Sustainable Strategy: Sustainable companies outperform the market

25-06-2013 Darren Chadwick

Sustainable companies outperform the market over the long term

With my Oxford tutor hat on this week I’ve been catching up on some reading and focussing on sustainability strategy. In particular, I wanted to revisit the literature that explores the link between business performance and sustainability and look at what companies do in order to deliver financial returns on investing in environmental and social programmes.

I came across a useful paper by Eccles, Ioannou and Serafeim which looked at the effect of corporate responsibility on financial performance and organisational process. It’s an ideal primer for senior managers who want to get their heads around introducing sustainability into corporate strategy.

Sustainable companies outperform the market

Neoclassical economic models assume that a company’s primary objective is to maximise profitability, but there are significant differences in the approach that companies take to do so. Companies can vary in the how they judge the importance of long-term versus short-term performance; the impact of externalities of their operations on stakeholders; the ethical impact of their decisions, or the relative importance they place on investors and other stakeholders. However, the objective remains to maximise profitability.

There is a school of thought (well characterised by the work of economist Milton Friedman in the 1970’s) that argues that focussing on sustainability issues detracts from shareholder returns. In essence it’s argued that sustainability is a type of agency cost, where the management and employees receive the private benefit from engaging with environmental and social issues at the expense of profitability (through increased wages, higher administrative costs or forgone commercial opportunities on ethical grounds). Consequently, those companies which focus on sustainability will be outperformed by companies who are not encumbered with such constraints, and will either be eliminated by the competition or will survive only by consuming their economic rents, to paraphrase the words of Michael Jensen.

There is, however, another thesis that suggests that companies can “do well by doing good”, characterised by Porter and Kramer’s work on shared value. The case is based on the concept that meeting the needs of all stakeholders (e.g. employees – through investing in training, for example) directly creates value for shareholders, and indeed that not meeting the needs of wider stakeholders actively destroys shareholder value, through boycotts, the inability to attract the best talent, and paying punitive fines.

The Eccles paper (and a large supporting literature) gives good evidence that companies that fully embrace sustainability and incorporate the issues into their business model and operations will perform better in the long term.

In their work, Eccles, Ioannou and Serafeim compared early adopters of sustainability practices (referred to as High Sustainability companies) with peer companies of similar size, capital structure and industry that hadn’t implemented sustainability practices. Looking at 90 pairs of companies over a period from 1993 to 2009, their research showed that companies that embraced sustainability issues significantly outperformed their counterparts over the long term (both in terms of stock market and accounting performance) and had distinctive organisational structures.

The graph above taken from the Eccles paper shows that High Sustainability companies delivered better returns on equity and returns of assets. Investing $1 in 1993 in a value weighted portfolio of High Sustainability firms would have grown to £22.60 by the end of 2010, compared to $15.40 in the low sustainability portfolio.

The research also showed that High Sustainability companies had implemented distinctive organisational structures to better manage environmental, social and governance issues. These included board level ownership of sustainability issues, longer term decision making horizons, an active programme of stakeholder engagement and robust non-financial reporting.

It is important to focus on those issues that are material to a company’s performance and operations. Through a materiality approach, the key sustainability issues and impacts for a company can be determined, including issues identified through dialogue with key stakeholders. For sustainability to support financial returns, the approach must be strategic and fully incorporated into the business model and operations. Failure to do so will lead to ineffective programmes that will detract from rather than enhance profitability.

The case for sustainability

The case for integrating sustainability into corporate strategy is strong and has become increasingly widely acknowledged in recent years. Rather than sustainability management reducing competitiveness, the evidence supports the opposite when a focussed and strategic approach is adopted.

Good sustainability strategy allows companies to:

  • Better identify and manage risk,
  • Reduce operating costs through resource efficiency,
  • Maintain a more secure licence to operate,
  • Improve workforce engagement and loyalty,
  • Improve trust and transparency,
  • Articulate to investors and other stakeholders the management’s ability to add financial and non-financial value, and
  • Innovate to create products and services that are better suited to customer needs in an increasingly resource constrained world.

As a result of the growing acknowledgement that we live in a world with important ecological and social constraints and that the consequences of breaching these limits will be severe and long lasting, business faces regulatory and market pressures to embrace more sustainable business practices.

Unsustainable business practices are increasingly being penalised by governments and regulators. Environmental regulation is becoming more stringent and far reaching, and market mechanisms such as the CRC energy efficiency scheme and the EU ETS are seeking to put a price on pollution and resource depletion. There are, however, still large differences in the legislative regimes between countries and regions, and gaining global consensus on issues like climate change policy is proving difficult.

There are also increasingly important market drivers for better sustainability management. The direct cost of raw materials is increasing with greater global demand and with greater scrutiny from investors and customers, maintaining a licence to operate requires companies to maintain good operating practices and improve transparency and reporting.

Rather than detracting from investor returns, fully incorporating sustainability issues into corporate strategy provides the basis for growth and profitability, and taking a long term view is starting to allow companies to fully realise the potential benefits.

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