Investing in Sustainability – Violations of the Sole Interest Rule or Good Business?
“The property of being environmentally sustainable; the degree to which a process or enterprise is able to be maintained or continued while avoiding the long-term depletion of natural resources.” … Definition of Sustainability in the Oxford English Dictionary
One of the hottest topics in business over the past few years has been that of “Sustainability,” often framed within the broader context of “ESG” (for “Environmental, Social and Governance”). For good reason, companies, managers, and the C-suite in particular have become increasingly concerned about the impact that the company has on its surrounding environment. Indeed, the national discussion on the “Triple Bottom Line” (People, Planet, Profits) continues to grow.
Much of this discussion has centered on the trade-offs that companies seemingly need to make between profits and the company’s impact on the environment (used here interchangeably with “sustainability,” the focus of this article). As a result, many Chief Sustainability Officers (increasingly, this is being elevated to the C-suite) express frustration with doing no more than “shuffling carbon credits around” rather than having a real and material impact on the environment.
However, should corporate officers be concerned with having a real and material impact on the environment and if so, under what conditions? Recently, corporate environmental, social and governance investment decisions have come under increasing scrutiny and fire. For example, in early August, nineteen state attorneys general sent a letter to Blackrock CEO Laurence Fink accusing Blackrock of “rampant violations” of the sole interest rule, a well-established legal principle that requires investment fiduciaries to maximize shareholder financial returns rather than promoting some political or social agenda. Attorneys general in Louisiana and Indiana warned their state pension boards that ESG investing was likely a violation on their fiduciary responsibility under the sole interest rule, while Governor DeSantis of Florida recently barred the state’s $186b pension investment fund from considering ESG when making investment decisions.¹
All of this begs the question: does it have to be the case that a firm’s sustainability policies necessitate a trade-off between profits and environmental impact? Under what conditions might more sustainable business models lead to higher earnings? Is it possible for a concern for the environment to become a win-win for the company’s bottom line and the environment? If so, how can firms find these opportunities?
This article addresses these questions from two perspectives: 1) the past – what does the evidence show regarding the financial performance of ESG investing and 2) the future – focusing solely on sustainability, how and under what conditions might firms use sustainability to improve firm financial performance.
A. The past – what does the evidence show regarding the financial performance of ESG investing?
While there is some older evidence of ESG policies leading to higher equity returns,²more recent evidence is clear that these returns are negative on average.³, ⁴,⁵ Specifically, a 2022 study published in the Review of Accounting Studies concludes that “ESG funds appear to underperform financially relative to other funds within the same asset manager and year, and to charge higher fees,” and that ESG asset selection “accounted for an annual drag on returns of -1.45 percentage points.” Further, they state that “ESG funds’ portfolio firms, on average, exhibit worse performance with respect to carbon emissions, in terms of both raw emissions output and emissions intensity (i.e., CO2 emissions per unit of revenue).”⁵
Overall, the evidence suggests that, on average, the financial returns of ESG investing is negative. While some may argue that there are broader societal justifications that make these investments good business⁶, it is clear that, on average, there is a cost to these investments.
B. The future – how and under what conditions might firms use sustainability to improve firm financial performance?
It even possible for sustainable (we focus exclusively on sustainability here) business practices to lead to better firm financial performance and hence better share price performance? Does sustainable-focused investments need to be a violation of the sole interest rule?
At the end of the day, markets and firm financial performance are governed by economic principles – be it for sustainable business practices or any other activity, economic principles dictate outcomes. Thus, we begin with some basic market truths:
- A firm’s cost structure is inversely related to a firm’s financial performance (holding all else constant).
- A higher level of demand for a firm’s goods and services is positively related to a firm’s financial performance (holding all else constant).
- While there may be a difference between a firm’s short-term financial performance and short-term share price performance, in the long run, a firm’s financial performance will drive its share price.
When it comes to sustainability, we often forget these basic principles, thinking somehow that there is a magic “free lunch” out there. There isn’t.
So, let’s examine each of these in turn:
Impact of Sustainability on Costs.
In strictly economic terms, a firm should be making decisions that maximize shareholder value. Higher costs mean lower earnings. Full stop.
Sustainability initiatives, via a search for more environmentally friendly alternatives, may lower a firm’s cost structure by unearthing a more efficient means of getting the firm’s offering to market (e.g., by finding ways to use less material in production, utilizing more efficient distribution routing or IoT enabled / performance-based logistics approaches). Such “low hanging fruit”’ can indeed simultaneously lower costs and produce a solution that is more environmentally friendly, consistent with what others have claimed.7 Increasing the immediacy of such initiatives may push firms to achieve a lower, more efficient cost structure more quickly thereby improving both the firms cost position and its strategic advantages in the marketplace beyond its current efforts. In short, a firm’s sustainability efforts may be the impetus to unlocking additional cost reductions sooner though initiatives (e.g., IoT enabled supply chain, Performance-based Logistics, etc.) that would eventually have needed to be put into place at some later date.
Impact of Sustainability on Demand.
