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How sustainability benefits profits, people and the planet

Sharpe Thinking

Home / Perspectives / How sustainability benefits profits, people and the planet

Andrew Parry, Head of Sustainable Investing

With a complex web of macroeconomic challenges currently destabilising societies and economies, the impact of business operations has come under more scrutiny than ever. At the same time, interest in sustainable investment has grown exponentially, as investors and their clients seek to understand how they influence the well-being of the planet and society.

Taking a sustainable approach can not only benefit society and the environment but can also make businesses more resilient and strengthen their performance in the long term.

Sustainable investing: high on investors’ agendas in an uncertain world
The world is currently facing a myriad of macroeconomic challenges. Globalisation and cross-border collaboration are under threat, seemingly replaced by insularity and self-interest. The recovery from the global financial crisis, driven by quantitative easing, has been uneven across societies while trust in the political establishment is at an all-time low. Rapid technological developments mean an everincreasing range of jobs is under threat from robotics and artificial intelligence. And despite 2016 being the warmest year on record, climate change denial is back on the political agenda. It is unsurprising that against this backdrop, investors’ interest in sustainable investing has surged, as they seek ways to counter the retrograde consequences of populism.

People, planet and profits
Although sustainable investing is not new, its influence is accelerating as it attracts a rapidly growing pool of assets. Increased regulation has played its part but, encouragingly, companies, employees, consumers and investors are also beginning to see the fundamental benefits of creating a more sustainable future for society and the planet.

The UN’s Brundtland Commission in 1987 defined the concept of sustainable development, and in 1989 Swedish academic Karl-Henrik Robèrt introduced the highly regarded ‘Natural Step Framework’, which set out conditions for the sustainable development of human activity on the planet. The most famous concept to emerge from the early work in this space was John Elkington’s 1994 ‘triple bottom line’ – people, planet and profits.

Dr Robèrt’s work scientifically demonstrated that we live in a complex, adaptive ecosystem with a high level of interdependence between its various components. This is why investors and companies need to take a holistic approach to managing their activities. Maximising the utility of one part of the system, such as short-term profits, may well have significant impact elsewhere that ultimately renders those profits unsustainable over time.

Why take a holistic approach?
A recent medical study clearly illustrated why a holistic perspective on the interaction between businesses and the public is essential. The study pointed to a causal link between living in proximity to heavy traffic routes and an increased risk of developing Alzheimer’s disease. This reinforces the notion that you do not need to believe in climate change to recognise that an indifferent attitude to pollution could be damaging the quality of life for millions now, and building immense future healthcare costs for society. Beijing and Shanghai often hit the headlines for their appalling levels of pollution, but the air in London and Paris has also reached near toxic levels on some days. This puts the shareholder opprobrium and regulatory fines heaped on Volkswagen in the US following its decision to cheat emissions tests into appropriate context. Actions like these not only negatively impact people and the planet but ultimately damage shareholder returns.

Historically, sustainable investment has been left to specialist sections of the market focusing on socially responsible investing (SRI), environmental, social and governance (ESG) or social enterprise approaches, where social and environmental considerations were often placed ahead of financial returns. Increasingly, however, the focus is on integrating these considerations into all investment approaches as investors recognise that this can add long-term value to portfolios. In effect, investors are now applying the principle of ‘do no harm’ to investing.

Poor corporate governance destroys returns
When clients ask for proof that ESG investing works, we instead ask why one would not consider the ESG behaviours of a company when assessing a new opportunity? It makes long-term economic sense to invest in companies that limit their consumption of scarce, finite resources, eliminate harmful waste that is costly to recycle, and have high standards of environmental efficiency that allay the need for regulatory fines. Managing environmental considerations like these not only boosts financial returns, but makes a business more sustainable over time.

On the social side, companies with poor labour practices have higher staff turnover, more frequent strikes and increased instances of illness and injury – which all contribute to lower productivity and damage corporate reputations.

