Diana Glassman, CEO of Integration Strategy.
Diana Glassman, CEO of Integration Strategy, and Matt Potoski and Patrick Callery of The Bren School of Environmental Science and Management at the University of California, Santa Barbara (UCSB) have written “The Missing Metrics that Matter to Investors – How Companies Can Develop ESG Financial Value Creation Metrics” (2017), to be published by the Journal of Environmental Investing (JEI) (volume 8, number 1). The paper lays out metrics that make the financial impact of Environmental, Social, and Governance (“ESG” or “sustainability”) strategies visible to investors, executives and board directors. It’s important because seeing when it creates financial value will help investors take into account companies’ sustainability performance, which could increase capital flowing to companies that do well by doing good.
The article launches September 22 at the JEI’s Symposium on ESG Data and Metrics. In October Diana will speak at the National Association of Corporate Directors (NACD) Global Directors Summit and in November the United Nations Principles for Responsible Investment (UNPRI) will distribute the paper’s summary to investors.
In anticipation of the launch, impactmania spoke with Diana about financial and social capital; linking environmental and social values to a company’s core business, and how her mother’s book, Autumn Lamp in Rain impacted her professional DNA.
BY PAKSY PLACKIS-CHENG
How come investors are having a hard time investing in companies that demonstrate ESG value?
ESG terminology is its own worst enemy. It’s also called “socially responsible investing” (SRI), “sustainable investing”, “impact investing”, and more. Whatever you call it — investors often equate it with lower financial returns and nice, well-meaning people outside the business. I’d like to scrap all that and replace ESG with another word that connotes it’s an exciting way to increase financial performance.
Institutional investors need more evidence that ESG increases value because the pensioners, foundations, and others who rely on them can’t afford lower returns.
Investors want companies to provide a few meaningful metrics that in the aggregate convey how much a company’s environmental and social practices contribute to its value. A challenge of existing ESG data is that there’s a lot of it and investors don’t know how to use it. Sometimes they spend money on outside resources to try to make sense of it and still can’t figure out if it increases or decreases financial performance.
How can a company leverage its ESG practices to create financial value?
At a high level, companies create financial value by increasing revenue or reducing costs to maximize return on investment. Similarly, ESG practices create value by helping the company grow revenue or lower costs. [cite Lubin and Esty – Lubin, D.A., and D.C. Esty. 2014. “Bridging the Sustainability Gap.” MIT Sloan Management Review.]
You want to get as much return, bang, for your dollar.
What are examples of ESG value creation metrics that can be incorporated in financial analysis?
Let’s start with two broad high-level metrics. The UNPRI has put out communications about what metrics drive the most value in general across companies and industries. [cite Lubin and Krosinsky – Lubin, D.A., and C. Krosinsky. 2013. The value Driver Model: A tool for communicating the business value of sustainability. United Nations Principles of Responsible Investment.]
One of them is sustainability-driven revenue growth. The other area relates to total cost, whether it’s used to pay bills or put into something that increases future financial performance.
Sometimes the way to maximize the return on the cost is not to reduce the cost. Sometimes by reducing inefficiency, savings go straight to the bottom line without loss in the top line.
You can call the overall “cost” metric sustainability-driven driven productivity increase. [cite Lubin and Esty.]
What if I am an investor or even a customer and environment is a third consideration after a good and fair cost product. What metric could I look at to indicate future growth?
If you have two products with the same quality and cost, most people would prefer to buy the one with better ESG performance. But historically, many companies did not track ESG related revenue. Companies could include that as something that they capture data on. It is very helpful to measure it over time so that you have a sense of what is changing and you can link it to your business building efforts.
What companies do is they take surveys of their customers. You’ve probably been surveyed, probably more than you want, “What caused you to buy from us? How likely are you to buy from us again? Would you promote our company?” (ESG-conscious customers tend to be more loyal and more likely to promote companies they like.) These become strategic (and predictive) metrics that indicate the health of your business.
Do I understand correctly that ESG is not a separate line item I would see in the financial statements, it’s integrated in the way you do business, and it will reflected in the existing financial items?
What our metrics do is they provide justification to adjust existing line items. The published financial statements don’t include much detail, so adjustments are rolled in. But we break it out first.
Basically, the way companies forecast their financial statements — as they go line by line by line — they make lots of assumptions, about its growth rate, about new products. They look at data, evidence, to help them justify each assumption: “We anticipate a price increase or we have plans to hire 200 people.” Investors also make adjustments.
