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Lagniappe
Investing
in sustainability: An interview with Al Gore and David
Blood
By
Lenny T. Mendonca and Jeremy Oppenheim
Investing in sustainability: An interview with Al
Gore and David Blood
The former vice president and his partner in an investment-management
firm argue that sustainability investing is essential to
creating long-term shareholder value.
As
McKinsey research indicates, executives around the world
increasingly
recognize that the creation of long-term shareholder
value depends on a corporation’s ability to understand
and respond to increasingly intense demands from society.1
No surprise, then, that the topic of socially responsible investing
has been gaining ground as investors seek to incorporate concepts
like sustainability and responsible corporate behavior into
their assessments of a company’s long-term value.
Yet
socially responsible investing has always been an awkward
science.
Early approaches simplistically screened out “sin
sectors” such as tobacco. Subsequent evolutions tilted
toward rewarding good performers, largely in the extraction
industries, on the basis of often fuzzy criteria promulgated
by the corporate social-responsibility movement. These early
approaches tended to force an unacceptable trade-off between
social criteria and investment returns.
Three years ago, former US Vice President Al Gore and David
Blood, previously the head of Goldman Sachs Asset Management,
set out to put sustainability investing firmly in the mainstream
of equity analysis. Their firm, Generation Investment Management,
engages in primary research that integrates sustainability
with fundamental equity analysis. Based in London and Washington,
DC, Generation has 23 employees, 12 of them investment professionals,
and a single portfolio invested, at any given time, in 30 to
50 publicly listed global companies.
The
two partners recently sat down with McKinsey’s Lenny
Mendonca and Jeremy Oppenheim to discuss reconciling sustainability
and socially responsible investing with the creation of long-term
shareholder value.
The
Quarterly: What do you mean by the term “sustainability,” and
how does it influence your investment philosophy?
David
Blood: Sustainability investing is the explicit recognition
that
social, economic, environmental, and ethical factors directly
affect business strategy—for example, how companies attract
and retain employees, how they manage the risks and create
opportunities from climate change, a company’s culture,
corporate-governance standards, stakeholder-engagement strategies,
philanthropy, reputation, and brand management. These factors
are particularly important today given the widening of societal
expectations of corporate responsibility.
Al
Gore: When, several years ago, David and I were separately
looking
for ways to integrate sustainability into investing,
mutual friends told each of us of the other’s search.
We discovered immediately that we had a common goal, and that
led to a series of meetings and a friendship and, ultimately,
to a decision to form a partnership. We researched the history
of sustainable investing under its various names and decided
to start a new partnership in order to design it, from the
ground up, according to the architecture that we believed was
essential to address the challenges in the investment-management
industry.
The
Quarterly: What did the history of sustainability investing
teach you?
David
Blood: Sustainability investing has a long history, starting back
with the first wave of negative-screening strategies,
where investors excluded entire sectors based on a set of ethical
criteria. This strategy remained niche; returns were lackluster
due to the fact that your investment-opportunity set was limited.
The next wave of sustainability investing was called the positive-screening,
or best-in-class, approach. That’s the philosophy of
the Dow Jones Sustainability Indexes and the KLD Broad Market
Social Index—these indexes replicate the underlying benchmarks
but select only the best performers on environmental, social,
and governance parameters.
However,
the problem with this approach is that it’s
difficult to get a real sense of what’s happening in
those businesses, because it’s basically a one-size-fits-all
approach, often using questionnaires for decision making. In
addition, often one team does the sustainability research and
then hands it over to the investment team to do the financial
research. That approach, we believe, has too much friction
in it because it misses the explicit acknowledgment that sustainability
issues are integral to business strategy. So in setting up
Generation, we saw the need to fully understand sustainability
issues alongside the fundamental financial analysis of a company.
Al
Gore: We don’t think it’s acceptable to force
a choice between investing according to our values or according
to the ways most likely to get us the best return on investment.
Our objective in innovating with this new model was to focus
on the best return for our clients, full stop. But we wanted
to do so in a way that fully integrates sustainability into
the model.
The
Quarterly: That suggests greater complexity.
David
Blood: Yes, sustainability research is complicated because it requires
you to think long term and to think about the first-
and second-order effects of an issue. We like to describe our
approach to sustainability research as taking a systems view.