This is where it gets trickier. Given activism, both at the shareholder and consumer level, the mere appearance of being “green” can drive certain segments to your products and services – or at least have them look more favorably on your brand and offerings. Thus, one could argue that “green” company policies present a new opportunity for firms today. A classic example of this is what is happening in the suddenly exploding market for second hand clothing. Companies like The Real Real are gaining in popularity through a novel positioning – buying new clothes is bad for the environment. This positioning has proven to be quite effective in a number of segments and has helped them grow the top line.
Thus, to the extent that such a positioning can attract additional customers and/or customer segments, positioning (and indeed actually being) “green” can increase demand for a company’s offerings. For this to be profitable, the financial return to this increase in demand must be greater than any cost increase.
So, in principle, there is an inherent tradeoff between a higher level of demand and a potentially higher cost structure. Brand reputation, tradeoffs involving short-run versus long-run and various other pressures also clearly play a role. Certain companies have been better than others in navigating this tradeoff, but make no mistake this is a tradeoff.
Impact of Sustainability on a Company’s Financial Performance.
In the long run, a firm’s financial performance will drive its share price; markets are efficient and any short run difference between a firm’s performance and its share price will dissipate in the long run.
A recent McKinsey report suggests that there are five ways that ESG can create shareholder value: (1) facilitating top-line growth, (2) reducing costs, (3) minimizing regulatory and legal interventions, (4) increasing employee productivity, and (5) optimizing investment and capital expenditures.⁷
All of these present opportunities for management to improve a firm’s financial performance beyond what it is at current. Cost reduction vis-à-vis supply chain efficiencies, for example, may be unearthed by sustainability concerns (to wit, PepsiCo’s initiatives in sustainable agriculture and trucking). Minimizing regulatory and legal interventions are important to efficient operations and they can be uncovered by sustainability initiatives (e.g., Aviall uncovering more efficient ways to dispose of chemicals within regulatory guidelines). Investment and capital expenditures can focus on more efficient and green initiatives that are uncovered during sustainability efforts (e.g., PepsiCo’s supplier pricing initiatives to streamline supply chain and reduce costs). In short, taking “a long view” and investing in capital equipment now for “dramatically lower costs and higher yields” can be uncovered during sustainability initiatives and should be undertaken – but only if such investment is accretive. Anything else should, by definition, put a constraint on the firm and lead to less efficient allocation of resources.
Thus, one could argue that sustainability initiatives really do three things: i) push the firm to find more efficient ways of getting the offering out the door and into the customer’s hands, ii) bring additional segments to the firm’s offerings, and iii) force management to carefully examine these tradeoffs. All are a good thing for management to do and, if done properly with the bottom line in mind, can lead to better financial performance in the long run – and hence better share price performance in the long run.
Bottom Line: if done right, a firm’s investment in sustainable business practices doesn’t have to be in conflict with the sole interest rule.
Are there examples of companies do this well in practice and what are the lessons for managers?
Examples of companies who have done this well to success include PepsiCo (e.g., their work on their Positive Agriculture initiative), the supply chain industry overall (e.g., route optimization, use of EV and alternative fuel vehicles), Boeing (Aviall, IoT and chemical and parts efficiencies), Knauf in the building industries (e.g., use of cullet and recycling), and John Deere (e.g., Precision Ag).
Lessons for managers:
- Strategic decisions on sustainability doesn’t have to involve an either/or choice – profits or the environment. Unearthing more efficient operations, less material, etc., can often lead to cost savings and a lower impact on the environment. In well run businesses, the drive for a more profitable company can be inherently sustainable and have a positive impact on the company’s bottom line. It’s false thinking that profitability is always a trade-off with sustainability. In fact, they can be synergistic. Making processes more efficient, radically changing them using new technology, or eliminating them entirely can reduce costs and reduce the impact on the environment at the same time.
- Start with the low hanging fruit. If you do find cost savings, it suggests that there may be more opportunities if you dig deeper.
- Perform a Value Chain analysis and draw a Competency Map (as detailed in The Carrot and The Stick).8 This will provide not only detailed insight into where sustainability can lead to higher profitability, but also provide detailed information about precisely how to do this. The process for unearthing opportunities is well established and can be quite effective in unearthing these opportunities (as companies like the Boeing Company, PepsiCo, John Deere, Lincoln Industries, Knauf and Owens Corning have done).9
- Recognize now that industries will need to transform – to wit, trucking will consolidate and transform – IoT and supply chain, re-thinking how business models impact sustainability and focusing on the correct low-hanging fruit are all ways to lead transformation.
- Be proactive – price environmental impact into supplier contracts.
Don’t settle – use the Value Chain and Competency Map concepts to find revenue enhancing, cost saving and productivity enhancing opportunities. This process requires discipline, but we know it is the key to creating a strategy that is both sustainable and accretive to the company’s bottom line.
Written by Dr. William Putsis. Credit goes to my colleague Phil J. Burns, partner at The Platform for Strategic Growth for challenging me on many of the assumptions that are standard is the popular ESG discussion.
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