Sustainability and Performance

The dust of the recent economic implosion has yet to settle. Capital assets and fortunes have been dreamed up, liquidated and lost more times than any industrial-size paper shredder can handle in a lifetime. For years to come, analysts and investors will bear the burden of having ignored the high debt loads of many of the now-fallen giants of technology, and former executives and employees of now-defunct companies will continue to battle in the courts. CEO tenure has gone from eight years in 1980 to four years in 2000,1 even as the media and the public have hotly debated whether corporate returns have kept up with hyperbolic CEO pay.2 Meanwhile, the number of business failures has increased — more than 80,000 company failures per year in the last 20 years, compared to 19,000 per year, on average, in the previous 30 years.3,4 And corporations seem less and less able to predict their true earnings.5

Image courtesy of Flickr user Leo Reynolds.

Not surprisingly, in this environment investors and other corporate stakeholders have begun to take a keen interest in the sustainability of businesses. Witness the growth of socially responsible investing, where economic as well as social and environmental goals drive investment decisions. Although analysts may not always speak the language of sustainable development, Wall Street is gradually becoming aware of the importance of measurement and disclosure of nonfinancial elements of a business. For example, 50% of oil and gas industry analysts surveyed by Cap Gemini Ernst & Young confirmed that regulatory compliance on environmental issues, community service and lawsuits do indeed affect the value of a company; 68% believe that intangibles related to employees also have significant impact.6 In part in response to this demand, more companies have taken to filing corporate sustainability reports — The New York Times reports that 487 were published in 2001, up from 194 in 1995 and seven in 1990.7

Yet the word “sustainability” remains ambiguous and politically charged, particularly within the lexicon of business. When, as is commonly the case, the term is limited to encompass environmental management or social equity, sustainability is often perceived to be at odds with fiduciary responsibility and unlinked to business strategy. This article makes a business case for sustainability by adopting a broader view: A sustainable organization is one whose characteristics and actions are designed to lead to a “desirable future state” for all stakeholders. For investors a desirable future state would surely include sustained revenue growth over the long term. For the talent market it would include workforce diversity. Regulators and the community at large value environmental stewardship and social responsibility. Consumers seek useful, reliable, price-efficient products and services. From the view of employees of the company itself, a desirable future state includes maintaining viability and profitability as well as managing risk while promoting innovation. Companies that actively manage and respond to a wide range of sustainability indicators are better able to create value for all these stakeholders over the long term.

Intangibles and Value Creation

In the past two years, the European Commission,8 the U.S. Securities and Exchange Commission,9 and the U.S. Financial Accounting Standards Board10 all commissioned studies on the importance of intangibles in the economy. All conclude that the drivers of wealth creation for business and the economy are less about physical and financial assets and more about intangibles such as intellectual property and employee talent.

While conventional accounting and financial metrics yield some insight into a company’s market value, forward-looking sustainability indicators — anything from confidence in a company’s management to research leadership to the management of environmental liabilities — are becoming more relevant to a business’s overall value proposition. As a result, more effort is being paid to codifying the nonfinancial and intangible aspects of businesses. In France, its Nouvelles Regulations Economiques mandates (among other things) reporting on human resources, community and labor standards. And in the United Kingdom, the government requires ethical, social and environmental information about occupational pension funds’ investment policies.

At the Cap Gemini Ernst & Young Center for Business Innovation, we have developed a Value Creation Index (VCI), which not only quantifies nonfinancial performance, but also links key intangibles to a company’s valuation in the market. The results clearly reveal the importance of business assets that most companies do not measure, manage or disclose. Although social responsibility and environmental responsibility were among the top intangible factors identified, the VCI offers a far broader picture of the elements of sustainable business. Although they vary somewhat by industry, measures related to management credibility, innovativeness, brand identity, ability to attract talented employees and research leadership also correlated highly and consistently with market value across industries.

