Sustainable development and improved corporate governance will be the hallmarks of successful business in the 21st century. Those who ignore this trend risk a backlash from financial markets as much as from society itself. Robert Kinloch Massie reports on how the combined forces of two powerful investor movements are redefining investment risk and boardroom strategy –

On Friday, November 8, 2002, appearing before hundreds of investors at the annual meeting of the Securities Industry Association in Boca Raton, Florida, the chairman of the New York Stock Exchange, Richard Grasso, apologized for the breakdown in US corporate governance and transparency that had led to a loss of more than $7 trillion in equity value.

“The American people must be told that we will never guarantee you a profit, but always guarantee you fairness,” Grasso said, standing beside an immense image of the word “Trust”. “We lost our moral compass … and these events have led to the darkest days in our history. Let us hope we can learn from them.”

For nearly two years the world’s business press has been demanding reforms to restore investor confidence and trust. But what is trust? Individually, it is a person’s willingness to lower his or her defences and venture into a relationship knowing that there is some unavoidable possibility of harm.

In economic terms, trust is the belief among consumers and investors that risks are manageable because markets are open, transparent and fair. The economic benefits of trust are well documented: trust strengthens people’s willingness to experiment, lowers the “policing costs” for transactions and increases the likelihood of social and economic gains.

Pressure for sustainable development

Over the past quarter of a century, institutional investors have been working to build new openness, transparency and fairness into the capital markets through two major but unconnected initiatives.

The first has come from a broad alliance of stakeholders – investors, environmental groups, human rights and labour activists, as well as forward-looking public officials – who have pressed companies on the question of sustainable development. Stakeholders, often working together across national borders, have successfully persuaded companies to integrate a broad range of environmental concerns such as biodiversity, greenhouse gas emissions and water-borne toxins into their strategic plans. They have also won changes in the human rights and labour practices of corporations operating in such countries as South Africa, Vietnam, Mexico, Nigeria, Burma and China.

In the second initiative, triggered by the rapid expansion of pension assets in the developed world in the 1980s, as well as the global merger and acquisition movement, large institutional investors have demanded and obtained significant reforms in corporate governance.

These parallel campaigns for sustainability and governance have grown rapidly in size and impact. Thousands of NGOs, linked globally and instantaneously by the internet, now track the social and environmental performance of companies, share information and strategy, and can readily concentrate their efforts on a single industry or even company.

To take a recent example, Staples Inc, one of the largest retailers of office products in the world, announced in late 2002 that it would eliminate paper goods made from endangered forests and increase the average amount of recycled content in its paper from 10% to 30%.

The decision came after a well-coordinated campaign by dozens of organizations which held 600 demonstrations in front of Staples stores across the US.

Large alliances of international investors – such as the Pension Investment Research Center, the Investor Responsibility Research Center, the International Corporate Governance Network and the Interfaith Center on Corporate Responsibility – have joined forces with partners around the world to press companies to disclose and improve their social and environmental performance.

Until recently, the global drive for more openness and transparency had been frustrated by the lack of a consensus-based standard for sustainability disclosure. But the past

12 months have witnessed a powerful and hopeful step forward with the creation of the Global Reporting Initiative (GRI) as a permanent new institution.

Originally convened by the US-based Coalition for Environmentally Responsible Economies (CERES) in partnership with the United Nations Environment Programme, the GRI brought together hundreds of organizations in a painstaking process of discussion, research and pilot testing that lasted more than five years.

The partners in this undertaking included such disparate groups as the Association of Chartered Certified Accountants (UK), the World Business Council for Sustainable Development (Switzerland), the Centre for Science and the Environment (India), General Motors (US), the Instituto Ethos (Brazil), the Environmental Auditing Research Group (Japan), the UN High Commissioner for Human Rights, the International Confederation of Federated Trade Unions, Amnesty International and Greenpeace.

