Drivers of long-term Stakeholders, stats, and strategy Drivers of long-term business value

About the authors

Eric J. Hespenheide Tel: +313 396 3163 E-mail: [email protected]

Eric J. Hespenheide is a retired partner with Deloitte & Touche LLP. While active at Deloitte & Touche LLP, he served as a global leader in DTTL’s Sustainability group within Audit and Enterprise Risk Services. He represented DTTL in various forums such as the World Business Council for Sustainable Development. He was DTTL’s organizational stakeholder at the Global Reporting Initiative and was also a member of the Working Group of the International Integrated Reporting Committee.

Dr. Dinah A. Koehler Tel: +212 436 5664 E-mail: [email protected]

Dr. Dinah A. Koehler leads research on sustainability as senior manager at Deloitte Research, Deloitte Services LP.

Acknowledgements

We wish to thank Bruno Bertocci (UBS AG), Emma Coles (Ahold N.V.), Mark Fulton (Deutsche Bank Climate Change Advisors), Ron Jarvis (Home Depot), Bob Laux (Microsoft Corporation), Steve Leffin (United Parcel Service of America, Inc.), Ernst Ligteringen (GRI), Tom Lyon (University of Michigan), Bruce Schlein (Citigroup), Craig Smith (INSEAD), Jan Kees Vis (Unilever), and Alan Willis (CICA) for their helpful comments to our research. We are grateful for contributions of our colleagues Dan Konigsberg (DTTL), Laurel Martin (Deloitte Consulting LLP), Will Sarni (Deloitte Consulting LLP), Val Srinivas (Deloitte Services LP), and Jon Warshawsky (Deloitte Services LP). Stakeholders, stats, and strategy

Contents

Executive summary | 2

What is at stake? | 3

Stakeholders: The new scorekeepers | 5

Statistics: Business on sustainability | 7

Moving up: From value destruction to value creation | 11

Strategy: The new rules | 16

Stakeholders and a path to long-term business value | 19

Endnotes | 20

1 Drivers of long-term business value

Executive summary

takeholders have always mattered to is essential to understand what value means for Sa company. However, in an age of increas- stakeholders, and what value a company gains ing transparency, any stakeholder—includ- (or loses) from how stakeholders (including ing many that may not have been considered shareholders) perceive its actions. Stakeholder stakeholders a few years ago—can act, and perception of value itself is not based solely many do.1 How stakeholders view a company, upon objective outcomes but also in part upon what they expect of the company, and how social constructs, such as whether the company they understand the company’s impact on follows the UN Declaration of Human Rights. society and the environment matters to busi- Stakeholders may also be biased regarding ness value. A growing number of shareholders a company’s ESG performance, viewing it agree. For example, positive community rela- through their own lens based on how they tions have had a significant effect on mining perceive risk. companies' financial valuations, emerging as Without a deeper understanding of stake- a key factor in production alongside invest- holder judgment, a company risks being adrift ments in capital and labor. Today, a broader in a vast sea of information, facing difficulty range of stakeholders are raising the bar on in crafting a strategic response and mapping business performance. a course to long-term business value creation. Determining the value of environmental, This paper seeks to shed light on stakeholders, social, and governance (ESG) issues to multiple taken as a whole, and when they might have stakeholders is becoming central to how many a material economic impact on the company companies craft their sustainability strategy and thereby impact valuations. While demon- and report on their performance. This opens strating that ESG performance does matter for the door to a new vision of the business objec- financial in the near term, statisti- tive: enlightened value maximization, which cal evidence also points a way to long-term seeks greater alignment between various stake- business value creation—not only for senior holders to generate long-term business value. executives but also for shareholders who seek If a business’s objective is to seek and maxi- to identify companies that are committed to mize total value for all its constituents, then it creating long-term value.

2 Stakeholders, stats, and strategy

What is at stake?

Friedman vs. Freeman squared off in the Harvard Law Review. One In 1962 Nobel laureate Milton Friedman argued that the corporation is solely the declared, “There is one and only one social property of its owners (that is, shareholders) responsibility of business—to use its resources and should be managed in their interests. The and engage in activities designed to increase other contended that a corporation is a social its profits so long as it stays institution that also bears a within the rules of the game, social responsibility.6 Today, which is to say, engages in open If the unity of the as we emerge from the Great and free competition without corporate body is real, Recession, advocates for 2 “ deception or fraud.” Simply then there is reality and the “greater good” of busi- put, Friedman was saying ness continue to argue that that maximizing shareholder not simply legal fiction a company needs to earn value is the business objec- in the proposition that its social license to operate tive. Managers can choose to the managers of the every day and that unsustain- pursue activities with a social unit are fiduciaries for able business practices will angle, including investments in ultimately fail. On the other “shared value,”3 as long as these it and not merely for its hand, challengers of the stake- generate profit. individual members, holder-centric view of the Two decades later, Edward that they are… trustees corporation cite Friedman. Freeman laid out his stake- for an institution holder theory of corporate A new goal: [with multiple management: Stakeholders Enlightened value include any group or individual constituents] rather maximization that can affect or is affected by than attorneys for the the achievement of an organi- zation’s objectives.4 He pro- stockholders. Not everyone accepts fessed that even as a company —E. Merrick Dodd, Jr., Harvard the dichotomy, however. pursues profitability, it needs to Law Review, 1932 ” In the view of noted busi- create “as much value as pos- ness and finance scholar sible for multiple stakeholders, without resort- Michael Jensen, if the focus is on long-term ing to trade-offs.”5 Freeman believes that the performance, then the apparent contradiction business objective should be to augment the is resolved. According to Jensen, “It is obvi- greater good for the many. Stakeholder theory ous that we cannot maximize the long-term is commonly used as an argument for why the market value of an organization if we ignore interests of stakeholders, such as communities or mistreat any important constituency.” and employees, should be considered along Enlightened value maximization means that a with those of shareholders. business should “get the most out of society’s In the United States, the debate on the role limited resources” while returning greater of business in society dates back at least to the value to society, that is, maximizing total value Great Depression, when two legal scholars creation for all important constituencies of the

