Creating sustainable capitalism
Responsible investing has long been a term in investment vocabulary. Until recently, however, it was on the periphery: a feel-good activity for ethically minded investors, but not a mainstream concern. However, this is changing. Responsible investment strategies are now becoming mainstream. The Principles for Responsible Investment membership now represent assets under management (AUM) in excess of US$80trn. In their report ‘Foundations of ESG Investing’, released in July 2019, MSCI highlighted a link between ESG (environmental, social and corporate governance) integration and the valuation and performance of companies, both through their better risk profile (lower exposure to idiosyncratic risk) and enhanced resource management and profitability leading to a lower cost of capital and better valuations.
It’s a key time to act. World economies are facing growing indebtedness and unsustainable asset prices as we enter an unsettling geopolitical reality, where nationalism and populism are creating go-it-alone state mentalities leading to rising military, economic and commercial tensions. At the same time, failure to mitigate climate change and growing cybersecurity breaches continue to grow as threats to global stability.
The distinction between ESG v impact investing
In this environment, it’s clear that sustainable investment approaches are needed to assess an organisation’s resilience, adaptability, long-term sustainability and capacity for growth. At Earth Capital, we believe the focus should be on impact investment, that has a more forward-looking approach than ESG evaluation which tends to focus on past performance, rather than exploring the future impact. ESG is often seen as changing finance, but impact investing is consciously financing change. Both strategies seek to improve sustainability outcomes, but impact investing allows investors to make more focused and measurable contributions - and this is the most critical area - although the latter is a minnow in global AUM terms. GIIN (Global Impact Investing Network) estimates the current impact investing market to be $502bn of AUM.
An acceptance that traditional capitalism is damaging
Over the longer term, responsible and sustainable business practices must become just part of ‘the way companies do business’ - a form of sustainable capitalism. However, for this to work, the world must accept that capitalism and the traditional business as usual model is a driver of, and complicit in, social injustice and environmental degradation in many cases. Capitalism in its current form threatens value. Sustainable capitalism, on the contrary, creates it.
When it comes to social injustice and environmental crises, business leaders can no longer stand by and watch from the sidelines. There is an increasing convergence of views from important stakeholders including policymakers, regulators and business leaders - hubris from those at the very top is waning. A business leader taking a stand on sustainable business practices will now simply be meeting growing expectations in the process, not only from their employees but their customers and wider society. Also look at Central bank regulators, who are increasingly concerned about the effect on financial stability from issues like climate change, given our investment levels in fossil fuel-intensive businesses globally. Political leadership around the need for genuine change is growing, but still mixed depending on the territory it operates in. One needs to look no further than Jair Bolsonaro in Brazil to see climate change sceptics in powerful positions.
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There is no ‘trade-off’ between ethical practice and profitability
One of the most frequent arguments against sustainable investing is that there is a trade-off between sustainability and financial performance. For example, ESG principles encourage investors to eschew ‘sin stocks’ or fossil fuel companies; companies which continue to perform well. Critics argue that a boycott by ESG or impact-motivated investors limits the investment universe, curbing potential returns from the highest-performing assets. But the data tells a different story. The definition of what is ‘good’ or ‘bad’ for business is critical here. What is good from an ethical standpoint, may prove good for business too. So, boycotting unethical markets should have a positive impact on the business in the long-run. They enhance businesses’ social licence to operate, creating social and business value.
How can business owners making ethical decisions - like refusing to sell cladding materials they know to be flammable; preventing the supply of fossil fuel-intensive products; paying fair taxes; having responsible supply chains or even merely treating employees decently (all of which could potentially lower overall net revenues) - be considered negative for business? We need to redefine what ‘good’ or even ‘profitable’ business is. Making ethical decisions should only be regarded as a positive approach.
It would be flawed to assume, for business to adopt the role of an environmentally and socially responsible white knight, that a sacrifice in performance must be made. The view that ethical practices are not necessarily 'good for business’ is highly damaging, and this view relates to short-term financial returns rather than the creation of long-term business value. There is increasing evidence that responsible and sustainable business decisions will create rather than destroy value.
Oxford University and Arabesque Partners Meta Study analysis found a positive relationship between sustainability and financial performance of stock prices for 80% of the 200 sources reviewed. This analysis, along with many others, tends to suggest that firms considering ESG issues increase returns and/or reduce risks compared to those that don’t. They also have a lower WACC (weighted average cost of capital).
There is simply no need for any trade-off between sustainable investing and alpha. Consumer perceptions from the Global Investor Study 2018 also counter this myth. Only one in four respondents believed that sustainable investment products do not offer as profitable returns as non-sustainable investments.
Meeting the sustainable capitalism challenge
The challenge is whether capitalism can transition to a more sustainable form - one that recognises, in its decision making, a wider range of essential issues. The investment sector is beginning to get to grips with this need for change and the power of this capital is critical to that transition. Business leaders now need to make decisions that are sustainable for their business. The smartest business leaders are slowly realising that making decisions through a sustainable lens is ultimately good for the business and its stakeholders in the long run, including its investor base.
Richard Burrett is Chief Sustainability Officer at the sustainability-focused Private Equity firm, Earth Capital, and a fellow of the University of Cambridge Institute for Sustainability Leadership.
