Pamela Cohen Kalafut and Jonathan

Predictiv

There is no question in my mind that business and the free enterprise system are essential to making sustainability work. Our focus at Dow is on hard-wiring it into our company in the same way we have fully institutionalized environment, health and safety into our culture and into our work and people processes. Our challenge is to make sustainability sustainable. Ultimately, the world will judge our commitment to sustainability not by what we say, but by what we do.

— William Stavropoulos, CEO of The Dow Chemical Company, quoted in Fiksel et al. (2004)

A recession in 2001, accounting scandals in 2002, record-breaking unemployment in 2003, and conflicting evidence of economic recovery in 2004 - all these recent contexts and events in the United States have led investors and other corporate stakeholders to re-think their position on just what is "fundamental" to the valuation of a company. Both institutional and retail investors have learned some painful lessons, re-examined their assumptions about what constitutes tangible and intangible value, and broadened their scope to consider characteristics that can lead to longer-term financial success. One area that has begun to capture the attention of investment professionals is the mounting evidence of financial risks associated with corporate liabilities, including accountability for the environment and for human rights, as well as global problems such as climate change. indeed, a look at the websites of the Fortune 100 companies reveals that companies such as DuPont, Alcoa, and General Electric think it is smart to address environmental or social responsibility1 right on their Investor Relations home page. But why would investors care?

Because of stock price, for starters. The link between shareholder value and environmental and social performance is a phenomenon that has spawned a large body of research, literature, and investment activity in recent years. Insurers claim that in the next decade, the annual cost of global warming will rise to $150 billion a year (Webber, 2002). The stakes are increasing as multinationals in the finance community band together to buttress their arguments for sustainability

1"Social responsibility" is used here as a general term to encompass the community relations information that appears under different labels on the companies' websites (corporate citizenship, charitable work, community service, etc.).

considerations in their finance portfolios. For example, ten leading banks from around the world announced in 2003 a set of voluntary guidelines called the "Equator Principles," whereby they intend to meet the International Finance Corporation's environment, health and safety guidelines in their projects in developing countries. This is an interesting and unprecedented expectation: banking clients must adhere to these principles, and this is relevant to all corporations. Principle #8 states that if a project goes out of environmental or social compliance, this constitutes grounds for a default on the loan. The cost of capital will simply increase for companies that fail to address these concerns.

There are now over 200 mutual funds, run by over 800 portfolio managers and analysts, dedicated to socially or environmentally responsible investing. In sum, socially screened portfolios now represent over $2 trillion in assets, over 10 percent of the $19.9 trillion assets currently under management in the United States (Social Investment Forum, 2001). Different investment styles have emerged among funds using socially responsible, ethical, or environmental criteria.2 The majority of the $2 trillion figure consists of screened investments, but credible organizations in the past several years have been developing scoring and ranking tools that rate companies according to environmental, social, and economic criteria. The Dow Jones Sustainability Index scores companies based largely upon their responses to extensive questionnaires (see http://www.sustainability-index.com/), while the FTSE4Good Index analyses Environment, Health and Safety (EHS) and social responsibility activities, with the stated intent of promoting a stronger business commitment (see http://www.ftse. com/ftse4good/index.jsp). These indexes have generally performed in line with or have outperformed the broader market averages.3

Researchers at Cap Gemini Ernst & Young take this correlation as further testimony that intangibles - that is, nonfinancial or nontraditional financial capital -matter. The Ernst & Young Center for Business Innovation (CBI) Value Creation Index (VCI) provides insights into these intangible "value drivers" that are strongly correlated with market value. These may vary according to industry, and among durables and nondurables manufacturing we have found consistently that measures related to intangibles such as management credibility, innovativeness, ability to attract talented employees, and research leadership are highly correlated with market value.4 "Environment," as measured by environmental, social, and community service scores, also ranks consistently among the top ten value drivers in our VCI model,

2Distinct investment styles include environmentally effective investing (e.g., Winslow Management), socially responsible investing (e.g., companies screened by FTSE4Good Index), and sustainability investing (e.g., companies screened by Dow Jones Sustainability Group Index or ranked by Innovest EcoValue'21).