You can look at all of the financial impacts of an integrated ESG strategy, and ask how does this impact the projections? And traditionally, they are not captured, all we’re saying is, “Okay, in a very systematic way, let’s look at all the impacts on the financial statements. Let’s look at what the evidence is, that’s where our operational level metrics are. And let’s adjust the financials accordingly“. Investors can see impact on earnings.
To calculate value, we look at how much cash the company is expected to produce into the future, and discount it to the present. And we can see how much of that is contributed by the ESG strategy. This mechanism is taught in every business school, every CFA [Chartered Financial Analyst] knows it. It is widely used by corporate CFOs [Chief Financial Officers] today to make capital allocation decisions.
How do you respond to investors who say it is too hard to separate the impact from different decisions that far into the future?
There’s a lot of wisdom and business judgment in the whole art of financial statement analysis and projections. No information is perfect. There are mechanisms you can use to tease out what is a contribution of what factor.
For example, if you have technology, how do you know what the contribution of technology is to your productivity and to revenue? How do you really, really know?
If you think you might have competition from China, how do you measure that in financial statements?
Investors and executives make decisions under uncertainty all the time.
There’re lots of activities today that somehow are measured and I would argue that we could do that with sustainability as well.
Give me an example of a company that currently has incorporated these ESG numbers in their financial statements.
Companies with ESG products and services can simply tie them to their financial performance. This would be a company like Tesla. They know how much revenue comes in and they know their cost structure, asset utilization, and financial performance.
The real benefit is in companies that don’t sell specifically identified products and services where you wouldn’t necessarily expect to find these benefits, but are somehow gaining these benefits. And that’s why I go back to a retail environment; I used to work for a retail bank. People would ask, “Why would a bank be interested in environment?” It’s really simple, if you want to attract loyal customers, millennials and upper middle class moms; this is a mechanism you have to differentiate yourself against the competition.
In a bank, you’re hiring many millennials, women, and Hispanics. They’re the most ESG-aware demographic categories. This can be linked to reduce employee turnover and that goes straight to the bottom line. Retail businesses frequently have 35 – 40 percent or more turnover rates. That is a real savings, and real cash.
It comes right down to this financial value that you’re creating. We were very successful infusing ESG into the bank’s culture within three years because we developed credible metrics that the company could use to measure our performance. Because we contributed to financial performance, we were able to spread our program across the company’s operations in a very short period of time.
What is a lesson learned by the bank from incorporating ESG in their business strategy?
When I came into this company, they weren’t really thinking so much about the quantitative financial benefits. It was more about a general need to engage their employees and enhance the brand. Low expectations about ESG financial value can be self-fulfilling in many companies, but I had high expectations and a sense of urgency.
What did you learn that you would take to the next company?
We had to find innovative ways to overcome numerous practical challenges, such as how to capture clean data, including in our technology systems. But the company didn’t necessarily report the economic benefits to external investors. And so if an investor were to compare this company to another company in the same sector, the financial impact might not have been fully visible. They could have missed a signal of future outperformance. Investors like predictive signals.
Very often, what you find is that corporates are not measuring the economic benefits of these activities. They’re not communicating them. Investors historically have seen these sorts of investments as losing money. That seems to be a very widespread perception.
There are examples, historically, where investments selected on the basis of their social-environmental governance performance have not done as well as others. So, they have reason to believe this. There’s an assumption that these things don’t make money.
I think we hear of so few of these organizations — those that do well with an incorporated ESG strategy that are equally great (or better) financial investments.
That’s exactly right. We have a lot of metrics about those externalities, about the number of trees that you plant, about the number of young girls that you educate. But again, none of those directly ties to earnings — to cash.
It’s not that they don’t add value. But if you want to help an investor and a CEO really understand the economic value, you’ll have to link it somehow to financial performance in a credible way.
Investors don’t know which companies are using that to create economic value for their shareholders. We’re not saying that a company that’s doing well on its ESG performance is also using it to do well financially.
We provide metrics that help investors identify which ones are doing both; there is this large volume of pent up demand from a many investors that are looking for those investment opportunities.
What other industries should consider incorporating ESG numbers?
Clearly business to consumer, services, and product manufacturing industries. There are many companies that say, “I’m too small, this doesn’t impact me, or my investors don’t care, or my customers don’t care.” That may of may not be true today. What we argue, the first step in identifying the right metrics is a strategic assessment of the entirety of your value chain. [cite Lubin and Krosinsky.]