What that means is, if you’re thinking about climate
change you first need to understand the physical, regulatory,
and behavioral impacts on business. But you also need to understand
what a changing climate means for disease migration and public
health, what it means for poor populations in developing countries,
what it means for water scarcity or demographic and urbanization
trends. The most important and challenging research is trying
to determine how all these factors interact. Without that understanding,
you can miss a significant part of the business implications.
The
Quarterly: What principles drive your approach?
David
Blood: The first principle, categorically, is that it is best practice
to take a long-term approach to investing.
We think that the focus on “short termism” in the
marketplace is detrimental to economies, detrimental to value
creation, detrimental to capital markets, and a bad investment
strategy. It’s common corporate-finance knowledge that
something on the order of 60 to 80 percent of the value of
a business lies in its long-term cash flows. And if you’re
investing with a short-term horizon you’re giving up
the value creation of a business.
The second
principle is that the context of business is clearly changing.
We are now confronting the limits of our ecological
system, and at the same time societal expectations of business
are widening. On top of that, multinational businesses are
oftentimes better positioned than governments to deal with
some of the most complicated global challenges, such as climate
change, HIV/AIDS, water scarcity, and poverty. Technology and
communications have changed, and we’ve reached a point
where civil society is now demanding a response from business.
The
Quarterly:
What’s your perspective on how that changes
corporate strategy?
David
Blood: In effect what’s happening, unbeknownst
to many corporate leaders, is that the goalposts for their
businesses’ license to operate have moved. There are
higher expectations and more serious consequences, and the
implications go way beyond protecting your reputation or managing
costs. Rather, we see this changing context for business as
an opportunity for companies to establish competitive positioning,
grow revenues, and drive profitability. In the end, that’s
the holy grail of sustainability investing—to seize the
opportunities, not just avoid the risks.
The
Quarterly: What has been the reception from pension funds
and longer-term investors to this notion?
David
Blood: Very good. They recognize that they have long-term liabilities,
and it is their fiduciary duty to match those
liabilities with assets. The recent adoption of the UN’s
Principles for Responsible Investment by asset owners and managers
representing over $8 trillion is a good example of the institutional-investment
community beginning to commit to a long-term time horizon and
the explicit recognition that environmental, social, and governance
factors drive value creation.
From Generation’s perspective, we’re
pleased with this awakening. If you go back to when we founded
this firm,
we thought that sustainability investing would eventually be
mainstream, but we never would have guessed that the reception
and focus on sustainability would be as loud and as urgent
as it is today versus three years ago.
The
Quarterly: Why do you think that is?
David
Blood: It’s because people realize that there
are reputation issues related to sustainability, but they also
recognize that, in the end, this is about driving profitability
and competitive position. Asset owners are beginning to get
this and they are looking to invest in the companies that understand
it.
Al
Gore: The market is long on short, and short on long. There’s
a widespread recognition within the industry that what has
emerged over time doesn’t really make any sense. They
know that it needs to change and they are ready for change.
We are
in a period of history, right now, when the contextual changes
are larger than the ones we’ve been used to in
the past. Changes that we’ve associated with very long
cycles are now foreshortened and are occurring much more rapidly.
Positioning a company to ride out these changes and profit
from them often means making stretch investments to change
the infrastructure, change the energy source, change the physical
plant, and adapt to the new realities. And if there is the
tyranny of a three-month cycle, then companies won’t
make those investments. So focusing only on the quarter can
blind you to the most important factors of all.
The
Quarterly: How many executives really understand the complexity
and interconnection of the trends you describe?
Al
Gore: It’s a rapidly growing number. I recently spoke
at a conference, in Copenhagen, focused on carbon trading,
with thousands of companies represented. As part of an internal
survey, attendees were asked how many of them had internalized
their “carbon budget” and begun to drive down their
internal emissions.
A year
ago it was 15 percent. This year it was 65 percent. That
would correspond with what we’ve found in multiple
other areas—a kind of tipping point that we are at right
now. For example, I had a chance to visit Wal-Mart in Bentonville,
Arkansas, around the time they launched their commitment to “green” their
supply chain. And David and I spent time with [GE CEO] Jeff
Immelt, and we could give you lots of other examples of CEOs
who, a few years ago, might not have talked this way and yet
are now not only knowledgeable but highly sophisticated. They
may have started with concerns about brand protection and reputation
and the like. But once they got into it, it was as if a whole
new world of opportunity and new markets opened up.
