Five ways to make sustainable capitalism a reality
Since its inception in 2004, Generation Investment Management has been an advocate of the mainstreaming of sustainability in financial markets. Unfortunately, we believe that global progress towards this effort has reached a plateau. This is because of a number of factors, including a widely shared failure to rigorously make and reinforce the economic case for sustainable capitalism.
For that reason, we have published a white paper which seeks to re-energise the discourse around sustainable capitalism, refine our arguments and, thus, make a stronger and even more persuasive economic case.
In the paper we present, discuss and prioritise five ideas which we believe have the potential to accelerate the transition to sustainable capitalism by 2020. We recognise these ideas are not exhaustive and that they are necessary, but not sufficient, to achieving our goal. They are:
1. Identify and incorporate risks from ‘stranded assets’
Stranded assets are those with a value that would change dramatically, either positively or negatively, under certain scenarios such as a reasonable price on carbon or water, or improved regulation of labour standards in emerging economies. Stranded assets have the potential to result in significant reductions in the long term value, not just of particular companies but of entire sectors, ranging from oil and gas to pharmaceuticals. As a result, there is the potential for ‘stranded businesses’, a prospect which seems to be giving many people an interest in maintaining and defending the status quo and slowing the transition to more sustainable models.
Efforts to prevent progress on this front are as overt as lobbying for favourable policy and as covert as financing inaccurate, pseudo-scientific ‘studies’ on the climate crisis, with the aim of creating false doubts about the reality the world is facing. Until there are policies that establish a fair price for widely understood externalities, academics and financial professionals should strive to quantify the impact of stranded assets and analyse the subsequent implications for assessing investment opportunities.
2. Mandate integrated reporting
Despite an increase in the volume of information made available by companies and the frequency with which it is produced, access to more data for public equity investors has not necessarily translated into more comprehensive insight into companies.
Integrated reporting addresses this trend by encouraging companies to integrate both their financial and ESG (environmental, social and governance) performance into one report that includes only the most salient or material metrics. This will enable both companies and investors to make better resource allocation decisions about how ESG performance can contribute to sustainable, long term value creation. While voluntary integrated reporting is gaining momentum, it must be mandated to ensure swift and broad adoption.
3. End the default practice of issuing quarterly earnings guidance
Quarterly earnings guidance can create incentives for executives to manage for the short term and encourage some investors to over emphasise the significance of these measures at the expense of the longer term, more meaningful measure of sustainable value creation. Ending this default practice, in favour of only issuing guidance as deemed appropriate by the company (if at all), would encourage a long term view of the business, rather than the current focus on quarterly results. More thoughtful issuance of earnings guidance is compatible with enhanced standards of disclosure.
4. Align compensation structures with long term sustainable performance
Presently, most compensation schemes emphasise short term actions disproportionately and fail to hold asset managers and corporate executives accountable for the ramifications of their decisions over the long term. Instead, financial rewards should be paid out over the period during which these results are realised, and compensation should be linked to fundamental drivers of long term value, employing rolling multi-year milestones for performance evaluation.
5. Encouraging long term investing with loyalty driven securities
Short termism fosters general market instability as opposed to useful liquidity, and undermines the efforts of executives seeking long term value creation.
Companies can take a proactive stance against this growing trend of short termism by attracting long term investors with patient capital through the issuance of loyalty driven securities. Loyalty driven securities offer investors financial rewards for holding a company’s shares for a certain number of years. This practice encourages long term investment horizons among investors and facilitates stability in financial markets and, therefore, plays an important role in mainstreaming sustainable capitalism.