Sustainability in Practice

Managers are discovering that the intangible indicators that gauge sustainability can also be indicators of efficacy — that is, how well a company is run. From the management of corporate liabilities to new market ventures, a sustainable business strategy can improve all segments of corporate activity. Indeed, some argue that environmental management, in particular, is a good proxy for gauging overall management capabilities at both the strategic and operational levels. Matthew Kiernan, founder of Innovest Strategic Value Advisors, an investment research firm, believes environmental issues are a robust metaphor because they touch upon all aspects of a business’s operations from product design to finance and have implications for a wide range of stakeholders from the government to investors to community citizens.11 Perhaps more significantly, environmental problems are relatively “young” issues; addressing them demands strategic foresight, superior execution and organizational agility, factors that cannot be fully identified on a balance sheet.

As managers seek revealing and reliable performance measures of these factors, they can make use of information that their companies already have available — not only data that they are required to report, but also data that is collected for one purpose and may be used to glean information on other dependent issues. For example, emissions data is required for some regulated toxics, but this same information can also help to establish materials-use goals in a production process. Proactively managing and interpreting these kinds of data will better allow companies to be in control of the measures that matter in their market and industry. Indeed, companies may not have a choice: As data gathering and management systems get more sophisticated, monitoring performance will by necessity be more tightly linked to improving performance. In many ways, the metrics for sustainability and market performance are strategically linked.

Sparking Innovation Traditionally, environmental compliance and social welfare expenditures were viewed as costs that correlate negatively with returns. However, recent studies suggest that there are several opportunities for competitive advantage and increased profits by engaging in strategic sustainability initiatives.12

This reasoning reflects a shift from viewing business expenditures in a static world to viewing them in a dynamic one based on innovation. Claas van der Linde and Michael Porter13 argue that in a static model, companies have already made their cost-minimizing choices and therefore any imperative to spend in the name of the environment or social responsibility “inevitably raises costs and will tend to reduce the market share of domestic companies on global markets.” A static world, they say, falsely assumes that through profit seeking, companies are already pursuing all profitable innovations. However, a dynamic (that is, real) world is shaped by the stimulation and development of innovations. Porter and van der Linde argue that “net compliance costs [for environmental regulations] are overestimated by assuming away innovation benefits.”14

In other words, regulation and market pressures have helped spark innovations that have eventually improved process efficiencies, tapped new markets, streamlined production and materials use, and led to many other benefits beyond reduced pollution.15 For example, plastics producer Spartech thinks of its recycling program not as a necessary evil, but as a value-added customer service. In 2001, Spartech bought 220 million pounds of spare plastic and trim from 2,000 of its customers and cost-effectively recycled the materials back into its products. Ten of Spartech’s plants also participate in a program to reuse wood pallets used for shipments, obviating the need for customers to deal with the disposal of wood waste and saving Spartech and its customers $134,000 in material costs and disposal fees per year.16

To measure performance, Spartech looks beyond mere environmental compliance, which it considers a “lagging indicator.” Suzanne Riney, Spartech’s director of environment, health and safety, points to many continuous improvements at the company that are beyond compliance and “make good business sense” —such as reducing greenhouse gas emissions, improving energy efficiency, and widening the company’s recycling program to include all materials and discharges. With many of the cost savings of Spartech’s programs, turning the company’s environment, health and safety function into a profit and loss center17 does not seem like an unreasonable goal. Forward-looking indicators that measure a company’s ability to make efficient use of materials and energy (for example, throughput data or energy use per consumer product unit), as well as any downstream revenues, can therefore be a measure of innovative ability, effective capital utilization and value creation.

Leading Regulation Devising innovative ways to meet or beat compliance targets has not only reduced costs; it has also helped steer environmental regulation in a direction beneficial to producers as well as to social and environmental well being. Harvard Business School Professor Forest Reinhardt claims that a company may “manage” its competitors “by imposing a set of private regulations or by helping to shape the rules written by government officials.”18

Robert Larson of the U.S. Environmental Protection Agency confirms that observation. Larson was in charge of the rulemaking behind the U.S. emission standards for two-stroke, hand-held engines. He says that a particular John Deere technological innovation, compression wave injection (CWI), “absolutely helped drive the standard for handheld lawn and garden equipment.”19 That created a competitive advantage for John Deere. Its CWI technology exceeded the EPA’s proposed standard at a lower cost and with fewer barriers to widespread adoption than other options. The EPA demonstrated that the environmental benefits of this technology were great, and that CWI presented a technologically feasible way of attaining them. John Deere has since licensed the technology to its competitors, making the cleaner-burning engine more widely available and ensuring a future revenue stream.