3 Drivers of long-term business value

firm (investors, employees, customers, suppli- will vary according to its industry, business ers, and local communities).7 Business value model, value proposition, product portfolio, is created in a context that is based on what and competitive playing field. both the company and its stakeholders value.8 A second practical implication of Jensen’s Consequently, the pursuit of stakeholder value vision is that when senior managers consider and a healthy environment helps a business the interests of their stakeholders, including maximize its financial value. shareholders, these interests need not be at In practical terms, Jensen’s vision means odds. Any trade-offs between a company’s vari- a business can, and should, adopt a broader ous stakeholders ought to be resolved, at least approach to value maximization for a wide in part, by focusing on the business objective range of stakeholders, not just shareholder of long-term value maximization; as we explain value. Specifically, enlightened value maximi- later, better alignment can increase market zation incorporates value created for employ- value. Management needs to consult with rep- ees (through HR policies), for the community resentatives of key stakeholder groups (internal (through investment in the community), for and external) and consider how, when, why, suppliers (through resource efficiency gains), and by how much an ESG issue might impact and for the environment (through ecosystem the business.9 Identification of key stakeholders enhancement and protection), among many also needs to consider the company’s industry, others. There is no one-size-fits-all strategy, , value proposition, product however. Each company’s strategic objectives portfolio, and competitive playing field.

4 Stakeholders, stats, and strategy

Stakeholders: The new scorekeepers

hen Freeman first proposed his stake- large customers with multiyear contracts) are Wholder theory in 1984, the concept of also making new demands of management. corporate social responsibility was not well In many cases, this can impact valuation and formulated, nor was there much talk of sus- for several years, particularly when business tainability in the private sector until the 1992 disruption occurs. Research of 827 incidents Earth Summit.10 Scientific understanding of of supply chain disruption finds a drop of up and ability to measure to 40 percent in the impact of industrial Figure 1: Process of ESG materiality creation returns of the companies activity on the planet making the announce- and public health were Stakeholder: ment.12 In fact, much of nascent. Without the P(action)|P(value creation the underperformance or destruction) Internet, our global occurs in the year before society was much the announcement, on the

less transparent. Relevant P(positive or negative day of the announcement, Today the situation impact on company) and during the following could not be more dif- year—showing that the ferent. We are tracking stock market anticipates the rise in greenhouse P(change in valuation of the bad news (sometimes company) gas (GHG) concentra- six months in advance). tions in the atmosphere, Materiality Furthermore, these are we can measure toxic P(disclosure/ long-tailed risks that chemicals in human non-disclosure) can lead to deteriorating blood and in the foods performance for at least we consume, and we are Graphic: Deloitte University Press | DUPress.com two years after the disrup- counting the demise of tion and are often associ- many species. ated with lower operating A wide range of stakeholders are keeping score income and sales growth, and higher costs. of corporate impact on society and the envi- The research also finds an average 13.5 percent ronment, and, by seizing the megaphone of higher equity risk, particularly in the firm-spe- the Internet, challenging corporate leaders to cific component of risk. For some companies reframe their objectives and beliefs.11 and some ESG issues, such risks may affect at There are innumerable examples of how least 5 percent of the company’s revenues—a stakeholders impact a company’s opera- commonly used threshold to determine what is tions, from regulatory pressures to consumer financially material and ought to be disclosed.13 boycotts and concerns over labor issues, Freeman’s definition implies that virtually including those in the supply chain. A com- anyone and anything can affect or be affected pany’s business partners (for example, sup- by the decisions and actions of a company. pliers, logistics partners, retailers, and other Yet not all ESG issues raised by stakeholders

5 Drivers of long-term business value

Ask yourself: Which ESG issues are the most likely to be material for my company?

How do my company’s business model, industry, reputation, media presence, brand, and sustainability program maturity influence which ESG issues may be material?

are likely to be material to a company, though is conditional on whether the stakehold- many may be relevant. Figure 1, drawn from ers perceive a company as either creating or our prior research, shows how materiality destroying (what they) value: P(action)|P(value can be applied in the context of ESG issues, creation or destruction). We suggest that those starting with the action of stakeholders based ESG issues with the greatest probability of upon their perception of a company’s ESG having a material impact on the company and performance.14 Here the probability (P) of its valuation in a given time frame should be stakeholder action (for example, a protest) disclosed, in other words, those issues that lie on or above a materiality frontier—the border Figure 2. Materiality: Function of likelihood and between issues likely to be material or not (see impact (illustrative) figure 2). Beyond the likelihood of financial impacts

Materiality frontier due to business interruption (described ear- lier), consumer boycotts, or loss of license to operate, there can also be reputational or brand impacts. These may not pose a direct threat to a company’s cash flow but may affect enter-

R prise value, even if these impacts are below the e

Impact p u t materiality frontier. They should therefore also at B io r n be carefully evaluated in a materiality deter- an d mination. Given research on market value, it is likely that valuation impacts associated with the brand exceed those associated with Likelihood reputation.15 In the remainder of this paper, we explore how stakeholders (including share-

Graphic: Deloitte University Press | DUPress.com holders) can impact a company’s cost of doing business, license to operate, reputation, and brand value.