The
Quarterly: What do those executives and companies that
are doing this well see differently?
David
Blood: The first is that they understand their long-term strategy.
Secondly, they understand the drivers of their business—both
financial and nonfinancial. The leading CEOs are the ones who
explicitly recognize that sustainability factors drive business
strategy.
In our
minds, the best businesses have always understood the importance
of culture and employees and ethics. And they get
it in their soul. But what’s now becoming true—particularly
for the industrials, the retailers, the pharmaceuticals, the
utilities, and a broader array of industries—is that
managers are realizing that there are broader factors affecting
how they operate. They can recognize that over the next 25
years their strategy will depend on leveraging new opportunities
and must operate within the changing context of business.
The
Quarterly: Can you give us an example?
Al
Gore: In Denmark, Novo Nordisk clearly gets this. They
take a holistic view and a long-term view. They look at the
whole system. Take their presence in China. They went into
China at a very early stage with genuine concern for what they
could do to help forestall the diabetes epidemic there, which
is growing at a faster rate than it is in the rest of the world
due to the transition to a Western diet and lifestyle.
Novo Nordisk
has 60 percent of the Chinese market for insulin and they’re
focusing their business plan on trying to cure and prevent
diabetes. If they succeed then presumably
sales of insulin will not increase at the current rate, but
they think the problem is large enough that it is more important
to address the root cause of the problem. This commitment comes
out of the phenomena that David was just describing to you.
The
Quarterly: Is this approach possible in all sectors? Clearly,
the pharmaceutical industry is an interesting case. Can you
get there in tobacco? Fast food? Or are these just sectors
that are fundamentally, somehow, no-go territory?
David
Blood: There are material sustainability challenges in all industries.
In the fast-food or food-manufacturing industry,
there’s a very strong move toward healthy living and
eating, organic food, and the implications for sustainable
agriculture. And how do food companies deal with the upstream
challenges of these trends, challenges such as water use? While
we don’t invest in it, the tobacco sector faces a whole
host of issues which are very much sustainability driven—not
just the health impact of the product. But, again, sustainable
agriculture is a big story, as is litigation risk. In another
sector, like financial services, the key sustainability issue
is how a company manages its human capital. In the energy sector,
climate change is one of the most significant issues. In the
health care sector, we look at ethical marketing practices
between companies and doctors. Even in industries like luxury
goods there are issues around excessive materialism, authenticity,
and consumption.
What I’m
describing here is what we call a materiality-based approach
to investing. Rather than looking at 50 different
tick-box sustainability criteria, we think you need to tackle
the three or four long-term issues that will really affect
corporate profitability.
The
Quarterly: What examples come to mind of companies that
have thought beyond managing sustainability risks and moved
on to creating revenue opportunities?
David
Blood: A company like Johnson Controls, for example, is interesting
because of its focus on demand-side energy efficiency.
About 50 percent of its business is batteries for hybrid cars
and products to run buildings efficiently, the other 50 percent
is automotive interiors and controls. We think it’s the
former that’s going to be growing and driving that company.
They understand that their products will help reduce their
clients’ environmental footprint. This strategy is completely
revenue driven. GE’s Ecomagination is another example.
If you think about how GE’s stock price is going to trade,
it’s going to trade primarily on growth. Jeffrey Immelt
knows this. He’s betting his reputation and his company
on the notion that the businesses related to the environment
will enable GE to grow faster than GDP. In Mexico we cover
two Mexican home builders that are linked to demographic trends
and to the very strong demand and need for affordable housing
in Mexico.
These are just some examples of how companies can see sustainability
trends as growth opportunities or as new niches for existing
products and services.
The
Quarterly: One of the important interfaces between the
investing world and management is the board. What role do boards
of directors play in trying to ensure that this kind of mind-set
is embedded in corporate activity and communicated to investors?
Al
Gore: I think that the board of directors has a growing
responsibility to address these very topics. As stewards of
shareholder interests, boards should be focused on the long-term
sustainability of the firm rather than on the market noise.
If I were on the board of a company doing business primarily
in the European Union, I would ask questions about how long
it will be before my fiduciary responsibility required attention
to the aggressive management of carbon. Because even though
natural resources are not depreciated and even though pollution
is treated as an externality and a reputation risk, where regulations
and laws are involved, pollution now has an economic cost.