The level of R&D investment in addressing upcoming regulatory requirements can be an indicator of likely competitive advantage. In addition, any incentives in place for employees, divisions, or business units to develop “beyond compliance” processes and technologies would similarly give stakeholders an understanding of whether a company is a leader or a follower when it comes to regulatory involvement.

Creating Differentiation In commodity industries, product differentiation is particularly difficult, and companies typically compete through operational efficiency and economies of scale. Yet, some companies have differentiated themselves through improved intangibles performance — and have seemingly been rewarded in the marketplace.

When Paul O’Neill (formerly secretary of the U.S. Treasury) became CEO of Alcoa in mid-1987, the company’s worker safety record was one-third the national average. O’Neill sought not to squeeze out a higher profit margin, build up more economies of scale or diversify the business, but to elevate health, safety and environmental issues to a strategic level. With an emphasis on such values, O’Neill has explained, “You will go beyond what seemed possible before. Workplace safety is just one example —when you become effective at organizational problem solving, many of the targets that seemed out of reach, whether that means profits, growth, innovation or new markets, become easy to grasp.”20 By 2000 O’Neill had reduced Alcoa’s workplace injury rate by 90%, increased sales to $22.9 billion (from $4.6 billion in 1986) and increased the company’s market cap to nearly $30 billion (from $2.9 billion in 1986).

Because intangibles related to environmental or social responsibility highly interact with customer satisfaction and other stakeholder preferences, improvements in one area can have quite unexpected gains in another. According to Alcoa’s executive vice president for environment, health and safety: “To improve safety, you have to get deeply into a manufacturing or business process. If you get deeply into the process, you discover opportunities to increase quality and reduce cost.”21 Consistent with that viewpoint, measures related to worker safety — number of Occupational Safety and Health Administration violations, worker days lost and accrued disability liabilities — are leading indicators of efficacy. A wider measure of commitment to environmental, health and safety issues may be the number of environmental staff in a company and the number of those at the executive level.22

Managing Risk Proactive investing in environmental measures beyond that required by law can be good for the bottom line, if for no other reason than to limit the downside risk23 of damages, hefty litigation fees and public relations disasters. Often, that is relegated to an environment, health and safety office that is far removed from the hub of corporate activity. But if pursuing sustainable business strategies can increase a company’s expected value, it is sensible to infer that integrating sustainability considerations into other kinds of risk management will lead to better decision making. Forest Reinhardt argues that “environmental problems are best analyzed as business problems … the basic tasks do not change when the word ‘environmental’ is included in the proposition.”24

For example, using materials more efficiently to meet environmental standards can also help to stem product obsolescence, an important strategic concern. In the computer industry, where obsolescence is often countered by fast and frequent product introductions, a better strategy might be to minimize the risk of obsolescence by extending product life — designing parts for ease of upgrade rather than disposal. The bottom-line benefits could include customer loyalty or even customer lock-in with a service relationship over a longer product lifetime and lower disposal costs, particularly in countries that mandate product take-back.25 Measures related to sustainable risk management include accrued environmental liabilities, fines, warnings and penalties, as well as product take-back programs in compliance with or in addition to regulatory initiatives.

Enhancing Growth and Global Expansion A company expanding its worldwide operations would be wise to tie sustainability considerations to its strategic management of social, political and economic factors. Some famous episodes in the public eye — Shell’s conflict with the Ogoni people of Nigeria and allegations about Nike’s labor practices, for example — demonstrate that sustainable operations are an opportunity to avoid or reduce future costs. Early measurement and reporting of leading indicators of sustainability initiatives also helps build better relationships with stakeholders, especially at the local level. Sarah Severn, director of corporate sustainable development at Nike, states that listening to the concerns of local stakeholders has helped Nike prioritize and address multiple issues from water use to climate change to the use of organic cotton — and create initiatives to improve its performance along each of these objectives.26

Adopting a sustainability mind-set can also lead to increased access to capital for expansion initiatives. Although the primary negotiation lever is likely to be focused on price, profit and economics, concern for sustainability could certainly be a differentiator. Some host governments may even demand adherence to sustainable development principles as a price of entry.