6 Stakeholders, stats, and strategy

Statistics: Business on sustainability

hile enlightened value maximization surprised to see changes in market value based Whas a certain logical appeal and may be upon ESG performance. required in today’s transparent and informa- Indeed, statistical analysis of the response tion-rich world, it raises an obvious question: to new information on a company’s environ- Do shareholders and business leaders reflect mental performance reveals that the average this in their beliefs and behaviors? capital market participant is already paying attention. An MIT research study of publicly Shareholders traded US companies over a 30-year time span (1980–2009) showed that stock prices dropped There are signs that shareholders increas- an average of 0.65 percent within the two-day ingly pay attention to ESG performance. Since window following the release of negative envi- the United Nations Principles for Responsible ronmental news—possibly driven by inves- Investment (UN PRI) were introduced in 2006, tor expectations that the company will face over 1,000 financial services firms (includ- diminished cash flows. Furthermore, investors ing asset owners, investment managers, and reacted more strongly to negative environmen- professional service partners) have signed on, tal news with each passing decade.20 jointly managing over $30 trillion in assets.16 Positive news on a company’s environmen- In 2012, nearly one out of every nine dol- tal behavior produced an average increase lars under professional management in the of 0.84 percent in stock price. However, over United States ($3.74 trillion) fell under socially time, positive investor response to good envi- responsible investment—11 percent of the ronmental news has been tapering off. This $33.3 trillion in total assets under management suggests that shareholders are increasingly in the United States.17 Since 1995 the respon- biased against companies with poor environ- sible investment category has seen steady and mental performance, and less impressed with exponential growth. (that is, more demanding of) stronger per- Many commentators believe we are reach- formers. This behavior seems to be tracking a ing the tipping point18 where investor interest skewed view of value that has been identified in corporate ESG performance is sufficient to in many situations by researchers in behav- affect valuations. Several years ago, research- ioral finance—a concept we build on later in ers predicted that this is more likely once 20 this paper. percent of managed funds incorporate aspects Underlying these changes is the growth in of corporate ESG performance, which was pre- data on corporate ESG performance, along dicted to cause a drop in stock prices of firms with greater data accessibility. The number with poor ESG performance and an increase of “green” business news stories grew from in their .19 Today the combined less than 160 in 2000 to over 1,700 in 2007.21 $30 trillion in UN PRI signatory assets under Research on users of ESG data on a Bloomberg management constitutes approximately 20 terminal shows that equity and fixed-income percent of the world’s capital. We should not be investors are interested in ESG performance

7 Drivers of long-term business value

Figure 3. Growth in sustainability indices and GHG emissions in particular.22 Both sell- No. of sustainability indices side firms (broker dealers) and buy-side firms 120 (hedge funds, insurance firms, pension funds, Exchanges and money managers) are interested in ESG 100 Private performance and are trying to integrate ESG data in valuation models.23 Cumulative 80 Shareholders interested in ESG perfor- mance today have many more investment 60 options. The first ESG tilted index, the Domini 400 Social Index, was launched in 1990. Today, 40 there are many more sustainability indices issued by private index providers (such as Dow 20 Jones or MSCI) and by world stock exchanges (see figure 3). Many stock exchanges issue a

0 sustainability index to specifically encourage

… corporate disclosure of non-financial perfor- 24 1990 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 mance and ESG indicators in particular. Growing shareholder interest is also evident Source: World Federation of Exchanges, Deloitte analysis in the number of shareholder resolutions filed Graphic: Deloitte University Press | DUPress.com targeting an ESG issue (see figure 4). The 35

Figure 4. Trends in shareholder resolutions targeting ESG issues

500 Animal welfare Human rights Labor and global labor Political contributions Sustainability reporting and sustainability related Environment Climate change Total 400

300

200

100

0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Source: Institutional Shareholder Services, a division of MSCI Inc.; Deloitte analysis Graphic: Deloitte University Press | DUPress.com

8 Stakeholders, stats, and strategy

lead filers in 2011 collectively managed over $500 billion in assets.25 In the 2011 proxy sea- son, resolutions addressing social and environ- mental issues comprised the largest portion (40 percent) of all shareholder proposals that came to a vote. Furthermore, 31.6 percent of all corporate responsibility resolutions got at least 30 percent shareholder support—a level at which many boards begin to respond. Most of these resolutions called on companies to issue a sustainability report and disclose more infor- mation on exposure to climate change risks.26 According to empirical research, share- holder resolutions can pressure companies in the S&P 500 index to increase ESG disclo- sure more effectively than regulations can. Companies targeted by a shareholder resolu- tion are 62 percent more likely to disclose GHG emission data, especially if their industry is already under scrutiny for GHG emis- sion levels and has been targeted by multiple resolutions. In contrast, the likelihood of GHG disclosure is only 24 percent when a company is faced with the possibility of regulated disclo- sure of GHG emissions (at the state level).27 that sustainability factors have an impact on compliance and risk management, and Corporate managers foresee changes in financial accounting and reporting. Over 75 percent of surveyed CFOs The perceived importance of sustainability view communicating on sustainability issues is resonating with business leaders. A recent to shareholders and institutional investors Deloitte survey of 208 global CFOs from as important. 10 countries found that over 70 percent are A survey of UN Global Compact member currently fully or periodically involved in all CEOs found that 93 percent view sustainability aspects of sustainability strategy and gover- as a critical driver of their company’s future nance at their firm.28 The majority believe success, and up to 81 percent responded that

Ask yourself: Do shareholders consider my company’s ESG performance in their investment decisions?

Do shareholder resolutions increasingly target my company or my industry peers?

Do I think stakeholders (increasingly) impact shareholder preferences and affect my valuations?

Can I influence my valuations by disclosing ESG information?

9 Drivers of long-term business value

sustainability is an important factor in strat- sustainability is necessary to remain competi- egy and operations.29 By 2020, these CEOs tive. Similarly, three-quarters of respondents expect sustainability to be fully integrated into to another recent global survey31 believe corporate capabilities, processes, and systems, companies should consider socially respon- and across global supply chains and subsidiar- sible investors and NGOs when crafting their ies. Motivated to build their company’s brand, sustainability strategy (see figure 5)—with trust, and reputation, these CEOs believe good reason. Preliminary research indicates sustainability activities can positively impact that when shareholder activists file a resolu- their company’s valuation by driving revenue tion related to a company’s environmental growth and reducing costs, though mak- performance, its financial performance— ing that connection is still opaque for most measured with Tobin’s Q ratio (market value managers. Most CEOs surveyed have difficulty divided by book value of assets)—declines.32 communicating the value proposition for ESG We can deduce that the average investor management to financial analysts. believes the company is riskier and a less Similarly, 70 percent of 3,000 corporate attractive investment. executives surveyed say that sustainability is In combination, these research findings permanently on their management agendas, indicate that ESG performance is influenc- despite current economic uncertainty.30 Driven ing shareholder beliefs and behaviors. This is by investors, NGOs, consumer preferences, reflected in changes in share price and cost of and rising social media platforms, two-thirds capital, and it may also be changing the beliefs of respondents believe that a commitment to of corporate leaders.

