In its most recent 10-K filing, Host Hotels & Resorts included two charts showing energy and water use at its properties over the prior three years. Each chart showed steep descents in the company’s consumption of those resources. The disclosure, and the circumstances leading up to it, were unusual in at least two respects.
One was that the company, a publicly traded real estate investment trust (REIT), reported those numbers in its financials at all. Indeed, in the fiscal-year 2015 annual reports of the 10 companies with the largest revenue in each of 79 industries, only 19% of about 4,000 possible sustainability disclosure entries were reported as metrics, according to the Sustainability Accounting Standards Board.
In contrast, the most common form of sustainability disclosure was generic boilerplate language, which was used in 43% of all disclosure entries analyzed by SASB. The organization, which sets voluntary corporate sustainability disclosure standards for those 79 industries, tends to frown on boilerplate, defining the word as “generic statements that are not specifically tailored to the individual company and the risks it faces” and branding its use as “inadequate for investment decision-making.”
To SASB, the specificity of Host Hotel’s charts in its 2017 Management Discussion and Analysis (MD&A) was a shining example of investor-friendly sustainability reporting. Most often, the impetus for reporting such environmental, social, and governance (ESG) factors in 10-Ks stems from someone with a title like that of Michael Chang, Host’s director of energy and sustainability.
But here again, the REIT, which owns 96 mainly luxury and “upper-upscale” U.S. hotels containing about 53,500 rooms, is an anomaly. While Chang’s sustainability group worked on the disclosure, it was the company’s finance team members who “were the main drivers … to get this information into a 10-K” for the first time, he says.
With Host’s CFO Gregory Larson getting buy-in from the rest of senior management, the effort to fit the water and energy data into a financial reporting context was led by Brian McNamara, the company’s controller. McNamara’s team led the move “because they control the 10-K and everything that goes in it,” Chang said.
At many other companies, however, senior finance executives have long interpreted their responsibility for control of financial report contents as meaning that they should report as little sustainability information as possible. Until recently, large institutional investors, pension funds, and money managers showed a parallel lack of interest, reasoning that the link between ESG factors and future cash-flows was vague at best.
But now it appears investors have grown more hungry for sustainability metrics. In their view, the gender breakdowns of boards, the possibility of droughts, or the likelihood of regulatory crackdowns have suddenly become the stuff of material disclosures. And, perhaps more significantly for investors, they may be the secret to outsized rates of return.
A Proxy for Alpha?
Investor demand for sustainability data has been surging. In its 2016 report on sustainable investing, US SIF, the association formerly known as the Social Investment Forum, reported that investors consider ESG factors across $8.72 trillion of professionally managed assets — a 33% rise since 2014.
“Companies need to understand that they need to satisfy the demand. But there’s a disconnect between what investors are [demanding] and what companies are reporting,” says former SEC chair and current SASB director Mary Schapiro.
Part of the disconnect may come from finance executives’ failure to grasp that investors’ newfound lust for ESG information may be fueled by a desire for better returns in a low-interest-rate environment. For their part, many money managers are indeed starting to see sustainability data as a proxy for alpha, an indication of above-average returns.
Will Ortel, a researcher at the CFA institute, for instance, blogged his belief last year “that the investment profession sees at least the seed of alpha generation within ESG disclosures.” He saw evidence of that in the 7% of 535 respondents to a CFA poll who answered “Of course” when asked, “Do you think analyzing ESG factors can boost returns?” Further, 37% answered “Somewhat—these factors enter into any complete analysis.”
Despite the existence of studies suggesting links between sustainability reporting and higher returns, however, skeptics on both the corporate and asset management sides still abound. For example, 15% of the respondents to the CFA poll answered, “No way—they’re called nonfinancial for a reason.”
There are, however, powerful advocates for the incorporation of sustainability and other nonfinancial factors into fundamental financial analysis and valuation. “With intangible assets accounting for more than 80% of the market value of S&P 500 companies, and stocks trading at multiples of book value, analysts require better information on ‘nonfinancial factors’ to understand what the market is paying for,” UBS Asset Management contends in a case study that appeared in ESG Integration Insight, a SASB publication, in 2015.
The asset manager offers examples of nonfinancial ESG factors “that have changed the value-creation prospects of public companies, but for which fundamental equity analysis does not readily account.” The examples include droughts like the one in Kerala, India, that marred the reputations of U.S. beverage makers, and labor practice risks like the 2013 collapse of the Rana Plaza clothing factory in Bangladesh.
“Increasingly, many asset managers and a growing number of investors view ESG factors as complementary to fundamental analysis. Examining corporate performance on material ESG factors ties into financial theory to complete the picture on valuation,” according to the UBS case study.
