6. Investors and the Power of Markets

The preceding chapter outlined a framework and set of principles and practices that an organization, particularly a public corporation, can use to effectively manage its ES&G issues and activities. This chapter suggests that implementing this approach, while entailing considerable effort, can be justified. It has been shown to be effective, and it creates the conditions required for the firm to create new financial value. More specifically, I delve into the workings of our capital markets, and I develop and explore one of the major themes of this book: capital markets are reshaping how companies are approaching sustainability. They will drive corporate America toward a more sustainable future, whether or not it is ready to go there. To further support this argument, and particularly for your benefit if you remain unconvinced of the value proposition presented by sustainable business practices, Chapter 7 reviews the established empirical evidence that addresses this issue.

This chapter explores in depth why investors might have an interest in corporate sustainability behavior. It also looks at whether financial market actors appear to consider sustainability endpoints and, if so, how and to what degree. This chapter also explores how market forces appear to be shaping interest in and the practice of corporate sustainability activities. I will show that financial community actors are playing a substantial and growing role. I also will offer some suggestions for appropriate responses on the part of those working in and for companies on sustainability issues.

To begin, I will review some basic information about the financial markets, including their size and prominence, and the primary interests of market participants, focusing on those who play the most pivotal role—investors. This perspective is supplemented by a brief discussion of the evidence that suggests that financial market actors are paying increasing attention to corporate sustainability issues. (This discussion is expanded on in Chapter 7.) I will then examine some of the important requirements and constraints that apply to professional investors and to companies that offer financial securities to investors. This discussion takes place at both a general level and, more specifically, with regard to ES&G considerations. With this foundation, I then describe some of the major evaluation methods investors use. This discussion is followed by a delineation of the major information providers and other intermediaries that serve investors. I also review some important recent developments and major trends that may influence the behavior of both companies and investors with regard to ES&G issues during the next few years. The chapter closes with a summary and discussion of the implications of financial market involvement for those working on sustainability practices both within and outside of the firm.

These points are elementary and well-known (at least intuitively) to most people. What is less well-understood and often forgotten is that the generally accepted theory of how markets can and do work is based on a number of important assumptions. If these assumptions are violated, it becomes far less clear that markets, even “free” markets, will deliver what their advocates promise.¹ In the current context, the more important of these assumptions include the following:

• The market is fully competitive (no monopoly sellers or buyers).

• All participants have perfect information (about prices, availability, product/service features, and so on).

• There are no transaction costs.

• All participants maximize their personal utility (and, presumably, that of their organizations).

If examined closely, each of these assumptions is of dubious validity—at least under conditions that are quite common in a large and diversified economy such as that in the U.S. Competitiveness varies greatly among industries, in some cases because of structural factors and in others as a function of industry maturity. It is widely known that certain types of activities, particularly those that have significant economies of scale, tend to become natural monopolies (or their close cousin, oligopolies). This is why, to promote economic efficiency and societal welfare, we have regulated monopolies to provide such basic goods and services as electric power, natural gas, and other utilities in many parts of the country. Monopolies also can take shape on their own over time. As an industry matures and competitive forces produce stronger and weaker firms and, in turn, growing consolidation (the stronger overcoming [and often buying] the weaker), a smaller number of companies have increasing market power. Recognizing the adverse impacts of increasing industry concentration on consumer choice and prices and more generally on social well-being, U.S. lawmakers enacted federal antitrust laws nearly 100 years ago. This happened precisely because markets cannot be relied on to continuously produce full, open, and fair competition among all participants. There may be a diversity of views on whether U.S. antitrust laws have been enforced adequately or are fully effective. However, I believe that there can be little doubt that they have provided a useful control mechanism for curbing egregious, self-serving corporate behavior and limiting volatility in the supply and price of many goods and services.

It may seem a bit odd to contemplate the availability of information in 2011, more than a decade into the Internet age, when it seems that information is all around us. Nonetheless, it is worthwhile to consider how much of what we see and hear through the Internet and various other media channels is truly useful. In the context of participating in one or more markets, information asymmetry has always existed between and among various buyers, sellers, and intermediaries. Moreover, I believe that most people understand and are comfortable with the fact that some people and organizations work harder and more skillfully to develop facts and insights than others. These attributes allow them to engage in commerce more successfully. In fact, the ability to benefit from one’s own diligence and talents is a major component of our “cultural DNA.” The results of these diverse efforts demonstrate that not all relevant information is instantly available to all market participants, and this evidence is all around us. Indeed, you need look no further than the countless commercial databases, industry-specific publications, membership organizations, books (such as this one), and training courses and seminars available online, in print, and in person. These and other offerings enable the purchaser to obtain insights that he or she did not possess previously and either could not develop independently or could not obtain cost-effectively (make/buy considerations). Many billions of dollars change hands in this country every year to try to correct existing information asymmetries and gain competitive advantage. If anything, such activity is increasing rather than diminishing as information technology advances. Later in this chapter I will return to this topic as it applies to ES&G management and investing.

Given the foregoing, the notion that market transactions are costless seems particularly unrealistic. Yet it is commonly accepted by many people, at least informally. Many transactions between buyers and sellers do not have any definable fees or explicit costs. But in other cases (including purchases of many securities), selling or, more commonly, buying through an intermediary involves a payment or markup. If we then consider the indirect costs of participating in a transaction, such as, purchasing information, time spent performing research/evaluation, travel, shipping, and taxes, it becomes clear that the “friction” surrounding many sales and purchases of goods and services in our economy is not zero. In fact, it may be quite significant.

Finally, one of the cornerstones of market theory is the idea that people are rational and always act to maximize their personal utility. A commonly stated and important corollary is that personal utility means wealth. In other words, people continuously seek greater wealth. In terms of our discussion here, another important implication is that people working in organizations also are rational, informed, utility-maximizing agents who in all cases make optimal decisions to benefit (increase the wealth of) their employer. As noted in Chapter 2, this book doesn’t have enough space to discuss all the flaws in and counter-examples to these related theories of human behavior.

In the context of this chapter, what is most relevant is the notion that people always (or at least routinely) make rational decisions that are in the best interests of their organization. Until the last 15 years or so, this idea had been accepted (indeed, embedded) widely and deeply in the business community. So ingrained was this belief that it was difficult to even have a conversation about advanced ES&G practices with certain constituencies, or to induce public sector entities to entertain the possibility that they could be doing more to promote sustainable business behavior. The emergence of the field of behavioral economics has illuminated the factors that really drive human thinking, decision-making, and behavior. Even so, deep skepticism remains in some quarters that any intervention into the workings of markets or individual companies to promote sustainability or other desirable practices is either necessary or desirable. Such skeptics still voice concerns about whether, for example, an array of public sector programs and partnerships are necessary. They seem unconvinced that these programs produce any significant net benefits and are worthy of support.² This is true despite the success of initiatives such as the myriad voluntary pollution-prevention programs operated at the state level and the federal Energy Star program, which addresses the energy efficiency of a variety of building types, building components, appliances, electronics, and other goods. These diverse programs share at least one common feature: they provide information and, often, tools and other assistance to companies to help them make environmental and/or health and safety performance improvements in a cost-effective manner. That is, they help produce win-win outcomes by reducing energy use, pollutant emissions, waste, unsafe working conditions, and/or other undesirable aspects in a way that saves money, net of investment cost. They do so by creating open access³ (no competitive barriers), overcoming information asymmetry, reducing transaction costs, and demonstrating, in tangible ways, that the partnering organization may not presently be maximizing its utility. In other words, these programs have proven that there actually are lots of “$20 dollar bills lying on the sidewalk” waiting to be picked up.

Although some of this discussion may seem a bit esoteric, it provides an important foundation for the treatment of capital market (and corporate) behavior that is presented later in this chapter.

Markets for financial securities (such as stocks, bonds, and options) are highly developed and efficient in the U.S. and in many other economically advanced countries. Generally, these securities are traded on exchanges that establish rules concerning how trades are to be made and executed, and they provide guarantees that the promises made by buyer and seller are fulfilled.⁴ At this point in time, and enabled by the great advances in information technology that have occurred during the past 20 years (including growth of the Internet), it is fair to say that, at any time, one or more stock markets are open and operating somewhere. The importance of international investors to sustainability thinking and practice is discussed later in this chapter.

Companies that participate in these markets compete with one another, offering their bonds or stock as one investment option available among thousands. To be successful in this competitive environment, they must be able to demonstrate a sound business model and “financials” warranting the trust of the investing public.⁵ Both debt and equity investors are looking for value. Debt, or fixed income, investors obtain value by receiving a predetermined income stream (typically a fixed percentage of the stated value of the debt security) in exchange for a given and generally well-characterized level of risk.⁶ Equity investors receive no assurance of a positive return on investment but also face no limit on its upside potential. Importantly, under both investment scenarios, it is incumbent upon companies to demonstrate the efficacy and worth of their business models (including ES&G activities and programs, if any) to their investors. Sustainability improvements, just as with any other investment of the firm’s capital, must contribute, if even in an indirect way, to revenue growth, improved profitability, and/or risk reduction. As discussed next, the practice of sustainability investing involves determining the financial value that each firm’s ES&G activities creates (or destroys) and evaluating this net impact along with many other criteria of various kinds.

It is vital to understand, however, that such benefits do not comprise “value” to an investor. Instead, value is created through one or more of three distinct means, as illustrated in the following sidebar. This chapter identifies the major types of investors in corporate and other securities and describes how these securities differ from one another. First, however, I review a few fundamentals about how investors think and behave. This foundation is integral to an understanding of whether and under what circumstances an investor might show an interest in ES&G management practices and performance.

Investing is about making money and intrinsically involves making a prediction about the future. No rational investor buys an equity security unless he or she expects that it will be worth more in the future, or unless it yields a stream of dividends that are adequate to offset the absence of a share price increase. Assuming that the market for such securities is efficient and that all relevant information is available to motivated market participants, the market price today reflects the consensus judgment of all buyers and sellers as to any given security’s true worth. Similarly, a rational purchaser of a bond expects that the yield (periodic payments) he or she receives is adequate to compensate for the lack of access to his or her capital for the holding period and to offset the risk of default by the bond issuer. Yield is determined by a bond rating, with riskier securities requiring a higher yield (interest rate) than less-risky securities. Bonds can either be held to maturity, when the original investment amount is repaid, or sold through an exchange on the secondary market, much like a stock. Because most bonds are issued with a fixed yield, changes in interest rates (or riskiness of the issuing entity) induce changes in the bond’s market price. Again, a bond’s market price reflects what the market overall believes is an accurate value, based on the current interest rate climate, company position, and perceived trends.

This means that any information on corporate ES&G posture, activities, and/or performance must tell the investor something about the future. Information on past performance is of interest only to the extent that it helps the investor make an informed judgment about the company’s future. More specifically, such information must be relevant to the prediction of the firm’s future revenues, earnings, cash flow,⁷ or risk. The extent to which conventional ES&G data responds to these needs is discussed in depth in a subsequent chapter.

Professional investors evaluate these major financial endpoints at several levels.⁸ First, they generally decide how to invest their capital among the different available asset classes. These include cash and very short-term investments, fixed income (bonds), stocks, options, commodities, and even real estate. Because we are primarily interested in corporate behavior here, I will focus on stocks and bonds. The investor then filters his or her investment choices for whatever capital is to be invested in stocks and bonds by assessing which economic sectors appear to offer the most favorable characteristics. This choice is based on such factors as the current stage of the economic cycle, the interest rate environment, and other macroeconomic characteristics. Finally, within the sectors chosen for investment, the focus turns to individual companies.

Investors maintain a diversified portfolio. That is, they don’t hold a few securities at a time, but rather dozens to hundreds. This is because, as demonstrated by both investment theory and empirical evidence, adding securities to an investment portfolio, at least to a certain point, reduces volatility in returns (risk) without adversely affecting its expected overall return. As discussed further later, the principle of diversification is so widely accepted that it has been adopted as a component of securities law across the U.S.

As discussed previously, investors, even individual investors, often diversify across asset classes. These classes can range from those that pose little or no risk (U.S. government securities) to those that pose minimal to moderate risk (corporate bonds, from “investment grade” to “junk”) to stocks and, finally (in some cases), futures and options. Assuming that markets are working efficiently and assets are not mis-priced, in every case, and for every component of the portfolio, there is a direct relationship between the risk it poses and the potential reward it offers. In other words, the higher the risk, the higher the potential reward, and vice versa. So government bonds pose little or no risk but also do not offer a high potential payoff. Stocks pose a substantial risk, up to and including the loss of your entire investment, but they also offer an unlimited upside that is difficult to replicate using less-risky investment options.

In the context of relating ES&G issues to investing, a key point to consider is how a sector, industry, or company’s ES&G posture and trends may affect future revenues, earnings, and risk to either the organization itself or future cash flows. Another point to consider is whether the current valuation fully and accurately accounts for all important facts, including ES&G issues. Additional returns (above what can be obtained through investing in broad indexes) may be generated by identifying sources of hidden value and investing aggressively in the firms positioned to capture it. Returns also may be generated by identifying underappreciated sources of risk to future returns that result in securities that are currently overvalued. In the latter case, the investor can both divest any securities owned and invest more aggressively by “shorting” the relevant stock(s).⁹

As you will see shortly, a substantial and growing segment of the investor community is examining specifically how ES&G issues and criteria can help them identify such opportunities to outperform both their competitors and standard investment industry benchmarks.

