Ethics and Corporate Governance
If marketing, accounting, finance, are the various pieces of the sustainability puzzle, each playing its part in creating more sustainable companies, ethics forms the glue that holds these pieces together. Business ethics goes beyond choosing to ‘do the right thing’ in day-to-day operations and business decisions; it is a core principle of good management and sustainability.
Without good management, strong corporate governance, and open and transparent relationships with customers, business partners, and stakeholders, sustainability issues, policies, and goals can go nowhere. Ethics enters into every aspect of the sustainable business, such as quality standards, honest payment terms for both customers and suppliers, staff relationships, and tax returns to mention only a few. Regardless of your position in a company, ethics is a foundational part of your job.
Despite its importance, ethics is often forgotten, pushed aside, or taken for granted. Most companies have some set of ethics and management codes in place that the company stands for, but many employees just assume that their company is properly managing ethical issues. Thus, general managers play an important role in ensuring that ethical standards are upheld, and in promoting sustainability principles throughout their workplace.
Why is it important?
Investors are looking for good governance. Investors are looking at companies that have good, strong governance practices and principles and see sustainability as a proxy for good management.
Quality of relationships. A company or manager that conducts business ethically and legally develops higher-quality relationships with customers, suppliers, employees, and others, which can directly improve the business.
Reputation. Companies with policies and practices based on less than the highest ethical standards, or that are enforced with a relaxed attitude to compliance, risk damaging their reputation. This is especially true today as news, both positive and negative, travels fast.
Financial costs. There is clear evidence that in many countries corruption adds more than 10% to the cost of doing business and as much as 25% to the cost of public procurement. Other unethical behavior can have significant costs, such as fines for non-compliance, lost customers, and damages to brands due to loss of reputation, to name just a few.
Legal risks. Many forms of unethical behavior, such as corruption, are illegal both in the country in which they occur and in the country the company is originally from. This is particularly relevant for companies based in OECD countries and was universally recognized in 2003 with the adoption of the UN Convention against Corruption.
Indices. Respecting human rights and other topics within ethics are part of the criteria in a number of indices and standards, such as the UN Global Compact, ISO 26000, and the Dow Jones Sustainability Index. In 2012, several companies were deleted from the FTSE4Good for human rights violations.
The key concepts
Good governance comprises the actions that managers and companies need to take in order to ensure legal and ethical underpinnings of their organization and operations. Many people consider ethics and governance to be vague topics; however, there is plenty of practical and specific guidance available for businesses to operate ethically. This includes:
Upholding universal human rights
Promoting worker rights and standards
Making difficult decisions
Creating strong control systems in organizations
Business and human rights
Labor and working conditions
Ethics and the individual manager
Stopping the misuse of power
Stopping the misuse of power for private gain
Getting access to information
Moving the sustainability agenda forward
Business and human rights
The Declaration of Human Rights, which has been translated into more than 360 languages, is the foundation of international human rights law. It is codified in international law through two treaties: the International Covenant on Civil and Political Rights and the International Covenant on Economic, Social and Cultural Rights, each of which has been ratified by over three-quarters of all countries.
These, in addition to the International Labour Organization conventions and laws, provide a universal benchmark for minimum standards of behavior. According to the Office of the High Commissioner for Human Rights (OHCHR), ‘Human rights are fundamental principles and standards that enable individuals every-where to have the freedom to live in dignity. All human rights are universal, interrelated, interdependent and indivisible.’
In order to assist business in understanding the growing number of declarations related to human rights, the UN Norms for Business with regard to human rights were compiled. These include:
Right to equal opportunity and non-discriminatory treatment. Business should ensure equality of opportunity and treat-ment for the purpose of eliminating discrimination based on race, color, sex, language, religion, political opinion, national or social origin, social status, indigenous status, disability, or age.
Right to security of persons. Business should not engage in, or benefit from war crimes; crimes against humanity; genocide; torture; forced disappearance; forced or compulsory labor; hostage-taking; extrajudicial, summary, or arbitrary executions; other violations of humanitarian law; or other international crimes against the human person. Business should observe international human rights norms as well as the laws and professional standards of the country or countries in which they operate.
Rights of workers. Business should:
not use forced or compulsory labor;
respect the rights of children to be protected from economic exploitation;
provide a safe and healthy working environment;
provide workers with remuneration that ensures an adequate standard of living for them and their families;
ensure freedom of association and effective recognition of the right to collective bargaining.
Respect for national sovereignty and human rights. Business should:
recognize and respect applicable norms of international law, national laws, and regulations, as well as administrative practices, the rule of law, the public interest, development objectives, social, economic, and cultural policies (including transparency, accountability, and prohibition of corruption) and the authority of the countries in which the enterprises operate;
not offer, promise, give, accept, condone, knowingly benefit from, or demand a bribe or other improper advantage;
refrain from any activity which supports, solicits, or encourages States or any other entities to abuse human rights;
respect economic, social, and cultural rights as well as civil and political rights, and contribute to their realization – in particular, the rights to development, adequate food and drinking water, the highest attainable standard of physical and mental health, adequate housing, privacy, education, freedom of thought, conscience, and religion, and freedom of opinion and expression, and shall refrain from actions which obstruct or impede the realization of those rights.
Obligations with regard to consumer protection. Business should take all necessary steps to ensure the safety and quality of the goods and services they provide, including observance of the precautionary principle. They should not produce, distribute, market, or advertise harmful or potentially harmful products for use by consumers.
According to the UN Global Compact, ‘Business should support and respect the protection of internationally proclaimed human rights and make sure that they are not complicit in human rights abuses.’ An organization can do this in two ways:
Sphere of influence concerns the boundaries of a company’s human rights responsibilities, whose human rights the company should be concerned with, and which human rights a company should pay particular attention to. Each company has a particular sphere of influence based on their geographic presence, industry, size, and particular business relationships, which can include the workplace (rights of employees), supply chain (partners do not engage in rights abuses), marketplace (products do not harm customers), community (no negative impacts on the communities in which they operate), and government (using influence to develop public policy that promotes and rewards good behavior).
Complicity is about business ensuring that it does not assist or encourage human rights abuses committed by governments, rebel groups, other companies, or individuals. It is made up of two elements:
An action or omission (failure to act) by a company or individual representing a company that ‘helps’ (facilitates, legitimizes, assists, encourages, etc.) another, in some way, to perpetuate a human rights abuse. The company was or should have been on notice that its action or omission could provide such help,
The Declaration of Human Rights (and the short online course on human rights and business) (www.ohchr.org) and the UN Guiding Principles on Business and Human Rights. International standards for corporate responsibility on human rights include the OECD Guidelines for Multinational Enterprises, the ILO Tripartite Declaration of Principles Concerning Multinational Enterprises and Social Policy, the UN Global Compact, and the IFC Performance Standards on Social and Environmental Sustainability.
There are also a number of voluntary initiatives, often industry-specific, including the Ethical Trading Initiative and the Voluntary Principles on Security and Human Rights. Take a look at toolkits developed by the UNEP Finance Initiative, the Institute for Human Rights and Business, and the Guide to Corporate Human Rights Impact Assessment Tools. For a good overview, see Monash University’s Human Rights Translated: A Business Reference Guide (www.law.mo nash.edu.au).
Labor and working conditions
Today, globalization has made rights and standards more relevant than ever and companies need to uphold local and international labor standards. According to the International Labour Organization (ILO), a specialized agency of the UN responsible for protecting and promoting worker safety and standards, such standards provide the following benefits:
To ensure that economic development remains focused on improving the lives of human beings rather than treating labor as a commodity, which can be bought or sold for the highest profit or lowest price.
To provide an even playing field by helping governments and employers to ‘avoid the temptation of lowering labor standards in the belief that it could give them a greater comparative advantage in international trade.’
To improve economic performance because although many companies believe that there are significant costs associated with meeting such standards, there is growing research indicating that compliance often accompanies improvements in productivity and economic performance.
The ILO has established an extensive series of labor standards, including a series of ‘fundamental conventions’ that cover:
Child labor. The ILO provides a minimum age to be able to work. In developing countries, this is 15 for regular work, 18 for hazardous work, and 13 for light work while in developing countries it is 14, 18, and 12, respectively. It is estimated that over 215 million children are involved in child labor. June 12 is the World Day Against Child Labour.
Collective bargaining. This is a voluntary process through which employers and workers discuss and negotiate their relations in particular terms and conditions of work and can organize themselves into organizations and trade unions.