To Goldman Sachs, the picture appears close to completion. In an April equity research report, the investment bank claims to have found direct links between corporate environmental and social factors and company financial performance. “Our analysis shows that by focusing on a selective suite of key ESG metrics, mainstream investors can add a differentiated and alpha-additive complement of risk analysis to their toolkit,” according to the report. “Where robust data is available, [environmental and social] metrics make a tangible difference to performance.”
The authors of the report go on to advise portfolio managers to use sustainability data as a risk management tool that could help them identify and avoid companies with lagging ESG performance. For instance, since 2011, companies that fell in the bottom quartile of sustainability performance have underperformed sector peers by 135 basis points per year on average, according to Goldman.
The investment bank lists employee and board diversity, resource conservation, and low employee turnover as indicators of superior company financial performance. Companies employing more women, for instance, “have seen average annual alpha of 3.3%,” according to the report. Using less energy and water per unit of space generated 2.6% (energy) and 1.8% (water) in alpha annually. And companies with low employee turnover spurred 0.8% annual alpha on a three-year test and 3.0% in a 5-year test.
If equity research proceeds in the direction of requiring more ESG disclosures, pressure on CFOs to dig deep into their companies’ data to find and report potential sources of sustainability excellence is sure to mount. Even passively invested institutional investors like CalSTRS, the California teachers’ retirement fund, are finding ways to turn up the heat on the companies they invest in.
Since CalSTRS invests largely in index funds, it can’t exert market pressure by selling the stock of companies that are known polluters or that don’t report sustainability metrics. Instead, the pension fund’s managers take a more direct approach, meeting with sustainability executives at companies whose behavior they want to change.
“We look at our portfolio and say: ‘Which companies aren’t paying attention to [a] particular issue, whether it’s carbon emissions, energy use, methane emissions?” says Brian Rice, a CalSTRS sustainability portfolio manager. “Then we reach out to them and try to have a conversation about the risk and the value proposition.”
In a recent case, the fund pressed companies to disclose more about their performance in curbing methane emissions. Its ultimate position was that, instead of letting the chemical into the atmosphere, polluters should try to capture it and profit from its safe use. In a number of instances, CalSTRS officials told companies they needed to report the percentage of company infrastructure that was checked for leaks, how often it was checked, and the kind of technology that was used, according to Rice.
After the pension’s representatives present what they consider to be a good case based on the value to the company of adopting a given ESG measure, company executives might protest, contending that they don’t think it’s “in the best interest of the broad shareholder base [or that] the broader shareholder base doesn’t care,” he says. “So we say, ‘We want to file a proposal about the issue. Let’s take it to the shareholders for a vote and see what they say,’” Rice adds.
While he tends to have these discussions with company sustainability executives rather than with their finance chiefs, Rice thinks that the issues the talks raise are inevitably matters of corporate finance. “Certainly it all comes down to the valuation of the company,” says Rice. “We pursue these issues because we think that paying more attention to ESG, climate-change risk, water use, pollution, and worker health and safety all translate to the bottom line.”
Many companies have only just started to buy into the notion that their financial reporting should incorporate ESG factors. Even more, perhaps, still resist the idea of reporting any ESG information at all. Corporate finance attitudes like those expressed by General Motors and Aflac in response to a concept release published last year by the SEC are much more typical than those of Host Hotels.
In the release, the commission floated the idea of requiring companies to make line-item sustainability disclosures in their 10-Ks: “Would line-item requirements for disclosure about sustainability or public policy issues cause registrants to disclose information that is not material to investors?”
Firing back in a September 30, 2016, comment letter to the SEC, Thomas Timko, GM’s controller and chief accounting officer, argued that mandating sustainability disclosures would amount to “overburdening what is principally a financial and operational report with information that is immaterial to financial or operational performance, or, more importantly, immaterial to an investor’s investing or voting decisions.”
For his part, Aflac CFO Frederick Crawford pleaded for the exclusion of his industry from any such rules. The hospital-care insurer’s management doesn’t believe that “companies such as those in the insurance industry should be required to disclose immaterial public policy and sustainability matters,” he wrote.
Crawford also made the case that standard MD&A risk disclosures, instead of more-detailed revelations, would be enough. “Rather than reporting [ESG] factors in a standalone section, we recommend identifying and reporting them as risk factors,” he added.
But finance teams could still choose to report only sustainability information that they deem material to their company’s fortunes. That would certainly be the case if SASB’s standards come into widespread use. “SASB standards address the sustainability topics that are reasonably likely to be material and to have material impacts on the financial condition or operating performance of companies in an industry,” according to the nonprofit organization’s website. The standards “are designed to be integrated into the MD&A and other relevant sections of mandatory SEC filings such as the Form 10-K and 20-F [the annual report for foreign private issuers],” the board says.