Table 6-1. Global Financial Assets by Region for 2006 (in Trillions of Dollars)

To purchase these debt and equity securities, money managers collect financial capital from a wide array of sources, including public and private (corporate) pension funds, insurance companies, and individuals and trusts. Firms that collect, deploy, and manage this invested capital include commercial and investment banks, private equity firms, hedge funds, and mutual fund companies. A number of intermediary and supporting organizations also play important roles in supporting the functioning of our financial markets. These include the following:

• Stock, bond, and commodity exchanges, on which securities are traded

• Numerous data and research providers, who support investment analysis and decision making by providing crucial data, projections, and other information and tools

• Bond rating agencies, which evaluate the business prospects and risks of organizations issuing debt securities

• Analysts, who evaluate securities and their issuers—some from the standpoint of the issuing companies (“sell side”), and some from the point of view of the prospective investor in the securities (“buy side”)

Finally, several types of organizations play important regulatory roles in ensuring that our capital markets function effectively, efficiently, and transparently. These include the U.S. Securities and Exchange Commission at the federal level; state-level securities commissions that exist in every U.S. state; and several voluntary, self-regulatory bodies representing some of the market participants, the most prominent of which is the National Association of Securities Dealers (NASD). Table 6-2 summarizes the major types of entities involved in the capital markets and their respective roles.

Table 6-2. Major Capital Market Participants and Their Roles

Most of the empirical work linking ES&G improvements and financial value is focused on equities (stocks). In fact, most of the current activity in the ES&G investing space is focused on equity securities. Table 6-3 shows the value and ownership of the U.S. equity market as of mid-2010.

Table 6-3. Value (in Billions of Dollars) and Ownership of U.S. Equity Securities

This table shows that despite the strong recovery of U.S. (and other) equity markets since mid-2009, the total value of U.S. equities still has not reached even 2006 levels, much less the precrash peak of $25.6 trillion observed in 2007. U.S. households directly own about 36 percent of U.S. shares (by value), and mutual and closed-end funds own nearly one-quarter. Together, private and public pension and retirement funds own more than 17 percent, and insurance companies account for an additional 8 percent or so. Governments, brokers and dealers, and banks together account for less than 2 percent of the total. Interestingly, nearly $2.3 trillion in U.S. equity securities, or 12 percent of the total, is owned by investors outside the U.S. Notwithstanding the fiscal and economic difficulties faced by our country, particularly in the long term, the U.S. remains a popular and highly regarded place in which to invest.

Fundamentally, the balance sheet is an end-of-period snapshot. It lists and quantifies what the company owns and what it owes. It provides financial values for the various pieces of the business. This includes both liquid (short-term) assets such as cash on hand, accounts receivable, and inventory, and long-term assets such as land and plant and equipment. On the other side of the balance sheet are listed the firm’s liabilities (what it owes), again subdivided by short- and long-term obligations. Accounts payable, interest owed, and the like are listed here. The difference between the total value of assets and the total value of liabilities is equal, by definition, to the value of shareholders’ equity, or the net value of the business. Healthy businesses have substantial positive net equity. The balance sheet incorporates many assumptions and conventions that have been developed within the accounting profession over the years and commonly includes many explanatory notes. Review and analysis of these notes is a key activity in investment analysis.

The balance sheet also is where any ES&G liabilities are supposed to be identified and quantified. These generally are listed in the Long-Term Debt and Other Obligations category (with the exception of the current portion, if any) and are explained in notes. Such obligations may include responsibility for cleanup of contaminated sites and other liabilities that can be reasonably quantified. As discussed in Chapter 7, however, such liabilities have been chronically under-reported by U.S. companies to this point. To address this problem, several years ago the standards organization of the public accounting profession issued guidance. It made clear that firms were required to analyze and report their contingent liabilities from retired assets (such as idled, potentially contaminated plants and sites) using specified methods. Although it is still early in the process, it does not appear that disclosure of such liabilities in financial statements has increased markedly. I discuss this issue in more depth later.

The income statement quantitatively describes the firm’s activities from an economic perspective. It addresses, in order, revenues (sales), the costs of producing these revenues (labor, materials), the more general costs of operating the firm, and the difference between revenues and costs, which is income (earnings) or loss. Finally, any earnings may be distributed in various ways, including in the form of payments to shareholders through dividends. In contrast with the balance sheet, the income statement considers the period (year or quarter) as a whole. It also commonly includes many explanatory notes.

In similar fashion, the cash flow statement describes the firm’s activities in terms of their cash impacts on the business. These activities are organized into the following categories: Operating activities (conducting the firm’s main business[es]); investment activities, such as purchasing new land, equipment, or other firms; and financing activities, including securing the funds needed to operate the firm, such as through obtaining bank loans or issuing bonds or stock. The cash flow statement collects and tallies all these sources and uses of cash into and out of the firm and again considers the period as a whole.

On a yearly basis, the 10-K versions of these financial statements are incorporated into the firm’s annual report, which also must include a written management discussion and analysis (MD&A). The MD&A often includes crucial information about and insight into the company’s recent experience, future plans, significant challenges, and likely responses. Company senior management is expected to acknowledge and adequately discuss any and all issues that may exert a significant influence (positive or negative) on the firm’s future performance. This includes ES&G issues. Unfortunately, however, again this is an area of relatively clear regulatory coverage that historically has been widely downplayed or ignored.

Together, the three financial statements, along with the annual report, provide much of the key information investors require to make informed decisions about a particular company’s existing businesses, ability to compete successfully and accomplish stated goals and commitments, and prospects for the future. As you will see a bit later, the adequacy of this information to satisfy the needs of all investors, particularly those focused on or interested in ES&G issues, is far from clear. This fact has had several important implications.

Despite clear signs that there were gaps in the coverage and/or enforcement of existing SEC disclosure rules, the requirements just described provided the basic road map for developing and reporting corporate financial information for many decades. Generally, it appeared that most investors were satisfied with the types and depth of information they were provided at quarterly intervals, although some financial institutions were not. These money management firms leveraged their relationships with the senior management of certain publicly traded firms to obtain information that had not been publicly disclosed to that point. In exchange, some touted the shares of these companies over those of competing firms, or otherwise used this information to further their own interests and/or those of their clients.

These and many other abuses came to light about ten years ago in a series of major scandals and the spectacular failures of several previously high-flying firms such as, Enron, WorldCom, Adelphia, Tyco International, and Global Crossing. In the wake of these scandals, the resulting billions of dollars in losses to investors, and the ensuing recession, the U.S. Congress enacted the Sarbanes-Oxley Act of 2002 (Public Law 107—204). Sarbanes-Oxley, or “Sarbox,” contains three major requirements: disclosure controls and procedures, internal control over financial reporting, and Officers’ certifications of controls. More specifically, Sarbox and implementing regulations require independence of auditors and the Audit Committee of the Board of Directors and effective oversight of the auditing function by the Committee, which must include a financial expert. In addition, to comply with the certification requirement, the company Chief Executive Officer (CEO) and Chief Financial Officer (CFO) must sign a statement of responsibility. In this statement they claim ownership of the completeness and effectiveness of the firm’s internal financial information systems and controls, as well as the accuracy and completeness of its regular (quarterly) financial reports. Notably, Sarbox does not apply to privately held firms. Its purpose is expressly to protect public investors from fraudulent and abusive behavior and to promote effective corporate governance in publicly traded firms. The actual costs and benefits of Sarbox are still being debated, but its enactment has brought a greater focus to information integrity and a better understanding of risks to the firm.

Certain other SEC rules¹¹ also apply to ES&G issues, particularly those concerning impacts on the environment and their consequences. Core SEC requirements include a complete “Description of the Business,” discussion of any legal proceedings (such as for permit violations), and, in the required MD&A, delineation of any risks or opportunities that might be material to the firm’s future prospects. Such risks include contingent liabilities such as possible future contaminated site cleanup responsibilities. Existing SEC rules cover three substantive areas: accrual of liabilities in financial statements, disclosure of these liabilities in financial statement footnotes and SEC filings, and estimations for both accruals and disclosures. Many of these rules apply only to matters that are “material” to the company’s financial condition. Generally, a matter is understood to be material if a prudent investor would reasonably want to know about it. That said, the SEC has consistently declined to define materiality, preferring instead to rely on established case law when and where necessary. As I will demonstrate in the next chapter, in a number of clearly documented instances, one or more ES&G issues have risen to the level at which any rational investor would want to know about them, yet the required disclosure was not made.

Recognizing this problem (or at least some aspects of it), the organization representing the financial accounting profession in the U.S., the Financial Accounting Standards Board (FASB), issued a standard in 2002. It was followed by a more definitive Financial Interpretive Note (FAS 143/FIN 47) that related specifically to environmentally impaired assets and systems. FAS 143/FIN 47 explicitly rejected the generally accepted (and vague) preexisting estimation scheme and replaced it with a mandated approach consisting of a probabilistic analysis of future liability. In other words, it is no longer acceptable to, in effect, throw up your hands and say that there are too many uncertainties to estimate a liability. Rather, the owner of a contaminated property must now use quantitative analysis (such as Monte Carlo simulation modeling) to generate and evaluate probability distributions of the different possible outcomes and generate an expected value of the property’s future liability. This may sound somewhat esoteric, but the net effect of this significant policy shift is to pull liability recognition forward. This may have major income statement and balance sheet implications for affected firms (Smith, 2005).

Not all corporations have contaminated property from legacy operations that is affected by these emerging requirements. Nevertheless, this issue provides a tangible example of how ES&G issues can affect a company’s financial strength and capability and pose financial liabilities that may not be fully recognized or monetized. It also is emblematic of the types of concerns that have prompted interested investors to seek additional disclosure requirements addressing ES&G issues and concerns.

Indeed, pressure from certain portions of the investor community has resulted in several recent steps by the SEC. These measures are intended to compel corporate senior executives to be more forthcoming about how they are addressing ES&G issues and/or to take steps to improve their own structure and performance, particularly in the area of governance. Recent SEC activities include ongoing coordination with the EPA to review and assess conformance with existing SEC disclosure regulations, and the formation of a study group to evaluate whether ES&G disclosure should be made mandatory, as well as formal regulatory activity. In the latter category, the SEC issued proxy disclosure enhancements in December 2009.¹² It issued a memorandum “clarifying” that firms have an existing, affirmative duty to disclose the potential impacts of major environmental issues, specifically global climate change, in February 2010.¹³ And it issued a final rule providing enhanced access for shareholder nominees in December 2010.¹⁴ In addition and, in some ways, most importantly, the SEC is still considering petitions submitted by the U.S. Social Investment Forum (SIF) and the NGO CERES urging the SEC to require mandatory ES&G reporting. It seems clear that the SEC under the current presidential administration is far more focused on shareholder rights and transparency than it was during the preceding eight years. But it remains unclear whether the SEC will ultimately require comprehensive ES&G disclosure, reporting on GHG emissions and related issues only, or neither. Those interested in corporate sustainability from any and all perspectives might want to monitor this issue, because it could be a game-changer.

As discussed in Chapter 3, over the past two decades, the members of several industry and trade organizations have developed codes of conduct and standards for managing ES&G issues. Most of them now include provisions for at least limited reporting of results. An example is the global chemicals industry’s Responsible Care program (ICCA and Responsible Care, 2008). Another example is the Sustainable Forestry Initiative (SFI) and the Forest Stewardship Council-US standards that have been adopted throughout much of the U.S. forest products industry (SFI, 2010; FSC-US, 2010).

At a more general level, corporate reporting of ES&G performance has been promoted by a range of organizations during the past 20 years or so. Over time, these efforts have consolidated into a small number of prominent and active programs that are now organized as nonprofits. At the same time, the scope of the issues they address has expanded, at least in some respects, to cover not only environmental issues, but also health and safety, social/equity, and economic issues. That is, they now directly take on the issue of corporate sustainability. The most prominent among these are the Global Reporting Initiative (GRI), the United Nations Global Compact (UNGC), and the Carbon Disclosure Project (CDP). Table 6-4 describes major features of these programs and how they compare and contrast.

Table 6-4. Comparison of Major Third-Party Programs Influencing Corporate ES&G Disclosure

The GRI and the UNGC are intended to reflect the interests of society at large. They seek to stimulate the adoption of more comprehensive and aggressive management, tracking, and reporting of company responses to a variety of ES&G issues. Both reflect a heavy emphasis on labor rights and the interests of organized labor generally, but they also speak to a number of important EHS issues. The CDP, in contrast, is fundamentally about investments and investors, although its goals similarly are given effect mainly through the use of principles and/or a reporting template.

The GRI, UNGC, and CDP all are targeted at and seek to directly change the behavior of corporations.¹⁵ But nominally they have relevance to and can be adopted by other types of organizations as well.