As research by our Global Equities team has demonstrated1, companies with the poorest standards of corporate governance systematically diminish shareholder returns and typically suffer lower valuations, raising the cost of capital. We integrate ESG considerations into our thinking because it makes financial sense and improves the sustainability of those returns over time.

Companies have a complex set of effects – positive and negative – on the environment and society. Measuring these is often a hard task and can lead to an excessive focus on the here and now. This can mean that not enough consideration is paid to the direction of travel of a business and can fail to recognise those companies that are improving. As responsible investing goes mainstream, the data available to measure companies’ ESG impact will increase dramatically. While this will improve the scrutiny and awareness of the sustainability of businesses on the margins, we believe a truly holistic approach to investing must go much further.

investment-practive-chart

Integral to system-wide sustainability is the role of investors in encouraging credible and lasting change in companies. As agents of change, investors will need to rethink many aspects of their investment processes, from the way they engage with companies through to the time horizon of their investments. Public market equities provide a significant opportunity for driving future prosperity for all, given the breadth and scale of their effect on society. Shared prosperity would enhance society’s ability to create a sustainable system for allocating increasingly scarce resources.

While having a different emphasis, the UN’s Sustainable Development Goals for 2030 are a useful guide to sustainability for companies and investors alike. Although these goals do not explicitly translate into business, they can help identify negative outcomes from human activity, particularly poverty, which companies can contribute to resolving through positive working practices. It is not sufficient to look solely at ‘best in class’ businesses because, to achieve a sustainable economic model in a world of scarce resources, we need to eradicate poor behaviours and compound the positives.

Sustainability in the value chain
Investors seeking strong holistic returns should consider whether sustainability is embedded into a company’s value chain. Planting trees to compensate for pollution emitted elsewhere is nowhere near as valuable as reducing the primary level of pollution. Even an environmentally friendly business, such as a wind turbine manufacturer, should not rest on its green laurels. It must ask whether its manufacturing process is environmentally friendly and lowering the consumption of raw materials? Is it considering products’ life cycles and facilitating the refurbishing or recycling of its products?

Central to the ability to encourage and influence change is active and collaborative engagement between investors (acting as the agents of asset owners) and companies. But collaboration is not only about asset owners joining forces to convey a louder and more consistent message to company boards. It is also about working with management to understand and support long-term business objectives that will lead to a more sustainable system. Engagement provides the additional benefit of an effective feedback loop that better informs the investment manager, supporting a long-term approach.

Thinking actively about a company’s sustainability characteristics at the start of the research process is essential to increasing the sustainability of returns. Investors who consider these characteristics can engage from the offset with management on areas of concern where improvements could lead to higher and more sustainable future returns. By establishing a culture of active engagement at the outset of an investment, an investor reduces the necessity of reactive and more strident action later.

The investment management industry is accused of being short term in its assessment of business success and in its management of client assets. While some investors see companies as little more than tickers and factors to be traded at ever higher frequency, a greater awareness is emerging of the investment industry’s influence on the economy and society. A more holistic approach to investing should consider the long-term nature of value creation, and how it can deliver improved prosperity without degrading the environment. Prosperity as a concept goes beyond measuring the profitability of individual businesses or the notion of personal wealth. Instead, truly holistic investment should focus on how purposeful economic activity can contribute to the development of a more sustainable system overall.

"I don’t believe that the solutions in society will come from the left or the right or the north or the south. They will come from islands within those organizations; islands of people with integrity who want to do something...

This is what a network should do – identify the people who would like to do something good. And they are everywhere. This is how the change will appear – you won’t notice the difference. It won’t be anyone winning over anyone. It will just spread. One day you don’t need any more signs saying “Don’t spit on the floor,” or “Don’t put substances in the lake which can’t be processed.” It will be so natural. It will be something that the intelligent people do……It will just appear.."

