Why sustainability indexes miss the mark

The U.N. Global Compact recently launched the Global Compact 100, its first index comprised of multi-sector companies ranked for their adherence to its 10 principles, which include human rights, labor standards and environmental stewardship.

Initial back-tested performance shows a neutral or positive correlation to financial performance: The GC 100 outperformed the FTSE All World index over the past two years, illustrating the potential for a sustainability-screened group of stocks to outperform the market.

While there are more 1,000 publicly traded signatories to the U.N. Global Compact, the GC 100 was created from a representative sample of slightly more than 700 companies for which environmental, social and governance (ESG) information was gathered by Sustainalytics, the U.N. Global Compact's partner for the index.

The GC 100 includes companies long appreciated by sustainable shareholders, such as Ericsson, Hewlett Packard, Johnson Controls, Novo Nordisk and Electrolux. But there are some surprises, such as companies in sectors that include oil -- even tar sands -- natural gas, mining, petrochemicals, automotive and airline sectors, as well as companies with significant military contracts, such as General Electric.
 
If these are the best representatives of where the U.N. wants the global economy to go, let’s just say, for the record, that this is unacceptable.

The problem with sustainability indexes

Any list being promoted, representative sample or not, as an example of what the world needs more of in terms of corporate practices simply should set a much higher bar. It is notable, for example, that companies widely regarded to be the cornerstones of the green economy, such as organic food and agriculture, biodegradable household products, renewable energy, natural fiber clothing and cosmetics, are not found in the GC 100. Some of this is due to size, but therein lies the central problem with such indexes: They tend to pick only the largest companies in the world in order to better compare to a conventional index.

Investment professionals and government officials looking at this sort of list interpret it as some sort of barometer of where the economy could go if people invested in companies that demonstrate a commitment to sustainability. What people may not realize, however, is that many companies in such lists have developed extensive corporate responsibility and sustainability initiatives because of the reputational risks they face by their companies' operating in inherently problematic economy sectors.

They go to great lengths to publicly illustrate their commitment to responsibility, sustainability and environmentally friendly efforts because they have a lot to prove; their survival as a company depends on a positive public perception.
 
Social research organizations love to see such evidence of responsibility as a good faith effort. But a company in the business of polluting or releasing toxins into the world shouldn’t be singled out for leadership when its core business is still harmful to society.

It’s wonderful that companies want to become more energy efficient or better monitor and report on their environmental impacts, but it truly isn’t enough. The implication in creating indexes such as the GC 100, or the Dow Jones Sustainability Index (DJSI), is that these are better investments than companies that don’t sign the Global Compact or show an interest in sustainability. Nevertheless, investing in many of these companies just because they may be making an effort is not the way to reduce society’s dependence on these products and services. It’s certainly not the path to sustainability or a world without poverty.

Sustainability’s narrow definition
    
If you’re traveling in the wrong direction, slowing down doesn’t really matter. Sure, reducing carbon emissions and waste while conserving energy and water are critical, but society should not celebrate industries that are, in fact, the primary cause of ecological and health problems. The truth is that the global human response to climate change and degrading ecological systems is grossly inadequate. Industries in the business of polluting or whose processes and products create toxicity that cannot biodegrade should be required to stop what they’re doing, not be championed as if they are saving the planet.

These indexes may include corporate information across numerous categories, including some social and governance issues, but they truly aren’t leading the transformative charge to the green economy. Evaluating the largest companies in all sectors across relative ESG criteria is less meaningful than establishing higher ESG standards and measuring companies of all sizes against them. For example, any serious assessment of environmental and social performance should address the following issues:

• Board of directors minority representation or options expensing
• Management fraud and SEC violations
• EPA violations
• Climate change risk
• Environmentally friendly products and services
• Political contributions disclosure
• Cultural diversity in management
• International Labor Organization standards for child labor and workplace conditions
• National Labor Relations Board cases and findings
• Equal Employment Opportunity violations
• Hazardous or unsafe products
• Deceptive marketing or consumer fraud
• Offensive images in labeling or marketing
• Animal cruelty in research, development and production
• Operations in oppressive political regimes
• Relocation to countries that allows practices that are against domestic law

Without standards in these realms, investors lack a more comprehensive set of criteria they can use to determine which stocks to own. The GC 100 and DJSI would gain greater credibility in sustainable shareholders' eyes if they strengthened their inclusion methodology.

Transparency and disclosure is a low bar
    
One problem with ESG analysis in general is that it relies primarily on corporate self-disclosure. Welcome as it is that more companies are choosing to share information with ESG research firms and investment managers, awarding points for transparency and disclosure means little if what’s being revealed is still harmful to employees, customers, investors, communities and the environment.

For example, a company may report its supply chain procurement standards, risk management protocols or its environmental impact and sustainability measures. But reports that illustrate harmful policies and practices should not be valued over companies that avoid these challenges or implement credible solutions to these problems. If performance expectations are not established, then voluntary disclosure is simply a low standard, especially if only some companies in a given sector disclose information. Mandatory disclosure using clear performance standards is the only true way for the public to develop an accurate understanding of ESG issues across an industry and for investors to make truly informed investment decisions.
    
In addition, disclosure of CEO and median employee compensation is not the same as assessing whether executive compensation is excessive in both absolute terms or relative to cuts in companywide labor costs during hard times.
    
Finally, a company can have a code of conduct regarding employee behavior, but if the code’s standards are not assessed by the rating agency, the public doesn’t know if the code is adequate.

Unless one looks closely at the underlying methodology of ESG investment indexes, it’s difficult to know what is being evaluated. Nevertheless, even though corporate leadership within a given sector does have an impact, companies placed on a list claiming to reflect principles of sustainability truly should push society in this direction. Being best of the biggest is not good enough.

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