The new organization held its formal inauguration at UN headquarters in New York in April 2002, released the most recent version of its Sustainability Reporting Guidelines at the World Summit on Sustainable Development in Johannesburg in August, and opened its world headquarters in Amsterdam in September.

Commenting on the dramatic advance of the GRI, UN Secretary General Kofi Annan praised its “unique contribution … in fostering transparency and accountability of corporate activities beyond financial matters”.

Even as one set of investors, business leaders and activists have pressed forward with innovations in sustainability, rapid changes have also been introduced in the field of corporate governance.

The rewards of good governance

Over the past few years we have seen an increasing number of studies showing that superior corporate governance is rewarded by a premium in the market place. Studies by consultancy McKinsey in 2000 and 2002, for example, have shown that investors were willing to pay more in emerging markets for the shares of companies that had implemented high standards of corporate governance.

Many intergovernmental and multilateral bodies – including the OECD, the EU, the World Bank and the King Commission in South Africa – have established codes, pushed for best practices or issued new regulations related to corporate governance.

New organizations have been formed to advance corporate governance globally. The most influential is the International Corporate Governance Network (ICGN), representing institutional investors that collectively control about $12 trillion in global equities. A special ICGN committee recently approved recommendations for global standards on executive compensation and intends to press for the adoption of these standards worldwide.

The drive towards improved openness and transparency has also swept through financial markets, exchanges and securities regulators.

Governments in Britain, France, the US, South Africa and Japan have either called for or already implemented significant new disclosure requirements for both financial and nonfinancial information.

Individual listing exchanges – such as those in New York, Săo Paulo and Johannesburg – have implemented new rules and requirements on governance and reporting.

Valuing intangibles

Recognizing that in some equity markets the value of intangible assets – reputation, brand, intellectual property and so forth – has grown to three and four times the value of physical capital and other tangible assets, accounting societies and securities experts around the world are asking for such intangibles to be measured and properly accounted for on corporate balance sheets.

The US-based Financial Accounting Standards Board and the International Accounting Standards Board recently announced their commitment to creating convergence between their accounting standards. They said such a move would reduce confusion, restore confidence and “improve comparability of financial statements across national jurisdictions”.

Although these parallel developments in sustainability and corporate governance have been gaining in strength, until very recently they have remained on separate tracks. In a trend that has broad significance for corporate management and global capital markets, the two movements have recently begun to merge, both conceptually and politically.

More and more people from all perspectives – companies, NGOs and investors – have come to realize that in the 21st century strong corporate governance requires a strategic approach to sustainability.

What is creating this dramatic convergence? In two words, climate change.

As a result of the US government’s perverse refusal to lead, the intergovernmental process has failed to produce a fair and predictable carbon-trading system. This vacuum has thrown capital markets and corporate boardrooms into confusion about how to predict their risks, manage their assets and make capital investments.

Recent studies in the UK and US have demonstrated that “embedded climate risk” is a serious danger to the long-term productivity of the global economy and to the value of large portfolios – meaning that trustees and corporate board members are under increased fiduciary pressure to assess and mitigate the mounting future costs.

The economic costs of climate change are already starting to pile up around the world. In 2002 massive drought and storms damaged agriculture in California, South Dakota and Florida, hurt tourism in New England and the Rockies and contributed to the immense and unexpected forest fires that consumed nearly 10,000 square miles of land.

Some US companies, facing frequent disruption of their businesses from severe weather events, are already relocating their centralized phone and other operations from Florida to the Midwest.

In the face of these disruptions, mutual fund and retirement plan beneficiaries are starting to wonder whether the trustees in charge of their life savings are risking a breach of their fiduciary duty by failing to analyze the climate risk in their portfolios. Although the risk will vary by sector and by portfolio, one can no longer pretend that the largest physical changes in human history will have a zero effect on the long-term market valuation of firms.

As professor Paul R Kleindorfer, co-director, Risk Management and Decision Processes Center, Wharton School of Business, put it recently: “The real question for those of us who are hoping to enjoy our retirement is whether those years will be golden … or, because of unexpected climate risks to our investments, brown, crisp and burnt.”

