From the May 2007 issue of Research Magazine • Subscribe!

May 1, 2007

Sustainability Goes Mainstream

Sustainability has evolved from a niche issue to an established feature of the investment landscape. As part of this transformation, the concept has expanded from a focus on respect for the natural environment to encompass human resources, social issues and even corporate governance. The term was first defined as "meeting the needs of the present generation without compromising the ability of future generations to meet their own needs" by Norwegian Prime Minister Gro Harlem Brundtland in 1987.

Wall Street observers point to two fundamental reasons for the increasing traction of sustainability: reducing business risks and enhancing shareholder value. By following the basic tenets of sustainability, businesses can limit their exposure to a host of costly legal and regulatory risks which, in turn, can yield smoother long-term performance. In addition, by adhering to best practices with regard to sustainability, companies can strengthen their relationships with all stakeholders -- customers, employees and investors.

As a result, more and more mutual funds, pension funds, wealth-management organizations and other groups are including sustainability criteria in their investment screens. And corporate management is taking notice -- both in the United States and abroad.

Risk and Opportunity

The growing acceptance and importance of sustainability is reflected in the fact that major players like Dow Jones have created indexes to rank companies with respect to their adherence to sustainable practices.

Launched in 1999, the Dow Jones Sustainability Indexes (DJSI), produced in partnership with SAM Group and STOXX Limited, were the first global indexes to track the financial performance of sustainability-driven companies worldwide. Today this family of indexes -- covering global, North American, U.S. and European stocks -- provide asset managers around the world with objective portfolio management benchmarks. In fact, over $5 billion in assets are managed using the DJSI as a benchmark -- up from just a few million in 1999 -- according to the Zurich-based SAM Group, an independent investment management firm.

"We look at long-term economic, environmental and social issues, because we believe that trends in these three dimensions have an impact on the long-term success of companies," explains Alexander Barkawi, managing director of SAM Group. "To give a concrete example, climate change is definitely on the radar screen of a growing number of investors, because people realize that the implications of climate change -- both physical and regulatory -- have very significant impacts on companies in different industries."

But, Barkawi believes, sustainability does more than just reduce risk; it also creates new opportunities for profit. "Climate change is obviously an issue on the risk side, as when the European Union mandates a carbon-emissions trading scheme and suddenly CO2 emissions have a cost that must be factored in by analysts," he says. "At the same time, the need to reduce CO2 emissions brings significant opportunities for companies that are developing technologies that target emission reduction -- companies in the renewable energy space, for example, but also automotive companies that produce cars that are less carbon intensive. There are always these two sides to every sustainability issue."

Long-term performance statistics appear to support Barkawi's views. From December 1993 to January 2007, stocks included in the DJSI World had a total return of 278 percent, compared to 204 percent for the MSCI World universe of stocks, with similar levels of volatility.

Driving Leadership

Arguably, few businesses have a greater impact on the natural and social environment than the automotive industry, which may explain why sustainability is such a critical concern to carmakers. Reducing harmful emissions, improving fuel economy and managing physical and human resources more effectively are all becoming key success factors for this highly competitive global market.

With a corporate code of conduct built on three core values -- quality, safety and environmental care -- it's not surprising that Volvo Group is a leader in the field of sustainability. "These core values are taken into consideration in everything we do -- from the beginning of our product design to the recyclability of older products," says John Hartwell, vice president of investor relations. All Volvo business units have their own quality, safety and environment managers, Hartwell adds: "These issues are integrated into our daily routines and are a normal aspect of operational responsibility."

Moreover, sustainable principles do not simply guide the company's conduct of its own business. Volvo encourages its suppliers, dealers and other business partners to follow them as well, according to Hartwell. The company also takes sustainability into account when evaluating prospective partners and business ventures.

Increasingly, companies are reporting their progress in the area of sustainability in the same way that they report their financial performance. Volvo published its first environmental report in 1990, and sustainability has been included in its annual report since 2002. The company's 2006 annual report devotes over a dozen pages to reporting on its efforts in sustainable development and social responsibility.

From designing more efficient engines and reducing emissions from the tailpipe and factory to human factors such as fostering diversity, labor relations and human rights, Volvo has clearly staked out a leadership position. This leadership is reflected in Volvo's inclusion in the DJSI for the last five consecutive years -- one of only five Swedish companies to make the list.

"Sustainable development, both in environmental and social terms, is a vital prerequisite for long-term profitability and increased customer and shareholder value," concludes Hartwell.

Advancing via Technology

For enterprise-software giant SAP, sustainability is definitely a top priority, according to Friederike Edelmann, director of investor relations. Sustainability and the related concept of corporate social responsibility are guiding principles and also the focus of some of SAP's new product development.

"Unlike oil and gas or chemical companies, as a software company, we define sustainability a little differently," notes Edelmann. "By the nature of our business, we have fewer concerns with environmental issues, but more concerns with issues like corporate governance, transparency and resource management. When we look at sustainability, we seek to maximize our utility to all stakeholders -- investors, customers, employees and society at large."

SAP's first step is to identify and manage risks relating to sustainability. "Then we look at where SAP can make the most valuable contribution to society through investment in technologies that enable greater transparency and accountability at every level in a company," Edelmann shares.

"Our enterprise software makes a powerful contribution to global sustainability," she continues. "For example, we recently announced the formation of a new business unit for governance, risk and compliance (GRC) management to help our customers comply with Sarbanes-Oxley, manage emissions and so forth. We believe that the concepts of sustainability and GRC are entirely complementary. There's no doubt that as organizations seek to reduce their risks, they will need better information technology."

In recognition of its efforts to promote sustainability and generate strong financial performance, Germany-based SAP has consistently been included in the DJSI. And, according to Edelmann, sustainability helps companies reduce risk, comply with regulatory requirements and serve as good corporate citizens. "We believe that companies must not lose sight of good governance as they strive to improve business processes and stay ahead in the global economy," she concludes.

The Future of Sustainability

For SAM Group's Barkawi, sustainability is at a turning point. "We're seeing a 180-degree shift in the debate. When SAM started off 12 years ago, issues such as climate change or water scarcity were largely seen as concerns of ethically motivated investors. Today, institutional asset owners are increasingly viewing sustainability as a significant driver of financial returns."

"I think we will see sustainability extending into new regions such as Asia Pacific and emerging markets," he concludes. "We will also probably see sustainability making inroads into other asset classes beyond the equity space, such as bonds and real estate. Finally, we expect to see more sustainability criteria being integrated into mainstream analysis."

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MAKING THE GRADE

Companies selected for inclusion in the Dow Jones Sustainability Index rank among the top 10 percent of the largest 2,500 global companies in the Dow Jones Global Index, with respect to sustainable practices and financial performance. The DJSI, launched in 1979, and related indexes are managed by Dow Jones Indexes, STOXX Limited and the SAM Group. See www.sustainability-index.com for more details.

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Kenneth Overholt is a San-Francisco based freelance writer.

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