Further, SASB often avows that, unlike the Financial Accounting Standards Board, its strictures are voluntary and market-based—leaving senior finance executives very much in the driver’s seat about what ESG factors are essential for investors to know about.
A Fragmented World
Because sustainability disclosures are voluntary and market-based, though, there’s no single disclosure standard that companies can follow. One reason for CFOs’ wariness of sustainability reporting may be an uncertainty spawned by the current blizzard of ESG reporting frameworks (see “A Surplus of Standards,” below).
“We live in a very, very fragmented world of sustainability disclosure,” says Sara Neff, senior vice president for sustainability at Kilroy Realty, a REIT.
As tough as it can be for corporate executives, it can also be difficult for investors to find the right scorecard to use in assessing sustainability. “In the investor community, everyone is really hungry for [a] standard disclosure so that they don’t have to wade through a bunch of noise,” Neff adds.
Some experts claim the SEC could be doing more in this area. The requirements for material disclosure in financial statements, including rules mandating reporting of material information regarding climate change, “already exist, and through the comment process, the SEC could be encouraging more complete disclosure,” says SASB’s Schapiro.
The current commissioners could focus on climate change by moving forcefully to comment on the adequacy of environmental disclosures in 10-Ks “without the SEC having to write any new requirements, interpretations, or guidances,” Schapiro adds.
In the meantime, companies that are motivated to disclose sustainability data to investors will have to maneuver through some uncharted waters.
Like Host Hotels, Kilroy Realty disclosed water and energy metrics for the first time in its 2017 annual report. (Both companies followed SASB guidelines for the REIT industry.) In deciding which years of sustainability data to report in its most recent 10-K, though, Kilroy executives faced a dilemma in bringing ESG data into its financial statements. Beginning with 2013, the company had been making full years of energy and water data available to the public. Although a third party had verified the data, it hadn’t been audited for SEC reporting purposes.
In the run-up to closing the 10-K, the problem was that Kilroy’s full calendar-year environmental data had yet to be verified and wouldn’t be available until March 30, 2017. The company’s finance and sustainability teams agonized over which data set to employ. “Do you use 10 months of correct data and then start estimating?” Neff says. The other alternative was to use the less timely, but fully verified, 2015 data to complete the reporting of a three-year trend.
Kilroy took the latter route, deciding to disclose “tightly, rigorously reported data rather than risk some estimating,” Neff explains. But the decision was a difficult one because the company felt it had timely data to support a sustainability story that it was eager to tell to its largely youthful and environmentally committed tenants.
Neff feels that the potential difficulties in getting ESG data in time for the closing of the annual report might put off some CFOs. “The timing of this stuff is really tricky,” she notes. On the other hand, CFOs in industries with a less positive ESG narrative might be fearful of reporting too much of it to investors. “If you are in an industry that is an extreme polluter, there may be some questions about how you present the data,” says Host Hotels’ Michael Chang.
Even executives at Host, which is eager to tout its ESG-friendly investments, hesitated about reporting the results of the company’s efforts in its annual report. “There was definitely concern that we were putting new information out there, and that new information brings more scrutiny,” says Chang. “We’ve been reporting for several years [outside the financials], and it’s taken that time for our executives … to buy into these metrics and get a level of comfort with them to report them out.”
Are the struggles and risks of disclosing sustainability information worth it? The market is beginning to answer that question for CFOs, and the answer is in the affirmative. As one high-level Goldman Sachs executive reportedly put it, “As a company, if you ignore sustainability, you’re going to be worth less.”
David M. Katz is a deputy editor of CFO.
A Surplus of Standards
One reason finance chiefs may be uncertain about incorporating sustainability metrics in their companies’ 10-Ks is that there are so many environmental, social, and governance reporting standard setters. Here are five of the most prominent.
Sustainability Accounting Standards Board (SASB)
Sets industry-specific standards for corporate sustainability disclosure that’s “material, comparable, and decision-useful for investors.”
Carbon Disclosure Project (CDP)
Runs a global disclosure system enabling companies to measure and manage their environmental effects. Claims to have amassed “the most comprehensive collection of self-reported environmental data in the world.”
Global Reporting Initiative (GRI)
An “international independent standards organization that helps businesses, governments, and other organizations understand and communicate their impacts on issues such as climate change, human rights, and corruption.”
Global Real Estate Sustainability Benchmark (GRESB)
An “investor-driven organization committed to assessing the ESG performance of real assets globally.”
International Organization for Standardization (ISO)
Sets standards that “enable businesses to plan their future growth around meeting consumer expectations. They enable transparency about products and best practices for limiting their impacts.”