A key feature of each initiative is required (or strongly suggested) corporate reporting. This reflects a shared belief that more consistent, regular, expansive, and meaningful reporting will accomplish the following:

• Offer an impetus for companies to institute stronger and more effective governance practices

• Improve companies’ ES&G management capabilities and performance

• Provide more convincing assurance to investors and other external stakeholders that the firm is upholding its responsibilities and is effectively managing risks and capitalizing on opportunities

This is true despite the disparate goals of the three initiatives.

These initiatives have been highly influential. A strong correlation exists between the indicators suggested by these programs and the information that is actually reported by companies that disclose ES&G data. A few points illustrate this influence:

• The CDP now represents 534 institutional investors with assets of $64 trillion under management. It solicits disclosure of investment-relevant information concerning the greenhouse gas emissions of 3,700 of the largest companies in the world. As of the most recent full report (2008), the CDP had obtained 2,204 responses covering 82 percent of the Financial Times (FT) 500.

• The GRI has grown from a program of an environmental NGO to a stand-alone international organization based in Amsterdam. As of 2008, its members included 507 SRI investors/analysts, NGOs, companies, labor organizations, academics, consultants, and individuals drawn from 55 countries. Reporting guidelines have been in effect for 12 years and have been revised twice. Reporting organizations have increased steadily, although only about 10 percent of these are U.S. companies or other entities. In 2010, 164 U.S. organizations submitted GRI reports; the worldwide total was 1485.¹⁶

• As of mid-2009, the UNGC claimed 8,000 participants, including more than 5,300 businesses in 130 countries around the world. U.S. participants numbered 438 as of early 2011, of which 247 were businesses. Interestingly, the UNGC recently expelled 2,048 of its members (about one-quarter) for failing to meet their periodic public reporting obligations (UNGC, 2011). (This type of rigorous enforcement of commitments is quite rare among voluntary ES&G initiatives and perhaps is a harbinger of things to come.)

A subsequent chapter will explore the suitability of the information generated at the behest of these initiatives to investment analysis and decision making. For now, the important point is that, in combination with SEC requirements and conformance to any industry-specific codes of conduct, the GRI, UNGC, and CDP largely define the information developed and reported by companies that is available for use by investors. The following sections examine what types of information are of interest and how it is used to make investment decisions. But first, here are some “rules of the road.”

Organizations or individuals that manage money on behalf of others have certain obligations under the law. They are defined as “fiduciaries” and, as such, assume an obligation to act in the best interests of the party or parties they represent. Fiduciary duty exists whenever a client relationship involves special trust, confidence, and/or reliance. Fiduciaries are obligated to exercise the duties of using all available skill, care, and diligence when performing their work, and they must maintain a high standard of honesty and full disclosure with their client(s) at all times. They are precluded from obtaining any personal benefit at a client’s expense. That is, in the discharge of their responsibilities, they must always put the client’s interests above their own.

Fiduciary duty is important in the current context because it is the foundation of securities law in the U.S. and many other countries. For example, pension fund trustees have a fiduciary duty to their members and any other beneficiaries to manage the funds entrusted to them with the utmost care and to invest them prudently using all their available skills and effort.

Professional investor behavior also is heavily influenced by the Modern Prudent Investor Rule, which is a fundamental principle of securities law in all or essentially all U.S. states.¹⁷ Under this doctrine, investors must do or observe the following:

• They must deploy the assets with which they have been entrusted as if they were their own.

• They must avoid excessive risk. (As a practical matter, this means developing or maintaining a portfolio rather than a single asset or a small number of assets.)

• They must avoid excessive costs.

• Although there is no duty to maximize returns, investors must implement a rational and appropriate investment strategy.

• The portfolio must be diversified unless doing so would be imprudent.

• Prudence and decisions generally are to be judged at the time of investment.

The clear intent here is to ensure that fiduciaries such as money managers understand and abide by a set of behaviors that ensure that the risks taken in investing client funds are reasonable, given the client’s investment objectives and risk tolerance. At the same time, the absence of detailed guidance or more specific requirements gives the professional investor wide latitude in determining the appropriate range of options to consider for a particular client and in choosing the best course of action.

Unfortunately, over time, some common interpretations emerged and received widespread acceptance to the point where they stood largely unchallenged for many years. One such interpretation was that the duty of loyalty owed to the client implied that the money manager was compelled to attempt to maximize returns. This way of thinking became particularly pronounced during the great “bull run” from 1982 through the bursting of the Internet bubble in 1999 and to some degree since. During this period, many individual and other investors became convinced that making money in stocks and, to a lesser extent, bonds was easy and that the markets had only one overall direction—up. In such an environment, investment risk seemed muted. To many, it appeared that the biggest risk was to get left behind as stock prices climbed inexorably higher.

A related factor was an interpretation of modern portfolio theory that held that because diversification lowered investment risk, more diversification (owning more different stocks in a portfolio) always was to be preferred over less diversification. Those who favored socially responsible investing (SRI), or ES&G investing in its formative stages, therefore were confronted by great skepticism. Critics of SRI contended that the use of nonfinancial criteria (such as, environmental performance) that might restrict the number of companies the investor could consider (the “investable universe”) would pose an unacceptable risk to the diversification of the overall portfolio. SRI advocates were not helped by the fact that many of the early SRI screening and evaluation methods were crude. (They often focused on exclusions according to one or a small number of criteria.) This led to the formation of investment portfolios that did not perform well on a relative basis (in comparison with a relevant market benchmark).

Thus, one of the important factors limiting the growth of ES&G investing has been an entrenched interpretation of fiduciary duty as applied to investing. It suggests that factoring environmental, health and safety, social, or broad economic considerations into investment analysis is misguided, improper, and potentially illegal. This belief has been reinforced by the available interpretations of the U.S. federal statute that governs the management of private (corporate) pension funds—the Employee Retirement Income Security Act (ERISA). Interpretations of ERISA made by the implementing government agency (U.S. Department of Labor) have allowed but not encouraged the use of SRI and similar approaches.¹⁸

During the past six years, however, the prevailing views on what types of factors investors can and cannot consider have changed significantly. In 2005, a detailed study of investment law in the U.S. and several other countries with advanced capital markets sponsored by the United Nations Environment Programme–Finance Initiative (UNEP-FI) provided a striking and compelling alternative view of the issue. Because the principal authors of the report were attorneys from U.K.-based law firm Freshfields Bruckhaus Deringer, the report became known as “the Freshfields Report.” It analyzes the evolution of investment law from the standpoint of whether and under what circumstances matters such as environmental, social, and governance considerations may be evaluated by financial fiduciaries as they carry out their duties to responsibly manage their clients’ assets. This document broke some significant new ground and provided the following major conclusions:

• Contrary to conventional wisdom, not only is it acceptable for fiduciaries to consider environmental, social, and governance issues, such issues must be considered when and where they are relevant to any aspect of investment strategy.

• Investment law in the U.S. and most other jurisdictions examined presents no barriers to integrating ES&G considerations into investment fund management activities, so long as the focus remains on the fund beneficiaries and the fund’s purposes (UNEP-FI, Freshfields Bruckhaus Deringer, 2005).

As described next, this report and its conclusions have induced a sea change in how ES&G issues are perceived and managed by both SRI investors and, increasingly, money managers and analysts in some of the world’s largest mainstream financial institutions.

Recognizing these trends, and in the interests of providing more detailed guidance for institutional investors and others who want to incorporate ES&G considerations into their business models, UNEP-FI commissioned an update of the Freshfields Report. It was published in 2009. This study confirmed the findings of its predecessor and also reached a number of profound and wide-ranging conclusions, among them the following:

• Fiduciaries have a duty to consider more actively the adoption of responsible investment strategies.

• Fiduciaries must recognize that integrating ES&G issues into investment and ownership processes is part of responsible investment and is necessary when managing risk and evaluating opportunities for long-term investment.

• Fiduciaries will increasingly come to understand the materiality of ES&G issues and the systemic risk they pose, as well as the profound long-term costs of unsustainable development and its impacts on the long-term value of their investment portfolios (UNEP-FI, 2009).

Accordingly, the nature of the debate has swung from whether considering ES&G factors in investment decision-making is permissible or appropriate to how best to integrate these factors into the data collection, analysis, and investment process. What is particularly noteworthy is the implication that money managers who do not address ES&G issues may become increasingly vulnerable to charges that they have been negligent for not considering reasonably foreseeable risks that may have an adverse effect on the value of their clients’ portfolios. It is probably fair to say that more than a few financial market players remain either uninformed of or unconvinced by the findings of these two reports. Nevertheless, many indicators from the markets show that their impact has been widespread and profound.

In the future, if one or more key actions by U.S. federal agencies were to be taken accepting the reasoning presented in the UNEP-FI analyses, wholesale adoption of ES&G investing in U.S. capital markets could occur quickly. One such action would be a supportive interpretation of ERISA by the U.S. Department of Labor. Another would be action(s) taken by the SEC to either require or strongly encourage regular ES&G reporting by publicly traded corporations. If either were to happen, the sea change that I (and a number of others) have observed beginning to form during the past five years could become a tidal wave.

As discussed previously, investing is about appropriately perceiving risk and reward and making decisions about what (and when) to buy and sell over a period of time. Accordingly, I begin with a review of investment risk, which sounds like a simple concept but is not. I then describe some of the more commonly used techniques to identify and evaluate companies whose securities may (or may not) be appropriate candidates to add to an investment portfolio and to identify portfolio components to which investor exposure should, perhaps, be reduced or eliminated. To do this effectively, you must understand what investment risk is and be able to distinguish among different types and sources of risk to either your own capital or funds entrusted by someone else.

Nevertheless, it is possible to characterize the different factors that may influence a company’s fortunes and to understand how they differ. Table 6-5 shows some of the important distinctions between some of these factors and the risks they imply. Simply stated, systematic risks apply to all companies operating in an economy and include a number of aspects of the overall economic climate, such as interest rates and inflation. No individual firm can entirely escape the influence of these factors, nor can any one company change them. In contrast, nonsystematic risks are specific to a particular firm and include such factors as which lines of business the company chooses to pursue, its financing arrangements, and its management of cash. The remaining factors listed in the table have characteristics of both types of investment risk, in that they are both “macro level” concerns but also can be managed or avoided by choosing in which geographies and economies the firm operates.

Table 6-5. Sources and Types of Investment Risk

To mitigate these risks while seeking and exploiting opportunities to generate positive returns for investors, money managers employ a number of different methods. As discussed previously, one basic strategy fundamental to professional investing is diversification—employing the portfolio approach. Building a portfolio commonly involves diversification across several dimensions: changing the number of securities held, holding different asset classes (stocks, bonds, CDs), and adroit consideration of different economic sectors and industries to both diversify and limit risk to changing economic conditions.

In portfolio development, the investor seeks to position the investment holdings along the “efficient frontier.” Investment theory holds that it is possible to optimize the relationship between risk and reward through diversification. If you were to plot risk versus reward on a line graph, the efficient frontier would be the curved line along which the maximum reward could be obtained for a given level of risk. Conversely, you would find the minimum risk required to generate a given level of reward. All the points along this line yield an identical expected value. Where a particular investor would want to position a portfolio would (or should) be based on his or her investment goals and risk tolerance. An important corollary is that all points off of the efficient frontier represent inferior solutions. This means that investing according to their locations on the graph (such as by investing solely in a small number of very high-growth companies) is likely to yield a suboptimal result. For example, you might take on too much risk in pursuit of large gains, or achieve lower returns than would be possible with an optimally constructed portfolio having the same risk exposure.

The implications of this set of relationships are profound, from the standpoint of constructing and managing an investment portfolio. Accepting the notion of an efficient frontier imposes a discipline on the investor and his or her behavior. This manifests itself in an unwillingness to pay more for a security than is justified by both its future earnings potential and risk profile. Quantitatively, the relationship between risk and reward can be expressed through the use of the Capital Asset Pricing Model. In a simplified, normalized form, it states that the required rate of return for a given security is equal to the market rate of return multiplied by a measure of the security’s systematic risk (called the “beta”).¹⁹ Stocks that have higher systematic risk require a higher rate of return than those that have low systematic risk.

In addition, the efficient frontier and Modern Portfolio Theory imply that firm-specific (nonsystematic) risk can be largely removed from an investment portfolio simply by diversifying. This means that professional investors are assumed to be diversified, because by not being diversified, the investor has needlessly taken on a possibly significant source of risk. And as you saw previously, this would be viewed as a breach of fiduciary duty (and possibly state securities law) if the investor is managing funds on behalf of someone else in a fiduciary capacity. Viewed in this context, “risk” is not what we tend to think it is (losing our investment). Instead, it is volatility in returns. Portfolio volatility (or its inverse, stability) is an important concept that the investing public often overlooks—at least when markets are rising.

Most of the conventional methods for evaluating and valuing company securities involve assessing these endpoints and/or factors or conditions that have some direct relationship to them. I review some of the more commonly used methods in this section.

