Sustainability is real and smart investors know it

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is clinical professor for business and society, and founding director of NYU Stern Center for Sustainable Business

Amid a mounting backlash against ESG, critics have argued that investors should care less about benchmarks of environmental, social and governance issues and should focus instead more on traditional financial analysis.

But it still matters to investors if companies pollute our waterways, exploit their workers or poison their customers. Even US states with curbs on ESG investment products, such as Texas and Florida, prosecute businesses for bad behaviour on ESG issues, with a negative impact on the companies’ bottom line.

And it is not just a matter of risk control. More broadly, corporate strategies that take sustainability into account can boost financial performance.

Note I did not say ESG. Introduced by a UN Global Compact to ensure accountability around sustainability claims, ESG is a framework for measuring process and output. For example, reporting metrics from the Sustainability Accounting Standards Board, a non-government body set up to promote common ESG standards, look at factors such as whether a company has a policy on chemical waste management.

Such issues are important and despite its critics, ESG measurement is not going away — the EU, India, Brazil, Australia, South Africa, US and others are regulating ESG disclosures by companies and investors.

But ESG ratings and scores are typically divorced from financial performance. For example, they might not take into account benefits to the bottom line from a corporate initiative such as, say, the development of a more environmentally friendly dye that reduces water use and waste, cutting costs and creating competitive advantage with buyers.

That is why we believe investors should focus on sustainability, which takes into account financial factors. When companies embed strategies to tackle material sustainability risks and opportunities into their business strategy, there are many gains to be had.

Morningstar tracks the stock performance of what it calls US sustainability leaders — large-cap stocks with low ESG risks. It found that they have outperformed the US market by more than 25 percentage points over the past five years.

One example of the gains from managing for sustainability comes from Nike. It created its flyknit technology based on the twin goals of reducing waste and making lightweight shoes. The recycled plastic strands are knitted into the upper — creating a low-waste, high-performance shoe that has become a $1bn-plus business and a category disrupter. By innovating to improve sustainability, it has reaped strong benefits.

More generally, there are significant operational efficiencies to be derived from strategies that reduce waste, water use, energy use and chemical use. When we buy more than what we need and pay to dispose of what is left over, we are creating operational inefficiency.

Sales and customer loyalty benefits also accrue to the providers of sustainable products and services. Our annual analysis of US retail data from sector specialist Circana finds that sales of sustainability marketed consumer products are growing market share at twice the rate of conventional offerings at a 28 per cent premium, on average.

Companies with sustainable approaches to their workforce also do well. Our research with a purpose-driven activewear company, REI, found that their focus on sustainability and purpose improved productivity and retention to the tune of $34mn annually, or 5 per cent of payroll.

Climate change is also creating risk for all businesses dependent on natural commodities. Managing for that risk is critical to company performance as well. For example, from 1980-2022, we had approximately eight extreme weather events in the US per year that led to damage of more than $1bn (adjusted for inflation). From 2017 to 2022, that average jumped to 18 $1bn-plus events a year, with significant financial implications for utilities, insurers, homeowners, infrastructure, manufacturing facilities and others.

Critics of ESG are right to point to some of the challenges with the current ESG reporting metrics and rating systems, which must be improved. But they are dead wrong to assert that managing material sustainability issues well is unimportant to a company’s financial performance.

The opportunity to increase revenue, reduce cost and avoid risk through managing for sustainability is real. The smart investors know that, and are acting on it.