Dr Karl-Henrik Robèrt, cancer scientist and sustainability advocate,
in an article in In Context, published 1991

Profit is a powerful force
Fiduciary responsibility is often cited as the reason why maximising short-term profits and returns is given precedence over a more holistic approach to business and investment management. As Adam Smith opined, profit is a powerful force for advancement, but as the sophistication and knowledge of our society grows, so our approach to investing should also evolve and reflect the broad influence of our actions.

Total shareholder return (TSR) – capital appreciation plus dividends – is a simple mantra that still dominates how we measure investment success. It plays an important part in executive remuneration and yet fails to consider the wider impact of a business. Indeed, TSR is often driven not by the success of management, but by an exposure to an existing financial characteristic. As quantitative easing stripped bonds of most of their return after the financial crisis, companies in the food and tobacco sectors benefited from a search for yield in equities as their reliable income streams became increasingly sought after. This drove share price appreciation well ahead of profits and dragged up equity remuneration in its wake.

More attention should be paid to total stakeholder return, whereby the wider impact of businesses on society and the environment plays a more prominent role. Using scarce resources and damaging the productive environment more generally reduces the net present value of future cash flows and renders a companies’ business model unsustainable in the long term. Sustainability should be incorporated into financial analysis, not considered alongside it.

 

Companies rise to the challenge
Many companies are already attempting to contribute to a more sustainable world within their business models. For example, Unilever has committed to becoming a more sustainable business, recently announcing plans to make 100% of its plastic packaging recyclable by 2025. The Business & Sustainable Development Commission, supported by Unilever, has reported on how the UN’s Sustainable Development Goals can provide businesses with a framework for sustainability. As we saw with the Millenium Development Goals, the SDGs could be a powerful force for change. Innovation is a key strength of business and, if correctly directed, can have a significant impact on sustainability, alongside increasing profitability. We are encouraged
by the breadth of initiatives appearing in the financial and business communities. Better reporting and regulatory standards are helping to promote improved transparency and sustainability measurement.

Over a decade ago, the UN Principles of Responsible Investing established a menu of six actions for incorporating ESG into investment practice. With nearly 1,500 signatories from over 50 countries, it has been an important force in introducing sustainable investment considerations to mainstream asset management. However, to provide an economic system that is future-proof, we need to go further. As ESG data becomes more widely available, we need to see it as a mechanism for change and not an end in itself: it not only allows companies to better manage their outcomes, but provides investors with a mechanism for assessing performance and advocating for improvements. We must encourage investors to pursue truly holistic
approaches so that sustainability considerations become central to, not separate from, generating long-term financial returns that will endure.

"Let us not become weary in doing good, for at the proper time we will reap a
harvest if we do not give up."

Galatians 6:9

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Andrew Parry Head of Sustainable Investing Andrew Parry is Head of Sustainable Investing and a member of the Hermes Strategy Group. He joined the firm in 2009, initially as Chief Executive and Co-Head of Investment for Hermes Sourcecap, now Hermes European Equities, becoming Head of Equities in 2014. In 2006, Andrew jointly founded Sourcecap with the aim of building a best-in-class investment boutique focused on excellence in European equity management. Prior to this, Andrew established Pembroke Capital Management in 2003 and successfully launched the Magenta Fund, a global equity non-directional fund. Before that, Andrew worked at Northern Trust Global Investments (Europe) Ltd as Chief Investment Officer of International Equities and was responsible for the management of global, international and regional portfolios. He has also held a variety of senior investment roles, including Head of International Equities at Julius Baer Investments, Chief Investment Officer at Lazard Brothers Asset Management, and Head of UK Equities at Baring Asset Management. Andrew holds an MA in Mathematics from the University of St Andrews. Andrew is a member of the Investment Committee of the Trafalgar House Pension Trust and a non-equity director of Aerion Fund Managers. He was formerly an independent investment advisor to the Investment Sub-Committee of the Mineworkers’ Pension Scheme.
Read all articles by Andrew Parry

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