Figure 5. Influencers of sustainability strategy and policy

80%

60%

40%

20%

0% Socially NGOs Trade/labor Social Business responsible unions activists associations investors

Source: GlobeScan/sustainability survey 2012 Graphic: Deloitte University Press | DUPress.com

10 Stakeholders, stats, and strategy

Moving up: From value destruction to value creation

inding the value in ESG management is being can find herself Every organization 35 Fbecoming central to how many companies in. Stakeholders, like attempting to craft their sustainability strategy: very much in all humans, make their “ the spirit of enlightened value maximization.33 judgments based on accomplish something Based on its experience with stakeholders, predictive cognitive biases has to ask and ABN AMRO adopted a value-based frame- and emotional reactions. answer the following work (see figure 6). The bank traced its trajec- How we make decisions question: What are we tory from the late 1990s, when it was targeted in real life is not always by NGOs (for example, Friends of the Earth, rationally optimal. These trying to accomplish? known as FOE) for its investments in mining biases can, according to Or, put even more 36 and paper companies, to a growing commit- research at INSEAD, simply, when all is ment to the protection of forests and sensitive help us understand ecosystems. In 2003, ABN AMRO partnered how stakeholders said and done, how with other banks34 to set up principles for perceive a company’s do we measure better financing projects in the mining, forestry, and ESG performance: versus worse? Even energy sectors, culminating in the Equator more simply, how do Principles on the management of social and • Reference depen- environmental risks in project finance. ABN dence: Perhaps the we keep score? AMRO identified a shift from value destruc- most important tenet of prospect theory —Michael C. Jensen, tion to loss avoidance (that is, risk manage- Business Ethics Quarterly, 2002 ment) and to value creation with new product relative to stakeholder ” development in carbon markets. judgments of cor- The question is: How might this same porate ESG performance is that people do journey appear to stakeholders? Stakeholder not judge value in terms of absolute states judgment is likely to be based on perceptions of or outcomes, but rather in terms of gains how a company’s actions either add or destroy and losses relative to a reference point. Thus value. Adopting Jensen’s line of question- stakeholders are likely to view a company’s ing: How do stakeholders perceive better or ESG performance relative to their own worse performance on a variety of ESG issues? reference point or target level. Sometimes Given this perception, how will they respond they may be satisfied; other times, they may to changes in ESG performance? Can these remain critical because the company’s per- decisions be anticipated, or are stakeholder formance is below the reference point. actions unpredictable? Decades of scholarly work in behavioral sci- • Two more tenets of prospect theory create ences (for example, behavioral economics and additional challenges for managers who behavioral finance) finds that certain cognitive expect recognition from their stakeholders. biases—summarized in prospect theory—are These are loss aversion (losses hurt more prevalent in any number of situations a human than gains feel good, because people have a

11 Drivers of long-term business value

Figure 6. ABN AMRO sustainability learning curve Sustainable finance

Value Let’s take another look at the challenge large creation Carbon markets global banks could face with respect to their Equator Principles investment decisions, this time from the per- Oil & Gas policy Loss spective of stakeholders and prospect theory avoidance Mining policy (see figure 7). Projects such as China’s Three Forestry dialugue Gorges Dam, Indonesian palm oil plantations, Dialogue with FOE the Camisea Gas Project in Peruvian Amazon, Critique of mining and and the Chad-Cameroon pipeline galvanized Value forestry investiments activists, who launched a full-blown inter- destruction Wake up Proactive Industry Level New national campaign against funding of large, call dialougue policies playing product field ideas rainforest-destroying projects. Citigroup was targeted in 2000 with protests on university Source: Adapted from ABN AMRO presentation, February 2005 campuses and in front of the bank’s branches Graphic: Deloitte University Press | DUPress.com across the globe. In 2003, activists gathered in Italy to draft the Collevecchio Declaration on Figure 7. Sustainable finance Financial Institutions and Sustainability. By 2003, the banks were ready to act, and Stakeholder value gain drafted the Equator Principles, as noted ear- 2005 Chase: “No Go” zones, FSC lier. Citi started negotiations with Rainforest 2004 Citi Action Network (RAN) and agreed to partially Decreasing Increasing ESG ESG cancel the financing of the Camisea pipeline performance performance project. By 2004, Citi reached the reference 2003 Equator principles point prescribed by the activists, when it came 2000 Citi No funding of rainforest destruction to an agreement with RAN to cease funding any operations that risk degrading primary Stakeholder value loss forests. Other financial institutions quickly fol- Source: Deloitte analysis lowed. In 2005, JPMorgan Chase established an Graphic: Deloitte University Press | DUPress.com investment policy that included “no-go” zones, such as sensitive ecosystems, and set as priority hard time giving up something) and the financing of Indonesian forests certified by diminishing sensitivity (each incremental the Forest Stewardship Council (FSC). Based change in gains and losses is valued less). on this information we can even say that Chase The first tenet implies that stakeholders moved above the reference point adopted by tend to be more concerned when a com- activists into value creation. By 2006, 40 banks pany’s ESG performance falls relative to a had adopted a revised version of the Equator preferred level. The second tenet implies Principles. The sustainable banking mandate that a company that improves its ESG was extended beyond protecting forests to performance from a very low level—for addressing climate change with strategies such example, increases energy efficiency—will as carbon footprint reductions and investment be rewarded more than another one that in renewable energy. is already performing at a higher level of Thus, in the perception of bank leadership energy efficiency and makes a similar-sized and the NGO community, the banking indus- improvement. These two tenets lead to a try moved from value destruction to greater value function that is curved rather than a value creation by adopting policies targeting straight line, as shown above. issues of importance to stakeholders in the

12 Stakeholders, stats, and strategy

area of project finance and adding another 1997. Home Depot—at the time the world’s top business objective: pursuit of opportunities in seller of old-growth wood products—refused, climate change. remaining below the reference point. Starting in 1997, activists increased the pressure on Old-growth forests Home Depot, until the company committed to phasing out products using wood from endan- Another example serves to illustrate how gered forests and environmentally sensitive important reference points can be to under- areas in 1999. Home Depot, along with other standing stakeholder perception of a com- pany’s ESG performance. In the early 1990s, Figure 8. Old-growth forest case RAN, together with Greenpeace and the Natural Resources Defense Council, launched Stakeholder value gain a campaign against the destruction of old- FSC certified wood growth forests, targeting the Fortune 500 ‘97 Kinko’s, IBM ‘99 Home Depot companies. These stakeholders wanted them to Decreasing Increasing cease using or buying pulp and paper prod- ESG ESG performance performance ucts sourced from old-growth forests. In other words, the reference point adopted by the ‘97 Home Depot No old-growth wood stakeholders was “no old-growth wood” (see figure 8). Some Fortune 500 companies, such as Kinko’s and IBM, stopped using wood and Stakeholder value loss paper products from old-growth forests, mov- Source: Deloitte analysis ing closer to the stakeholder reference point by Graphic: Deloitte University Press | DUPress.com

13 Drivers of long-term business value

Ask yourself: Is my company’s ESG performance compared to particular reference points adopted by my stakeholders?