Leading indicators of this kind of risk and growth management would be the monitoring and disclosure of information important to stakeholders in any given region of operation, the involvement of local action groups and the level of investment in local development, and measures of political and economic risks.

“Servicizing” Products A good deal of recent literature has heralded the “service economy,” making the case that services can provide higher margins and retain their value proposition longer than products, which can rapidly become obsolete. Indeed, the U.S. Census Bureau reports that service industries created more than half of all new jobs between 1992 and 1997, and service industries in the aggregate made up more than half of the U.S. gross domestic product in 1999.27 Software and computer manufacturers have clearly illustrated this shift, as Microsoft has moved into online and entertainment services, and IBM has staked a claim to a share of the information technology consulting market.

Recent research and policy literature suggests that there are also good environmental reasons to replace products, which must be manufactured and disposed of, with services. Indeed, most consumers buy products in order to perform a function. If that function can be delivered as a service, there exists the potential that materials intensity for physical goods may decrease, thereby reducing the environmental burden of these transactions.28

It would be sophomoric to claim that a service economy can supplant products altogether, but we can imagine what the Tellus Institute describes as a “functional economy,” where “consumers buy cleaning services instead of washing machines, document services rather than photocopiers, and mobility services rather than cars.”29 Zipcar, for example, has been nationally recognized in the United States for its innovative approach to car rental — by the hour, available 24 hours a day, with no paperwork. Environmental benefits accruing from the reduced car usage (with each shared car replacing four to eight private vehicles) include reduced emissions and reduced load on the transit infrastructure.30

In a service economy, businesses may consider monitoring such forward-looking metrics as the percentage of their current product offerings that have a service component, what fraction of the customer’s perceived value they currently provide over the lifetime of the product, or whether and to what extent they offer products with an expandable service or a service with an embedded product. These measures will help set goals and track improvements.

A Company-Level Sustainability Model

As a complement to the broad suite of intangible value drivers that make up the industrywide Value Creation Index models, many of the leading indicators discussed in this article can be configured as inputs to a company-specific sustainability model. The indicators used for the Value Creation Index studies were derived from publicly available information. A company-level model of sustainability would comprise additional kinds of metrics — beyond public information. Identifying the proper company-specific performance measures should resonate with common sense, but does not have to rely solely upon it.

By mining what they already know, managers can obtain a more comprehensive view of how to encourage sustainable growth. For any given business, a host of qualitative evidence, quantitative measures and the particulars of its industry context can be mined to create a hypothetical model of the relevant sustainability drivers (such as innovation, risk management, environmental impact and reputation). Surveys of internal and external stakeholders as well as existing operational data can then be used to identify, for each driver, groups of measurable sustainability indicators that cut across all the business’s functions (procurement, supplier relations, product design and so on). That might, for example, include such indicators as R&D investment, worker-safety statistics, accrued environmental liabilities and the percentage of service components associated with each product.

The resultant company-specific model can be tested empirically. The impact of indicators on drivers and, in turn, on overall sustainability can be quantified, and changes in both indicators and drivers can be mapped to such performance factors as stock price, earnings and market share.

Identifying leading indicators of sustainability may never be a perfect science, but performance measurement that is incomplete and imperfect is better than measurement that is disconnected from business objectives. Competitive advantage will likely go to those who avoid getting caught managing what they can’t measure.

A long-term strategic view of sustainability may seem to contradict the urgency of immediate results for this quarter, but it is precisely the availability of both financial and intangible performance information — and the ability to take action on the basis of its interpretation — that can give decision makers a more comprehensive understanding of what’s important for performance over the long term.