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Sustainability and Capital Markets: How firms can manage the crucial link


By Ioannis Ioannou and George Serafeim

Corporate sustainability and socially responsible strategies have emerged in recent years as prominent issues, both in the world of business as well as within society at large. At the same time, the rather radical transformation that we witness today by some leading business organizations – from an exclusive focus on shareholder value creation, towards a focus on creating “social value” for a broader set of stakeholders – reflects the changing attitudes and expectations that society places upon them. For winning firms however, sustainability strategies also translate into significant bottom line contributions. Consider for example, Wal-mart and its $4 Prescription program and Tesco’s successful entry in the highly competitive US market with its Fresh & Easy neighborhood markets; or Siemens’s targets to generate $25 billion in revenue from products and solutions in their Environmental portfolio for fiscal 2011. These strategies have admittedly achieved a significant positive social impact, while increasing profits substantially.

Such changing attitudes and expectations from society towards corporations and the changes within corporations themselves, are intrinsically linked to the world’s growing acute problems such as global warming and climate change, the energy crisis, and extreme poverty, among others; issues that nowadays rank high on the agendas of local and national governments, politicians, NGOs and the scientific community, around the globe. The underlying fundamental debate however, is still far from being resolved: Having effectively addressed the economic problem in the past, can the business organization through sustainable business modeling, meaningfully contribute towards the efficient resolution of these grander challenges that the world is facing today, and do so profitably?

The answer that global business leaders provide to this question seems to be in the resounding affirmative: in the latest and largest-ever UN Global Compact-Accenture CEO study (2010) for instance, ninety-three percent (93%) of the 766 CEO participants worldwide, declared sustainability as an “important” or “very important” factor for their organizations’ future success. In fact, eighty-one percent (81%) stated that sustainability issues are already fully embedded into the strategy and operations of their organizations.  But how can such a milestone transition towards more sustainable business models be accomplished? In the same survey, eight-six percent (86%) of the CEOs saw “accurate valuation by investors of sustainability in long-term investments” as “important” or “very important” for reaching a tipping point in sustainability; a finding that highlights the important role that capital markets more broadly, are called upon to play in this radically changing global landscape.

Importantly, the role of capital markets is to efficiently allocate the available capital to its most productive use. It is clear to us, by observing the leading sustainability organizations around the world, that in the long-term the most productive uses of capital will accrue to firms that target through their operations solutions to fundamental social and environmental problems while generating substantial profits in the process. Currently however, various forces restrict the flow of capital to such long-term objectives. Most investors are focused on the short-term as a result of their compensation structure; quarterly relative performance evaluation forces fund managers to maximize next quarter’s fund performance, net fund flows and as a result management fees. Fund managers, in turn, put pressure on corporations to deliver earnings in the short-term. This induces a short-termism that potentially impedes capital markets from funding long-term oriented sustainability projects.

“We explored how sell-side analysts perceive and assess sustainability strategies and, how such perceptions of potential value-creation translate into realized value via market capitalization.”

To better understand how capital markets and sustainability strategies are linked, in our work, we explored how sell-side analysts perceive and assess sustainability strategies and, how such perceptions of potential value-creation translate into realized value via market capitalization.

Sell-side analysts are perhaps the most important information intermediary, functioning at the interface between firms and capital markets. Past research has shown for example, that analysts’ recommendations reduce informational asymmetries, and shifts in their investment recommendations have a profound impact on the firms’ market capitalization. In fact, studies have shown that analysts’ recommendations may influence significantly both the trading volume as well as the price of the stocks they follow. Indicatively, a change in their recommendations may cause persistent stock price increases up to 4% of market cap, for a stock that is added to the buy list, or a decrease of 3.8% for a stock added to the sell list, within a three day window of the change.

In our study, we found strong evidence that in earlier periods (1993-1997), sustainability was perceived by analysts as value-destroying in the long-run and thus, had a negative impact on investment recommendations. In other words, positive sustainability strategies lead analysts to issue recommendations closer to the ‘sell’ category. On the other hand, in later time periods (1997 onwards), we found that attitudes towards sustainability shifted: it was now perceived as value-creating and thus, led analysts to issue recommendations closer to the ‘buy’ category.
Since prior studies have documented a positive link between firm size and societal expectations (i.e. larger firms were expected to contribute more towards philanthropy, for example), we asked whether firm size had any impact on how analysts perceived sustainability strategies. We found that firms that were more visible in the public domain (i.e. larger firms in terms of market capitalizations or firms that were followed by a larger number of analysts), and thus more likely to be publicly scrutinized by various stakeholders, were more likely to receive favorable investment recommendations for their sustainability initiatives. Our findings therefore, suggest that winning firms are the ones that educate analysts about the long-run value implications of their sustainability strategies, and in doing so they are fully aware that when it comes to ripping the long-term benefits of sustainability, size does matter.


“Our findings suggest that winning firms are the ones that educate analysts about the long-run value implications of their sustainability strategies.”

Simply communicating the long-term value of sustainability however, even for more visible firms, might not be enough. It is crucial for winning firms to identify who are the analysts that follow them, and educate them accordingly. We also examined how the analysts’ ability and skill moderates the relationship between sustainability and investment recommendations. The results show that analysts with more years of firm-specific experience, or analysts with broader sustainability awareness, as well as analysts with greater availability of research resources (i.e. analysts working for larger employers), are more likely to perceive sustainability as value-creating. This finding is particularly important given that there is enough evidence to suggest that capital markets are more responsive to recommendations of more experienced analysts employed by larger brokerage houses, relative to any other analysts.