3Research reveals that there was no statistically significant difference between the risk-adjusted returns of socially responsible or ethical funds in the United States, Germany, and the United Kingdom and those of conventional funds during the time period of January 1990 through March 2001 (Bauer et al., 2002).

4Our analysis of actual nonfinancial performance as correlated with market value revealed the following value drivers: Innovation, Quality, Customer, Management, Alliances, Technology, Brand, Employees, Environment. Multiple, statistically independent measures are used as inputs for each driver in order to ensure a robust model.

which explains up to 90 percent of variability in market value.5 Encompassing a much broader suite of measures than environmental performance, this model touches upon what many would argue are components of sustainability. Certainly, sustainability means different things to different stakeholders; for now let us define "sustainability" as embodying a "desirable" future state for any given stakeholder. For investors, this desirable future state would surely include sustained revenue growth over the long term.

6.2.2.1 Over the Long Term. Traditional financial data is historically ... well, historical. A desirable future state demands forward-oriented indicators. Companies have the opportunity to use nonfinancial variables as bellwethers: just as sensors can monitor pollution levels in real time, helping to warn of impending problems and, when combined with databases and analytical techniques, they can help to establish causality.

Without deciphering the links between intangibles and a firm's performance, companies are abrogating a significant opportunity for value creation. Using findings from our research, as well as industry literature and conversations with business and academic researchers, we developed a list of the most critical categories of nonfinancial performance that determine corporate value creation (Table 6.7).

In the chemicals industry, our model showed that innovation, alliances, leadership, and sustainability were the four most significant drivers of value. Companies are increasing both their global reach and their innovative capabilities by acquiring smaller companies and creating new alliances. And as knowledgeable chemical industry insider Calvin Cobb has written, "The fact that leadership and social responsibility and the environment placed third and fourth, respectively, on the list of intangible drivers speaks to the 'chemophobia' that is prevalent in society today. Consumers love the products chemicals companies produce. But they hate the chemistry, if you will, behind those products. Due in part to the negative image chemicals corporations must fight, and in part to regulation, chemicals companies need strong leaders who can communicate effectively about what they are doing to preserve the environment" (Cobb and Hunter, 2002)

Doing good is not only the right thing to do; it also makes smart business sense. Many would argue that environmental spending does nothing more than improve a company's reputation for environmental management, and mitigate liability or regulatory risk down the road. And most investors would argue that there is no proven correlation between environmental responsibility and shareholder wealth. Both fair points.

On the other hand some advocate that companies should bear the full "social" costs of their operations, thereby "internalizing" these externalities. But Wall Street bestows rewards for companies that externalize as much of their cost as possible. In some very specific cases, externalities can be addressed through nonregula-tory means such as shareholder advocacy and public relations (Vogel, 1977). But

5Drivers and results are for durables and nondurables manufacturing sectors.

TABLE 6.7. The Measures That Matter

Customer: The ability to develop customer relationships, satisfaction, and loyalty. Leadership and Strategy: Management capabilities, experience, and leadership's vision for the future.

Transparency: Does management communicate honestly and openly? Are its communications believed and trusted? Does it hold itself accountable? Brand Equity: Strength of market position. The ability to expand the market, perception of product/service quality, investor confidence. Environmental and Social Reputation: How the company is viewed globally, such as: environmental concerns, community concerns, regulators' concerns, inclusion in "most admired company" lists, triple bottom line. Alliances and Networks: Supply chain relationships; strategic alliances; partnerships. Technology and Processes: Strategy execution; IT capabilities; inventory management;

turnaround times; flexibility; reengineering; quality; internal transparency. Human Capital: Talent acquisition, workforce retention, employee relations, compensation;

what makes a "great place to work." Innovation: The R&D pipeline; effectiveness of new-product development; patents, know-how, business secrets. Risk: The ability to effectively manage the balance between potential liabilities and potential opportunities.

let's not mince words. Externalities are, by definition, market failures and are unlikely to be addressed without regulatory intervention.6

However, proactive investing in environmental measures beyond that required by law can be good for the bottom line, if for no other reason than to limit downside risk (Rienhardt, 1999). And despite the many studies that debunk statistical correlations (many of the positive correlation studies have been limited in analytical rigor; McWilliams and Siegel, 2000), there has been a proliferation of "green" funds in response to investor demand, and researchers find a paucity of published data implicating a negative correlation between environmental performance and share price among industry peers.7 Please see Section 8.3, "Sustainability and Performance," for additional discussion on intangible value drivers for the chemical industry.