Discrimination and equality. This occurs when a potential candidate is treated differently or less favorably because of characteristics that are not related to his/her merit or the inherent requirements of the job. These characteristics include race, color, sex, religion, political opinion, national extraction, or social origin and can also include sexual orientation, age, health issues, etc. This can occur in respect to recruitment, remuneration, hours of work and paid holiday, maternity protection, job assignments, training and promotion opportunities, etc.
Employment Promotion. Businesses should endeavor to increase employment opportunities and standards. Youth employment opportunities are a particular area where companies can play a major role, for young men and women as well as persons with disabilities.
Forced labor. This is any work or service that is exacted from any person under the menace of any penalty and for which that person has not offered himself or herself voluntarily. Providing wages or other compensation does not necessarily indicate that the labor is not forced. The ILO estimates that at least 12.3 million people are victims of forced labor worldwide. Furthermore, labor exploitation can occur in many forms and includes threatening workers with severe deprivations such as withholding food, land or wages and physical violence.
Freedom of association and the right to organize. Freedom of association implies a respect for the rights of all employers and all workers to freely and voluntarily establish and join groups for the promotion and defense of their occupational interests.
Occupational safety and health. It is estimated that 160 million people suffer from work-related diseases and an estimated 337 million fatal and non-fatal work-related accidents occur every year. The ILO estimates that 4% of the world’s annual GDP is lost as a consequence of occupational diseases and accidents. Workers have an important role to play in ensuring safe work-place practices and cooperation between workers and management is essential.
Security of employment. This is about actively managing a business's human resources needs to provide to the greatest extent possible stable employment for their employees. Arbitrary dismissal should be avoided.
Wages and benefits. This calls for policies with regard to wages and earnings, hours and other conditions of work, designed to ensure a just share of the fruits of progress to all and a minimum living wage to all employed and in need of such protection. It looks at best possible wages, benefits, and working conditions, promotion of equal pay for equal value.
Working time. Excessive hours of work and inadequate periods of rest and recuperation can damage workers’ health and increase the risk of work accidents. Most countries have statutory limits of weekly working hours of 48 hours or less. This also includes overtime and paid holidays.
Swedish jean company Nudie Jeans believes that everyone who participates in the manufacturing of their clothes should have a wage enough to live on. So since 2012 they are paying their share of the living wage to workers at suppliers in India, an increase of approximately 17% of a worker’s annual salary.
Ethics and the individual manager
Why do managers make unethical choices? Our ethical judgment is influenced by our moral principles, which come both from our background (e.g., religion, upbringing, social and cultural norms) and also from norms learned from working in a particular industry or firm. Research shows that there are four main reasons why managers make bad choices:
A belief that the activity is not ‘really’ illegal or immoral. Be clear about the kinds of activities that are acceptable, those that will be tolerated, and what behavior will be condoned.
A belief that the activity is in the individual’s or the corporation's best interests. Often this belief results from pressure to achieve short-term results. To prevent this, do not focus too much on short-term gains while neglecting the long-term consequences of management decisions.
A belief that the activity is ‘safe’ because it will never be found out or publicized. To discourage this belief, engage in communications that increase the perceived probability of being caught, persecuted, and punished, and announce misconduct.
A belief that because the activity helps the company, the company will condone it and even protect the person who engages in it. To prevent this, stress the responsibility of senior managers to clearly communicate the norm that company loyalty should not go against the laws and values of society.
Sometimes unethical decisions are made as a result of ‘groupthink.’ It has been observed that a group of people working together will sometimes make unethical decisions that few, if any, of them, would make individually. This appears to be due to the reluctance of individuals to press for the serious consideration of sensitive ethical issues.
Managers encounter complex business problems on a day-to-day basis that have strong social and ethical components. These problems have no simple solution and neither the optimal decisions nor their consequences are always obvious. The Ethics Resource Centre recommends applying the following ethics filters to decision-making:
Policies. Is it consistent with my organization’s policies, procedures, and guidelines?
Legal. Is it acceptable under the applicable laws and regulations?
Universal. Does it conform to the universal principles and values my organization has adopted?
Self. Does it satisfy my personal definition of right, good, and fair?
They have also come up with a six-step ethical decision-making model for use by managers and their teams:
1. Define the problem. Describe why the decision is called for and identify the most desired outcome(s).
2. Identify available alternative solutions to the problem. Consider more than five in most cases. At a very minimum, three options should be identified to allow people to escape from having to choose between two opposing options.
3. Evaluate the identified alternatives. Look at the likely positives and negatives for each and differentiate between what information you know for a fact and what you believe might be the case.
4. Make the decision. Ensure that all members of the team have clear information about the problem and alternatives.
5. Implement the decision. Once decided, tangible steps should be put in place to move forward with the solution. A decision only counts if it is implemented.
6. Evaluate the decision. Did it fix the problem? Is it better now, or worse, or the same? What new problems did the solution create? What lessons were learned that could be applied to help next time a similar problem arises?
Once a decision has been made, the next most important step is how employees can voice these concerns or put into place their solutions. This is where the challenge lies for individual employees, as they often do not know who to turn to or what the repercussions of exposing what they believe to be unethical behavior will be for them.
Siemens provides employees with in-person and web-based training on how to make more ethical decisions. They also provide a helpdesk where employees can call anonymously to get advice on how to handle ethical situations. The company has developed a policy for whistle-blowers, which includes a confidential 24-hours-a-day helpdesk in 150 languages and an external ombudsman. There is also no retaliation against those who have reported compliance concerns in good faith.
The OECD defines corporate governance as the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as shareholders, board members, managers, employees, and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs.
Corporate governance also refers to the rules governing the process through which the company objectives are set, and the means of attaining those objectives and monitoring performance.
The OECD Principles of Corporate Governance represent certain common characteristics that are fundamental to a good corporate governance framework. These principles are:
Ensuring the basis for an effective corporate governance framework. Promote transparent and efficient markets, be consistent with the rule of law, and clearly articulate the division of responsibilities among different supervisory, regulatory, and enforcement authorities.
The rights of shareholders and key ownership functions. Protect and facilitate the exercise of shareholders’ rights.
The equitable treatment of shareholders. Ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights.
The role of stakeholders in corporate governance. Recognize the rights of stakeholders established by law or through mutual agreements and encourage active cooperation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.
Disclosure and transparency. Ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company.
The responsibilities of the board. Ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders.
When analyzing a company’s corporate governance structures, companies such as Deutsche Bank look at four factors:
Board independence. This is the board’s ability to act independently from management in the best interest of shareholders, including the board’s structure, composition, and overall capabilities.
Shareholder treatment. This addresses questions relating to the treatment of minority shareholders as well as issues around capital structure and its impact on shareholder rights.
Information disclosure. This focuses on the quality, extent, and timeliness of the information provided by companies to analysts and investors as well as internal verification mechanisms.
Corporate compensation. This addresses the compensation of directors and executives as well as systems to monitor and measure this compensation.
Corruption is defined as the misuse of entrusted power for private gain. According to the World Bank, corruption is the single greatest obstacle to economic and social development. The bank estimates that it costs more than 5% of the world’s GDP, or approximately US$3 trillion. For business, corruption is estimated to add 10% or more to the cost of doing business in many parts of the world and up to 25% to the cost of procurement contracts in developing countries.
Further research found that moving a business from a country with low levels of corruption to a country with medium or high levels of corruption is the equivalent to a 20% tax on foreign business.28 The Global Compact and Transparency International suggest three practical steps to fight corruption:
1. Internal. Introduce anti-corruption policies and programs within the organization and business operations.
Top management must send consistent messages, directing all managers to apply stringent codes and high standards, while at the same time making it clear that these codes are not open to interpretation.
A company should adopt its own business principles and ethics code, and publish it to employees.
Training and continuous efforts must be made to ensure that principles and codes are integrated into other management systems.
Adopt internal reporting procedures to ensure that appropriate systems are in place to ensure that if something does happen, the company is the first to know.
2. External. Report on anti-corruption work and activities in the annual communications and share experiences and best practices.
3. Collective. Collective action among businesses can help business managers in making the right decisions. For example,
Publish What You Pay, a coalition of over 200 NGOs, calls for the mandatory disclosure of the payments made by oil, gas, and mining companies to all governments for the extraction of natural resources.
German chemical company BASF put in place a Chief Compliance Officer who is supported by a network of over 100 compliance officers worldwide. Their work is not only to train employees in this area but to prevent a wide range of legal violations, including incidents of corruption.
The growing number of international initiatives aimed at helping companies to stop and deal with corruption indicate how important anti-corruption practices have become in the global business community. The UN Convention Against Corruption is an independent legal instrument against corruption started in 2000, and December 9th is International Anti-corruption Day.