Do I find that there are certain ESG issues where I cannot seem to win—that is, ideal-state or zero-state?

Is my company constantly being pushed to a higher level of ESG performance?

major home improvement retailers, commit- engagement (conflictive or cooperative) could ted to preferential purchasing of wood certi- explain why the market valuation of 19 gold- fied to the independent FSC standard, thereby mining companies traded at a 72 percent dis- exceeding the original reference point adopted count rate compared with the net present value by the activists—no old-growth wood. of the gold they owned (calculated based upon As of 2000, Home Depot adopted a proac- the amount of gold in the ground, the cost of tive approach to how it sources wood products. extraction, and the world price of gold).37 The Between 2000 and 2003 the company pulled researchers found that measures of stakeholder out of $90 million in purchases from vendors relations and country risk were worth twice as in Indonesia and other Southeast Asian coun- much as the value of the gold. Furthermore, tries whose supply chains could not be vali- support from the local community, govern- dated. From 2000 to 2002, Ron Jarvis, VP of ment, and civil society could reduce the merchandising and sustainability, traveled the discount placed by financial markets on the net world to understand Home Depot’s suppliers present value of the gold controlled by these 19 and their forestry practices. Upon his return, firms from 72 percent to as low as 12 percent. he convened a meeting of key stakeholders The research indicates that investing in the and shared his findings on where Home Depot social license to operate is an important input sourced its wood (of which 95 percent comes factor to production for gold-mining companies. from North American forests). That experience Conversely, it has been shown that poor showed that Home Depot knew more than ESG performance tends to reduce stake- many stakeholders about the issue, and has holder value, as evidenced by the drop in become a valuable resource with deep knowl- property values around a polluting plant.38 A edge of forestry practices around the world. widening “value gap” between an industrial The process of “stakeholder value creation” operation and the surrounding community is can be tied to improvements in a company’s inviting trouble. financial value. Empirical research finds that In all likelihood, analysis would identify stakeholder responses to a company’s actions and quantify a similar process of joint stake- can affect its social license to operate as well holder and creation (or as company valuations. Asking why the value destruction) in industries with a large local of one gold mine can differ so greatly from environmental and social impact, such as another, Witold Henisz and his collabora- extractives, mining, forestry, or utilities. tors at Wharton tested whether stakeholder

14 Stakeholders, stats, and strategy

Stakeholder value: aspirational goal for one company can become A moving target an industry norm (see figure 9), as more com- panies agree on industry-specific policies—for In addition to the challenge of identifying example, the the Equator Principles. what level of performance stakeholders really Sometimes stakeholder demands, such as care about (that is, the reference point), com- the ideal of carbon neutrality, can be very dis- panies have to consider that stakeholders are ruptive, because they fundamentally challenge likely to look at ESG performance from con- the company’s business model. One example stantly shifting vantage points, or “reference is the “zero-state” situation, such as the local states.”39 To understand what a reference state community in water-scarce areas questioning might be, let’s start with the status quo. Most the very presence of the company. Similarly, managers tend to refer to their company’s past stakeholder demands led companies selling performance, that is, the status quo, in their baby products containing bisphenol A (BPA, communication to stakeholders. Stakeholders, an endocrine disruptor) to withdraw these however, will instead tend to compare a com- products from store shelves. It is very dif- pany to its industry peers and other norms ficult for companies to overcome these types such as regulatory standards and industry of zero-state situations, where stakeholders policies. An action or investment undertaken are expressing a value set that is defined by by the company that exceeds the norm is absolutes: right or wrong. Stakeholder sup- more likely to be perceived as a gain in stake- port for the precautionary principle40 is also holder value. For example, JPMorgan Chase an expression of such a value set. It is wise to established an aspirational goal through its acknowledge that such situations will arise and “no-go” policy against lending to projects that may require changes in corporate strategy.41 threatened sensitive ecosystems. What was an

Figure 9. Race to the top

• Aspirational goal • Ideal state • Industry norm • Zero state – Average performance • Status quo – Past performance – % reduction target

Graphic: Deloitte University Press | DUPress.com

15 Drivers of long-term business value

Strategy: The new rules Avoid losses, seek gains, don’t always expect applause, and adapt

Strategic consideration 1: negative news, as shown by steeper drops Know your stakeholders in stock price in more recent decades.42 We might deduce that as strong ESG performance Investors and their advisors tend to treat increasingly becomes the norm, it is harder ESG management as a downside risk, in to impress even the average shareholder, who part because it is costly to companies and has also become more risk-averse to negative the upside has been harder to show. Because environment news. people are more risk averse on losses, ESG per- Another equally important question is formance below stakeholders’ (including share- when the stakeholder response reaches a tip- holders’) reference point is likely to be more ping point or threshold and poses a financially financially material than performance above material risk to the company. We can deduce the reference point. Recall that over the past that this point occurs somewhere between 30 years investor response to positive environ- nascent discussions and outright media cam- mental news has been diminishing, whereas paigns, boycotts, or shareholder resolutions. investors are punishing companies more for For guidance we refer to the policy life cycle, as set forth by Maxwell, which identifies Figure 10. Policy life cycle various phases of an ESG issue, starting with issue identification and limited awareness (see figure 10).43 As the ESG issue infiltrates various segments of our Private policy life cycle society, goes viral on social media, and flashes across traditional news media, the financial impact for an affected Traditional policy life cycle company tends to increase. The first thing to note in figure 10 is the difference in costs to the com-

Financial impact pany between the traditional policy life cycle—where activists and NGOs push regulators and legislators to govern company actions—and the private policy life cycle. The private policy life cycle is driven by activists who engage Issue Politicization/ Legislative/ Implementation/ directly with companies and can force identification NGO demand direct engagement dispute resolution change and impose costs—via protests, Source: Adapted from Maxwell, 2010 media campaigns, and boycotts—more Graphic: Deloitte University Press | DUPress.com dramatically than regulations.