Firms with winning sustainability strategies are the ones that understand that for their market capitalization to reflect the long-term value they are creating, it is critical that they convey material and credible information about their strategies to the broader investor and stakeholder community. Winning firms therefore, are the ones that identify the most impactful actors and build effective communication channels with them. Firms that fail to credibly communicate their sustainability strategy to investors will find themselves at a significant disadvantage. Increasingly investors, such as Aviva Investors, take an active approach in engaging companies in sustainability by asking them to fully disclose material sustainability information. Corporate leaders need to understand that failure to disclose information produces uncertainty and decreases investors’ confidence in the quality of management.

“In order to be accurately assessed by capital markets, companies need to integrate their corporate communication strategies by accounting for all the dimensions of performance, that is financial, social, environmental, and governance, simultaneously.”

But what does an effective communication channel really mean? What kind of information should firms convey to the capital markets to facilitate their long-term evaluations of the firm’s profit generating potential?   In order to be accurately assessed by capital markets, companies need to integrate their corporate communication strategies by accounting for all the dimensions of performance, that is financial, social, environmental, and governance, simultaneously. Consequently, corporations need to understand which social and environmental issues are material to their business. Materiality is an important criterion that separates projects with the potential to address significant social problems and promote financial returns, from other projects. For example, Coca Cola concentrates its efforts in managing water consumption, an ingredient that is absolutely critical to its product and a scarce resource of our planet. An essential stage of the materiality process is developing and deeply understanding cause-and-effect relationships between non-financial and financial measures. Intel is a good example of a company that strives to perform this exercise. The company has developed the “Integrated Value Framework” that attempts to demonstrate how projects can contribute to one of four categories, revenue growth and innovation, operating efficiencies, risk management, and brand reputation.

Certification of an integrated report that would communicate all dimensions of corporate performance is also crucial for effective disclosure. An integrated report needs integrated auditing and as a result substantial investments by accounting firms to develop the capabilities to audit practices that have traditionally fallen outside their expertise. Accounting firms need to invest heavily on attracting and developing human capital that will have the capabilities of engaging in an integrated audit. An important challenge for an audit then, will be to move beyond plain certifications of the reasonableness of the processes to calculate the numbers. Auditors will need to engage intellectually with companies and evaluate the materiality of the issues, whether the causal links exist and whether reported numbers provide an unbiased measure of realized social, environmental, governance and financial results.

Providing material and credible sustainability data with clear causal links to financial performance will enable investors to move from financial modeling to business modeling. Business modeling will be achieved by creating valuation models that incorporate sustainability and financial data in an integrated causal way. Consider for example, Oddo Securities, a leading French brokerage house, that produces investment recommendations based on sustainability data by considering issues like biodiversity, human capital, social ecosystem capital, the presence of sustainable development strategy, and governance among others. In this process, information intermediaries will arise to reduce search frictions for market participants and supplement the information provided by corporations. An example of such an information intermediary is Good Guide, a company that provides ratings for thousands of food, paper, household, or even toy products on multiple dimensions including health, environment and society.

To summarize, in recent years around the globe, the issues of sustainability and social innovation have come to center stage. And they did so because the challenges that humanity is facing today are immense: global warming and climate change, the energy crisis, environmental pollution, corruption, extreme poverty and income inequality, to name just a few. Sustainability arises as the most viable long-term solution to these severe problems. Yet to achieve sustainability would be equivalent to bringing about changes in society and business, comparable perhaps only to the industrial revolution; in relative terms, what the world needs today might even be grander than that. To achieve a tipping point in sustainability therefore, it is vital to realize the immense role that the capital markets, as the institutions that effectively allocate available resources to their most productive uses, are called upon to play. And it is equally crucial for leading corporations around the world to realize the potential of the markets to promote and support sustainability, as well as to develop their strategies with such fundamental insights in mind.

The days when social performance and profitability were considered mutually exclusive and contradictory objectives have passed. Winning corporations are already making the transition from the old-world financial way of modeling to more sophisticated, and more sustainable holistic business modeling: they realize that a strict focus on shareholder value maximization is a necessary but by no means a sufficient condition for long-term survival. It is the broader focus on stakeholders, it is the strategic engagement with them, and importantly, it is the communication of such goals and objectives to the capital markets that will differentiate winners from losers in the sustainability endgame. Effective communication of the sustainability strategy of the organization, in way of credible and material information towards the capital markets is a key ingredient for not only creating but also capturing some of the value that’s being created. In the process of course, and while the business world does what it knows how to do best, to generate profits, sustainability will unleash all those global creative and innovative forces, that could effectively tackle the world’s biggest problems.

About the authors

Ioannis Ioannou is an Assistant Professor of Strategic and International Management at the London Business School. His research focuses on two major issues: the links between sustainability and capital markets, and the determinants of corporate social performance around the globe. His broader area of expertise is the strategic role of corporate social responsibility in the business models of organizations.  Ioannis holds a B.A. degree in Economics and Mathematics from Yale University, and a PhD degree in Business Economics from Harvard University.

George Serafeim is an Assistant Professor of Business Administration at the Harvard Business School. Professor Serafeim’s research interests are international, focusing on capital markets and on the social, environmental, and governance performance of firms. His work has been published in prestigious academic journals such as the Review of Accounting Studies, Journal of Accounting Research, Best Paper Proceedings of the Academy of Management and Financial Analysts Journal. Professor Serafeim earned his doctorate in business administration at Harvard Business School, and his master’s degree in accounting and finance from the London School of Economics and Political Science.

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