The Global Corruption Barometer is a survey that assesses general public attitudes toward and experience of corruption in dozens of countries around the world. The Corruption Perceptions Index ranks more than 150 countries by their perceived levels of corruption as determined by expert assessments and opinion surveys.
Bribery is a major part of corruption. According to Transparency International, bribery is an offer or receipt of any gift, loan, fee, reward, or another advantage to or from any person as an inducement to do something which is dishonest, illegal, or a breach of trust, in the conduct of the enterprise’s business. Different forms of bribery include:
Bribes. An enterprise should prohibit the offer or actual transfer of a bribe in any form, including kickbacks on any portion of a contract payment, or the use of other routes or channels to provide improper benefits to customers, agents, contractors, suppliers, or employees of any such party or government officials. The enterprise should also prohibit employees from accepting bribes.
Political contributions. An enterprise, its employees, or agents should not make direct or indirect contributions to political parties, organizations, or individuals engaged in politics, as a way of obtaining an advantage in business transactions. The enterprise should disclose these contributions.
Charitable contributions and sponsorship. Ensure that these sorts of contributions are not being used for bribery. An enterprise should publicly disclose all its charitable contributions.
Facilitation payments. These are small payments made to secure or expedite the performance of a routine or necessary action to which the payer of the facilitation payment has legal or other entitlement. Recognizing that facilitation payments are a form of bribery, the enterprise should work to identify and eliminate them.
Gifts, hospitality, and expenses. The enterprise should prohibit the offer or receipt of gifts, hospitality, or expenses whenever such arrangements could affect the outcome of business transactions and are not reasonable and bona fide expenditures.
Several initiatives such as the OECD Anti-bribery Convention and the anti-bribery provisions of the revised OECD Guidelines for Multinationals attempt to curb its effect and in fact, for the over 40 countries that have signed the convention, bribery is illegal. The ICC Rules of Conduct to Combat Extortion and Bribery provide the following guidance on how to approach anti-bribery policies:
Enterprises should make their anti-corruption policy known to all agents and other intermediaries and make it clear that they expect all activities carried out on their behalf to be compliant with their policy.
In order to prevent bribery and extortion, enterprises should implement comprehensive policies or codes reflecting these Rules of Conduct as well as their particular circumstances and specific business environment. These policies or codes should include (a) training, (b) confidential channels to raise concerns, (c) disciplinary procedures, and (d) applicability to all controlled subsidiaries, foreign and domestic.
All financial transactions must be properly and fairly recorded in appropriate blogs of accounts available for inspection by boards of directors (i.e., no off-the-blogs or secret accounts); transactions should be inspected within established independent systems of auditing and comply with all provisions of national tax laws and regulations.
The board of directors (or another body) with ultimate responsibility for the enterprise should take reasonable steps to ensure compliance with these Rules of Conduct.
The power of media
Media companies shape public opinion. They influence what we read, listen to, and watch. Despite this, companies in the media sector are often overlooked as major social and environmental actors. The responsibility of the media is not so much in terms of how sustainable their operations are. Rather, it is about their ability to influence, what they choose to report, what they don’t report, and how they report.
Despite this important role, media companies have been slow to engage in sustainability. Some journalists say that the word ‘sustainability’ itself can be both a common platform to explore these issues as well as a word that risks making people disinterested. Often, sustainability stories are given to specific ‘environmental’ reporters rather than being embedded into a range of stories or are just not reported on at all.
What can be done:
Develop the capacity of reporters. The UN Global Compact of Turkey organized a 2-day conference for nearly 30 journalists from daily national newspapers, television, and trade magazines with the aim of building the journalists’ knowledge about sustainability issues.
Create a platform for these issues. The Guardian in the UK has more than 25 editorial staff specifically focused on sustainability and on developing their range of sustainability and business-related events and online programs.
Get information to those who need it. One World produces Internet and mobile phone applications that the world ’s poorest people can use to improve their life opportunities and that help people everywhere understand global problems (www.http://oneworldgroup.org).
Provide in-depth news on sustainable topics. Many news initiatives, in particular online, cover sustainability stories exclusively, including Inside Climate News, GreenBiz (GreenBiz), and Just Means (www.justmeans.org).
Increase transparency in media companies. The Global Reporting Initiative has a set of reporting guidelines specifically for the media industry.
In many countries the media doesn’t have the freedom to choose what they report, making it difficult for citizens to have the information they need to make decisions. The Freedom of Press Index and the Media Sustainability Index rank countries and their media systems yearly. They look at a range of issues, including but not limited to:
Free speech. Protection of free speech, free access to media, access to information.
Diversity. The diversity of viewpoints, multiple news sources.
Supporting environment. Institutions that protect the professional interests of independent media, access to journalistic education, entry to media markets, penalties for libel.
Ethics and human rights. Crimes against media workers, corruption, self-censorship, transparency of media ownership.
What is legal versus what is ethical? Just because a practice is not illegal, this does not mean it is ethical. Ethics is much wider than law.
Implementation. Ethics programs, codes of conduct, and other mechanisms put in place to stop unethical behaviors provide little help if managers at all levels do not know them or implement them consistently. It is not enough to have an ethics statement, it needs to be understood, used, and enforced.
Consistency. Even companies with strong ethical policies and processes will encounter problems with ethics. Create a safe environment where employees can raise concerns about possible misconduct and wrongdoings. Despite the proliferation of helplines and ethics offices, employees still suffer from a ‘fear of retaliation.’
Pressures to be unethical. A study based on in-depth interviews with 30 recent graduates from the Harvard MBA working in banks, consulting, and advertising firms found that many young managers received explicit instructions from their middle-manager bosses or felt strong organizational pressures to do things that they believed were unethical or even illegal.
Misleading the public. There are many groups working in the field of sustainability. While some are working to raise awareness, others are not quite what they seem – they are, in a sense, ‘greenwashed’ organizations. Full Frontal Scrutiny, a joint project by the Consumer Reports WebWatch and the Centre for Media and Democracy, looks at raising awareness of what it calls front groups – organizations that state a particular agenda while hiding or obscuring their identity, membership, and/or sponsorship. This can include organizations that avoid mentioning their main sources of funding or have misleading names (e.g., the National Wetlands Coalition actually opposes policies to protect US wetlands)
Incentives. The fact is that there is still a place in society for both responsible and irresponsible companies. Good companies, even good employees, aren’t penalized for doing the ‘right thing’ but they are not necessarily rewarded either.
Trends and new ideas
Transparency and honesty
Increased honesty is helping businesses move forward in sustainability, and protecting them when they encounter problems. In fact, companies are choosing to disclose more and more information, both the positive but also the negative. In its Footprint Chronicles, Patagonia allows consumers access to the complete picture of the impact a product has on the environment – the good, the bad, and the ugly.
They openly recognize that they sometimes have a negative impact, and they are working to minimize this. Mountain Equipment Co-op (MEC) in Canada disclosed a list of factory names and locations from where they source MEC-brand products, the first Canadian retailer to do so.
In their annual report, they also discuss their progress made in being a more sustainable company and openly discuss their challenges. For more about transparency and trust, see the Edelman Trust Barometer which measures the level of trust in institutions, industries, and leaders.
The company of the future
What would a corporation look like that was designed to seamlessly integrate both social and financial purposes? Management Lab wondered what would happen if you asked progressive business thinkers to reinvent management for the 21st century, throwing away years ’ worth of assumptions and radically re-imagining the ways in which companies could work. Some of the thoughts collected include:
People. Manage as if everyone mattered – stakeholders, employees. Work to maximize system success. Enable communities of passion. Increase trust and reduce fear.
Purpose. Seek orientation in a higher and broader purpose. Purpose generates energy, passion, and commitment.
Rewards. Stretch executive timeframes and perspectives. Change incentives to reward executives and investors who nurture the small projects that have the potential to become big ones over time. Develop holistic performance measures.
Question. Substantially reduce the gravitational pull of the past. Explicitly challenge industry (and corporate) orthodoxies.
Structure. Expand the freedom for autonomous action. De-organize – dissolve (formal) hierarchy, eliminate silos, and collapse the distance between center and periphery. Abolish the myth of the imperial CEO. Lead from behind.
Decisions. De-politicize decision-making. Surface conflict – allow minority views to be heard. Exploit the wisdom of the crowd in critical decisions.
Information. Create a democracy of information. Create an internal market for ideas, talent, and resources.
Creativity. Overcome the prejudice that people aren’t creative; create space and time to give them time to reflect, dream, and innovate. De-stigmatize failure and build cultures that reward much more small-scale innovation
According to the Fair Trade Labelling Organization (FLO; www. fairtrade.net), ‘Fairtrade is about better prices, decent working conditions, local sustainability, and fair terms of trade for farmers and workers in the developing world. By requiring companies to pay sustainable prices (which must never fall lower than the market price), Fairtrade addresses the injustices of conventional trade, which traditionally discriminates against the poorest, weakest producers.