16 Stakeholders, stats, and strategy

Consider, for example, the consumer Based on the empirical record, various fac- response to the fish-consumption advisory tors appear to influence stakeholder behavior issued by the US Environmental Protection and impacts on the business: Agency (EPA) in 2001 to warn of high mercury content in certain species. Many US consum- • Common stakeholder targets tend to be ers stopped buying fish, even fish deemed safe large companies in consumer products that 47 by the EPA, and canned fish sales plunged by are financially sound and heavy polluters. 50 percent.44 Similarly, even though the US Activists also tend to target companies with Food and Drug Administration concluded that a strong brand or those that are considered 48 bisphenol A (BPA, an endocrine disruptor) was leaders within their industry. safe in 2006, after several national newspapers reported on the potential dangers of BPA to • Stakeholder protests targeting labor (for infants and children, mothers stopped buying example, fair labor practices) or consumer baby products containing BPA. While the sci- issues (for example, product safety or per- entific evidence of BPA risks remains inconclu- formance) with more media coverage tend sive, large retailers, manufacturers, and finally, to have a greater negative effect on stock 49 regulatory agencies effectively eliminated baby returns than do boycotts alone. products containing BPA in North America and Europe by 2009. • Companies with an already tainted reputa- A similar phased framework for under- tion are even more susceptible to the nega- 50 standing how to prioritize an ESG issue was tive effects of media attention. developed by Novo Nordisk45: • Activists prefer to target firms that have 1. Latent: Weak evidence, little awareness signaled a desire to change, and often con- front them with greater demands.51 Once a 2. Emerging: Focus of NGO campaign company has signaled a willingness to act, and research the bar can rise even more.

3. Consolidating: Awareness moves into pub- • Companies that have been targeted by a lic and media; strong evidence in support shareholder campaign, or whose industry peers have been targeted, will likely be 4. Institutionalized: Case for issue has been targeted again. Similarly, boycotts are often made, accepted, and addressed as part of repeatedly targeted at companies in the business norms or regulations same industry, particularly large companies with a strong reputation. In fact, the impact Second, private policy dynamics are on sales is less than the impact on a targeted 52 speeding up in an age of social media and company’s reputation. Internet connectivity, which has significantly reduced the costs of mobilization. For example, Strategic consideration 2: Adapt on September 29, 2011, Bank of America announced its plan to charge a monthly $5 One challenge for a company is how to debit card fee starting in 2012. Within a move across an inflection point to where it is month, the bank backed off due to intense no longer perceived as destroying value on a pressure from various stakeholders, including particular ESG issue. To navigate this terri- opinions on Twitter and Internet petitions.46 tory, companies need to identify how stake- holders perceive a particular ESG issue—as relative to an external norm, industry peers,

17 Drivers of long-term business value

an aspirational level, ideal state, or as a zero ESG performance that invest in employee (unacceptable) state. Managers also need to relations, environmental policies, and product understand the reference point espoused by strategies. Companies that seek to reduce their stakeholders on the ESG issue, which can be cost of capital have found that ESG disclosure quantitative (for example, tons of emissions, can help. ESG disclosure tends to attract insti- quantities recycled, money invested) or quali- tutional investors with a long investment hori- tative measures of management practices (for zon. Companies with strong ESG performance example, labor policies). have increased analyst coverage and improved Prospect theory tells us that the highest forecast accuracy. Conversely, companies with value gain is likely when a company moves poor ESG performance are less likely to main- from below-threshold ESG performance to tain profitability due to regulatory, customer, above, as stakeholders value this transition and investor pressure.54 highly. Due to “diminishing sensitivity,” com- Furthermore, issuing a steady stream of panies need to work harder for each incre- positive and credible ESG performance news mental gain in stakeholder value. The long-run can create a halo effect and insulate the com- goal should be greater consensus between the pany somewhat from future activist pressures business and its stakeholders around an ESG and a possible drop in stock price.55 Once a issue, because it creates value for both—that is, company has exceeded the ESG performance enlightened value maximization. threshold through prudent actions, stake- holders are much more likely to be positively Strategic consideration 3: inclined to the company, and may even help 56 Disclose strategically and it uphold and strengthen its ESG halo. This opens up new opportunities. The company cultivate your ESG halo can move from risk management to creating value both for its stakeholders and its investors. Information is money, a relationship that However, it can pay to watch the company you applies quite often when it comes to ESG keep. If a competitor in your industry falters, disclosure. Researchers have known for over 20 then it is likely that activists and sharehold- years that companies that disclose more (man- ers will monitor your company more closely dated) financial information have lower capital and even drive down your company’s market constraints, for the simple reason that disclo- value. Thus, investing in industry policies, sure reduces transaction costs to investors.53 industry associations, and benchmarking with Similarly, voluntary disclosure on sustainability your industry peers is a good way to maintain and corporate responsibility may lower the cost a solid level of ESG performance and protect of equity capital for companies with stronger against the negative events that inevitably arise.