One basic approach is technical analysis. This method involves forecasting price fluctuations, focusing on supply and demand conditions that may apply to a particular security. To the technical analyst, sometimes called a “chartist,” the causes of these fluctuations are unimportant. He or she is simply trying to find out whether excess supply (or demand) for a stock can be detected by analyzing patterns of price fluctuations or movement in indicators or rules. Technical analysis focuses on momentum—trends in price and/or earnings growth rather than on more fundamental factors. Because technical analysis is not based on causal factors, its relationship to the ES&G factors considered in this book is minimal, if not nonexistent, so I will not consider it further here. The important point to understand is that investors relying chiefly (or solely) on technical analysis exist, although they are likely to be a small minority. Also, the ES&G value-creation message I promote in this book (and that others share) is not likely to have any influence on this constituency.

The other major approach used in investing is fundamental security analysis. Typically, this method proceeds in steps, as discussed earlier in this chapter, beginning at the top. Analysts examine, sequentially, the economy and market conditions, major sectors and industries, and, finally, individual companies. At the level of the firm, investors and analysts apply several different types of analysis. Typically, these include net present value analysis (again, the current value of future cash flows), multiplier analysis (discussed later), and, in some cases, other techniques.

First, the overall economy and markets are evaluated. This is important because it has been shown empirically that general economic and market conditions typically account for between one-quarter and one-half of the variability in company earnings from period to period. Moreover, in many cases, stock prices have led the wider economy, particularly out of economic downturns. The state of the capital markets and investor confidence (or lack thereof) can affect the rate of return investors require to accept the risk of acquiring certain securities. This phenomenon was vividly illustrated during the recent global economic meltdown when, for example, the interest rate on high-yield corporate securities (junk bonds) soared and prices plummeted, regardless of individual issuer characteristics.

When evaluating the effect of big-picture concerns on an investment portfolio, investors consider such factors as the current stage of the economic cycle (are we in strong growth or facing a looming recession, for example), rates of inflation, interest rates, and the expected overall levels of corporate profits. Although these factors affect all companies, some of them tend to affect certain types of industries (and firms within them) more strongly than others. For example, if inflationary pressures are gathering force and interest rates are rising significantly, many investors avoid companies (and even entire economic sectors) that are sensitive to this factor, such as, residential construction and some types of banking.

The next step of the analysis is performed at the sector and industry level. Depending on the principal information sources used and their own preferences, analysts organize the firms in the economy into approximately 12 sectors, many of which contain a number of distinct industries. Table 6-6 shows commonly evaluated sectors and a sample of the major industries within each.

Table 6-6. Major Economic Sectors and Illustrative Industries

Again, investors will carefully consider which sectors and industries offer favorable prospects in light of macro-level factors and their particular return expectations and risk tolerance. They will evaluate, at the sector and industry level, growth opportunities (as a function of industry/market maturity and other factors), protection against economic downturns, cyclicality of revenue streams, and sensitivity to interest rates and other factors.

In particular, perceived opportunities to grow revenue in a nonlinear fashion can substantially boost the appeal of a particular company or industry with investors. The huge influx of investment funds into many forms of renewable energy during the past several years is a good example. It has in many ways paralleled the growth (and pitfalls) of investing in previous “hot” technologies such as biotechnology, the Internet, and wireless communications.

It is important for those interested in promoting corporate sustainability to understand that, as shown here, investor behavior is influenced by many factors beyond whether and to what extent a particular firm has advanced sustainability management practices. With that said, whatever the circumstances of a particular sector or industry, firms in even less dynamic, slower-growing sectors can show leadership and distinguish themselves among their peers by putting in place the policies, goals, and infrastructure described in Chapter 5. In doing so, it is important that they at least consider how they can improve their performance with respect to some of the factors I will consider next—those that investors use to evaluate individual companies.

As noted previously, as an initial matter, the investor is faced with only one question when considering a particular stock, bond, or other investment for a portfolio: Should I add, remove, or hold this security? The appropriate answer to this question is influenced by two related questions:

• What is it worth?

• Is it priced correctly?

The answer to the second can be readily deduced by comparing the answer to the first (the true value) with the current price on the market, assuming that we are discussing a reasonably liquid security issued on a major market exchange. So essentially, the task (and much of investment analysis) involves determining the security’s true value.

There are several ways to accomplish this. The true value is equal to the net present value of all the firm’s future cash flows, discounted to today’s terms using an appropriate rate. Many professional investors and, certainly, the larger information providers and money managers have detailed knowledge of company operations and sophisticated models with which to perform the necessary calculations. Such discounted cash flow (DCF) models are in common use throughout the financial services industry and in academia as well.

Another approach to both inform the development of estimates to use in DCF models and to perform screening and periodic evaluation of individual securities is to use ratio analysis. I present some commonly used ratios in Table 6-7 and then discuss them briefly.

Table 6-7. Commonly Used Financial Ratios Applied to Company-Level Analysis

In either case, the investor or analyst is seeking hidden value and/or risk. Recall that the market has already rendered a judgment about the current value of any security that is liquid and frequently traded. The question then is, have market participants overlooked anything that might affect the company’s future revenues, earnings, or cash flows? Or have they overlooked latent sources of risk that could jeopardize anticipated financial results? So those seeking to outperform the market are constantly looking for what is unrecognized but important, and also what might change in the future and in what ways. Those interested in corporate sustainability tend to believe that ES&G issues and how they are managed provide significant and tangible examples of some of these latent factors. And based on the published literature (discussed in depth in the next chapter), there is reason to believe that their views have been substantiated. I will introduce and discuss ES&G investing in greater depth shortly. For now, however, it is important to return to the types of endpoints that are familiar terrain for the investment analyst. In this way, as we consider new sources of value that can be created by ES&G improvements, we will be able to put them into terms that will be accessible to and valued by the professional investor.

Again, investors consider both risk and reward and try to strike a reasonable balance between them.²⁰ Typical reward factors include profitability, cash flow, efficiency/productivity, and growth. Risk factors include capital structure, liquidity, and cash flow (or the lack thereof).

Commonly, these factors are evaluated through the use of ratios, which compare one number (such as net profit) to another (such as sales). Most of the data required to compute traditional financial ratios is directly available from the company’s financial statements (balance sheet, income statement, and cash flow statement). Because these data must be reported at regular, defined intervals, must be calculated according to certain conventions, and must be independently audited,²¹ they have certain attributes that are extremely helpful to the analyst.

Specifically, financial accounting data reported by companies are provided on a timely basis and are (presumably) accurate, consistent, comparable across time periods and organizations, reliable, and meaningful within the context in which they are reported and used. Many observers have questioned whether this information set and reporting conventions (which date from the 1930s or earlier) adequately capture the current workings of a company’s operations and performance or provide much insight into its future prospects. This topic is explored further in Chapter 8. In any event, there can be no doubt that having a set of independently validated data describing each company’s financial results is of great utility to the financial analyst or investor.

Some commonly used ratios are listed in Table 6-7. I provide these here without significant elaboration simply to make the point that these types of basic indicators are in widespread use, are limited in number, and are not mathematically complex. Moreover, most can be readily found (already computed) on many investment company and financial web sites (such as, those of Charles Schwab, Morning-star, and the Wall Street Journal). These types of data are part of the common language of “Wall Street” and must be understood, at least at a general level, to address investors’ concerns. In addition, some of the published literature on the relationships between ES&G issues and corporate financial results and investment returns reviewed in Chapter 7 refers specifically to these ratios.

Briefly, the categories listed in Table 6-7 and the ratios within each are meaningful in the following respects:

• Profitability ratios. Return on equity, assets, or sales provides insight into how well the company (and its management) are converting invested capital (equity), materials, plant and equipment, (assets), or funds paid by customers (sales) into profits. High profitability ratios are considered to be a good indication that the firm is converting the resources entrusted to it into profits effectively. A high ROE is particularly prized by investors.

• Efficiency ratios. Sales normalized by inventory, net working capital (which includes inventory), or assets tell the analyst how well and quickly the firm is converting its available resources into new sales. As discussed previously, vigorous and growing sales are the lifeblood of any business, particularly one seeking new investment capital.

• Growth. In a related vein, substantial return opportunity is intimately tied to company growth rates, both in an absolute sense and as indicated by certain key ratios, such as, price/earnings:growth (PEG). The PEG normalizes the P/E multiple (discussed in a moment) by the firm’s growth rate. Firms with a PEG ratio less than unity (ones that are growing faster than their price-earnings multiple) are often viewed as promising investment candidates.

• Liquidity. Although true investors are primarily interested in long-term return prospects, it is widely understood that there will be no long term unless the firm is continuously managed properly in the short term. This includes having adequate liquid financial resources to meet the company’s ongoing needs and obligations. Liquidity ratios, such as, those listed in Table 6-7, provide a quantitative measure of what sort of “cushion” of cash and other liquid assets the company has, relative to its short-term financial obligations. Generally, investors (and most lenders) like to see several times more short-term assets than short-term liabilities. This ensures that it is unlikely that the firm will run short of cash, even in the wake of an emergency or significant unexpected event.

• Other ratios. Several other ratios are important and are often used by analysts and investors to develop a sense of a company’s position and prospects. The debt/equity ratio (or “leverage”) quantifies how much of the firm’s capital has been contributed by investors versus borrowed from lenders or secured by debt. A high debt/equity ratio (high leverage) indicates greater risk, due to the cash drain from the associated regular interest payments, which have the effect of reducing profits. The price/earnings (P/E) ratio is widely followed. It indicates the multiple of a company’s current earnings at which the firm’s stock price (per share) is selling. Historically, the P/E for all publicly traded stocks in the U.S. has averaged about 14, but during bull markets (not to mention market bubbles) the P/E can regularly exceed 20. The bond rating and stock beta (discussed earlier) indicate the risk of a company’s fixed income and equity securities, respectively. Higher bond ratings mean lower interest rates (and costs), due to lower perceived risks of default by the issuer. In contrast, a high beta means higher-than-market stock price volatility (risk), and hence, a higher required rate of return. Finally, a stock’s yield is the value of the firm’s annual dividend payment per share divided by its stock price. The average yield for U.S. stocks in recent years is about 2 percent, which is well below long-term historical averages. It is worthy of note, however, that dividend payments have represented a majority of the total return provided by U.S. stocks over the past 30 years or so.

In addition to these conventional types of financial measures, a number of alternative frameworks and methods have emerged in recent years that provide a means by which investments may be evaluated. I will briefly mention two that have attracted their own following and that may be of interest to particular types of organizations. One is Economic Value Added (EVA), which is a technique invented (and copyrighted) by the firm Stern Stewart. EVA provides a method by which a company, or a component thereof, can be rigorously evaluated according to its value-creation performance. It takes the profit or earnings produced by the company, a market segment, or even a single production line and considers (subtracts) the cost of the capital that was required to produce that profit.²² Entities (or subunits) that have a positive result (that earned more than their cost of capital) have created value. Those with a negative result have, in effect, destroyed a portion of their organization’s available capital, notwithstanding the fact that they generated positive earnings on a financial accounting basis. EVA provides some real analytical power to company and segment evaluation and is in use in a wide array of companies. Those interested in promoting corporate sustainability should be aware of this technique. Its usage involves no new endpoints or variables, but it does bring a tight focus to one of the themes of this book—value creation in a true sense.

Another approach to organizational valuation is called the balanced scorecard. The balanced scorecard is actually a strategic planning tool, but it is often used to define performance metrics and track their attainment. Its value for our purposes is that its use explicitly links financial results with some of the organizational considerations and activities that often play important but underrecognized roles in attaining the financial performance sought by senior management (and investors). The balanced scorecard combines and encourages the development of linkages among variables addressing the key dimensions of customers; internal business processes; the organization’s capacity, capability, and learning; and financial performance (Rohm, 2008). As a result, proponents of this method believe that it addresses “value” in a more complete sense. It also tells a richer and more meaningful story than relying solely on the financials or on the financials plus the firm’s “growth story.” By explicitly considering both the desired financial results and some of the key variables that will produce them, the balanced scorecard offers more numerous and obvious linkages to ES&G endpoints than more conventional approaches. Moreover, because internal processes and employee capabilities (and, implicitly, well-being) are fundamental components, it is not unreasonable to conclude that it is closer to a true corporate sustainability concept than many other formal planning and management approaches. In addition, by working through the logic of the balanced scorecard, those interested in corporate sustainability can introduce some of the important ES&G issues discussed in previous chapters. Or, viewed from the outside, they could determine some of the issues that are most likely to confer financial risk or opportunity.

This brings us to a discussion of “intangibles.” These are aspects of a company’s structure and operations that confer strength and competitive advantage but that are not quantified or reflected on the firm’s financial statements. The study of intangible assets has become a major focus of investment analysis and decision making during the past 20 years or so, and there is every reason to believe that this emphasis will continue.

