“Not everything that can be counted counts, and not everything that counts can be counted.”
— William Bruce Cameron
I thought of the aforementioned quote while reading through a trove of public company sustainability reports. At the request of Two Centuries Investments founder and CEO, Mikhail Samonov, I have been analyzing sustainability reports across industries from the lens of a fundamental research portfolio manager.
One thing I can say for certain, companies are spending a lot of resources counting the activities they do related to sustainability.
Certifications, greenhouse gas emissions, water, waste, energy, materials, offices, safety, employee diversity, suppliers, communities, surveys, interviews, self-assessments, employee compensation, training, data security, ethics, privacy, management compensation, board diversity…the list of items goes on.
The quantity of items measured and discussed is impressive. The presentation quality is impressive. The goals are noble. The narratives are emotionally appealing. Yet, as a fundamental portfolio manager, I often found the reports unsatisfying.
Specifically, I believe that ESG (Environment, Social, Governance) activities should be linked to improving business fundamentals because without that link, allocating resources and making business decisions loses effectiveness. In other words, value creation for shareholders, i.e., sustainable profitability, is necessary to sustain activities that create value for society, i.e., other stakeholders.
As an investor, I want to know WHY what a company is counting counts.
Will it benefit the income statement or cash flow statement? Will it improve product design, manufacturing, or sales? Does it align with a new market opportunity? Will it accelerate revenue growth? Will it allow the company to charge a higher price for its products and services? Will it reduce operating expenses, capex or increase productivity? Will it make a current competitive advantage more sustainable? Will it reduce working capital?
Or will it benefit the balance sheet? Will it reduce the cost of capital by mitigating a risk or making the company more attractive to investors?
Or is there an intangible benefit? Will it help attract and retain talent? Will it lead to better decision making? Will it accelerate innovation? Will it help the company’s brand?
In summary, I am interested in whether an ESG activity is increasing value or sustaining value creation for shareholders. Such activities are optimal as they provide value for all stakeholders.
Some sustainability reports were insightful as to why some activities being counted count. See a few examples below.
As an investor, I also want to know HOW a company allocates resources across various ESG activities and HOW what a company is doing in the ESG arena differentiates it from competitors.
These two items are qualitative and cannot be counted. But they count. And they are not adequately addressed in many sustainability reports.
Decision making involves acknowledging trade-offs and setting priorities. Resources are not infinite. As I read sustainability reports cover to cover, I was hard pressed to find any mention of a decision making process. I am not suggesting companies don’t have a process, I am only suggesting it would be beneficial if companies included a more detailed discussion of the process.
Examples of “WHY” in the traditionally less ESG friendly industries
In addition to identifying absolute ESG leaders, I also found it interesting to understand ESG activities in industries which are traditionally perceived to be less ESG-friendly. These activities have higher impact potential, including from an investment performance perspective, as the industries are neglected by many ESG investors. In addition, because of their link to business fundamentals, many of these ESG activities are executed with less green-washing risk.
NextEra Energy, U.S. utility
NextEra Energy emphasized it is “…investing in clean energy infrastructure to create a sustainable energy future for America that is affordable, reliable and efficient.” In the regulated utility business segment, it was clear that Florida Power & Light’s ability to deliver more than 99.98 percent service reliability, at prices well below the national averages, has enabled the utility to repeatedly obtain regulatory approval for capital spending which increases company earnings. As for the less regulated NextEra Energy Resources, an unparalleled expertise in wind and solar generation has not only allowed many North American utilities to use more renewables, lower customer bills, and reduce emissions, it has provided the parent company with well above average revenue and earnings growth for a utility.
Unilever, European Multinational Consumer Staples company
In its 2018 sustainability report, Unilever highlighted its 26 Sustainable Living Brands grew 46% faster than rest of business delivering 70% of company growth. The company also discussed its five Smart programs (5S), including initiatives to reduce the number of product designs, amount of packaging, and number of ingredients. Unilever clearly articulated these sustainability initiatives were not only tied to sustainability, they were critical to increasing sales and reducing costs. The company also discussed the ways in which it empowers human capital with entrepreneurial, multi-function teams (Country Category Business Teams) with their own P&L and over 90% of leadership locally developed. Management explained the approach is leading to product design better matched to local consumer demands and is increasing speed to market.
Conoco, U.S. Energy E&P company
Conoco’s sustainability report implicitly acknowledges an industry in decline with a heavy environmental footprint and a history of questionable corporate governance. Conoco aims to be different without explicitly saying so. The company will improve corporate governance, most clearly by tying senior management compensation to performance vs. the S&P 500, grow slower, maintain strong balance sheet, maximize Return on Invested Capital, and return a high percentage of free cash flow to shareholders. At the same time, it will continue to demonstrate best in class safety, will one of the lowest safety incidence percentages in the industry and inimize environmental footprint
Croda, European Speciality Chemicals company
Croda emphasizes its objective of “…using smart science to turn renewable raw materials into innovative ingredients”. It is the reason d’etre the company was founded. Consumers are demanding and Croda business customers are seeking more sustainable products. Thus, I understood why Croda management counts what percentage of raw materials are classified as organic from bio-based sources (currently 63%). Revenue growth will be tied to these “sustainable” ingredients.
Examples of “HOW” in the traditionally less ESG friendly industries
Conoco, U.S. Energy E&P company
On the issue of allocating resources, Conoco’s caveat was a rarity. ‘We recognize it is challenging to implement comprehensive integrated programs and we periodically assess the maturity and completeness of implementation. We also recognize that internal and external expectations and the business environment are not static. We adjust our plans and actions as needed over time. On the wide spectrum of change toward increasingly sustainable performance, we are seeking to understand the pace at which change is meaningful, lasting and appropriate for the business environment. We recognize that our system of performance management should drive increasingly beneficial economic, environmental and social performance.’ Still, I would have liked an example.
Croda, European Speciality Chemicals company
On the issue on differentiation from competitors, Croda’s discussion was outstanding, For each of ten items in its self defined value chain, Croda explicitly lists what makes the company different from competitors, the associated tangible value, and the associated intangible value. For each of its eight stakeholders, Croda clearly lists why and how management engages with the stakeholder.
ESG at Two Centuries
We are reticent to forecast where ESG is headed, especially since different investors have different views of ESG and annual sustainability reports lack the standardization of annual financial reports.
However, we believe we have some insights on incorporating ESG in an investment process. Mikhail has co-authored a paper on the topic (recently published in the Journal of Investing). And TCI’s Focused Quality Equity strategy is ESG-integrated as it focuses on intangible capital. I believe my experience as a fundamentally oriented equity professional will complement TCI’s efforts in the ESG arena.
In the coming months, we intend to share more of our insights.