ESG implementation

Once managers have decided which ESG approach to emphasise, they will then decide how best to incorporate it into daily practice. The challenges of systematic incorporation are virtually identical for whichever ESG model and investor type a company chooses to focus on. Incorporation essentially requires four steps or stages, during each of which managers must decide the extent of the commitments they are willing to make as they set about incorporating ESG concerns into their daily operations.

Strategic planning

ESG commitments need to be driven into corporate cultures and, in certain cases, into core business models. This ultimately requires incorporating ESG into strategic management planning and integrating what are often thought of as two separate considerations - finance and sustainability.

Policies and goals

Policies serve as a necessary guide for creating coherent, consistent goalsetting and action, and they help drive ESG into the corporate culture.

Practices

The company needs to allocate the time and resources necessary to institute these programmes thoroughly and effectively. Responsible investors, like any other investors, are interested in results: unless a company is able to demonstrate concrete progress on material issues, it will not be perceived as having achieved anything more than greenwashing. Consistency in long-term commitments to practical implementation is essential for the realisation of the value of these investments. Without this consistency, investment may be made randomly, changing management’s focus from year to year, and failing to succeed in any one area.

Communications

Finally, once ESG initiatives have been integrated and implemented, management will confront the question of how much of which kinds of data to report in what form and what resources to devote to communications more generally.

Reporting

Which kind of reporting management chooses will differ partly based on which approach to ESG has been chosen:

Enriching stakeholder relations

• If management has chosen to emphasise investments in stakeholder relations, it may want to report according to the Global Reporting Initiative (GRI) guidelines. Over the years, the GRI has engaged in a comprehensive multi-stakeholder consultation process to develop a widely accepted set of stakeholderspecific indicators. Reporting according to guidelines from the GRI, RobecoSAM, or similar organisations that stress a stakeholder-centred model, can provide credible and easily accessible frameworks for reporting.

Developing shared value business model

• If management has chosen to emphasise shared value, it may want to look to models for reporting provided by the impact investment community, such as those developed by the Global Impact Investment Rating Service (GIIRS) and the Impact Reporting and Investment Standards (IRIS). These models stress, as well as earning competitive returns on capital: the positive social and environmental impacts of the company’s business model; the creation of high-quality jobs and services for underserved populations; solutions to social and environmental challenges.

Addressing industry-specific materiality KPIs

• If management has chosen to focus on addressing the most material social and environmental key performance indicators, it may want to focus its in-depth reporting on industryspecific key performance indicators (KPIs), such as those currently being developed by the Sustainability Accounting Standards Board, the German Federal Ministry of Finance, and others. One unresolved question is how to integrate ESG and financial data into corporate reporting. The International Integrated Reporting Council (IIRC) is currently studying how this integration might take place most productively. Given stock exchanges’ interest in creating responsible investment indices and encouraging ESG disclosure through their listing standards, a movement towards compulsory integration of ESG and financial data appears well established.

Investor engagement

• As interest in the ESG aspects of corporate activities grows, responsible investors increasingly place demands on management’s time to discuss and, in some cases, alter their ESG policies and practices. Investors may seek dialogue or propose stockowner resolutions, and approach companies singly or in coalitions.

The rewards of corporate investment in ESG

Lydenberg notes that, when ESG programmes demonstrably reduce operational costs, produce efficiency gains, or otherwise have financial paybacks over reasonable time periods, managers need look no further than their bottom line to justify further investment in ESG, but that the business case for corporate social responsibility and sustainability is not always so straightforward.

The business case often depends on rewards that involve a complex mixture of tangible and intangible benefits such as enhanced reputation for quality management, increased customer loyalty, lower employee turnover, avoidance of legal liabilities or regulatory lawsuits, decreased criticism in the media and from corporate watchdogs, or early warnings about emerging social and environmental concerns. While often difficult to quantify, these intangible benefits, may well result in a higher price/earnings multiple for the company’s stock.

Conclusion

Responsible investors – whether they focus on norms and standards, ratings and rankings, stock valuation, or business-model impacts – share an underlying concern about the sustainability of our ecological and economic systems as the world approaches a population of nine billion, and where natural resources become increasingly scarce and social inequality increasingly visible. To address these broad concerns, responsible investors look for ESG initiatives that not only reward companies directly, but also create positive externalities that benefit all. A short-term, company-specific focus can fail to capture these positive externalities.

Corporations seeking a receptive and loyal base within the responsible investment community can benefit from understanding the growing interest in these environmental, social, and governance concerns.

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  RI Quarterly vol. 6: Focus on the PRI impact

  February 2015