“As recently as the mid-1980s, financial statements captured at least 75% on average of the true market value of major corporations. In the intervening years, however, that figure has dropped to a paltry 15% on average.” (Lev, 2001)

Quite simply, we have been living in a post-industrial economy in the U.S. (and other economically advanced countries) for the past 20 to 30 years. Today, the strength and future prospects of a particular firm generally have more to do with the talents and capabilities of its senior executives and workforce, intellectual capital, customer and stakeholder relationships, and other intangible factors than they do with the extent or value of their brick-and-mortar assets. Unfortunately, however, only the latter, along with the firm’s financial capital, are captured in the financial statements that are released to the investing public. The following are some of the more important intangible drivers of financial value, as demonstrated by quantitative analysis (source: GEMI, 2004):

• Customers

• Leadership and strategy

• Transparency

• Brand equity

• Environmental and social reputation

• Alliance and networks

• Technology and processes

• Human capital

• Innovation

• Risk

Interestingly, ES&G factors are explicitly among those with a quantifiable impact on corporate financial performance, as is transparency. Transparency is explored in more depth in subsequent chapters.

With the emergence of environmentalism and new environmental control laws and regulations (described in Chapter 3), the focus broadened to include a number of new indicators reflecting the expectation of legal compliance and the absence or minimization of environmental liabilities. Thus, “green” portfolio screening methods became commonplace within the SRI community and remain with us today. Over time, the focus of the more sophisticated players within this market expanded to consider resource efficiency and other indicators having a more fundamental connection to corporate value, in parallel with the maturation of environmental/EHS management practices in companies and in the public policy arena.

As I write this book in mid-2011, it is intriguing to consider how far SRI has come since my initial exposure to such “values-based” investing in the early 1990s. Despite the fact that the field has matured considerably during the past 20 years or so, it is still growing rapidly and has reached a scale at which it is difficult or impossible to ignore. According to recent data, SRI (broadly defined) now accounts for a substantial fraction (about 12 percent) of the total equity capital invested in U.S. markets. It comprises a significant, although smaller, portion of total U.S. fixed income assets as well. Accompanying and, arguably, allowing this growth has been an evolution in methods away from a “sin” emphasis and reliance on negative screens to the use of a broader and more sophisticated perspective. SRI investors and their representatives also are becoming increasingly activist. They regularly attempt to intervene in the governance of particular companies through proxy campaigns, direct interaction with company senior management, and participation in wider shareholder dialog activities. They also lobby regulatory agencies (such as the SEC) to enforce existing access and disclosure rules and institute new requirements. Moreover, as highlighted in the next chapter, the more sophisticated users of SRI research and perspectives have shown the ability to generate investment returns that are comparable to (or better than) those of their non-SRI (“mainstream”) peers. As a result, the SRI field and its practitioners now have a level of recognition and credibility among many other investors, ratings agencies, regulators, and corporate executives that would have been difficult to imagine 15 years ago.

It also seems appropriate to offer a few words about SRI and the recent financial crisis and its continuing aftermath. Many SRI practitioners see the events of 2008 and early 2009 as a vindication of their view that substantially greater attention must be focused on corporate governance and accountability (particularly on the workings of banks, insurance companies, and other financial services firms); effective internal controls (even after implementation of Sarbanes-Oxley requirements); full, consistent, and meaningful disclosure; adequate shareholder access to the boardroom; and effective regulatory controls and oversight. From where I sit, it is difficult to argue with the validity of this view or any of its constituent parts, or to downplay its public policy implications.

Given the importance of the SRI community in terms of promoting greater consideration of ES&G factors in the domain of investing, I provide some additional facts and perspectives here. Table 6-8 summarizes the growth of SRI in the U.S. during the past 15 years or so. Its contents were developed by the Social Investment Forum (SIF), the largest association of SRI practitioners and service providers in the U.S.

Table 6-8. Socially Responsible Investing in the United States 1995 to 2010 (in Billions of Dollars)

As shown in this table, SRI has grown by a factor of almost 5 during the past 15 years and now accounts for more than $3 trillion in assets. SRI assets have grown by more than 34 percent (versus 3 percent growth for all financial assets) since 2005. Since 2007, SRI has experienced growth of more than 13 percent as opposed to 1 percent for all assets. Note that this more-recent growth has occurred in the wake of the financial crisis. According to SIF, major drivers behind this trend include new (and looming) legislative mandates, greater investor interest in clean/green technology, and increasing public awareness of sustainability issues (SIF, 2010). Interestingly, tobacco involvement has been displaced as the most commonly applied SRI criterion. This distinction now applies to company involvement in Sudan ($1.7 trillion in assets).

Most of these assets ($2.3 trillion, or 75 percent) are held by institutional investors. These institutions strongly favor a strategy of incorporating ES&G factors into investment analysis and portfolio selection; this strategy is applied to nearly 90 percent of the funds held. Shareholder advocacy is applied to about 37 percent of funds, and 25 percent are managed according to multiple strategies. This represents a major trend that has gathered strength during the past few years. According to SIF, the number of investment vehicles tracked that incorporate ES&G criteria and the associated assets under management (AUM) both nearly doubled from 2007 to 2010. The number of funds that incorporate ES&G factors in the U.S. now approaches 500. About 60 percent of these are registered investment companies such as mutual funds, exchange-traded funds (ETFs), and closed-end funds.

Interestingly, alternative investment vehicles such as hedge funds, private equity funds, and responsible property funds, which typically are available only to accredited institutional and high-net-worth investors, also are moving into the ES&G investing space. As of 2010, 177 such funds incorporated ES&G criteria, with $37.8 billion in total assets. According to SIF, this segment has grown nearly 300 percent since 2007, making it the most rapidly growing segment studied. During this same period, the AUM in these vehicles increased more than 600 percent (SIF, 2010). Much of this new money has been earmarked for investments in clean technology and/or renewable energy (thematic investing), as well as for so-called “impact” investing at the community level.

In parallel with and enabling the growth of SRI, the past 15 years or so have witnessed significant maturation of the methods that are used to screen and evaluate companies relative to their ES&G posture and performance. One significant trend is, quite simply, better and more sophisticated analysis of not only environmental (and social) performance, but also active consideration of some of the factors that should lead to performance improvement (or the lack thereof). Thus, many SRI researchers and investors now consider such factors as the presence and provisions of a company’s EHS/sustainability and/or climate change policies, the use of formal management systems, commitments and goals, and other indicia of coherent and effective ES&G management practices. These advances have been enabled by and promoted increasing demands for a greater array of ES&G metrics and data, as discussed in greater depth in the following chapters. At a more general level, given the experiences of the past couple of decades, many SRI analysts and investors understand (sometimes in excruciating detail) the strengths and limitations of the ES&G data that they use to perform their evaluations. Many of the data are collected from regulatory agency web sites and databases, or otherwise retrieved from public sources. Through experience and dialog with both companies (generally, the original source of regulatory compliance data) and regulators, SRI analysts are in general in a far better position to make appropriate decisions about which data to use and how much weight to give them than they were in the early days of green investing.

Another major change is a bit more nuanced but nevertheless is significant. Many SRI investors, and the research firms that serve them, are either deemphasizing or abandoning rigid screens, particularly negative screens, in favor of alternative approaches to identifying eligible investment candidates and making specific stock or bond selections. In some cases, positive screens are employed, such that all firms providing evidence of one or more particular attributes are screened “in,” thereby becoming candidates for further evaluation and, perhaps, investment. Positive screening is commonly used to identify firms (and industries) involved in activities viewed as having favorable growth prospects (renewable energy, for example) as well as policies and practices favored by particular investors (such as significant philanthropic activity, or commitments to reduce greenhouse gas emissions). In other cases, rigid screens are not applied. Instead, ES&G factors are evaluated in various ways as components of fundamental industry or company analysis (such as, ratios developed in addition to the conventional ones discussed here). Or they are evaluated as a final “filter” following completion of the investor’s established security selection methods.

In any case, use of these more-inclusive approaches yields several distinct benefits to the SRI investor. One is that it can substantially increase the pool of acceptable investment candidates, providing (potentially) greater portfolio diversification. In addition, avoiding exclusionary screens allows SRI investors to construct portfolios that closely mirror many of the mainstream stock indexes, enabling “apples-to-apples” comparisons of performance over time that are problematic otherwise. In so doing, SRI investors have overcome one of the major objections posed by critics and mainstream investors unconvinced of the value of considering ES&G endpoints: that by artificially constraining the investable “universe,” SRI investors were damaging their own (and/or clients’) interests by limiting access (and potential investment upside) to major and economically important segments of the market.²³ Today, most SRI investors eschew exclusionary screening in favor of a “best in class” approach that provides exposure to all economic sectors and most industries, while still reflecting active consideration of the ES&G factors that are important to them and/or their clients/beneficiaries.²⁴ Perhaps most importantly, as discussed in the next chapter, the published literature shows that this more nuanced and sophisticated approach to ES&G investing significantly outperforms negative screening and, in many cases, conventional investing using either market indexes or non-ES&G active investing approaches.

Another important consequence of investing in a broader array of firms is that SRI investors can apply more focus to engagement with companies, particularly those lacking the ES&G practices and/or performance they seek. Engagement with company senior management and other representatives has naturally led to greater understanding of the issues and internal workings of these companies, which is very important in evaluating future investment prospects.

Finally, and of direct relevance to the major themes of this book, as a general matter, SRI investors have shifted their emphasis in recent years. They have moved away from notions of “responsibility” and toward more comprehensive evaluations of investment risk and opportunity. In other words, increasingly investments are being made more on the basis of which companies appear best (and least) able to adroitly manage ES&G issues and less on whether and to what extent companies are “doing the right thing.” I view this as a positive and, indeed, necessary development for a true alignment of corporate, investment, and societal interests and pursuit of more sustainable corporate behavior. To put this concept into effect, leading SRI analysts and investors often use or embody certain principles in their security selection processes. I will refer to such financial market participants from this point forward as ES&G analysts and investors to distinguish them from those using more traditional SRI methods. Common ES&G evaluation principles and processes include the following:

• Long-term perspective. In contrast to many participants in contemporary capital markets, ES&G investors often hold a long-term perspective. Among other things, this means that they can (and often do) hold individual company securities for an extended period. Therefore, they can appreciate the positive financial impacts of appropriate sustainability investments made by the companies in their investment portfolios.

• Eco-efficiency. As discussed in Chapter 5, this approach focuses on reducing the material and energy intensity of production and dispersion of toxic materials while promoting sustainable use and reuse of resources. Pursuing eco-efficiency criteria in a skillful way reduces costs (thereby increasing earnings), controls liabilities, and, in some cases, generates new revenue streams.

• Life-cycle analysis. This technique is used to evaluate the upstream ES&G (most often, environmental) aspects of a given industry sector or company’s supply chain. It also evaluates the possible downstream ES&G/environmental consequences, and investing risk exposure, of the sector/company’s products and services in use by the customer.

• Risks to intangible assets. As discussed previously, intangible assets represent the primary source of future competitive strength for most firms. Accordingly, ES&G risks, including possible impacts on brand strength/reputation and important stakeholder relationships, are often an area of focus for ES&G investors (as they are for a growing number of mainstream investors).

ES&G investors use many different approaches to constructing and maintaining their portfolios. Each brings to bear its own unique perspectives, knowledge, and beliefs in determining which assets to buy, sell, and hold. Nonetheless, I can make a few observations about the different general approaches that these investors have employed in recent years. I perceive at least three basic approaches:

• Thematic investing. This involves identifying high-potential technologies, companies, and/or industries and focusing investment funds on firms that allow substantial exposure to what may be perceived as rapidly growing demand (and, presumably, revenues and profits). Noteworthy examples of this approach include the many investment funds that are focused on alternative energy or “green” products.

• “Best of the rest.” In this approach, investors evaluate the participants in established, even mature, industries and select the firms within them that they believe offer the most assurance that they are positioned to take best advantage of important ES&G factors and trends.

• Indexing. Much like their mainstream counterparts, some ES&G investors (and research firms) construct indexes comprising the subset of firms within a larger investable population (such as, the S&P 500) that has the most favorable ES&G profile and, as a result, the best investment prospects.

Regardless of the approach employed, the investor will either perform its ES&G evaluation internally or purchase ratings/rankings and/or data from an ES&G research firm, along with the other components of its security assessment process. Then it will construct or modify its investment portfolio accordingly. Typical evaluation criteria include the presence and coherence of ES&G policies and systems, eco-efficiency considerations, and reported or normalized indicators of ES&G performance (such as, emissions, waste, accidents, or Board composition). Depending on the investor and the indicator in question, the evaluation may take the form of pass/fail, quantitative rating, or integrated best-of-breed evaluation.

Among the more sophisticated practitioners of ES&G investing, I have been observing the logical and necessary next step toward aligning the interests of the sustainability and investor communities—real ES&G integration. Some investors, particularly in Europe, claim to have fully integrated valuation models that explicitly consider ES&G endpoints and how they affect either intangible assets (such as product quality, customer benefits, brand value, and human capital), tangible financial results (sales/margin improvement, free cash flow, capital intensity, or capital cost, for example), or both. The proprietary (and, presumably, highly valuable) nature of these methods limits the extent to which I have been able to explore their specific components and algorithms. However, I can provide a few examples of the underlying theory and types of data used to populate these emerging methods:

• The prominent U.S. investment bank Goldman Sachs (GS)²⁵ has developed a stock evaluation approach called GS SUSTAIN. The approach is based on the belief that companies need to perform well in five broad categories to capitalize on the opportunities of globalization while minimizing the impact from environmental and social side effects: corporate governance, leadership, employees, stakeholders, and environment. GS SUSTAIN is applied through a weighted assessment of 20 to 25 quantifiable indicators (depending on the industry), of which one-third are sector-specific. These criteria reflect, among other factors, the ten UN Global Compact criteria as well as several key environmental indicators: energy use and carbon emissions; management of water, waste, and recycling; suppliers and sourcing; and biodiversity and land use. This process yields a list of recommended companies that are provided to firm clients for investment. GS has reportedly back-tested its method, focusing on what it considers the crucial variable (cash returns on invested capital). GS found that its method outperformed both the relevant benchmarks and other SRI methods (Goldman Sachs, 2007).

