Matthew Kiernan and James Martin explain why companies that pursue eco-efficient policies are likely to perform well
The unprecedented agreement on global warming negotiated in Kyoto, Japan, in late 1997, represents more than a last-minute triumph of multilateral diplomacy. It also represents the tip of a much larger – financial – iceberg. It is a harbinger of both a world-wide industrial restructuring and the emergence of the new, fundamentally different investment paradigm that accompanies it.
From Brussels to Bangkok, “eco-efficiency” factors are rapidly becoming critical drivers of corporate competitiveness, profitability and shareholder value. Taken together, these changes amount to what some senior Asian industrialists have recently termed an “Eco-Industrial Revolution”. Like any other fundamental economic restructuring, this revolution will create enormous dislocation and turbulence. It will also create unprecedented investment opportunities for those institutional investors who know where to look.
The eco-industrial revolution will – or should – also force pension funds and their advisers to think carefully about what it will mean to be a fiduciary as the new millennium begins. Historically, mainstream institutional investors have accepted unquestioningly the conventional industry wisdom that the pursuit of environmental or social excellence in companies can only be achieved at the cost of lower financial returns for investors. An important corollary of this argument held that, since environmental and social factors are, at best, irrelevant to the risk/return equation, fiduciaries are actually precluded from considering them.
It turns out that both the conventional wisdom and its corollary are wrong-headed: a fact explicitly acknowledged by the UK government’s recent pension reform legislation. From July 3, 2000, Britain’s occupational pensions schemes will be required to reveal what (if any) social, ethical or environmental considerations guide their investment decisions. At the very least, this new level of transparency will provide the impetus for some serious introspection by UK institutional investors and their advisors. And at best, it will provide fiduciaries with not only a clearer conscience, but with superior risk-adjusted financial returns.
It is now increasingly recognised by financial analysts and investors that there is a strong, positive and growing correlation between industrial companies’ eco-efficiency and their competitiveness and financial performance, whether measured as ROI, ROE, or total stock market return. Recent stock market research by ourselves and others confirm that a large, broadly diversified portfolio over-weighted with eco-efficient companies can be expected to outperform one composed of its less efficient competitors by a significant margin, even in the short term. The graph above illustrates the point in the context of UK large-capitalisation stocks.
In this case, an “eco-enhanced” FTSE 100 index was constructed, with companies demonstrating superior eco-efficiency over-weighted in the index relative to their industry competitors. A similar benchmark index portfolio was also constructed, this time deliberately over-weighting the eco-efficiency laggards. On a risk-adjusted basis, the eco-enhanced index outperformed its benchmark by more than 26% over a 17-month test period ending August 1999. Pension fund investors will notice that the eco-enhanced portfolio is also less volatile; while its performance certainly suffers along with the overall market during market declines, the drops are significantly less severe.
This performance is consistent with the results of an 18-month live simulation that we recently conducted with a leading Wall Street investment bank on the Standard & Poor’s 500 universe of stocks. Similar results are also emerging from an ongoing analysis of the FTSE Eurotop 300, a diversified universe of European large-cap equities. What is more, in particularly high-risk sectors such as chemicals, petroleum, forest products and energy, this “eco-efficiency premium” is almost invariably even greater. Yet most, if not all, of this outperformance potential currently remains invisible – and therefore unavailable – to mainstream institutional investors and their advisers.
Superior eco-efficiency can help generate competitive advantage and superior financial performance for companies and their investors by enhancing at least five well-recognised value drivers:
q Cost containment and liability reduction: 3M, Dow, and Baxter International are just three high-profile examples of companies saving hundreds of millions of dollars through pollution prevention and waste reduction. Almost by definition, the most eco-efficient companies are also the least exposed to legal and financial liabilities.
q Sales and market share growth: companies such as British Petroleum, DuPont, Electrolux and many others are already producing top-line revenue growth with new products and services predicated on superior eco-efficiency.
q Franchise and brand value: major corporations remain abjectly dependent on their “social licence to do business”, which can be revoked summarily over perceived environmental transgressions. The Brent Spar North Sea oil platform controversy, for example, cost Royal Dutch/Shell fully 30% of its market share in Germany within one month.
q Stakeholder satisfaction: senior executives from companies as diverse as Intel and Bristol-Myers Squibb are convinced their superior environmental performance and reputations have generated concrete shareholder value. For one thing, they lead directly to improved relations with regulators, which creates faster times-to-market for new facilities and products. That in turn generates additional market share and profitability. Superior eco-efficiency also enhances relations with other key stakeholders, such as customers, employees, suppliers and local communities.
q Innovation capacity: companies as diverse as Northern Telecom, Ford and British Petroleum can all point to concrete examples where environmental innovations have helped create an entirely new corporate ethos of innovation that extends far beyond the environmental area.
Each of these environmentally driven value drivers can and do contribute directly to a company’s ability to generate sustainable competitive advantage, profitability and shareholder value – and the eco-efficiency premium generated by these attributes can only increase in the next five years. A constellation of macro-level contextual factors is combining to make the competitive and financial stakes of eco-efficiency even greater than at present.
In the UK, Europe and the US, pension fund sponsors and their advisors have perpetuated the misconception that they are precluded from considering “non-financial” investment criteria by their fiduciary responsibilities. They have no choice, it is argued, but to strive to maximise investment returns; to consider “extraneous” factors, such as environmental or social performance, would constitute a dereliction of duty.
But overwhelming recent evidence suggests that fund managers, plan sponsors and the consulting industry have all had it backwards. We now have the financial technologies to demonstrate convincingly that environmental considerations do have financial ramifications for investors, and that they can be quantified and forecast with some precision.
Given the recent availability of these technologies, it is now fair to say that to fail to consider available information about companies’ environmental risk, performance and strategic positioning is to fail to discharge one’s fiduciary responsibilities, not to honour them. Traditional notions of fiduciary responsibility will need to be turned on their heads, and the forthcoming UK pension reform regulations should provide some much-needed impetus in that direction. Can the pension regulators – and institutional investors – in the rest of Europe be far behind?
Matthew Kiernan is executive managing director and James Martin is chairman of Innovest Strategic Value Advisors in New York