It enables them to improve their position and have more control over their lives.’ Today, fair trade organizations around the world come together under the FLO, which includes over 990 producer organizations, 1.2 million farmers, and workers in 66 countries. Fairtrade products are sold in over 120 countries and sales numbers have been steadily increasing. The six biggest fair trade products are bananas, cocoa, coffee, cotton, sugar, and tea. The key objectives of the FLO standards are to:
Ensure a guaranteed fair trade minimum price which is agreed with producers.
Provide an additional fair trade premium which can be invested in projects that enhance social, economic, and environmental development.
Enable pre-financing for producers who require it.
Emphasize the idea of a partnership between trade partners.
Facilitate mutually beneficial long-term trading relationships.
Set clear minimum and progressive criteria to ensure that the conditions for the production and trade of a product are socially and economically fair and environmentally responsible.
Crowdsourcing the truth
There are a series of websites and apps that allow the public to get more engaged in bringing out unethical behavior. Bribespot is an app that lets users report instances of bribery, including amounts that were requested. They place the instances on a map of the world so the public can see where these bribes are taking place (http://www.bribespot.com).
Bribr does the same in Russia (bribr.org). TruthMarket is a platform where users can pledge to pay for others to find evidence for or against the unverified statements of public and influential figures (www.truthmarket. com).
Threatened Voices tracks the suppression of online free speech (Tracking suppression of online free speech). In India, the zero rupee note created by 5th Pillar is a tool that aims to help fight bribery. When a bribe is asked for the individual can hand over fake rupees rather than real ones to send a strong message against corruption (www.5thpillar.org).
Whistleblowers, those who release information about suspected corruption and unethical behavior within an organization, are often seen as bad individuals, and whistleblowing actions are often seen as being disloyal and creating a distrustful atmosphere. The fact is, this could not be any further from the truth.
Having in place a system where individuals within the company and who deal with the company – such as suppliers and buyers – are encouraged to report unethical or corrupt behavior can be an important tool that allows the company to detect and fix eventual problems.
In addition, these systems can play a key role in preventing significant financial consequences in the company, or in extreme cases, have the consequence of bringing down the whole company, if such fraud were to become public. According to a 2007 study by KPMG, 25% of the incidents of fraud uncovered among 360 incidents analyzed came to light thanks to a whistleblowing system put in place by companies.
However, only 33% of companies surveyed in Europe had hotlines for employees to report incidents of possible fraud. In 2008, the International Chamber of Commerce launched a set of guidelines aimed at helping companies establish and implement internal whistleblowing programs:
Create a whistleblowing program as part of internal integrity practices.
Handle reports early on, in full confidentiality.
Appoint a high-level executive to manage the whistleblowing unit.
Communicate in as many languages as there are countries of operation.
Abide by external legal restrictions.
Allow reporting to be anonymous or disclosed, compulsory or voluntary.
Acknowledge, record, and screen all reports.
Enable employees to report incidents without fear of retaliation, discrimination, or disciplinary action.
The role of the CEO
‘Senior management commitment is key to a company’s successful approach to corporate responsibility; while it is essential that senior management assign clear responsibilities, resources, and authority to company managers for addressing corporate responsibility issues on an ongoing basis, leadership in these matters rests with the chief executive, the chairman and board directors.’
INTERNATIONAL CHAMBER OF COMMERCE
The World Economic Forum conducted a survey of CEOs around the world, which indicated that business leaders have three responsibilities:
1. Our companies’ commitment to being global corporate citizens is about the way we run our own business. The greatest contribution we can make to development is to do business in a manner that obeys the law, produces safe and cost-effective products and services, creates jobs and wealth, supports training and technology cooperation, and reflects international standards and values in areas such as the environment, ethics, labor, and human rights.
2. Our relationships with key stakeholders are fundamental to our success inside and outside our companies. Being global corporate citizens requires us to identify and work with key stakeholders in our main spheres of influence: in the workplace, in the marketplace, along with our supply chains, at the community level, and in public policy dialogue.
3. Ultimate leadership for corporate citizenship rests with us as chief executives, chairmen, and board directors. Although it is essential that we assign clear responsibilities, resources, and leadership roles to our managers for addressing these issues on a day-to-day basis, ultimate responsibility rests with us (www. The World Economic Forum).
It has been said time and time again that without the support of senior management, initiatives cannot have their full impact. The role of the CEO is not only to steer the ship in the right direction, but also to be able to see over the horizon and be able to plan ahead. As such, the chief executive plays a key role as a champion on sustainability strategies:
CEOs can make sure the issues are part of informal conversations that take place on a daily basis and make sure it is part of their language.
CEOs can make sure they walk the talk by sending clear and consistent messages about the importance of sustainability in the organization and matching this with their own actions.
They are the ultimate supporter and enabler of the issues within their organization and thus have a vital role to play in a company ’s adoption of sustainability.
According to the International Finance Corporation, ‘The biggest impact of banks, investors and insurers on sustainable development is not their own environmental footprint but their pivotal role in allocating financial capital between different economic activities, both at home and abroad.’ The financial sector plays a key role by sending signals to companies that can enable them to invest in longer-term opportunities.
Financial institutions, such as banks, are also partially responsible for managing social and environmental risks in decision-making and lending, as well as helping identify opportunities for innovative product development in new areas related to sustainability. In addition to what they choose to finance, the financial sector can have a crucial impact by not investing in products, initiatives, or projects that are unsustainable or damaging to society and the environment.
Why is it important?
To better understand companies. Evaluating environmental, social, and governance (ESG) factors can lead to a more thorough understanding of both the risks and opportunities and how these will impact the bottom line both today and in the future.
To anticipate problems. Many investors are reacting to bad corporate governance news rather than anticipating potential problems. A greater consideration of these issues allows investors and financial professionals to see the problems before they occur and plan accordingly.
To increase profitability. For companies that are able to move beyond merely looking at risks and to start identifying and acting on opportunities, there are many avenues to explore, for example in sustainable energy, cleaner production, biodiversity conservation, and the fast-growing environmental technology industries.
Intangibles. ESG issues can have a strong impact on intangible assets such as reputation and brand, which can represent over two-thirds of the total market value of a listed company. As the Chartered Financial Analyst Institute puts it, ‘Investors should consider what a company does to maintain and protect one of its most important assets: its reputation.’
As part of your fiduciary responsibilities. According to UNEPFI, ‘appropriate consideration of these issues is part of delivering superior risk-adjusted returns and is, therefore, firmly within the bounds of investors’ fiduciary duties.’
As a proxy for good management. Groups such as Goldman Sachs’s Sustain use management of environmental, social, and governance issues as a proxy for overall strong company management. ‘Because the world is more difficult to operate in, we think there are certain factors companies will need to manage if they are to succeed.’ Investors have a preference for companies with strong governance and are prepared to pay a premium for this.
Increased demand. There is an increased demand for sustainable finance options, from businesses and customers.
Mergers and acquisitions. Sustainability issues should be of particular concern for those involved at all stages of the M&A lifecycle, including target screening, deal structuring and valuing, assessing the strategic, financial, and operational goals of the deal, merger integration, and long-term planning for operations or exit strategies. These issues can affect both the viability and the ultimate value of deals.
The key concepts
Sustainability affects both the financial sector and financial activities undertaken by a company.
Incorporating sustainability issues into investments
Integrating ESG criteria into investments
The responsibilities of those people who manage money
Shareholders seeking to influence companies
Providing global indexes to benchmark sustainability performance
Exploring sustainability issues within projects
Providing financial services to the poor
According to the World Economic Forum, sustainable investing (SI) ‘is an investment approach that integrates long-term environmental, social and governance criteria into investment and ownership decision-making with the objective of generating superior risk-adjusted financial returns.
These extra-financial criteria are used alongside traditional financial criteria such as cash flow and price-to-earnings ratio.’ Sustainable investment, also referred to as socially responsible investment or responsible investment, is a term used to describe an investment process which takes environmental, social, ethical, and governance considerations into account.
This process is in addition to, or is incorporated into, the usual investment selection and management processes and can be adopted across asset classes (private equity, real estate, etc.). There is an increasing demand for each of the different forms of SI:
1. Screening of investments
Negative screening. SI started with investors choosing not to invest in sectors or companies that were seen as ‘bad’ because of their policies, actions, products (e.g., tobacco and weapons), or services (e.g., gambling). For example, the Co-operative Asset Management in the UK has a long list of areas, determined in part by customers, where they will not invest.