• Calvert Investments operates a family of 20 mutual funds. It also offers several other investment products, such as variable insurance trusts and community investment programs, most of which are developed using ES&G criteria and research that the firm develops internally. Issues that are evaluated explicitly include governance and ethics, workplace, environment, product safety and impact, international operations and human rights, indigenous peoples’ rights, and community relations. In evaluating corporate environmental posture and performance for its primary offerings (“Solution Funds”), Calvert reportedly evaluates environmental performance, responsiveness to incidents, and compliance. It favors companies that take steps to mitigate their environmental footprint, have better-than-average environmental records relative to their industry peers, and are responsive to stakeholders. They assess corporate-wide sustainability strategies, such as integrating environmental factors into product design, and corporate management and governance. Calvert seeks to invest in companies that demonstrate leadership in addressing climate change; disclose and take actions to minimize sources of environmental risk and liability; implement natural resource conservation, efficiency, and pollution prevention programs; integrate environmental sustainability into senior management decision-making; and engage stakeholders in pursuit of environmental improvement. Similarly detailed criteria are employed to evaluate the other major ES&G issues. Calvert also operates two thematic funds. One focuses on alternative energy and another on water. Another fund (“SAGE Strategies”) gives investors the opportunity to support engagement with companies (some of which do not meet Calvert’s standard ES&G criteria) on particular ES&G issues of interest. Calvert states that all its investment portfolios integrate its thorough assessment of environmental, social, and governance performance with a rigorous review of financial performance. But details of how this integration is performed are not readily available.

• KLD Research & Analytics (now a unit of MSCI, Inc.) is a long-standing SRI research firm (one of the pioneers, in fact) and investment fund manager. For almost two decades, it has produced what was formerly known as the Domini 400 Index (now called the FTSE KLD 400 Social Index), which for many years was the most widely known SRI index. The firm also operates nine U.S. stock indexes (Social, Sustainability, Catholic) and nine global stock indexes (Climate, Environment, Sustainability), all in conjunction with FTSE. KLD has long employed a method that yields bond-style ratings (AAA to CCC) of individual companies. The analysis considers a firm’s impact on five types of “stakeholders”: environment, community and society, customers, employees and supply chain, and governance and ethics. Ratings are aggregated from four levels of scoring, beginning with raw performance indicators (of which there are more than 280); going through performance ratings, impact ratings, and an overall ES&G rating for each major stakeholder; and finally a company rating. Impact ratings are weighted by industry. For example, water use may be rated more heavily for a mining company than for an insurance company. EHS issues considered include management of environmental issues, climate change, other emissions, impacts of products and services, resource management and use, employee safety, and sustainability reporting and engagement.

A substantial number of other U.S. investors claim to employ ES&G evaluation methods in constructing investment portfolios. But they have not, to this point, divulged much information to either substantiate these claims or provide details on their methods. I expect that this will change markedly during the next several years, as ES&G investing continues to take market share and as broader adoption and full implementation of the Principles for Responsible Investment (PRI) occurs. The PRI is described later.

Before departing this topic to consider the next, I want to clarify the state of play regarding SRI and avoid the appearance of making predictions that I do not expect will come to pass. Despite the emergence of sophisticated approaches to ES&G investing in recent years, I expect that the two dominant approaches (such as ES&G integration) and more conventional SRI practices (such as negative screening) will continue to exist in parallel in both U.S. and international markets. This dichotomy reflects the distinction between values-based and risk-based investing. Because, as discussed previously, it reflects the interests of some investors to not associate with certain types of business(es), the values-based approach necessarily involves some degree of negative screening. In contrast, risk-based investing reflects a judgment that certain EHS and/or other ES&G characteristics impart differential opportunities to capture future financial returns and/or impart risks to these returns and the firm’s capital. And in practice, the two approaches may be used in a complementary fashion.

Given the substantial number of values-based asset owners (such as pension funds) in the U.S., it is highly likely that the traditional forms of investing behavior that they demand will continue indefinitely, even as methods and data enable more sophisticated risk-based analysis to evolve and expand. Given this dynamic, which I view as both reasonable and healthy, it is appropriate to focus on contributing to advancements in sustainability practice and appropriate recognition of ES&G value-creation potential within the financial community, rather than suggest that negative screening is obsolete or inappropriate for all informed investors.

In addition to the factors discussed in Chapter 2, many of the important phenomena limiting the spread of ES&G investing are related to the entrenched beliefs and attitudes common in the investment community, as well as to certain structural arrangements:

• Short-term perspective. One factor that is widely bemoaned and known to most observers is a focus on the share prices of equities over a short time horizon. Consider the logic of how and why a company makes the investments necessary to put in place the ES&G management structures and programs discussed in Chapter 5 and this chapter. It seems obvious that reaping the benefits accruing from these changes would take place over a period of years. In contrast, the relevant period of performance for some analysts and investors is a maximum of one fiscal quarter and, in many cases, from one press release to the next. Indeed, enabled by today’s electronic market exchanges, a sizeable cohort within the broader population of stock and bond traders operates (buys, holds, and sells) on a time horizon of minutes. Whether such people should even be considered investors, as opposed to traders (or speculators), is a matter of opinion. What is clear, however, is that such financial market actors do not and will not have any interest in sustainability issues.²⁶ These issues simply play out over a much longer time horizon than the one of interest to them.

• ES&G significance. Another concern has to do with the proven significance of environmental or other ES&G issues to a particular investor’s evaluation model(s). In addition to those who are skeptical about the importance of ES&G impacts on asset valuation, others have either performed quantitative analysis or reviewed available studies. They have concluded that although improved ES&G performance has a statistically significant impact on one or more financial variables, or on the value of a company’s securities itself, the effect is so small that it is overwhelmed by other, non-ES&G factors. In such cases, as a practical matter, it is far more tractable to collect and evaluate data on a smaller number of the most important variables concurrently for perhaps hundreds of companies than to include every variable having a marginal impact on firm value or one of its components. The problem becomes even more acute when you consider the numerous gaps in important ES&G data across large company populations, as illustrated and explored in greater depth in Chapter 8.

• Incentives. The ways in which money management and investment firms have been established and operated also play a role in inhibiting the spread of ES&G investing. One important factor is, as is often the case, incentives. Most firms have firmly established ways of conducting valuation analysis that have been successful over time. Those who would suggest a new or better way have a high burden of proof to surmount. If they are relatively early in their careers (they have not grown up professionally in the culture/work practices of their employer), they may be accepting significant risk by challenging the existing order, even if at the margins. Quite simply, questioning the wisdom of the existing hierarchy could often be considered a career-limiting move. In recognition of this pervasive problem, two initiatives have taken shape in recent years to provide support and, to some extent, financial incentives for firms to integrate ES&G factors into their business models and investing activities. These are the Enhanced Analytics Initiative (EAI) and the Principles for Responsible Investment (PRI). These are discussed further in a moment.

• Capability. The other major factor within investment firms that limits the adoption of ES&G principles and investment activity is a pronounced capability gap. The plain truth is that both established and entry-level investment analysts are woefully underprepared to truly understand ES&G issues, to formulate and develop answers to the appropriate questions, and to process whatever ES&G information they encounter so as to inform investment decision making in a sophisticated manner. The importance of this fact was highlighted several years ago in a report called “Generation Lost,” issued by the World Business Council for Sustainable Development (WBCSD) and UNEP-FI (WBCSD and UNEP-FI, 2005). As the old saying goes, “Enough said.” In terms of assessing important root causes of this problem, and without taking on the contentious issue of the adequacy of our public school system and educational establishment, I do believe it appropriate to point out that the general level of literacy about environmental issues and, more fundamentally, science is very low within our adult population. This is true even of recent college graduates, as discussed in Chapter 2. If we are to move decisively toward a more sustainable future, we will need to correct this deficiency. In the current context, those interested in corporate sustainability and in aligning ES&G considerations with those of the capital markets should be aware that the challenge extends beyond awareness-raising into what should more properly be considered education.

From a completely different perspective—that of the corporation seeking due credit for its ES&G advancements—additional barriers exist. A conversation about ES&G issues should be occurring between investors and analysts on the one hand and corporate senior management on the other. Unfortunately, although within most public companies these parties interact regularly, the conversation almost never includes discussion of ES&G factors. In some of my previous work (Soyka, 2009), I have documented the fact that there is almost no inclusion of environmental information in investor relations presentations or external dialog. I have no reason to believe that the situation is materially different for other ES&G issues. On the other side, corporate representatives typically state that mainstream investors never ask about environmental or other sustainability issues. So neither side appears to be broaching the subject of ES&G issues and their relationship to corporate success and investment quality. This is so despite the fact that both sides have an abiding interest in any issue that affects the firm’s future. Unfortunately, the more things change, as I have described in this chapter, the more they stay the same. Some major findings of a study that I coauthored and published well over ten years ago are summarized in the following sidebar.

I am seeing greater investor interest in ES&G issues and data. But the fact remains that those best able to articulate the value-creation potential of (and capture from) improved ES&G practices and performance are the individuals running those organizations. Therefore, and as suggested in the earlier research, for the state of play to reach the next level, corporate senior executives will need to become much more engaged on ES&G issues. They also will need to be much more proactive in explaining to capital market participants why the firm is making investments in this area—specifically, what it expects to gain, and how the firm’s enterprise value will be enhanced as a result. The good news here, if there is any, is that increasingly, corporate senior executives are beginning to become more engaged in ES&G issues and take the necessary steps to reorient their companies to at least consider the opportunities and risks posed by sustainability issues. This phenomenon is explored in greater depth in the next chapter.

And although I have great respect for the work done by the many thousands of EHS professionals deployed across corporate America, I believe that many of them need to raise the level of their game as well. In the work that I have done in recent years, I have encountered several common justifications for EHS (or ES&G) excellence. It is simply “the right thing to do,” it is “an extension of who we are as a company,” or it is simply the best response to an array of potential liabilities. In my experience, EHS people, perhaps because most are engineers or scientists, tend to be skeptical of the idea that the financial benefits of ES&G can be quantified or even estimated at a general level. And for understandable reasons, they generally hold the belief that investors are disinterested in the ES&G value story. To a significant degree, we all are products of our own experience, and I understand why EHS professionals tend to not be way out in front in communicating the ES&G value proposition. I suggest, however, that they have a potentially critical role to play. They could greatly improve their effectiveness (and their influence) by devoting some additional attention to the financial aspects of the work they do and casting the associated investments and benefits in a broader organizational context. This can be done in a variety of ways. Ideally it should result in the creation of facts and messages that are pertinent to the topics discussed among company senior management and external financial community stakeholders. Mike Pisarcik of Sara Lee Corporation offers an example of the type of thinking that is needed among far more people in the EHS profession:

One idea for doing this is that the quarterly meetings that are structured around earnings announcements could also be a good opportunity to inject the sustainability message in a way that connects it to business success. For example, the CEO or other senior executive could mention that our energy savings initiative saved $X million, or we continued our string of so many days without a lost-time injury. (Pisarcik, 2011)

As discussed earlier, some very important structural impediments to ES&G investing have only recently begun to undergo significant change. As broader acceptance of the findings of the Freshfields reports concerning fiduciary duty take hold within major investment firms and their clients, I have observed some changes that suggest that long-standing barriers are beginning to come down.

One important constituency is pension funds. As shown in Table 6-3, pension funds own about 17.5 percent of the total equity (stocks) in the U.S. Insurance companies, which invest and manage funds to produce the capital needed to pay future claims, own an additional 8 percent. These institutional investors, by their nature, operate in a conservative manner because they are accountable to their beneficiaries and must ensure that they receive the income streams or other benefits to which they are entitled. At the same time, these institutions generally invest at least some portion of the assets with which they have been entrusted in equity securities so that they can generate sufficient returns over time to pay their obligations. Generating such high returns is extremely difficult to do solely with fixed income investments. Many of these pension funds are quite large, with some exceeding $200 billion in assets. Out of necessity, such investors have their funds deployed in a wide array of investments, to such an extent that they are commonly referred to as “universal owners” because they literally hold at least a small position in every stock in the market. Accordingly, they tend to disfavor divestment, even in firms exhibiting behaviors that they find troubling. Instead, they often focus on engagement, with the goal of bringing about corporate behavioral and/or structural change. That is, rather than “voting with their feet,” they often try to get firms to change from inside the system. Because some institutional investors hold major positions in the stock of some companies (as much as several percent of voting shares), the senior management of such companies tends to receive and be attentive to their concerns.