And that cost is increasing.
The
Quarterly: Do you assess how the board compensates the
chief executive?
David
Blood: Remuneration is a very specific area that we look at. In
line with all the things we’ve already talked
about, perverse short-term incentives in the financial system
obviously are manifested at a corporate level by remuneration
structures.
The
Quarterly: What must CEOs do more of?
David
Blood: Some are taking on a host of issues and seeing the interlinkages,
but there’s an enormous segment that
is still single-issue focused. I think managing and understanding
climate risk is the first wedge into that. You would hope that
people then start to look at the second-order effects of climate
change. I think one of the biggest things that CEOs can do
is explain their longer-term story to the capital markets more
forcefully. Increasingly, the research community is interested
in the environmental, social, and governance factors that drive
company strategy and is integrating these factors into mainstream
research.
The
Quarterly: Can we explore climate change a bit more deeply?
How do you think about that from an investing standpoint and
what do you think that business should be doing that would
help not just with climate change but with investment returns?
Al
Gore: There is a big story and opportunity around the supply
side of cleaner energy. We would look for companies to recognize
that carbon constraints will be more aggressive in the future.
So we would expect to see opportunity in businesses that are
involved with lower-carbon energy, including renewable-energy
provision, such as wind, solar, and cellulosic ethanol2 production.
Or in businesses that are involved in cleaning up traditional
fossil energy, which we see as a very big trend. Or in companies
that are involved in technologies like carbon capture and storage
(CCS) and sequestration-ready power plants.3
The demand
side, we also think, is an underappreciated opportunity.
The efficiency of buildings—insulation, specifically—is
low-hanging fruit in terms of economic opportunity. The technology
has existed for some time; it just needs to be deployed and
implemented more effectively. There are also demand-side opportunities
around sustainable mobility and transportation—for example,
growth in hybrid vehicles or lightweight materials in vehicles.
The
Quarterly: What other indicators do you look for in gauging a company’s
approach to addressing a sustainability issue such as climate
change?
David
Blood: In addition to helping us assess the quality of a business
model, a company’s response to the climate
challenge can tell us an enormous amount about a management
team. We use its response and engagement in the issue as sort
of a litmus test or a lens into the quality of the team. A
company’s lobbying practices are also an interesting
line of inquiry around climate change. Auto companies are telling
people that they’re wonderfully green all of a sudden,
but it’s important to evaluate if they are concurrently
lobbying against emissions reductions, for example. That gets
you to the heart of what is the real truth in a company’s
culture. If they’re lobbying for something different
than what they’re telling everybody, you’ve got
a problem.
The
Quarterly: Any final thoughts for executives trying to
understand this trend toward sustainability investing?
Al
Gore: Be part of the solution and not part of the problem. Your
employees, your colleagues, your board, your investors,
your customers are all soon going to place a much higher value—and
the markets will soon place a much higher value—on an
assessment of how much you are a part of the solution to these
issues.
Notes
1 The research, summarized in “The McKinsey Global Survey
of Business Executives: Confidence Index, January 2006” (The
McKinsey Quarterly, Web exclusive, January 2006), indicates
that 84 percent of executives think business has a broader
contract with society.
2 Cellulosic ethanol is produced using enzymes to break down
vegetation into cellulose (the primary structural component
of plants), which is then converted into fuel.
3 Carbon capture and storage (CCS) is an approach to eliminating
carbon dioxide emissions from sources such as power plants
by capturing the carbon dioxide and then storing it underground
in deep geologic formations instead of releasing it into the
atmosphere. Sequestration-ready power plants have the appropriate
technology equipment and locations to perform CCS.
Lenny T. Mendonca is a director in McKinsey’s San Francisco office, and
Jeremy Oppenheim is a director in the London office. Petroleumworld
not necessarily share these views.
Editor's
Note:This article was published by The Mckinsey
Quarterly (Web
exclusive), May 2007.
The authors wish to acknowledge the contributions of Sheila
Bonini; Colin le Duc, the head of research at Generation; and
Lila Preston, an associate at Generation. Petroleumworld reprint
this article in the interest of our readers.
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comments posted and published on Petroleumworld, do not reflect
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