18 Stakeholders, stats, and strategy

Stakeholders and a path to long-term business value

ot long ago, business operations were include value creation for multiple stakehold- Ngrounded in the assumption that ESG ers. We suggest that the stakeholder’s reference issues are not financially material, because the point is as important as, if not more important impacts are sometime in the future and of little than, that espoused by managers. consequence to current business success. As A sound strategy requires an understand- we have shown, this assumption is no longer ing of human nature and the biases that we supported by statistical evidence for a growing bring to all decisions. With an understanding set of ESG issues and companies. There is value of prospect theory and stakeholders’ reference in these numbers, as evidenced by growing points and reference states, it should become shareholder interest and market value effects. easier to predict and prevent long-tailed ESG Stakeholders are keeping score, and companies risks. Stakeholder engagement may well help are expected to increasingly see an impact on protect your license to operate and strengthen financial performance. your ESG halo. Success is built, in part, upon a More corporate leaders are broadening more holistic approach to an ESG issue, such their understanding of business risks—some as recognizing that child labor management more proactively than others. However, many is tied to educational opportunity. Finally, as managers have yet to shift their frame of refer- more managers realize that management of ence in terms of ESG performance evalua- ESG issues is an input factor to production tion and disclosure. Much of the information and not an ad hoc undertaking and become disclosed in today’s corporate sustainability more transparent on performance, we can reports is self-referencing and hard to inter- expect risk reduction and lower cost of capital. pret. An assessment of what level of ESG per- Stakeholders do not merely challenge the busi- formance is better or worse cannot be judged ness model; they identify opportunities for relative to the company’s own internal standard value creation. or its past performance, because it does not

19 Drivers of long-term business value

Endnotes

1. Christopher Meyer and Julia Kirby, “Leader- Research, 2012, http://www.deloitte.com/ ship in the age of transparency,” Harvard view/en_US/us/Services/additional-services/ Business Review (April 2010); David P. Baron deloitte-sustainability/962cef0ae3c26310 and Daniel Diermeier, “Strategic activism and VgnVCM2000001b56f00aRCRD.htm. non-market strategy,” Journal of Economics & Management Strategy 16, no. 3 (2007). 10. The World Business Council for Sustainable Development (WBCSD) was founded in 1991 2. Milton Friedman, Capitalism and by Stephan Schmidheiny, who published his Freedom (University of Chicago Press, seminal book Changing Course in 1992. 1962); “The social responsibility of busi- ness is to Increase its profits,” New York 11. F. den Hond and F.G.A. de Bakker, “Ideo- Times Magazine, September 13, 1970. logically motivated activism: How activist groups influence corporate social change 3. Michael E. Porter and Mark R. Kramer, activities,” Academy of Management Review “Creating shared value,” Harvard Busi- 32, no. 3 (2007); Mike Lounsbury, M.J. ness Review (January-February 2011). Ventresca, and P.M. Hirsch, “Social move- ments, field frames and industry emergence: A 4. R. Edward Freeman, Strategic Management: A cultural-political perspective on US recycling,” Stakeholder Approach (Boston: Pitman, 1984). Socio-Economic Review 1, no. 1 (2003).

5. Bidhan L. Parmar et al., “Stakeholder 12. Kevin B. Hendricks and Vinod R. Singhal, “An theory: The state of the art,” The Academy empirical analysis of the effect of supply chain of Management Annals 4, no. 1 (2010); R. disruptions on long-run stock price perfor- Edward Freeman, Jeffrey S. Harrison, and mance and equity risk of the firm,” Production Andrew C. Wicks, Managing for Stakehold- and Operations Management 14, no. 1 (2005). ers: Survival, Reputation, and Success, The Business Roundtable Institute for Corporate 13. http://www.sec.gov/interps/account/sab99. Ethics Series in Ethics and Leadership (New htm#foot2, “One rule of thumb in particular Haven: Yale University Press, 2007). suggests that the misstatement or omission of an item that falls under a 5 percent threshold 6. E. Merrick Dodd Jr., “For whom are is not material in the absence of particularly corporate managers trustees?,” Harvard egregious circumstances, such as self-dealing Law Review 45, no. 7 (1932); Adolf A. or misappropriation by senior management. Berle, “Corporate powers as powers in The [SASB] staff reminds registrants and the trust,” Harvard Law Review 44 (1931). auditors of their financial statements that exclusive reliance on this or any percent- 7. Michael C. Jensen, “Value maximiza- age or numerical threshold has no basis tion, stakeholder theory, and the in the accounting literature or the law.” corporate objective function,” Business Ethics Quarterly 12, no. 2 (2002). 14. Koehler and Hespenheide, Disclosure of long-term business value: What matters. 8. Leena Lankoski, N. Craig Smith, and Luk van Wassenhove, Judgments of stake- 15. Philip Little et al., “Explaining variation holder value: Advancing stakeholder theory in market to book ratios: Do corporate through prospect theory, INSEAD, 2011. reputation ratings add explanatory power over and above brand values?,” Journal of 9. For an approach to stakeholder engagement Finance and Accountancy (2012). that can serve multiple objectives and multiple stakeholders, see Dinah A. Koehler and 16. 2011 UN PRI Annual Report, http:// Eric J. Hespenheide, Disclosure of long-term www.unpri.org/viewer/?file=wp-content/ business value: What matters?,” Deloitte uploads/annual_report2011.pdf.

20 Stakeholders, stats, and strategy

17. “SRI Basics,” US Social Invest- Australia, Brazil, China, France, Germany, ment Forum, http://www.ussif.org/ India, South Africa, United Kingdom, and sribasics, accessed July 3, 2013. United States. Participating companies had average annual revenue of $17 billion; none 18. UNEP FI Roundtable, December had annual revenue below $2 billion. 2011, http://unepfi.org/grt/2011/. 29. UN Global Compact/Accenture, “A new era of 19. Robert Heinkel, Alan Kraus, and Josef sustainability: UN Global Compact-Accenture Zechner, “The effect of green investment CEO study 2010.” Survey of 766 CEOs on corporate behavior,” Journal of Financial around the globe and extensive interviews and Quantitative Analysis 36, no. 4 (2001). with 50 of the world’s leading CEOs.