That said, in the past many institutional investors were content to defer judgment of whether or how best to deal with particular ES&G issues to company senior management. The general assumption has been that senior management had the specialized knowledge and expertise needed. And, in any case, performing triage and focusing attention on the most critical (and only the most critical) issues was part of senior management’s job description. In similar fashion, many major institutional investors who have deployed assets into mutual funds have entrusted all major decisions to the fund managers they have chosen. Fund managers, in turn, have historically displayed a more or less completely passive attitude concerning the management of ES&G issues in the companies held by their funds. Indeed, in reviewing the proxy policies of several major mutual fund companies in the middle of the last decade (circa 2005), I was struck by how disengaged these large, sophisticated financial market players were in the conduct of important business within the firms they owned. As illustrated in Table 6-9, however, the situation has evolved considerably during the past several years.

Table 6-9. Mutual Fund Proxy Guidelines for 2010

This table is excerpted from a larger compilation. It provides a sample of some of the larger and more prominent financial services firms in the U.S., several of which now claim to be active proponents of ES&G investing. For illustrative purposes, I have selected several “household names” that appear to have taken a more activist stance, several who appear to have not, and several who occupy intermediate positions on this spectrum. Several intriguing observations can be made about the data summarized in this table. First, the fact that all but one of the firms profiled has made its proxy guidelines publicly (and often easily) available is a major improvement in the transparency of this industry and its workings. Second, all but one has guidelines that specifically mention corporate social responsibility (CSR) (as discussed in Chapter 2, the common corporate shorthand for sustainability). Several have additional proxy provisions addressing either environment or climate change or both. Finally, some of these companies have frequently thrown their support behind shareholder proposals that a particular company address climate change in some fashion.²⁷ Quite simply, this type of behavior on the part of major banks, investment houses, and mutual fund companies would have been inconceivable just a few years ago. I believe this is further evidence that the landscape regarding the treatment of ES&G issues is evolving in some fundamental ways.

At a general level, belief in the importance of ES&G factors and issues to investment analysis and decision making among investors and asset owners appears to be substantially more widespread in Europe than in the U.S. This pattern also applies to interest in having ES&G issues integrated into mainstream investment strategies. Evidence for this observation can be seen by the active involvement of major mainstream financial institutions in Europe as well as substantial and early support for the Principles for Responsible Investment (discussed in detail a little later). Europe has, by a substantial margin, both a larger percentage of enrolled participants and participation of a larger number of major mainstream banks and other financial institutions than does the U.S.

In addition, notwithstanding the significant upswing in proxy activity in the U.S. in recent years focused on ES&G issues, it appears that trustees and managers of many European pension funds generally have a far more activist orientation on such issues than do their U.S. counterparts. Pension fund signatories to the PRI in Europe outnumber those in the U.S. by a substantial margin. Note that all U.S. pension fund PRI signatories manage funds on behalf of state government employees, teachers, clergy members, or foundations. In contrast, European pension fund signatories represent a more diverse set of organizations and constituents, including those representing employees of national governments (France, Norway) as well as several European multinational corporations (BP, BT, Storebrand). Some of these institutional investors rival the largest U.S. pension funds (such as CalPERS) in terms of total asset size, at more than $200 billion.

In terms of size and global prominence, European corporate financial institutions rival or exceed their U.S. counterparts. Of the 17 largest financial-services companies in the top 50 of the 2010 Fortune Global 500, only six are based in the U.S., and ten of the remaining 11 are based in one of seven European countries. Only one U.S. firm (Bank of America) is in the top ten (Fortune, 2010). This disparity also can be observed in the socially responsible investing (SRI) segment of the investment market. As of 2008, of the 30 largest self-reported SRI firms, 22 were based in Europe, and six were based in the U.S. As a group, the 30 firms managed more than $2.1 trillion, or about 16 percent of their total assets under management (AUM), according to one or more SRI criteria (Responsible Investor, 2008).

Within the European community, there is wide variation in the degree to which particular countries, and their capital markets, have embraced ES&G investing. From my vantage point, it seems clear that the U.K. and its major investment firms occupy a leadership position. That said, there is a noteworthy level of activity in more than a handful of other European countries (including France, the Netherlands, Belgium, Switzerland, and the Nordic countries) and on the part of individual financial institutions within them. Perhaps most significantly, in contrast to the U.S., where the ES&G/SRI dialog and most investing activity occur within and are driven by the SRI community, many major and venerable mainstream financial institutions in Europe are very active in the ES&G investing market space. Although several major U.S. investment houses also are moving in this direction (such as Goldman Sachs), their European counterparts seem to be significantly further down this path, at least in the aggregate.

At the level of the firm, many different approaches are being taken to consider ES&G factors in investment analysis and decision making. This reflects different investment philosophies and objectives, theoretical or empirically based beliefs about the appropriate factors to consider, legal requirements, cultural norms, and other considerations. Even with this diversity, several common themes emerge. One is the growing and widespread use of the integrated approach to consideration of ES&G factors in concert with operational and financial characteristics that I strongly advocate. Just as in U.S. capital markets, very few investors in Europe focus solely on environmental criteria.

Funds invested according to ES&G criteria in Europe are quite significant, both in absolute terms and as a percentage of the total, particularly in equity markets. Such investments exceed 2.6 trillion euros (about $3.4 trillion) and appear to approach, in the aggregate, 18 percent of total funds invested with the European asset management industry. Thus, the European ES&G total AUM exceeds that of the SRI AUM in the U.S., despite the fact that the total size of the latter is substantially greater than that of the former. In parallel, ES&G investing in Europe includes a significant number of major mainstream financial institutions. Using adherence to the PRI as a simple indicator, the distinctions between Europe and the U.S. are striking. U.S. money-manager signatories are, with a few exceptions, SRI firms and, generally, small-niche players.²⁹ Those based in Europe include both “traditional” SRI investors and several large, multinational, mainstream banks, such as, ABN AMRO and Robeco (Netherlands), BNP Paribas and Crédit Agricole (France), and HSBC (U.K.). These institutions are joined by a number of major European pension funds, including Fonds de Réserve pour les Retraites (FRR) in France, Dutch pension fund ABP, and Norway’s Government Pension Fund, among many others, in adopting mandates that require consideration of ES&G criteria in selecting and maintaining securities within fund portfolios. In some cases, these mandates were imposed by national legislation.

A number of large European banks now offer portfolios and/or individual investments selected, at least in part, on the basis of ES&G information. These include the U.K. banks Insight Investment, Newton Investment Management, and Schroders; the Swiss banks Bank Sarasin, Pictet Asset Management, and money manager SAM Group; and, in the Netherlands, SNS Asset Management. In addition, a larger number of European financial institutions reportedly have significant ES&G/SRI assets under management but have not disclosed much in the way of supporting information. These include Dexia Asset Management (Belgium); Robeco (the Netherlands); Baillie Gifford & Co., F&C Management, Hermes Fund Managers, and KBC Asset Management (U.K.); BNP Paribas Asset Management (France); and Carlson Investment Management and Nordea Investment Management (Sweden), among many others.

Despite its clear leadership position, some barriers and limitations have prevented ES&G investing in Europe from advancing even further and faster. These include country-level legal/cultural issues and the absence of consensus (or even widespread agreement) on how best to address ES&G considerations in this rapidly changing arena. I anticipate that both will diminish in the next several years, as a function of national-level implementation of recent EU directives pertaining to ES&G disclosure and accumulated investor experience. More important is the same major factor that limits more and better integration of ES&G considerations into investment analysis and decision-making in the U.S.—the lack of sufficient meaningful, complete, comparable, and timely data on ES&G management quality and performance. The fundamental sources of information used by all providers are the same—companies themselves and government databases.³⁰ In the absence of much more extensive, regular, and reasonably uniform ES&G reporting of the type I advocate in this book, it is difficult to see how this limitation will be overcome.

There is a distinction in the financial services industry between two camps, both of which may coexist in some organizations. One is the “sell” side, which involves, essentially, promoting the shares of particular companies, often those that are underwritten or otherwise supported by the firm. Sell-side analysts are a prominent feature of most investment banks. The other side is, not surprisingly, the “buy” side, which involves identifying and screening appropriate candidates for an investment portfolio. Buy-side analysts are frequently employed by mutual fund companies and other large investment firms with substantial ongoing needs to deploy new investment capital in additional shares of stock and other securities.

Sell-side analysts as a group have wielded considerable influence on investor sentiment around particular stocks, at least in the short term. As a group, they also have been decidedly skeptical of the idea that ES&G management and performance improvements can increase shareholder value. However, as discussed in the next chapter, at least some recent evidence suggests that this is beginning to change (Ioannou and Serafeim, 2010). Buy-side analysts tend to work under the direction and focus on the interests of one or more portfolio managers, who actually make the investment decisions. Regardless of which side of the transaction an analyst is working on, the degree to which he or she is motivated to evaluate and is fully capable of considering ES&G factors is a major impediment to more extensive and rapid integration of sustainability into investment analysis.

At the same time, however, the inability or unwillingness of mainstream analysts to address these factors has opened the door for others to fill the needs expressed by SRI and ES&G investors. I explore the ES&G research industry in some depth in Chapter 8.

As it happens, the factors that bond rating agencies consider include many of the same factors that equity analysts and investors evaluate. Table 6-10 lists some of the more important general considerations. These include factors that may apply at the industry level, such as, economic, market, and industry risk, as well as firm-specific variables such as, earnings, management quality, and funding and liquidity.

Table 6-10. Typical Factors Considered by Bond Rating Agencies

Because bond rating agencies are charged with evaluating the ability of the bond issuer to make payments of a cash stream over an extended period (typically years), they have a fundamentally longer-term perspective than at least some components of the equity markets. Consequently, these agencies generally have at least some awareness of major ES&G issues, at least to the extent that they can be quantified. For example, on the basis of exposure to site contamination cleanup responsibilities and major ongoing waste management costs, certain industries (mining, oil and gas production) are fundamentally viewed as higher-risk than others by the bond rating firms, all else being equal. So their ratings are correspondingly lower.

It is unclear at this point how actively the major ratings agencies are tracking or actively considering a broader array of sustainability endpoints. However, it would seem that they would be naturally amenable to the financial value-creation message espoused here and might welcome the opportunity to add sophistication and new insights to their rating process. In the short term, however, the focus of these firms is likely to be on restoring their credibility following the abject failure of their evaluation processes to identify the inherent risks posed by securities underlain by low-quality residential mortgages. This failure is widely recognized as a major root cause of the 2008 global financial crisis and its aftermath.

However, with a few exceptions discussed next, most of the existing flow of information to investors and analysts has been distinctly lacking content addressing ES&G issues in any complete or systematic way. This gap has been filled by what is now a well-developed subsector that focuses on these issues and specifically caters to the needs and interests of the ES&G investor. This collection of entities is worthy of elaboration and is profiled in depth in Chapter 8.

Recently, Bloomberg expanded the scope of its terminal to include, for the first time, a set of consistent ES&G criteria. These criteria are not only based on the GRI reporting guidelines but also include additional indicators requested by the firm’s clients, yielding an information base of about 110 variables. The terminal also includes some simple screens and indexes that allow sorting and ranking by industry and firm, according to (at present) the level of completeness with which a particular company has reported GRI data. One benefit of this approach is that all the information sources are fully transparent and can be viewed by the user (for example, the full environmental/sustainability policy text can be viewed, in addition to variables indicating its conformance to certain criteria).

If you’ve watched the steady and sometimes slow growth of ES&G investing, this development may mark an important watershed, for the following reason. Assuming that a reasonable number of mainstream investors can be convinced to be more attentive to ES&G factors in their investment analysis, the problem remains of which data to use, and ensuring that this information is available to the investor community. As described previously, the information provider portion of the value chain is populated with many different firms, philosophies, and approaches. This creates a regrettable lack of consistency and clarity for corporate executives regarding what factors are most important to manage and report, and why. In short, additional hurdles would presumably stand in the way of the mainstream investor who wanted to broaden his or her approach to consider ES&G factors, even if that person were sufficiently motivated. With the inclusion of ES&G data (even if limited to the GRI data) on the Bloomberg terminal, this hurdle is of greatly diminished importance. Today, any analyst or investor can immediately call up a respectable array of data on emissions, waste, sustainability policy provisions, and a number of other indicators. In recent discussions with Bloomberg company representatives, I was informed that new variables are being added regularly at the request of a “critical mass” of customers, as are new analytical capabilities.

Accordingly, if and when ES&G investing truly becomes mainstream, at least some of the basic data required to implement the approach will be ready and waiting. Those working on sustainability issues in or for companies should take careful note of this development.