Positive/norms-based screening. Portfolios are chosen based on a set of non-traditional criteria, which can include environmental, social, governance, and ethical issues. These screens are seen as having an impact on both financial and non-financial measures. Common positive screens include energy efficiency, environmental management, and employment standards.
Best in class. A subsection of positive screening, this involves selecting the best performers based on environmental, social, and governance parameters. There are a growing number of indexes that provide information on these companies.
Sustainability-themed. Investments are made in themes of assets specifically related to sustainability, such as clean energy, green technology, or sustainable agriculture.
2. Stakeholder engagement. Fund managers actively engage with companies in which they invest to seek improvement on environmental, social, and governance issues if their research indicates a shortfall in these areas.
3. Proxy voting and shareholder resolutions. Owners exercise their right to vote and their right to file shareholder resolutions in order to achieve better management outcomes from the companies they invest in. Even ESG resolutions that attract less than majority support can still capture the attention of a corporate board and lead to change. GE ’s Ecoimagination was created in part because of an environmental resolution raised by a group of nuns, even though at the time it only gained 24% support.
4. ESG integration. Sustainability issues are incorporated into investment decision-making in the same way as other financial information based on seeking opportunities or avoiding the risk associated with these issues. One example of a group working in this area is GenerationIM. They don’t have one team doing the sustainability analysis and another doing the financial. Instead, each analyst is trained to do both.
5. Community investing. Investor capital is used to finance or guarantee loans to individuals and organizations that have historically been denied access to capital by traditional financial institutions, such as disadvantaged urban and rural communities (The Forum for Sustainable and Responsible Investment).
There is a wide range of different types of sustainable investment, some of which – at the ‘ethical’ or deep green end – is very much about saving the Earth or meeting other social or environmental objectives, which deliberately take precedence over financial objectives. Investors in this type of product, driven by ethical values more than financial value, make up a small minority.
The term ‘responsible investments,’ on the other hand, represents investments that are focused much more on the potential for more attractive returns over the longer term by taking advantage of ESG trends or better managing ESG risks. Financial returns are still the driver and there is a clear recognition that it is simply not possible to maintain strong financial returns over a long period of time if they are achieved at the expense of people or the environment.
Financial markets have great transformational power to accelerate the transition toward more sustainable business practices and value creation. The integration of ESG factors into mainstream investment analysis is, therefore, key to moving the business sector forward.
Sustainable or responsible investment recognizes that the generation of long-term sustainable returns is dependent on stable, well-functioning, and well-governed social, environmental, and economic systems and that ESG issues are an increasingly fundamental part of assessing the value and performance of an investment over the medium and longer term.
It requires investors and companies to acknowledge the full spectrum of risks and opportunities facing them in order to allocate capital in a manner that is aligned with the short- and long-term interests of their clients and beneficiaries.
There is an increasingly strong case for sustainable investing. Evidence indicates that sustainable investing can lead to better risk-adjusted financial returns that help to identify new opportunities for revenue improvements. The investment community is becoming increasingly active in this area thanks to a growing awareness of these issues and increasing demand from asset owners and retail investors as well as increased external pressure from stakeholders such as the media and NGOs.
Investors themselves are becoming more active in this space and coming together in networks to move this space forward. The Principles for Responsible Investment, an investor initiative in partnership with UNEP FI and the UN Global Compact, currently has over 1000 signatories representing US$32 trillion in investment capital, and the Carbon Disclosure Project has over 700 institutional investors representing US$78 trillion signed up.
Although surveys have shown that the majority of the main-stream investor community believes sustainability should be part of discussions with financial analysts, only half admitted that they had achieved that. The challenge is similar to the ‘chicken and the egg’ scenario; more investors would consider ESG information if more corporations provided it and more corporations would pro-vide ESG information if investors demanded it.
So how do we move forward? There is a need to improve ESG information and ensure that it is widely shared between corporations and investors, ensure that both corporate executives and investors have the skills to assess ESG factors and link incentives in the investment chain to more long-term adjusted financial performance.
Investors. Asset owners and managers play a role in developing performance measurement systems for fund managers that balance long term and short term. Traditional valuation models do not sufficiently integrate ESG factors, which means investors need to be trained to be able to incorporate them into their decision-making process.
In particular, investors should look at how ESG factors contribute to long-term investment strategy, and how to access materiality of these factors and work with companies to determine financial material KPIs. Investors can also demonstrate more active ownership through engagement, shareholder resolutions, and/or proxy voting.
Corporations (listed and non-listed). There is a need to strengthen communication between investors and corporate executives around ESG issues, including what issues are financially material and in what timeframe. This is increasingly being done through CEO presentations, integrated reports, and structured, regular dialogue about not just how ESG factors are fully integrated into the process of developing corporate strategy, but also the process of corporate capital allocation. There is furthermore a need to link the remuneration of corporate executives not only to short-term financial results but also to longer-term financial and non-financial performance.
System-wide level. In order to mainstream responsible investing, changes need to be made to the system as a whole. This includes, but is not limited to, changing our focus from being disproportionately on the short term to putting equal weight on the medium and long-term.
Accounting bodies and public authorities play a key role in creating frameworks and tools to enable companies to disclose information. Last but not least, business schools need to incorporate responsible investing into their training so that the next generation knows how to do this.
One of the main challenges is bringing together the information required to make decisions, as it is often difficult to acquire consistent, comparable, and audited information. Many are finding that companies themselves are frequently doing more than they disclose (see Blog 6) and sometimes more than their ratings would suggest (see ‘Ratings and indexes’ in this blog). Much of the ESG data is presented without context, which can be misleading because of the different disclosure requirements around the world.
There are a growing number of companies, such as Trucost, who aim to make it easier for investors to get their hands on environ-mental data right next to financial data to allow them to make better decisions. There are also a growing number of CEOs pushing investors to take these issues more seriously. For example, on an analyst call, Paul Polman (CEO of Unilever) criticized analysts for not doing more to understand the company’s Sustainability Living Plan, which is a core part of their strategy today and moving forward.
A good resource for responsible investment is the Principles for Responsible Investment (PRI | Home), which also has an academic network with research in this area, as well as the UNEP Finance Initiative (Partnership between United Nations Environment and the global financial sector to promote sustainable finance).
The Chartered Financial Analyst Institute (CFA) has done some work in ESG, including a manual for investors on these issues (CFA Institute). See WWF’s 2050 Criteria Guide to Responsible Investment in Agricultural, Forest and Seafood Commodities (WWF - Building a future in which humans live in harmony with nature. );
International Corporate Governance Network’s Model Mandate Initiative, a model contract between asset owners and their fund managers (ICGN); CFA Institute’s Asset Manager Code of Professional Conduct (CFA Institute). The International Federation of Accountants has several resources, including Project and Investment Appraisal for Sustainable Value Creation.
They also give out prizes for Sustainable Investor and Investment of the year (IFAC |). Also, see the World Economic Forum’s work on sustainable investing (http://www.wef.org). Specific topics include:
Property. Global Real Estate Sustainability Benchmark (www.The Global ESG Benchmark for Real Assets - The Global ESG Benchmark for Real Assets); UNPRI Responsible Property Investing resource database (PRI | Home).
Hedge funds. Hedge Fund Standards Board standards (www.http://hfsb.org); discussion paper on the responsible investment of hedge funds (PRI | Home).
Private equity. The Environmental Defense Fund (business.Home) and the IFC (EsToolkit.com is for sale) have both created tools with leading private equity players which provide a framework to assess and improve ESG management across the investment lifecycle. See also the EVCA Professionals Standards Handbook (www.evca.eu) and Private Equity Growth Capital Council Guidelines for Responsible Investment (American Investment Council).
Today, the majority of investment assets are controlled by pension funds, mutual funds, insurance companies, or other institutional investment funds. In the case of pension funds, the assets are overseen on behalf of beneficiaries by a relatively small number of trustees who act as fiduciaries to control large pools of retirement savings. Legally, their job is to act in the best interests of the savers whose money is in the funds.
However, are they? What exactly are the best interests of those individuals? A report by UNEP and Freshfields law firm says,
‘This is where the interesting questions concerning fiduciary responsibility come to the fore: are the best interests of savers only to be defined as their financial interest? If so, in respect to which horizon? Are not the social and environmental interests of savers also to be taken into account?
Indeed, many people wonder what good an extra percent or three of patrimony are worth if the society in which they are to enjoy retirement and in which their descendants will live deteriorates. Quality of life and quality of the environment are worth something, even if not, or particularly because, they are not reducible to financial percentages.’
