The eco-efficiency revolution :
Evidence is mounting of a strong, positive, and growing correlation between
industrial companies' eco-efficiency and their competitiveness
Matthew J Kiernan , Innovest Capital Risk Advisors
In a single day, June 13, 1994, Exxon's total stock market capitalization fell by fully 5% on news of
the company's exposure to additional legal damages from the disastrous Exxon Valdez oil spill. In a
single month in 1996, another oil giant, Royal Dutch/Shell, lost over 30% of its total market share in
Germany because of its perceived environmental transgressions in decommissioning its Brent Spar oil
platform in the North Sea.
Despite these and dozens of other environmentally driven financial reversals, however, most plan
sponsors and analysts continue to conduct business as usual. Companies that are light years apart in
their environmental risk and performance levels continue to enjoy identical investment ratings from
Wall Street. Most analysts and investors, it seems, remain unpersuaded that environmental
considerations are anything more than a superficial and temporary blip on their Bloomberg screens.
Mounting evidence suggests they are dead wrong. What they are sleeping through is nothing less
than the beginning of a profound and worldwide industrial restructuring.
Kyoto-style multilateral environmental treaties, tightening environmental regulations,
multi-million-dollar cleanup costs, exploding lender liability, consumer boycotts, shareholder activism,
and even executive jail sentences for polluters, have begun to impact corporate bottom lines with
unprecedented speed and ferocity. Increasingly, managing environmental risk and investment
opportunities effectively will determine whether companies outperform their competitors, lag
behind-or disappear altogether.
The recent Kyoto climate change agreement, for example, will likely require reductions of as much
as 40% in US industry's CO2 emissions. This is not a trivial or incremental adjustment. In the electric
utilities sector, for example, even a modest carbon tax of $20 per ton would extract roughly $60
billion a year. Given the 2,500% differential in the "carbon efficiency" of the top 100 US electric
utilities, this burden clearly will not be shared equally by all companies. Investors will have a strong
incentive to distinguish the future winners from the losers.
Access to capital, customers, suppliers, and committed employees-in other words,
competitiveness-already depends more and more on companies' environmental performance and
efficiency. Some senior Asian industrialists have recently termed this an "Eco-Industrial Revolution."
In the early 21st century, individual companies and even entire industrial sectors will need to make
strategic and operational adjustments of unprecedented proportions, or else face obsolescence and
even extinction. British Petroleum and Monsanto are only two examples of major global companies
that are literally reinventing themselves largely in response to the imperatives of the Eco-Industrial
Revolution.
A few intrepid, leading-edge financial analysts and investors have recently recognized a strong,
positive, and growing correlation between industrial companies' eco-efficiency and their
competitiveness and financial performance, whether measured as rate of return, return on equity, or
total stock market return. Eco-efficiency is simply the capacity to produce greater shareholder value
with lower levels of environmental risk and resource inputs than one's competitors.
Back-test evidence published this year by several scholars as well as the Environmental Protection
Agency indicates that a diversified portfolio of eco-efficient companies can be expected to outperform
its less efficient competitors by anywhere from 240 to 290 basis points or more per annum [See, for
example, Richard Clough, Impact of an Environmental Screen on Portfolio Performance: A
Comparative Analysis of S&P Stock Returns (Duke University, 1997); US Environmental Protection
Agency, Environmentally Screened Index Investing (1996); Mark A White, Corporate Environmental
Performance and Shareholder Value (University of Virginia, McIntire School of Commerce, 1995);
Stuart L Hart and Gautam Ahuja, An Empirical Examination of the Relationship Between Pollution
Prevention and Firm Performance (University of Michigan School of Business Administration, 1994);
and Jonathon Snyder et al, The Performance Impact of an Environmental Screen (Winslow
Management Company/Eaton Vance, 1993)]. In sectors with particularly acute environmental risk
exposure-chemicals and petroleum, for example-research performed by my own firm has revealed
that the "out-performance premium" can easily reach or exceed 500 basis points. This gap will only
widen.
Best-kept secret
Sadly, however, all of this remains what must be the best-kept secret on Wall Street. Plan sponsors
and other institutional investors have remained almost entirely oblivious to both the risk minimization
and portfolio outperformance potential inherent in investment strategies predicated on industrial
eco-efficiency.