There’s been a maturity curve of when these considerations hit different industries. Walmart accelerated that when it asked vendors in its supply chain to start thinking about reducing packaging, environmental consideration, and social considerations.
When you looked at the financial services adoption rate for interest in environmental and social issues, it was down into single digits. Fast-forward a few years later, this is on the strategic agenda of every major asset management house. It takes longer to permeate different industries, but this is a global phenomenon. It is a multi-generational, multi-decade phenomenon of rising social-environmental awareness. It may not hit you today, but it behooves all investors and executives to look at what’s happening to their customers’ customers.
How do you infuse sustainability into a company’s culture? Give me a few steps that companies could take to start going that direction?
You show the company that you create economic value for the company and it will spread. There’s no doubt. If the environment does well for the company, the company will do well for the environment. Every company wants to eke out more economic value.
You do need to put in place the other components that are required to support a cultural change. You’ll need to have performance specifics for people, processes, and technology that capture these specifics. You’ll need to communicate and align because you need to have 360 degree support.
The inability to clearly link to financial performance is what keeps ESG from infusing core businesses, changing culture, and grabbing the attention of many CEOs and investors.
Companies do not take into account the output of polluted air and water in the total cost of producing their products. Doing this will only make a product more expensive. You mentioned earlier, “If the environment is good for the company, the company will be good for the environment,” isn’t there a conflict?
That’s the perception of many mainstream investors. Again, it is grounded in some reality and historic financial performance. However, it may or may not be true. Without really doing the analysis and the thinking and taking it internally to the next level, one may find hidden value that they don’t expect.
There are examples of companies and universities that are putting in place internal carbon pricing and internal water pricing mechanisms so that these are incorporated in long-term capital allocation decisions.
Companies have found that it leads to efficiencies that were unexpected. I go right back to a bank: why on earth would this benefit a bank? It’s a nice thing to do, but it costs money. Well actually, if you really think about it, you can find ways to maximize its financial benefits. ESG forms a higher level of engagement with employees and customers. If you can demonstrate substantial cost reduction and attract customers, these are the sort of things that raises the CEO’s eyebrows in a positive way.
Businesses and investors need to test their own assumptions. That’s just best practice strategic planning, best practice capital allocation, best practice investment decision making. We’re not arguing that we should treat ESG any differently from any other business consideration.
Diana Glassman during a PBS (MPTV) discussion about energy at a Town Hall. Photo courtesy of Diana Glassman and PBS.
You cited Autumn Lamp in Rain, your mother’s book about her life during the Japanese occupation and wars in Korea, and her immigrant life into the U.S. — it drove you to be passionate about these issues. How?
My mother grew up under the Japanese occupation in South Korea, being forced to learn Japanese. Then lived through the World War II and the Korean War.
Some of her earliest memories were about being forced to pick up scraps of metal for the Japanese war machine. That is environment — when you think about poverty and war — you save everything.
My father was a Holocaust survivor from Romania. He did forced labor as a kid; he had to pull out unexploded bombs. My grandfather was forced to work in cold dams. His legs never recovered. So when you talk about social conditions and workers’ rights, I think about my father and my grandfather.
My parents were survivors when most of their peers did not survive. I knew that growing up in this wealthy, special, privileged country we have access to education, resources, and people skills.
My mother always said that if you don’t do something for someone else, you’d wake up one day and wonder what your life has been all about.
I see business and investors as forces for good. You’d work from the inside to do what’s right for the business, make money for the business. Then with finance you have tools: resources, international networks, skills, technology, and people. All of these things can be used to create these broader benefits beyond economic and job creation benefits, which are very important. And on the investor side, you’re a multiplier. If you’re an investor, you make things happen in the manner by which you allocate money.
I wanted to go into the multipliers, where you could scale up quickly, affect the benefits that one person on their own could do. And everybody’s different, there’s room for lots of different skill sets. Going into business and investing was a great outlet for me to work from the inside, to help generate these benefits that are just part of my core.
Do you have any thoughts on social capital?
It’s very important. Customers, employees and communities are energized when they get to do what they feel is the right thing, which directly benefits the company.
Every religion around the world talks about helping other people and treating people like you want to be treated. Our country’s history is all about helping each other in our communities. What you see in reaction to perceived loss of social capital, often it swings the other way.
There are a lot of frayed relationships in this country, in Europe, and many parts of the world and it’s very important to rebuild them. Investors will do better, societies will do better, countries will do better — all of us will do better.