Many funds fail to look at these issues for two reasons. Many fiduciaries question whether they are legally allowed to take action on such issues, despite the growing body of evidence that ESG issues can have a material impact on the financial performance of their portfolio.
However, as the report says, ‘On that basis, integrating ESG considerations into an investment analysis so as to more reliably predict financial performance is clearly permissible and is arguably required in all jurisdictions.’ Much of this boils down to the simple rule of the Precautionary Principle: whereby if one may, through exercising a degree of caution, avoid exposing oneself (or one’s investments) to risk, one should certainly take appropriate steps to do so.
The second reason that many funds fail to integrate ESG issues into their investment decisions relates to the culture of investing. Investors have a ‘herd mentality’ in that they assume safety in numbers by following largely similar strategies when it comes to investing. In part they do this because of the pressure felt to justify their existence based on a quarterly if not the daily basis by focusing on short-term profit opportunities.
According to William Donaldson, former Chairman of the Securities and Exchange Commission, ‘Over time, analysts have become obsessed with the question of whether a company meets its quarterly EPS numbers and not with whether a company is built to last. And because of the considerable clout of the sell-side analyst, this shift from long-term thinking too short-term results has echoed through to company management and to professional investors.’
Fortunately, things are changing. The financial crisis is leading to major changes in public attitudes and regulations. The focus is on filling the gaps in the regulatory apparatus and legislative frameworks that allowed banks to get into such deep trouble with such unsustainable investments.
In some countries, such as France, ESG issues must be considered for investment, and have been put into the investment management mandate issued to fund managers by the French retirement reserve fund. In 2010 Intel amended its corporate charter to include mandatory reporting on corporate responsibility and sustainability performance after an investment firm introduced a shareholder resolution asking them to. Intel’s decision was also influenced after their corporate council stated that under Delaware law, directors had a fiduciary duty to address these issues.
A range of states in the USA has passed legislation enabling companies to register as a Benefit Corporation. Benefit Corporations are a new class of corporations that create a material positive impact on society and the environment, expand fiduciary duty to require consideration of non-financial interests when making decisions, and report on overall social and environmental performance using recognized third-party standards. A range of companies has changed their status to Benefit Corporation, including Patagonia and Seventh Generation.
Shareholders are becoming more aware of the financial risks associated with social and environmental issues and are deciding to voice their concerns with companies in which they own shares. Long-term activists are being joined by mainstream investors who are both looking to shape and influence companies through their rights as shareholders.
A shareholder proposal is a document that a shareholder formally submits to a publicly traded company asking the company to take a specific course of action. There are two kinds of proposals made.
1. Governance Proposals focus on traditional management issues such as the election of directors, board structure, and compensation as well as increased transparency, disclosure, and corporate investments in sustainability.
2. Social and Environmental Proposals call for changes in a company's response to issues such as climate change and employee discrimination.
Proposals can be submitted by individuals but are most likely submitted by one of the following groups on behalf of a group of individuals:
Socially responsible investors who make decisions based on a company’s social, environmental, and governance performance as well as financial returns. For example, Calvert Investment Management and Trillium Asset Management asked Smuckers Jam Company to report within 6 months on its plans for managing climate change risks to its coffee supply chain.
Pension funds are not only increasingly applying a sustainability lens to their investments but also doing a lot of research in this area. Several retirement fund groups, including the New York City Retirement System, recently urged Hewlett-Packard Co. to address corporate governance policy and board composition.
Faith-based institutions were instrumental in creating the movement of shareholder activism, a movement which gave rise to the Interfaith Center on Corporate Responsibility, an association of 275 faith-based institutional investors who sponsor 200 shareholder resolutions a year on behalf of its members who view their investments as a catalyst to promote justice and sustainability.
Special interest groups use resolutions to promote their own issues such as animal welfare. These resolutions usually get low votes but can be an effective way of raising awareness about a particular issue.
Individuals who own a certain amount of shares are also putting forward proposals.
Labor unions are looking at using their shareholder power to influence companies in the areas of labor rights and worker safety, for example.
Foundations such as As You Sow, which utilizes proxy voting to file resolutions on a range of issues and in partnership with other NGOs and organizations around the topics of energy, environmental health, waste, and human rights.
The number of resolutions being filed has been steadily increasing. While shareholder votes are typically advisory in nature, they send a strong message to management about issues of concern to investors. Companies do not have to comply with the vast majority of shareholder proposals; however, those with good management values generally respond to the concerns raised and those that do not respond put themselves at further risk.
Most shareholder concerns are addressed successfully via dialogue and do not end up at the resolution stage. In 2012, Calvert Investments won commitments from Colgate to source 100% certified palm oil for their products. Shareholders also pushed companies such as Garmin and Crocs to publish sustainability reports.
In 2009, in response to shareholder resolutions filed by among others Bard College Endowment, McDonald’s agreed to formally survey and promote best practices in pesticide use reduction within its American potato supply chain. This agreement led to the withdrawal of a shareholder resolution filed by the university endowment, as well as a project to share best practices across the industry in this area.
One challenge is that many shareholders do not know what their money is invested in, and if it is being invested through a fund, what that fund is investing in. There are several projects to raise awareness in this area. For example, Calvert Social Index, which measures the social performance of the largest 1000 US-based companies, has a service called Know What You Own, which allows you to see what is in your US mutual funds and if the companies held meet Calvert’s social standards.
Ratings and indexes
A variety of external ratings, rankings, indexes, and awards are seeking to measure and track the environmental, social, and governance performance of leading sustainability-driven companies around the world. They provide asset managers with increasingly reliable and objective benchmarks to manage sustainability portfolios and are used as a basis for responsible investment decisions.
They are also being used by consumers to influence their buying decisions and by employers looking at where to apply for jobs. For these reasons, it is important that these ratings be accurate and credible.
For businesses, participation in these programs can have several benefits:
Communication of their sustainability efforts to a wide audience, thus enhancing their reputation and brand as a good corporate citizen.
Third-party authentication for their ESG efforts, if the ESG firms rate them well or include them in indexes.
Access to additional investment through inclusion on sustainability indexes.
Understanding of their own strengths and weaknesses, identification of potential opportunities for improvement, and self-benchmarking against competition through the response process and research firm feedback.
Many companies also link management performance evaluation on ratings and indexes.
There has been a significant increase in ratings since 2005 (from 21 to over 110 today) as well as an increase in the variety of such ratings and how information is collected to create them. For some, the information is collected through surveys sent directly to businesses and is complemented by additional information collected through various media and stakeholder reports.
Some are focused entirely on publicly available information. In some cases, analysts personally contact individual companies to clarify points that arise from the analysis of the information collected. Some indexes provide in-depth information about their methodology on their website, while others disclose very little information on what they base their decisions on.
There are several different types of ratings. Investor-focused indexes tracking the financial performance of leading sustainability-driven companies internationally are increasingly important for investors and analysts. Launched in 1999, the Dow Jones Sustainability Index chooses companies based on a set of criteria and weightings cover-ing economic, environmental, and social areas. Every year the 2500 largest companies in the world are invited to take part in the assessment, which looks at:
Economic dimensions. Codes of conduct, compliance, corruption and bribery, corporate governance, risk and crisis management.
Social dimensions. Corporate citizenship, labor practice indicators, human capital development, social reporting, talent attraction and retention.
Environmental dimensions. Eco-efficiency, environmental reporting.
Another example is the FTSE4Good Index series launched in 2001. To be included, companies need to demonstrate that they are working toward environmental management, climate change mitigation and adaptation, countering bribery, upholding human and labor rights, and supply chain labor standards. A small number of sectors – such as tobacco and weapon companies – have been excluded. Companies who do not comply are taken off the list.
Indexes are also active at the national level. Brazil Nuevo Mercado, part of the São Paulo Stock Exchange in Brazil, has stricter reporting rules and expanded share-owner rights, in order to attract investment from outside the country. The promise of greater transparency and higher corporate governance standards by the companies listed has led to great increases in foreign capital invested in Brazilian listed companies. The Janzi social index consists of 60 Canadian companies that pass a set of broadly based environmental, social, and governance rating criteria.
The second group of indexes and ratings are those that are consumer focused, this includes ratings such as Greenpeace’s Supermarket Seafood Sustainability Scorecard or more product-level ratings such as Good Guide and the Sustainable Consortium. These ratings can be more influential for a company’s brand image.
The third group of indexes and ratings are those that are industry, region, or topic focused. This includes Tomorrow’s Value Rating, Global 100 World’s Most Sustainable Companies, regional indexes such as the Asian Sustainability Rating, topic-specific such as CR Magazines 100 Best Corporate Citizens or the Carbon Disclosure Project Leadership Index, or more industry-specific ones such as the Access to Medicine Index which measures pharmaceutical companies’ efforts to improve universal access to medicine.
