Companies must include environmental and social performance measures
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Pick up any Harvard Business School case study, the most widely used pedagogical tool by business schools around the world, and you will almost certainly see the word “performance”. Business school students are taught both the means to drive organisational performance and ensure that performance is perpetuated and grown through alignment of remuneration.
We train managers to make decisions — on the likes of product development, hiring, mergers and payouts — based on the potential for sustaining or improving performance. We use cases to illustrate governance mechanisms, such as pay for performance, by which boards align the incentives of managers to shareholders.
But what if the assumptions and measurements underlying the definition of performance are flawed? If the purpose of the company in society is to maximise short-term profits, then one need look no further than earnings and other core financial metrics to judge performance. Most of the capital markets use this definition; it is no surprise, therefore, that corporate earnings and, as a result, stock prices are at record highs. We have built an economy that maximises the performance that we all learnt to maximise: financial.
However, there are calls to explore the broader purpose of the company and include more stakeholders than just the owners of capital — reflected in the popularity of the course “Reimagining Capitalism” that I teach with my colleague Rebecca Henderson. A concept of performance that excludes corporations’ green, employment or product impact results in poor outcomes for staff, customers and the environment.
The implications of this error speak for themselves. We are destroying the natural environment at an alarming pace. Employees are treated in many cases as expenses to be managed, rather than as sources of innovation and growth one needs to invest and retain. Innumerable food, beverage and financial products have left customers worse rather than better off, as demonstrated by increasing obesity and diabetes rates and declining life expectancy in the US.
To reverse these alarming trends, we need to redefine performance to include societal considerations such as providing good jobs, paying responsible tax, finding innovative ways to solve pressing issues such as climate change, and producing products that truly benefit customers. Doing so requires measuring the impact companies have on society, converting it to monetary terms and reflecting it in financial statements.
Doing so means we can translate social and environmental costs and benefits into comparable units that business managers and investors can intuitively understand, meaningfully aggregate and compare without obscuring important details needed for decision-making. It permits the use of existing financial and business analysis tools, such as net present value and internal rates of return, to assess corporate performance.
This is not a pipe dream. We are actively working towards that process at the Impact-Weighted Accounts Initiative project at Harvard Business School in collaboration with the Global Steering Group for Impact Investment and the Impact Management Project. We are convinced of the feasibility of the effort and have found at least 56 large companies that have produced some version of impact-weighted accounts. We are now able to calculate the monetary environmental impact for more than 2,000 large companies around the world.
We have applied our framework to companies across the automobile, pharmaceutical, utilities and consumer packaged goods industries. For example, we calculated a total product impact for one automobile manufacturer of -$2.1bn largely because of the costs associated with emissions and the fuel price impact that limits affordability of the vehicle. However, that was balanced by $4bn of positive impact due to superior vehicle safety. At a large consumer packaged goods company, we found a -$9.7bn impact due to added sugar with adverse health effects and a positive impact of $1.5bn from nutritional whole grains.
Impact-weighted accounts could have high catalytic potential. Consider the development of modern risk measurement in the second half of the 20th century, which included the concepts of aggregate portfolio risk, risk-adjusted returns, risk-return optimisation and value-at-risk to provide investors with a systematic way of optimising return for a given level of risk. This had dramatic implications for asset allocation, generating high inflows to the nascent venture capital and private equity industries from the 1970s.
Monetisation of social and environmental impacts similarly permits the development of effective risk-return-impact optimisation tools and the identification of a new efficient frontier for our economy. This has the potential to change capital flows compared with the market practice of disregarding impact completely or conducting separate qualitative and quantitative assessments.
The environmental and social challenges we face require immediate action. An overhaul of accounting standards, while welcomed, would take too long. Capital markets could bring that change faster. Important levers will be companies understanding the value of information to make better decisions; investors incorporating impact-weighted measures in their decisions; and stock exchanges asking for disclosure of impact-weighted metrics. These forces can be important levers to change how we measure performance.
George Serafeim is Charles M Williams professor of business administration at Harvard Business School