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The Business Case for Sustainability

Investors have long feared that incorporating sustainability into their decisions would mean accepting a lower rate of return. But there is mounting evidence that sustainable investments do as well as – or even outperform – traditional investments.

BERKELEY – Investors worldwide are increasingly seeking investment opportunities that promise to bring environmental and social benefits, in addition to market rates of return. If this trend continues, with the advancement of environmental or social objectives enhancing an investment’s value, it will strengthen the commitment to sustainability that is already gaining momentum among businesses around the world.

Last year, one out of every six dollars of assets under professional management in the United States – a total of $6.6 trillion – was allocated toward some form of sustainable investment, especially public equities.

Some 1,260 companies, managing $45 trillion worth of assets, are signatories of the United Nations’ “principles for responsible investment,” which recognize environmental, social, and governance (ESG) factors – and thus the long-term health and stability of companies and markets – as critical to investors. One signatory, CalPERS, one of the world’s largest institutional investors, has gone a step further: it will require all of its investment managers to identify and integrate ESG factors into their decisions – a bold move that could transform capital markets.

The number of companies issuing sustainability reports has grown from fewer than 30 in the early 1990s to more than 7,000 in 2014. And, in a recent Morgan Stanley survey, 71% of respondents stated that they are interested in sustainable investing.

To be sure, a major barrier to incorporating ESG criteria into investment decisions remains: many investors – including 54% of the respondents in the Morgan Stanley survey – believe that doing so could lower the financial rate of return. But there is mounting evidence that this is not the case, with several recent studies indicating that sustainable investments do as well as – or even outperform – traditional investments.

A seminal 2012 study that analyzed two groups of companies – similar in terms of industry, size, financial performance, and growth prospects – found that those in the “high sustainability group” had superior share-price performance. And a new study by Morgan Stanley’s Institute for Sustainable Investing, which analyzed the performance of 10,228 open-ended mutual funds and 2,874 separately managed accounts in the US, found that sustainable investments usually met – and often exceeded – the median returns of comparable traditional investments for the periods examined.

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Many ESG factors come into play when evaluating sustainable investment options. For example, the Generation Foundation – the think tank of Generation Investment Management (on whose advisory board I serve) – identifies 17 environmental factors, 16 social factors, and 12 governance factors relevant to sustainability.

The challenge is to distinguish between the ESG factors that have a material influence on company performance and those that do not. But the data that companies currently report are inadequate to enable investors to make this distinction.

The non-profit Sustainability Accounting Standards Board (SASB) is attempting to change that by developing material sustainability accounting standards for 80 industries, consistent with the US Security and Exchange Commission’s compliance regulations. More than 2,800 participants – including companies with market capitalization totaling $11 trillion and investors with $23.4 trillion in assets under management – have been involved in the SASB process. Using the SASB’s proposed standards for 45 industries, as well as other metrics, a new study – the most definitive so far – has found that companies that perform well on material sustainability factors have better operational performance, are less risky, and earn significantly higher shareholder returns than companies that perform poorly.

Similarly, a new framework recently proposed by Morgan Stanley for valuations of companies in 29 industries includes ESG factors that pose material risks or opportunities. Whereas a company is traditionally valued based exclusively on how it deploys financial capital to generate returns, the new framework incorporates how it deploys natural, human, and social capital, as well as the transparency of its governance practices. This new approach to company valuation reflects the view that the most successful companies will be those that deploy all four kinds of capital responsibly.

Material ESG factors can affect a company’s financial performance and shareholder returns through several channels. For example, more efficient energy and resource use can lower costs; better management of human talent can boost productivity; stricter safety, health, and environmental rules can reduce the risk of serious accidents; and new green or fair-trade products that appeal to consumers can increase revenues.

Consider investments that improve the energy efficiency of data centers, which use 10-20 times more energy than average commercial buildings, and thus are responsible for considerable greenhouse-gas emissions. Decisions about data-center specifications are important for managing costs, obtaining a reliable supply of energy and water, and lowering reputational risks, particularly given the increasing global regulatory focus on climate change. Google’s construction of data centers that use 50% of the energy of an average data center has brought it considerable savings.

Similar success stories have played out across sectors. Since 2011, the US chemical company DuPont has invested $879 million in research and development of products with quantifiable environmental benefits; it has recorded $2 billion in annual revenue from products that reduce greenhouse-gas emissions, and an additional $11.8 billion in revenue from renewable resources like wind and solar power.

Likewise, the multinational consumer goods company Procter and Gamble reported $52 billion in sales of “sustainable innovation products” from 2007 to 2012. That is roughly 11% of the company’s total sales over that period.

There are good reasons to believe that, by investing in improving material sustainability, companies can increase shareholder value. In fact, if a company is to fulfill its fiduciary responsibility to its investors, it has little choice but to go beyond financial returns to incorporate ESG factors that are likely to have a material impact on its performance over time. This is precisely the kind of incentive that could propel the world toward a more sustainable future.