• Incorporating ES&G into investment analysis and decision-making processes

• Being active owners and incorporating ES&G issues into ownership policies and practices

• Seeking appropriate disclosure on ES&G issues by the companies in which members invest

• Promoting acceptance and implementation of the principles within the investment industry

• Working together to enhance members’ collective effectiveness in implementing the principles

• Reporting on activities and progress toward implementing the principles

Accordingly, active participation in the PRI is a clear indicator of the types of commitments and behaviors that are consistent with those that I advocate within the investor community. Participation in this initiative is growing strongly. According to the PRI web site, as of December 2010, there were 808 signatories with $22 trillion in assets, representing a near-doubling since 2008. According to the PRI (PRI, 2010), as of 2009, $6.8 trillion worldwide was being managed using an integrated ES&G investment approach, or 7 percent of the global total. With this magnitude of support from institutional investors and apparent progress on the difficult task of ES&G integration, I suspect that the capital markets may be approaching an inflection point, beyond which active consideration of ES&G factors becomes the rule rather than the exception. The answer will be clear within the next few years.

Funds invested by this market segment were one of the very few to grow during and throughout the 2008–2009 financial market downturn. In fact, it grew by 35 percent during this two-year period. This particular investor group also reportedly brings a sophisticated point of view to its sustainability investments, perceiving ES&G investing as a financial discipline rather than a specific investment style such as SRI. That is, they believe in the financial value creation thesis posited in this book, and they seek investments that offer attractive risk-adjusted investment returns as a function of their ES&G characteristics. Consequently, these investors believe that specific knowledge of ES&G issues is necessary to succeed in this market segment, as distinct from relying on simple indices and scores. As suggested at several points in this book, such knowledge is not widespread either in the general population (including the wealthy) or in the investor/analyst community. Other interesting recent survey results include the fact that fewer than 10 percent of HNWIs report that they are filling a philanthropic need when investing sustainably. Seventy-eight percent believe that sustainable investments will increase with the generational transfer of wealth that will occur as the previous generation departs and their descendants and other beneficiaries inherit their assets (Eurosif, 2010). The lives and investing activities of such people may be (and remain) unfamiliar to many of us at a personal or professional level. However, it is important to understand that collectively, HNWIs own significant investment capital and are increasingly deploying it into what they perceive as sustainable investments. Relative to their numbers, they exert disproportionate influence on the financial markets.

What does seem clear, however, is that respondents to the SIF survey share the unanimous view that client interest in ES&G and responsible investing is not a passing phenomenon. No respondents (of the 41) apparently believe that client interest in this topic will decrease in the near future, and nearly 90 percent believe it will grow over the next three years. These findings suggest that ES&G investing is steadily converting the skeptics, and that an additional tipping point may be near. If investment consultants as a group develop the conviction that ES&G investing is a winning strategy and then develop the expertise necessary to do it well, another significant lever in favor of the concept will be activated.

In a related development, the national stock exchanges of a number of countries have established “sustainability” indices and/or issued sustainability guidance, as shown in Table 6-11. These data reflect the situation as of mid-to-late 2010. Remember that, as with other aspects of the ES&G investing arena, events are evolving rapidly.

Table 6-11. Emerging Stock Exchange Practices in Support of Corporate Sustainability

Interestingly, national stock exchanges on every continent (except, of course, Antarctica) have either established one or more sustainability indices or issued corporate sustainability guidance. These types of structural support for the concept of ES&G investing are especially prominent in Europe and Asia.

It is clear that there is growing interest in and capital devoted to ES&G investing, in both the U.S. and other developed capital markets. Moreover, the approaches that are being used to allocate capital to specific investments are becoming increasingly sophisticated, more directly linked to drivers of financial value, and based on facts and data rather than supposition or belief. There is every indication that these trends will continue.

Substantial barriers to more extensive and thoughtful ES&G integration have existed from the outset, and some of these remain significant. With that said, many of the more important barriers are beginning to fall away. This includes the traditional interpretation of fiduciary duty, pervasive attitudes and beliefs within the mainstream investment community, and the passive approach to proxy voting exhibited by many mutual funds and other institutional investors. Other systemic barriers remain, not the least of which are existing incentive systems and the limited capability/capacity to properly implement ES&G investing within many money management firms. I am cautiously optimistic that the PRI will help address the former, but I believe that fundamental changes in educational approach and career development will be required to move the needle on the latter.

I believe that corporate EHS/sustainability professionals have numerous opportunities to provide clarity and add value to this ongoing dialog. Such people can best understand how ES&G issues are related to important business drivers. They have a key role to play in developing, organizing, and analyzing the material facts needed to support the business case for new ES&G investments; measure the direct and indirect impacts of improved ES&G management practices; and participate in the crucial translation of enhancements in ES&G posture and performance into financially relevant terms. External to their own organizations, they can participate in dialog with the ES&G research and investor communities to better align what is measured and reported with what is valued (and truly of value).

These efforts can be supported and amplified by senior management and those playing other significant roles in the corporation—particularly those with responsibility for or influence on interactions with financial community representatives (investor relations, finance), customer interactions (marketing, customer relationship management), product/service design and production (design, engineering, operations), physical plant (facilities, maintenance), and investments in employee capability (human resources).

Similarly, there are abundant opportunities for finance/investing professionals to add value and stimulate more sustainable corporate behavior in the companies that they study and (perhaps) invest in. These start with educating corporate EHS professionals and senior managers about their investment/value thesis and how ES&G considerations are factored in, what ES&G management practices and levels of performance they seek, and which types of investments in new organizational capability are, from the investor’s point of view, most likely to create financial value.

These and other opportunities are explored in the final chapters of this book. The next chapter looks at the empirical evidence for the financial value-creation potential of ES&G management and performance improvements. This discussion is provided in the interests of supporting the ideas and recommendations presented in this book with objective facts. You can judge for yourself whether and to what extent a convincing general business case for corporate ES&G improvements has been made, as well as how solid the case for ES&G investing truly is.

2. Unfortunately, this view is not limited to graduates of the “Chicago School” or other adherents of the teachings of Milton Friedman. Consider, for example, that the Obama Administration’s EPA Administrator summarily terminated two of the EPA’s most visible and successful voluntary environmental improvement programs shortly after assuming her new position.

3. Note that some programs may have performance-based entry requirements and that the newer and more carefully designed among them often require commitments to improvement goals and regular performance reporting.

4. Note that one of the main causes of the recent worldwide recession was the widespread use of credit default swaps and other exotic investment instruments that were not traded on exchanges. When the fundamentals underlying these securities eroded, they could not be readily valued, and they became highly illiquid.

5. The recent subprime mortgage debacle illustrates the perils of departing from this long-standing investment principle.

6. Risk levels are quantified through bond ratings. These indicate the creditworthiness of a company’s debt securities as a function of many operational and financial variables, as determined (generally) by one or more of the three major bond rating agencies in the U.S.: Standard & Poor’s, Moody’s, and Fitch.

7. Cash flow is an important indicator and is derived from corporate earnings. Under federal securities laws, publicly traded firms in the U.S. must include a cash flow statement as part of their 10-K and 10-Q filings, along with their income statement and balance sheet. Some investors focus more on cash flow than earnings. Cash flow tends to be less volatile and is unaffected either by activities that do not require cash payments (such as depreciation) or by episodic adjustments such as asset write-downs.

8. Note that this discussion describes the typical pattern of investment. Some investors expressly follow a strictly “bottom-up” approach that focuses exclusively on finding individual company securities that meet its criteria.

9. Short-selling, or “shorting,” involves selling a defined number of shares of a company’s stock at a stated price that is lower than the current market price. These shares are borrowed from a broker or other entity offering this service, so the seller does not actually own them when the sale occurs. The seller receives the proceeds from the sale and then has a stated period of time in which to conclude the transaction, which involves buying the same number of shares at the then-current market price. If, as the short-seller anticipates, the market price declines, he or she reaps the price difference (minus transaction costs) as his or her profit. If instead the market price goes up and does not decline before the contract closes, the short-seller must still purchase the shares at the available price. In that case the short-seller pays more than he or she received from the short sale, thereby losing money.

10. The authority to issue these regulations, as well as the formation of the SEC itself, was provided in the Securities Exchange Act of 1934 (SEC Act). This statute brought sweeping changes, including vastly greater transparency and accountability, to public company reporting and investment company/advisor behavior. It was a direct response to the abusive, and ultimately destructive, behavior that led to the 1929 stock market crash that precipitated the Great Depression. The SEC Act remains the principal source of federal authority to regulate securities markets and corporate financial reporting.

11. See Regulation S-K, Items 101, 103, and 303, for details.

12. The final rule is published at 74 FR 245:68334–68367.

13. The SEC interpretive guidance is published at 75 FR 25:6290–6297.

14. The final rule is published at 75 FR 179: 56668–56793.

15. In theory (and officially), initiatives such as the GRI are intended to be suitable for use by a wide spectrum of organizations, including small businesses, public sector organizations, and nonprofits. Nonetheless, it is very clear that the major target organizations for the GRI, UNGC, and CDP are corporations—particularly large, multinational corporations.

16. The GRI is well aware of its difficulties in penetrating the U.S. market. In January 2011 it officially launched a new initiative titled “Focal Point USA” (GRI, 2011). To this point, the specific activities of this new effort to induce greater uptake of the GRI guidelines and more extensive GRI reporting among U.S. companies have not been publicly described.

17. As noted, in the U.S., securities laws (including licensing of brokers) are administered at the state level. With respect to the Modern Prudent Investor Rule, a national model, the Uniform Prudent Investor Act (UPIA), incorporates the modern portfolio theory concept. It has been adopted by more than 45 U.S. states and the District of Columbia.

18. Doyle, R., 1998. Advisory Opinion. U.S. Department of Labor, PWBA Office of Regulations and Interpretations. 28 May.

19. As discussed in the next chapter, some alternative formulations of this relationship have emerged during the past few years. Most retain the beta as an important explanatory variable but also include one or more additional variables to provide incremental explanatory power and reduce error. These variables may include company size, leverage, intangible asset value, and price momentum.

20. As with so many other areas of human endeavor, the issue comes down to balancing fear and greed.

21. In the U.S., financial data are required to be prepared using Generally Accepted Accounting Principles (GAAP). Public companies must be audited by an independent accounting firm.

22. Further information on EVA may be obtained from the Stern Stewart web site: www.sternstewart.com/?content=proprietary&p=eva.

23. Empirical studies have shown that many “sin” stocks have performed well over time. This has caused portfolios lacking these securities to, in many cases, lag in investor returns relative to their market benchmarks, which do contain them. Indeed, a small number of “vice” mutual funds have been launched in recent years to allow investors to buy concentrated exposure to firms in such industries as gaming (casinos), liquor, tobacco, and defense/aerospace.

24. Note that this approach also provides benefits to firms in “dirty” industries and to society in general. It provides incentives for the participants in sectors with ES&G issues to improve their performance to become best-in-class, rather than simply accepting the earlier reality that certain investors would never consider buying their securities.

25. Technically, Goldman Sachs is now a “commercial bank,” reflecting a registration change that it was allowed to make in the immediate aftermath of the financial crisis in late 2008. Nonetheless, with minor adjustments, Goldman has continued its principal business activities with little interference from new regulatory requirements.

26. I could, however, envision some exceptions to this general rule, such as when a company experiences some adverse publicity in connection with its ES&G behavior or in response to an incident. In such cases, the short-term trader may seek to short-sell the company’s shares or take other measures to capitalize on these events.

27. With that said, I note with interest that two firms involved in some way in the ES&G market space (DWS/Deutsche Bank and State Street) supported no such resolutions in 2009. DWS operates a research unit that explicitly focuses on the investor-relevant aspects of climate change, and State Street has long operated a subsidiary that is an active member of the SRI community.

28. For further information, you could review a recent report that I coauthored along with two colleagues—one an internationally known sustainability expert, and the other a member of the U.S. ES&G research community. The report was prepared for the U.S. EPA and is available at www.epa.gov/osem/financial/reports.html.

29. I note with interest that this distinction is diminishing. When I initially performed this comparison in 2009, only one large, mainstream U.S. financial institution had signed on to the PRI. As of early 2011, it has been joined by several others, including Blackrock, CBRE Investors, JP Morgan Asset Management, Kohlberg Kravis & Roberts (KKR), and T. Rowe Price.

30. In many cases, European ES&G researchers and investors use data published by the U.S. EPA (such as Toxics Release Inventory [TRI] emissions) as a major source of environmental performance information for U.S. companies.

31. Smaller players include Egan Jones Rating Agency, and A.M. Best, which specializes in evaluating the creditworthiness of insurance companies and their fixed income securities.

32. Originally and for many years, subscribers actually had a hardware device installed in their workplaces by Bloomberg, which was then connected to a dedicated data line (and later the Internet). Today, the “terminal” is a software application installed on the subscriber’s computer of choice.

33. Once established, this effort effectively superseded and ultimately absorbed the Enhanced Analytics Initiative (EAI), formed in October 2004 by a group of institutional investors, including asset managers and pension funds. The focus of the EAI was to promote integration of ES&G factors into sell-side research by requiring commitments to sequester and award incentive compensation specifically for analysts who improved the quality and utility of their research and recommendations by factoring in ES&G considerations. After attracting significant early support (28 members from the U.S. and Europe with AUM of $2.4 trillion), the initiative appeared to lose momentum in the face of the broader PRI.