By Kenneth Scott, CFA
From the Winter 2010 Edition of Values

A report commissioned by the U.N.-backed Principles for Responsible Investment (PRI) and the U.N. Environmental Programme Finance Initiative found that global environmental damage caused by human activity totalled $6.6 trillion, equivalent to 11 percent of global GDP in 2008. The world’s top 3,000 public companies were reportedly responsible for one-third of that damage, and might face increased operating costs through higher insurance premiums, taxes, input prices, and clean-up costs.

While corporations are addressing sustainability, according to an MIT Sloan Management Review special report, they appear to be focused on regulatory requirements and environmental aspects and have not developed a clear business case. A survey by management consulting firm McKinsey & Company supports this point. McKinsey notes that most executives consider management of environmental, social and governance (ESG) matters “very” or “extremely” important in a wide range of areas and important to brand reputation and creation of long-term shareholder value, yet most do not proactively manage these issues.

At the same time shareholders are increasingly asking companies for ESG information. While the corporate impacts of ESG matters are often presented in the framework of financial risks, companies should consider the spectrum of financial outcomes that are associated with their ESG performance. This spectrum ranges in the five following areas from outcomes that are generally detrimental to those that are substantively beneficial:

License to Operate
Any corporation’s success depends on a broad range of stakeholders. The corporate “license to operate” may be effectively revoked by a consumer boycott, labor strike, community action, regulatory intervention, legal injunction or some other stakeholder intervention. The stock of blood-testing products maker Immucor slid 14 percent on June 26, 2009, when the U.S. Food and Drug Administration issued a notice of intent to revoke its license for two blood tests. Asarco, Owens Corning and W.R. Grace and dozens of other firms facing asbestos-related claims have gone bankrupt. After Operation PUSH launched a boycott of Nike, in order to promote employment opportunities for African Americans, a Gallup survey found that “31 percent of the public were aware of the boycott, [and] 20 percent were planning to buy fewer Nike products.”

Risk Reduction
Corporate ESG practices may prompt a variety of risks requiring mitigation. These risks include legal, regulatory, liquidity, credit, reputational or others that could be discontinuous and materially costly to the firm. In June 2010, BP established a $20 billion trust fund to assure reparations for the infamous Macondo oil well spill in the Gulf of Mexico. Two months later, BP agreed with the U.S. Occupational Safety and Health Administration (OSHA) to pay a $50 million penalty for failing to abate safety concerns identified by OSHA following the Texas City refinery explosion of 2005, and to spend at least $500 million on safety upgrades.

The costs of discrimination, as another example, also appear to be rising. According to The Bureau of National Affairs (BNA), the U.S. Equal Employment Opportunity Commission (EEOC) has more than 100 class action lawsuits under way. BNA highlighted the potential costs to companies of class action lawsuits by the EEOC; these costs include time, legal expense and monetary exposure to damages. Nor is the courtroom necessarily a friendly forum for corporations facing discrimination charges. The U.S. Court of Appeals for the Ninth Circuit certified a class of 1.5 million plaintiffs in a class-action lawsuit against Wal-Mart, implying potential exposure to liabilities measured in billions of dollars, while Novartis Pharmaceuticals settled a $175 million discrimination verdict in federal district court.

ESG risks can also express themselves as increased financing costs. A recent study by the European Centre for Corporate Engagement found that the credit spreads (yields relative to U.S. Treasuries of comparable maturities) of borrowing firms is influenced by legal, reputation and regulatory risks associated with environmental incidents.

Operational Efficiencies
Companies can reduce operating costs by leveraging capital and human assets. The MIT report cited above indicated that aggressive action on sustainability yields more opportunities and reaps material benefits. For example, efficiencies in the use of natural resources can often result in significant cost savings. Hewlett-Packard reports that by consolidating more than 85 internal IT data centers into 6 new data centers, the firm reduced its IT budget in half, reducing electricity use by 60 percent per year, and saving $1 billion per year.

Costco offers a comparable example in employer relations. By offering above market wages and benefits, the retailer experiences a lower turnover rate than peers, such as Wal-Mart. This is important because lower turnover results in lower training costs. One report estimates that turnover costs one and a half times an employee’s salary (The Saratoga Institute).

Compensation and benefits are one element of employer relations. A study in the Academy of Management Journal found that “organizations with a greater range of work-family policies have higher levels of organizational performance, market performance, and profit-sales growth.” And, University of Pennsylvania Wharton School assistant professor Alex Edmans found that, in general, “[e]mployee satisfaction is positively related to corporate performance.”

Integrated energy firm Royal Dutch Shell offers a counterexample in efficient governance. Until July 2005, the firm had operated under two separate boards of directors–an alleged contributing factor to its previous overstatement of its petroleum reserves.

Competitive Brand Positioning and Reputation
Sustainable corporate policies or practices can serve to enhance a firm’s overall brand and improve competitiveness. According to Accenture, “in 2008, 91 percent of consumers said they had bought a product or service from a company they trusted, whereas 77 percent had refused to buy a product or service from a distrusted company.” Consider, for example, the enhanced reputation of outdoor apparel and footwear maker Timberland due to its association with City Year. Moreover, reputation matters to more than just customers. As concluded by the Great Place to Work Institute, organizations with reputations as good employers tend to attract high quality staff, directly correlating to productivity.

Revenue Generation
A company’s success depends ultimately on growth. In recognizing the ability of a particular product or service to provide a more sustainable outcome relative to peers, companies can boost financial prospects directly through new market opportunities. Steve Reinemund, predecessor to Indra Nooyi as CEO of PepsiCo, argued, not only that diversity promoted better decision making, but also credited one percentage point of its 8 percent growth in 2004 to the (increasing) diversity of its employees. PepsiCo cited guacamole-flavored DoritosGatorade XtremoMountain Dew Red, and a wasabi-flavored snack.

Products and services that maximize the efficient use of resources may provide their customers substantial cost savings and boost their own top lines. Examples of companies that enable resource conservation include Baldor Electric, which makes energy efficient industrial electric motors; Commercial Metals, which engages in scrap steel recycling; and Watts Water Technologies, which makes water safety and water flow control products such as backflow preventers, water pressure regulators, and filtration systems, all of which enhance water conservation.

Thinking Long-Term
Given the associated spectrum of financial outcomes, corporate executives and investors who measure, manage and disclose their policies and performance on ESG factors may have the greatest insight on this key dimension of overall company performance. Companies have an opportunity to improve their financial performance by maintaining their licenses to operate, mitigating risks, realizing efficiencies, positioning themselves competitively, and identifying additional sources of revenues. For executives and investors an appreciation of material ESG factors over a long-term horizon is integral to a sustainable business model.