“Responsible Business” - which metrics to trust?
For the last five decades, triggered by Milton Friedman view that the only Corporate Social Responsibility of Companies is to make profit, most business leaders have grown in an environment where the only return that really matters was shareholder value creation. And several measures have been developed where the basic and unique concern was, one way or the other, the shareholder return. Based on any accounting bottom line metric (you name it, ebitda, ebit, net income, noplat, rcop) returns were calculated leading to the mother of all measures: ROCE (Return on Capital Employed, or any of its declinations).
The business community always felt very comfortable in understanding this clear numerical measure, and message associated – you did well, you did not.
In this new world where “Sustainability” becomes the strategic macrotrend, citizens and consumers are expecting a much more balanced view of managers, where all relevant stakeholders need to be taken in consideration (from suppliers to employees, from customers to local communities). It is becoming abundantly clear that the “measure of the last five decades” is not the ideal answer to measure performance. Investors need another sort of measure, but as reliable as the previous ones.
And there is where the current struggle and search for transparency, predictability and accountability is. What seems to be clear is that short term financial performance is not enough for current investors to judge long term investments. Short term metrics are of course key to understand performance of the companies, but they need to be “validated” by some sort of measures able to assure that future profit will be created.
Those measures are recognised as ESG (Environment, Social and Governance) metrics and are being increasingly used in investment assessments. ESG metrics give investors a more holistic view of a company’s operations, including its investments in things like reducing its environmental footprint and improving the quality of its supply chain. These kinds of metrics also help investors to better value companies addressing the big challenges, potentially reducing the firms’ cost of capital and making it less likely to be judged purely on short term financial results.
There are hundreds of ESG measures and that does not help in terms of accountability and understanding whether any “holistic” improvement is happening. On one side, it means that indeed there is a way to measure those areas but, on the other, they are too many and none really stands out. We are still very far from a common understanding of those that really “validate” short term and, at the same time, can guarantee the future.
In a recent report from Harvard Business School Professor George Serafeim, for the first time, a link has been drawn between public sentiment about a company’s sustainability practices and how that company is valued in the market. As the report states “the research shows companies with overall good performance in their Environmental, Social, and Governance (ESG) programs can increase their market value by carefully monitoring public sentiment about those efforts and proactively addressing issues when negative stories arise. The positive association between ESG performance and market valuation is stronger for firms with more positive public sentiment momentum. An increase in a firm’s ESG performance has nearly two to three times the effect on a firm’s market valuation for a firm with positive relative to a firm with negative public sentiment momentum.”
In the same tone a recent report from BCG, research based in four different industries, claim “we found clear links between financial and non-financial performance”, suggesting the notion of TSI (Total Societal Impact) as the way forward to “validate” the “old” TSR (Total Shareholder Return).
It seems that ESG metrics are becoming increasingly central to investment strategy and it obviously arises from the fact that more reliable data gathering and technology are providing evidence that ESG metrics are correlated with financial returns. But work remains to be done for the investment community to feel comfortable with the “right” ESG metrics, which will certainly vary from industry to industry.