As the number of indexes grows, so does the number of surveys companies are being asked to fill out. One challenge companies are facing in this area is that filling out the surveys takes up company resources, in particular time. In an attempt to solve this issue, HSBC has started having regular webcasts where analysts are invited to hear about the sustainability strategy and ask questions – hoping that these regular conversations will minimize the requirements to fill out questionnaires.
Companies are encouraging financial institutions and information requestors to take steps together to improve the information-request process in order to increase the likelihood of participation. There is also a growing movement to take these specialized indexes and merge them into traditional indexes in order to have all the information available in the same place.
Environmentalists, who have for decades been raising awareness on the negative social and environmental impacts of certain large infrastructure projects, are now beginning to make the connection between the projects they campaign against and the financiers who back those projects. At the same time, financiers have begun to understand that social and environmental risks pose a threat to long-term shareholder value and must be taken seriously.
Project finance, according to the Equator Principles, ‘is a method of funding in which the lender looks primarily to the revenues generated by a single project both as the source of repayment and as security for the exposure.’ Project finance is generally used to finance large projects such as processing plants, mines, infrastructure, dams, and power plants.
Owing to their complexity, size, and location, these projects often have challenging environmental and social issues that may include involuntary resettlement, loss of biodiversity, impacts on indigenous and/or local communities, worker safety, pollution, etc. Because these large projects generally face high scrutiny from regulators, civil society, and financiers, there is often a need to allocate more resources to manage environmental and social risks and, more importantly, prevent them from happening in the first place.
In 2002, led by the World Bank Group’s International Finance Corporation (IFC), banks working in the project finance sector developed the Equator Principles, a common set of environmental and social policies and guidelines that could be applied globally across all industry sectors.
The principles are voluntary and aim to ensure that projects – whether they are large infrastructure projects such as dams or smaller projects – are financed in a manner that is socially responsible and reflects sound environmental management practices. Basically, the institutions that are signatories have committed to not providing loans to projects where the borrower will not or is unable to comply with social and environmental policies and procedures.
While voluntary standards and principles are an encouraging step toward sustainable business in the project finance world, implementation of these standards and principles is where the greatest challenge lies. Sometimes, despite a company’s efforts in this area, things go wrong. In these cases increasingly institutions are looking to put mechanisms in place to create a space for those in the communities negatively affected by the project to have a voice.
In for example, the UN Business and Human Rights Guiding Principles, of which one is around grievance mechanisms. One example of such a mechanism is the Compliance Advisor Ombudsman (CAO), an independent recourse mechanism for the International Finance Corporation and Multilateral Investment Guarantee Agency – two private-sector arms of the World Bank Group.
The CAO responds to complaints from communities affected by IFC/MIGA-sponsored projects with the goal of enhancing social and environmental outcomes on the ground and provides greater public accountability for the work of the two agencies. The CAO has three roles: first, acting as a neutral third party to help resolve community/company disputes using dispute-resolution approaches, such as mediation, facilitated dialogue, and participatory processes that are voluntary between the parties;
second, overseeing compliance investigations of IFC’s/MIGA’s social and environmental performance; and third, acting as an independent advisor to the World Bank Group President and IFC/MIGA senior management on systemic social and environmental concerns.
From short term to long term. The financial sector is built around institutional incentives that reward short-term results more than long-term ones. Pressure to meet quarterly targets and market expectations make it challenging to focus on long-term results.
Shareholders and customers. There is still a disconnect between shareholders’ professed values and what they expect from their investments. The same is true of customers, who are pressuring banks to move forward on these issues without supporting the banks’ efforts by using these products. There are many reasons why this is the case, including staff and customers not being aware of the different sustainability products on offer and a continuing belief that all responsible investment products will underperform financially.
Failure to price. The failure to put a correct price on environmental and social goods and services that really matter means that they are often ignored or undervalued. The financial system as it now has limited capacity for exploring the wider social impact of investments.
Competencies. Most analysts have limited knowledge of sustainability, and new analysts are not receiving enough training to use non-financial criteria in financial valuation.
Free-riders. Companies will pay less than their peers for protecting the external environment if they can get away with it, and may even be rewarded by an increase in their share price (in the short term at least).
Siloed thinking. Many products and discussions are focused only on one topic, for example, climate change. But is that really your biggest and only risk? The range of sustainability issues is very broad, and all aspects should be considered.
Cost payback analysis. The number of years required for some sustainability projects to pay for themselves may appear high with a traditional payback analysis. However, many times these are revealed to be more than cost-effective over the long term.
Access to better information. The current availability of data varies widely between companies, sectors, and regions, and is based on different voluntary and mandatory reporting regulations.
Trends and new ideas
While many had their thoughts and opinions not just on what caused the financial crisis but how to prevent it from happening again, an unlikely group emerged with their suggestions; the biologists. A number of biologists have been advising the Bank of England on how to reform global finance. This is part of an emerging trend of interdisciplinary thinking around sustainability, brought up several times in this blog. Making sense of the relationship between the individual and the system is what biologists do.
After taking a look at a model of the financial system they were able to see parallels with their work in biology. For example, less stable ecosystems have less diversity and a high degree of connectedness between species. The banking model is a system that is not only relatively homogeneous but also very connected – meaning, like an ecosystem in the same state, it is very vulnerable to shocks.
Another field of biology also had its say; infectious disease epidemiology noted that when a disease outbreak occurs, the superspreaders need to be identified and isolated from the rest of the population. In banking, during the crisis, the equivalent of the superspreaders (those institutions with the most toxic debt), instead of being isolated, were supported with taxpayer money and encouraged to merge with others. Biologists are now working at providing some feedback on how, based on their experiences in their own field, the financial sector could be strengthened.
New landscape for corporate ownership
Shareholders in large companies are no longer limited to the wealthy, privileged few. Today, working people around the world have their pensions and other life savings invested in shares of the world’s largest companies. For example, the biggest share-holding body in Canada is the teachers and civil servants of Ontario, while in Denmark it is the workers’ pension fund.
TIAA-CREF, the pension plan for US teachers and university staff, itself controls about 1% of all US stock market capitalization, and CALPERS, the California Public Employees Retirement System, is almost as big.
Through pension, insurance, and savings institutions millions are inheriting power. So, as the World Economic Forum puts it, ‘Each pensioner owns a tiny interest in a vast number of companies. From the telecoms of Panama to the chemical companies of Germany, from the electronic companies of Silicon Valley to the oil wells of Nigeria, millions of citizens are the beneficial owners.’
This is important for two reasons. First, it means that the responsibility of investors will increasingly be to meet the intrinsic interests of owners in the long term, owners who represent people internationally. Second, this group of people could start speaking up as they become more aware and engaged.
At the other end of the spectrum, approximately 11 million high-net-worth individuals (HNWI) worldwide hold at least US$1 million in financial assets, a number which is increasing rapidly. These investors are increasingly interested in green tech and alternative energy investments in their portfolios (12% of HNWI and 14% of ultra-HNWI), according to the World Wealth Report produced yearly by Capgemini and RBC.
A yearly study by Eurosif found that sustainable investments by HNWI rose to 1.5 trillion euros in 2012 compared with 729 billion euros in 2009, reflecting persistent demand even in volatile markets.
Jack Welch, the former CEO of GE, was quoted as saying ‘Shareholder value is the dumbest idea in the world. (It) is a result, not a strategy. Your main constituencies are your employees, your customers and your products.’ The recent economic and financial events sent out a clear message about the consequences and costs of short-termism.
Survey after survey reports CEOs, senior executives, and sustainability experts agreeing that short-term profit motives are one of the biggest obstacles to environmentally responsible business and that the pressure to deliver immediate financial results is a big barrier to sustainability efforts.
In response to this the CEO of IKEA, Mikael Ohlsson, was quoted as saying ‘While many current-day CEOs may agree in principle, the pressure of quarterly earnings reports can nevertheless push executives to favor short-term profits over long-term success.’ He also said ‘What is good for our customers is also good for us in the long run. We are not on the stock exchange, so we can act long term.’
Another interesting quote comes from an article in the FT which says ‘Strong total shareholder returns are what ultimately matter to investors in a company. But there are reasons to think that shareholder value, like happiness and many of life’s other good things is best achieved by not aiming at it too directly.’ For example, an executive is compensated based on stock price which means that over the 3 years they have the job, they may take dangerous short-term business risks, the results of which will only become evident long after those options have been monetized.