In part, this is because fund advisors and Wall Street rating agencies persist in regarding companies
with differentials of as much as 500% in their environmental risk profiles as identical credit and
investment risks. A recent survey by the United Nations Development Program suggests that this may
be due less to skepticism about the financial impact of environmental factors than to the perceived
lack of coherent, credible, and readily available data and analysis on corporate environmental risk and
performance.
But here is a real-world example: Mobil and Unocal are both large-cap US petroleum companies.
Standard and Poor's regards them as virtually identical credit and investment risks, assigning both a
B+ common stock rating. But from an environmental risk perspective, that is where the similarities
end.
Depending on which environmental risk/performance metrics one wishes to emphasize, Mobil's
superiority ranges from 200% to 300%. One telling measure of the two companies' relative
eco-efficiency is the amount of toxic waste each produces per dollar of revenue: Unocal's emissions
are over twice as great. On aggregate, Mobil's environmental performance has improved by roughly
40% over the past three years, while Unocal's has actually deteriorated in both absolute and relative
terms.
Identical investment candidates? I think not. Over the past 10 years, Mobil's total stock market
return has outperformed Unocal's by a compound rate of nearly 600 basis points per annum. And
over the most recent three-year period-when, coincidentally, Mobil's environmental performance was
improving and Unocal's was deteriorating-the outperformance premium increased to nearly 800 basis
points, while its stock and bond credit rating remained more or less in line with Unocal's.
Can all of this "excess return" be attributed to environmental factors alone? Clearly not. But an
analysis of companies' environmental risk and performance profiles from a financial perspective can
reveal previously hidden insights about their ability to create sustainable shareholder value.
What has been lacking, until recently, is a set of robust, credible analytical tools and databases
capable of translating environmental risk and performance profiles into terms meaningful to financiers
and investors. These tools now exist, ranging from straightforward environmental data profiles to
sophisticated investment models such as Innovest's EcoRisc '21 model, which translates environmental
risk into share-price analysis and investment insights.
But these tools remain wholly unfamiliar to mainstream Wall Street. A recent survey of 380 Wall
Street analysts by the United Nations revealed that none of them had even heard of the three
longest-serving providers of environmental analysis and information.
ERISA is no excuse
Meanwhile, plan sponsors and their advisors continue to hide under ERISA's skirts, reciting the
shopworn cant that they are precluded from considering "non-financial" investment criteria by their
fiduciary responsibilities. They have no choice, it is argued, but to strive to maximize investment
returns: to consider "extraneous" factors such as environmental risk and performance would constitute
a dereliction of duty.
But the overwhelming preponderance of recent evidence indicates that to fail to consider available
information about companies' environmental risk, performance, and strategic positioning is to fail to
discharge one's fiduciary responsibilities. A recent Price Waterhouse study of 1,100 major US
manufacturers revealed that over 62% had major but undisclosed environmental liabilities.
Superior eco-efficiency turns out to be a remarkably robust-and empirically demonstrable-proxy for
superior, more strategic corporate management, and therefore for more sustainable earnings quality
and greater shareholder value creation. As environmental regulations continue to tighten and globalize,
competitive pressures mount, and capital markets become more sensitized to the financial
consequences of eco-efficiency, investment performance gains of 500 basis points and even more
should become achievable for companies with superior environmental risk profiles.
I am not suggesting that plan sponsors instruct their fund managers and consultants to trade in their
Bloomberg terminals for backpacks, Birkenstocks, and Sierra Club memberships. What I am
suggesting is that willfully ignoring newly available and increasingly strategic information on the risk
levels and outperformance potential of major investment alternatives serves nobody's interests, least of
all those of plan sponsors. ...
Matthew J Kiernan is chairman and CEO of Innovest Capital Risk Advisors, an environmental finance and
investment advisory firm with offices in New York, London, and Toronto. Prior to establishing Innovest, Kiernan
was director of the Business Council for Sustainable Development, in Geneva, Switzerland, which included the
chairmen of over 40 of the world's leading international companies. He recently published The 11 Commandments of 21st Century Management (Prentice-Hall/Simon & Schuster), on global strategy and innovation.
assetpub.com ... original link April 1998 |