Convergence of climate and capital

Such concerns are already being felt in the marketplace. Huge reinsurance companies such as Swiss Re are conducting major re-evaluations of their exposure to large-scale climate claims. The treasurer of the state of Connecticut, Denise Nappier, has intervened directly this year by tapping part of the state’s $21 billion pension system to file climate-related shareholder resolutions with major US companies such as Cummins Engine and American Electric Power.

The comptroller of the City of New York, William Thompson, is filing similar resolutions with nearly a dozen US companies, demanding that they disclose their environmental and social impacts, including their greenhouse gas emissions, under the GRI.

Such steps may be the precursor of much more aggressive legal action. If law firms such as Milberg Weiss can successfully sue Enron’s accountants to recoup stockholder losses, and if US state attorney-generals can recover hundreds of billions in public health expenses from tobacco firms, how long will it be before such powerful parties begin seeking to reclaim costs for unaddressed climate risk?

Such concerns have already spilled over into stockholder protests. In May 2002 ExxonMobil’s failure to articulate a credible climate policy earned it an unprecedented rebuke at its annual general meeting. More than 20% of its shareholders (worth more than $55 billion in share value) voted for a climate-related resolution that management had ferociously opposed.

Investment analysts were quick to note that the vote was a direct challenge to the company’s board. “Neither the CEO, nor the board, nor management have a plan for appropriately managing the assets of the company, given the challenge of climate change,” wrote the Investor Responsibility Research Center, an authoritative Washington-based organization that advises more than 560 major institutional clients on their proxy voting. It said the landmark vote demonstrated that investors “are going to treat [climate] as a governance issue, not as an environmental issue”.

The rise of sustainable governance

Future events are likely to focus an even brighter spotlight on the fusion of these two movements into a unified call for sustainable governance. Driven by the internet, globalization, rapid ecological decline and the tragic short-sightedness of many political leaders around the world, sustainable governance will become a key new concept and a benchmark for investors and corporate boards.

Companies that do not understand the challenges of sustainability – beginning with climate but including global income disparity, water usage, biodiversity, labour practices and human rights – and firms that do not build such an understanding into their long-term strategies will be viewed as poor risks. Portfolio managers and fund trustees who fail to analyze climate and other sustainability risks will be penalized and probably sued for mismanagement and breach of duty.

Fortunately, a demographic shift in corporate board membership may help US companies adjust to the new realities. The heightened demands of the new Sarbanes-Oxley law, which seeks to address the causes of the recent financial scandals, and the advancing age of many board members could trigger corporate board turnover of up to 50% in the next few years, according to some estimates.

New board members will be not only younger but probably more international in background and training, more aware of systemic problems and more willing to integrate those concerns into their business challenges and opportunities. This could lead to a renaissance in equity and prosperity, as companies learn to align their capital investments and corporate strategies with the planet’s inexorable trends.

Continued reticence and denial will also bring penalties. Those who fail to act on the concerns embodied in sustainable governance will be plagued by doubts and questions from NGOs, governments, consumers and major investors.

Companies that fail to understand sustainability, to pursue fair and equitable solutions to climate change, and to anticipate what lies ahead will be caught off guard by unexpected economic risks, environmental hazards and social demands.

Sustainable governance is not an option. It is a fundamental expectation bubbling up from governments, markets and every part of civil society. To restore confidence, to build the structure of trust, companies must commit themselves to openness, transparency and fairness. They must do this through innovations in listing exchanges, governance reform and disclosure through the GRI.

Executives and investors who commit themselves to sustainable governance will be in the forefront of history – not just prepared for the future but capable of shaping it to the benefit of all humanity.

Dr Robert Kinloch Massie
Dr Robert Kinloch Massie received his doctorate in business policy and corporate strategy from Harvard Business School in 1989. He is the executive director of CERES, the largest coalition of investors and NGOs in the United States, and a member of the board of directors of the Global Reporting Initiative.