20. Caroline Flammer, Corporate social responsibil- 30. “Sustainability nears a tipping point,” MIT ity and shareholder value: The environmental Sloan Management Review and Boston consciousness of investors, MIT Sloan School Consulting Group, winter 2012. of Management, 2011. From 1980 to 1990, the average abnormal return associated with nega- 31. “GlobeScan/SustainAbility survey 2012.” tive environmental news was -0.42 percent, 642 sustainability experts, the majority decreased to -0.66 percent during 1990–2000, with more than 10 years of experience in and further to -1.12 percent during 2000–2009. sustainability, from corporate, government, non-governmental, academic/research, 21. Donald W. Reynolds, “Green” reporting service/media, and other organizations in in business news sections, Arizona State 77 countries, completed an online question- University, Walter Cronkite School of Jour- naire during December 2–19, 2011. nalism and Mass Communication, 2007. 32. Ion Bogdan Vasi and Brayden King, 22. Robert G. Eccles, Michael P. Krzus, and George Social movements, risk perceptions, and Serafeim, Market interest in nonfinancial economic outcomes: The effect of primary information, Harvard University, 2011. and secondary stakeholder activism on firms’ perceived environmental risk and financial 23. I. Ioannou and G. Serafeim, “The impact of performance, Columbia University and corporate social responsibility on investment Northwestern University, 2011. recommendations,” Best Paper Proceedings of the Academy of Management, Annual 33. Information for case studies is drawn from: Meeting, 2010; Robert G. Eccles and George Thomas P. Lyon, ed., Good Cop, Bad Cop: Serafeim, “Accelerating the adoption of Environmental NGOs and their Strategies integrated reporting,” in Francesco de Leo toward Business (London: Earthscan, 2010) & Matthias Vollbracht, eds., CSR Index 2011 and Michael E. Conroy, Branded: How the (Boston: InnoVatio Publishing Ltd, 2011). ‘Certification Revolution’ is Transforming Global Corporations (Gabriola Island, BC, 24. Esty Environmental Partners, “Assessing and Canada: New Society Publishers, 2007). unlocking the value of emerging markets sustainability indices,” ed. IFC (Washington 34. Equator Principles, “Home,” http:// DC: International Finance Corporation, 2011). equator-principles.com/.

25. CERES, http://www.ceres.org/incr/ 35. Daniel Kahneman and Amos Tversky, engagement/corporate-dialogues/ “Prospect theory, an analysis of decision shareholder-resolutions/. under risk,” Econometrica 47, no. 2 (1979); Thinking, Fast and Slow (New York: Farrar, 26. Ernst & Young, Shareholders press boards Straus and Giroux, 2011). Daniel Kahneman on social and environmental risks—Is was awarded the 2002 Nobel Prize in econom- your company prepared?,” 2011. ics for establishing behavioral economics 27. Erin M. Reid and Michael W. Toffel, “Respond- and the related field of behavioral finance. ing to public and private politics: Corporate 36. Lankoski, Smith, and Wassenhove, Judg- disclosure of climate change strategies,” ments of stakeholder value: Advancing Strategic Management Journal 30 (2009). stakeholder theory through prospect theory. 28. Deloitte, Sustainable finance: The risks 37. Witold J. Henisz, Sinziana Dorobantu, and and opportunities that (some) CFOs are Lite Nartey, Spinning gold: The financial overlooking, 2011. CFOs were surveyed in returns to external stakeholder engagement,

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Wharton School, 2010; Witold J. Henisz, 47. Michael Lenox and Charles Easley, “Private “Mining for stakeholder cooperation,” environmental activism and the selection and Penn Gazette, 2011, http://www.upenn. response of firm targets,” Journal of Economics edu/gazette/0112/expert.html. Management and Strategy 18, no. 1 (2009); Sam Gupta and Robert Innes, Determinants 38. Kenneth Y. Chay and Michael Green- and environmental impact of private politics: An stone, “Does air quality matter? Evidence empirical analysis, University of Arizona, 2009. from the housing market,” Journal of Political Economy 113 (2005). 48. Conroy, Branded: How the ‘Certification Revo- lution’ is Transforming Global Corporations. 39. Lankoski, Smith, and Wassenhove, Judg- ments of stakeholder value: Advancing 49. Brayden G. King and Sarah A. Soule, stakeholder theory through prospect theory. “Social movements as extra-institutional entrepreneurs: The effect of protests 40. Under the precautionary principle, the on stock price returns,” Administrative burden of proof that any action or policy Science Quarterly 52 (2007). will not cause harm to the public or the environment falls on those taking the action, 50. Brayden G. King, “A political mediation even where scientific consensus is lacking. model of corporate response to social movement activism,” Administra- 41. Eric W. Orts and Alan Strudler, “The ethical tive Science Quarterly 53 (2008). and environmental limits of stakeholder theo- r y,” Business Ethics Quarterly 12, no. 2 (2002). 51. Baron and Diermeier, “Strategic activ- ism and non-market strategy.” 42. Flammer, Corporate social responsibil- ity and shareholder value: The environ- 52. King, “A political mediation model of corpo- mental consciousness of investors. rate response to social movement activism.”

43. Lyon, Good Cop, Bad Cop: Environmental 53. Douglas W. Diamond and Robert E. Ver- NGOs and Their Strategies Toward Business. rechia, “Disclosure, liquidity and the cost of equity capital,” Journal of Finance 46 (1991). 44. Jay P. Shimshack and Michael B. Ward, “Mercu- ry advisories and household health trade-offs,” 54. Dan Dhaliwal, Oliver Zhen Li, and Albert Journal of Health Economics 29, no. 2 (2010). Tsang, Voluntary nonfinancial disclosure and the cost of equity capital: The initiation of 45. Simon Zadek, “The path to corpo- corporate social responsibility reporting, Uni- rate responsibility,” Harvard Busi- versity of Arizona and The Chinese University ness Review 82, no. 12 (2004). of Hong Kong, 2010; Sadok El Ghoul et al., “Does corporate social responsibility affect the 46. Candice Choi, “Bank of American joins banks cost of capital?,” Journal of Banking & Finance charging monthly debit card fees,” USA Today, 35, no. 9 (2011); Jaepil Choi and Heli Wang, August 30, 2011, http://www.usatoday.com/ “Stakeholder relations and the persistence of money/industries/banking/story/2011-09-29/ corporate financial performance,” Strategic bank-of-america-debit-card-fee/50608896/1; Management Journal 30, no. 8 (2009). “Bank of America plans $5 debit card fee,” CBS News, http://www.cbsnews.com/2100- 55. King and Soule, “Social movements as 500395_162-20113708.html; Tara Siegel extra-institutional entrepreneurs: The ef- Bernard, “In retreat, Bank of America cancels fect of protests on stock price returns.” debit card fee,” New York Times, http://www. nytimes.com/2011/11/02/business/bank-of- 56. Witold Henisz, Stakeholder capital and perfor- america-drops-plan-for-debit-card-fee.html. mance in tough times, Wharton School, 2011.

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23 Drivers of long-term business value

24 Stakeholders, stats, and strategy

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