6.2.2.2 The Beginnings of a Sustainability Model. Many of the indicators used for the Value Creation Index studies mentioned above were limited to the availability of public information. But one could imagine some of the additional kinds of metrics - beyond that which is publicly available - that would constitute a firm-level model of sustainability. By mining what they already know from a host

6Externalities used here in the sense of market externalities (positive externalities and pecuniary externalities notwithstanding).

7There exist reports that "either criticize current regulatory regimes as overly costly, ineffective, or both. In addition, there are many studies that argue, on cost-benefit grounds, that some environmental standards are unjustified in a public policy sense. However, none of these studies examined financial impacts at the level of the firm or the shareholder" (Earle, 2000).

of qualitative evidence and quantitative measures, and seeking to identify indicators of sustainable business that cut across all their business functions (procurement, supplier relations, product design, and so on), managers can obtain a more comprehensive view of how to encourage sustainable growth.

As a complement to the broad suite of intangible value drivers that make up the industry-wide Value Creation Index models (Table 6.7), Figure 6.10 presents the leading indicators discussed in this article as inputs to an illustrative firm-specific sustainability model. Qualitative research and particulars of the industry context can also be used to create a model of sustainability specific to a firm. A survey instrument is designed based on a hypothetical model and given to representatives within the firm and business stakeholders. The results and the quantitative measures are used to test the model empirically. Each driver is made up of multiple indicators to ensure robustness and accuracy. The indicators are used to create scores for each driver (in the circles), which can be scrutinized statistically (checked for multi-colinearity, for their relationship to the prescribed intangibles, how well they group together, for independence and statistical significance). These in turn are weighted relative to each other and according to their impact on sustainability. The impacts (Is in the squares) represent the expected effect of a one-unit change in any of those drivers on a normalized score for sustainability, the intangible in question. Most interesting, the impacts leading to performance measures (on the right) suggest the expected effect of a one-unit change in sustainability on the various performance measures.

INTANGIBLE DRIVERS

• And sample indicators

• R&D investment and leadership in environmental technology

• Environmental technology licensing revenue

Communication and Transparency

• Level of stakeholder involvement

• Fines, penalties

• Disclosure of non-financial impact

Human Capital

• Worker safety statistics

• Number and role of environmental staff

• Employee incentives for "beyond compliance" performance

Workplace Organization, Culture

• Culture of continuous improvement

• Clear organizational goals and employee performance measures

CORPORATE FUNCTION

Social, Environmental Reputation

• Design for recyclability, upgradability

• Unit energy and materials intensity

• R&D investment and leadership in environmental technology

• Environmental technology licensing revenue

Communication and Transparency

• Level of stakeholder involvement

• Fines, penalties

• Disclosure of non-financial impact

Human Capital

• Worker safety statistics

• Number and role of environmental staff

• Employee incentives for "beyond compliance" performance

Workplace Organization, Culture

• Culture of continuous improvement

• Clear organizational goals and employee performance measures

Impact

Intangible Score

Impact

Intangible Score

INVESTOR RELATIONS METRICS

Stock Price

Earnings (S.

Market Share

Figure 6.10. Illustrative firm-level model of sustainability.

Companies have an opportunity to develop forward-looking tools like the Value Creation Index that link the strategic contributions of their sustainability efforts to enhanced market valuation. And with long-term success in mind, the importance of sustainability as a shareholder value driver can no longer be ignored. In the words of Gary Pfeiffer, senior vice president and chief financial officer at DuPont: "Every corporation is under intense pressure to create ever-increasing shareholder value. Enhancing environmental and social performance are enormous business opportunities to do just that" (Fiksel et al., 2004).

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