Several projects are underway to look at how we can move away from short term to long term. Aspen Institute’s long-term value creation guidelines focus on corporate–investor communication and look at aligning company and investor compensation policies with long-term metrics (Business and Society Program - The Aspen Institute). Also, see The Future Quotient by Volans (http://www.volans.org) and the World Future Council (www.worldfuturecouncil.org).
The role of the CFO
Traditionally, the CFO has not been involved in sustainability, instead of running the numbers and letting others handle these issues. Not anymore. The role of the CFO is in integrating sustainability with business planning to support targets and objects to embed sustainability within the core decision-making of the organization. CFOs can link sustainability to business performance systems to drive better decisions and then apply financial expertise to ensure they create more value.
Moreover, the corporate finance team often leads key business processes, such as budgeting, capital appropriations, internal and external financial reporting, executive compensation, and energy management that directly affect the achievement of sustainability goals. So, CFOs are increasingly pushing sustainability and becoming active about their efforts in this area.
One-third of CFOs surveyed on behalf of Deloitte by Verdantix said that they are ‘fully involved in all aspects’ of sustainability strategy at their firms; another 36% said they are periodically involved and these numbers are increasing. The Chartered Institute of Management Accountants provide the following guidance for CFOs to get engaged:
Make it strategic, not just tactical.
Apply a financial mindset and link sustainability business performance.
Identify and use the right metrics consistently.
Improve the process of data collection, analysis, and reporting.
Integrate with business planning and reporting.
The insurance sector is the world’s largest economic sector, which reaches virtually every customer and business around the world. Without insurance, businesses and individuals would be afraid to take the risks that are necessary for the continuous development of a capitalist society. It is in the insurer’s interest to reduce risks and improve sustainability. According to UNEPFI, ‘The insurance industry is a strong lever for implementing sustainability due to its size, the extent of its reach into the community and the significant role it plays in the economy.’
The sector is increasingly concerned with climate change, health, man-made risks, and environmental liability, to name a few. Two types of insurance products have appeared in response: products which differentiate insurance premiums on the basis of environmentally related characteristics; and (2) products specifically tailored for clean tech and emission reduction activities.
Argentina’s government is the first in the world to require companies involved in potentially hazardous activities to purchase insurance covering environmental damage to the country. In 2012 the Principles for Sustainable Insurance were created to provide guidance for insurance companies on how to progress in this area (www.unep.org/psi).
Another initiative in this area is Climate Wise, which is working to develop the insurance industry’s strategy on climate change and currently includes over 40 members (Cambridge Institute for Sustainability Leadership).
A new kind of bank
It is probably safe to assume that most individuals are not happy with their bank for some reason or another, from hidden fees to poor service. Combine high customer dissatisfaction with the current global financial turmoil and it is easy to conclude that banking is an area just begging for innovation and change. Now some banks are stepping up to answer the call for change – from new product offerings to redefining the whole concept of banking to be more transparent and inclusive.
Many mainstream banks, such as Nedbank in South Africa, have now started exploring how to be more sustainable first in their operations, for example by sending statements, invoices, and other notices by e-mail to save paper, but more importantly in the sustainability-related financial services and products offered to retail and business customers.
‘Green mortgages ’ are available with considerably lower interest rates for clients who purchase new energy-efficient homes and/or invest in retrofits. A range of green loans is available in all categories including home equity loans and car loans. An increasing array of credit cards donate a percentage of every purchase to different charities.
Where individuals and small businesses are getting fed up with the big banks, they are turning to a growing number of successful alternatives. In the UK, the Co-operative Bank continues to grow largely due to the explicit ethical policy first launched in 1992, which is based on continued customer consultation.
In Europe, Triodos Bank is committed to transparency and the realization of social, environmental, and cultural objectives in day-to-day banking. As a result, it only finances enterprises and organizations that add social, environmental, and cultural value. Community-based banks are often more focused on small business loans and personal service to the community.
Umpaqua Bank sets up its branch locations like neighborhood hubs, with a focus on community and a range of green products and free events and seminars. ShoreBank Pacific reported its tenth consecutive quarter of record earnings. San Francisco-based New Resource Bank formed in 2005 with the aim to build a bank that was ‘by the people for the people’ of their community. Khazana, a bank in India, is exclusively run by and for children, in particular, street children who earn just US$1 a day. Started in 2001, it now has 400 branches in six countries.
For the most part, the financial sector works well in countries where individuals have a place to put their money, borrow, and have access to a variety of other financial services. The story is very different in developing countries, where around 2.5 billion people have no or little access to financial services and when they do have money, they have nowhere to put it.
Historically, banks dismissed the opportunity to provide services to the poor because it was not seen as a viable alternative, and the barriers to working in certain countries, and reaching the customers, were seen as insurmountable. In the 1970s the shift to microfinance began – as different groups in Columbia, Brazil, and India started testing the disbursement of microloans to individuals (often women, pensioners, artisans, and small farmers), which could be used to start or build up their businesses.
The initiatives were a success. One woman in Bolivia who sold flowers from a street corner in La Paz, together with three other women, was able with a small loan from ACCION International to buy flowers in bulk at a much cheaper rate. Because of her strong repayment record, she was approved for larger loans until she was able to borrow on her own. Today she has been able to send all three of her children to school and even has money left to make improvements on her house.
Some 97–99% of loans from well-performing microfinance institutions are repaid. Experts point to several reasons for this repayment success. First, these loans represent one of few, often the only, opportunities poor people have to access money. Second, prompt repayment of loans allows individuals to have access to more funds and other financial services, which builds a continuing cycle of creating a better, more sustainable life for themselves.
Also, in some cases, group lending is used where a number of individuals provide collateral or guarantee a loan through a group repayment pledge. The incentive to repay is enhanced based on peer pressure to pay (the stick) and peer support to help a member in difficulty (the carrot): the group has a structural incentive to get involved because if one person in the group defaults, then other group members are required by the contract to pay back the loan.
Microfinance is often seen as a win/win solution. The availability of financial services to the worlds poorest gives them opportunities and options to go beyond meeting basic needs, increase their household income, save, and take on credit. Many microfinance institutions report having better returns on equity than large banks do.
Today the boundaries between microfinance and the formal financial sector are starting to break down and the term ‘microfinance’ now encompasses an ever-growing range of organizations and services, experimentation and new entrants, new delivery channels, and new clients. Finca, for example, provides micro-energy loans that allow Ugandans to buy solar energy systems for their homes.
This provides opportunities for a wider range of individuals to access microfinance and not just entrepreneurs. In effect, microfinance is now going mainstream – with national and international banks such as ICICI, Citigroup, Deutsche Bank, and HSBC testing the waters. Development finance institutions such as the International Finance Corporation are also getting involved.
Although the benefits and success of microfinance are clear, there have been some growing pains for this movement. Some institutions are charging higher interest than usual, up to 200%, and siphoning money to unrelated activities. Over-indebtedness, lack of professionalism, and corporate governance are also common criticisms of institutions. There is still much work that needs to be done.
From a charity to a business. Work needs to be done to change something that started as a charity into a proper business. This includes bringing down the cost of operation, which at the moment is very high, increasing efficiency, and focusing on human capital.
Information sharing. There is a need to increase transparency regarding performance, which is currently low and shares information systems such as client credit histories.
Interest-rate ceilings. Some countries impose interest-rate ceilings that discourage firms from entering the market because these ceilings make small loans cost more than large loans.
Expensive. Because of the small size of the loans and fixed transaction costs, the interest on the loan can be high. However, informal lenders can charge 100–150% per annum, so while microfinance is expensive, it still offers funds at rates way below the informal loan market.
Beyond business loans. Microfinance is slowly expanding to provide a larger variety of services for the poor, including credit, savings, remittances, insurance, and different kinds of loans for both consumers and businesses.
Source of money. The money in microfinance has historically come from charities, governments, and international organizations, with growing interest from large banks and private investors. Going forward, microfinance applicants will increasingly be funded by domestic savings and local banks with the aim to help build domestic financial markets. Increasing interest from mainstream social investors, a very fragmented sector, will continue to cause shifts and consolidations.
It isn’t just financial institutions getting into microfinance – several platforms have emerged online inviting the general public to invest their money in microfinance. Kiva, MyC4, and Zidisha are all person-to-person microlending websites where individuals can browse through real individuals in need of funding, including entrepreneur profiles. Once a person chooses who they want to loan to and make the loan, they receive e-mail updates and can track repayments.
Technology is also being used to make it easier for people to have access to their money. In Kenya, the M-Pesa telecommunications system allows people to send money over mobile phones. Cash is handed over to registered retailers who credit customers ’ virtual accounts. Customers can then send between 100 and 35 000 shillings via text message to another person, who can then pick up the money at another registered retailer using a secret code and ID.