Managing Unknown Unknowns
The next frontier of ESG investing
This summer, with wildfires raging to the north, south and east of my home in California, my family and I found ourselves simultaneously sheltering from the coronavirus pandemic and preparing to evacuate at a moment’s notice. The fact that we understood the risks we were facing did not actually mitigate them. That comes from hand washing, wearing masks and doing our part to curb the greenhouse gases that contribute to extreme weather.
Investors, who look to environmental, social and governance (ESG) factors to better understand the risks to their portfolios, also confront the gap between knowing and doing. If the spread of wildfires, the arrival of a pandemic, or the sweep of calls for racial equality have taught us anything, it’s that the current state of ESG disclosure is woefully inadequate given the frequency and intensity of the issues we face in our society and economy.
Seemingly overnight we have entered an era of unknown unknowns. To navigate it, investors need not better reporting but the ability to assess the capacity of companies to build sustainable businesses for the long-term, regardless of what comes their way.
When I set out a decade ago to create what would become the Sustainability Accounting Standards Board (SASB), my colleagues and I researched the financial implications of thousands of ESG issues. We canvassed companies and investors for their views of financial materiality and consulted experts in science and measurement, all with the goal of cataloging issues likely to be material for each of 77 industries.
The framework that ensued took eight years to build and rests on the contribution of disclosure to an efficient market and price discovery. Thanks to SASB, investors can identify material issues within an industry and adjust their strategies accordingly. The standards offer a comprehensive collection of known unknowns.
Increasingly, however, changes in business and society force companies and investors to allocate resources based on future materiality. No longer is materiality a “state of being, as George Serafeim and I described in a paper published last year, but “a process of becoming.” Standardized ESG data doesn’t convey to investors how liminal issues will affect any particular company or whether (and how) such issues might affect the bottom line. Due to changing societal norms and unrelenting environmental forces, the speed with which material ESG issues manifest is incompatible with the years that it takes to shepherd a single market standard through research to stakeholder consultation to public comment to issuance.
Future-proofing
Increasingly, investors need to understand how a company will manage unknown unknowns. For a window into future materiality, look not to a company’s reporting prowess, but to its resilience. Is it built for the long-term? Does it operate against a long-term strategy? Does it have purpose at the core and an authentic commitment to stakeholders? A company’s capacity to be resilient lessens not only risks endemic to that company, but it also prepares companies to withstand risks that run society-wide. Risks such as climate change, pandemics or racial injustice are not correlated with one another, however, they affect more than 50% of a typical diversified portfolio and hence, investors cannot diversify them away. Investing in resilient companies is a mitigation strategy for both idiosyncratic and systematic risks.
Typical ESG data is first-order data: It shows a company’s performance on things such as greenhouse gas emissions or diversity, but it doesn’t tell us anything about a company’s capacity to manage these issues. Understanding risk should not be equated with managing risk — a mistake even BlackRock makes when calling for disclosure using SASB standards. For that, you need to understand second-order data. Information that sheds light on what’s driving performance. Resilience is second-order information that is truly forward looking. It tells you what trajectory a company is on. Resilient companies have a long term strategy, and invest against it. They align their resources with their priorities. Resilience appears in such markers as:
A transformative vision with social purpose at its core. Bigness of vision can create momentum that carries a company through tough times and volatile events. Employees, customers and investors rally around companies they want to succeed. Think Tesla, which makes cars with a mission to accelerate the planet’s transition to sustainable energy. (And has a legion of customers who showcase the cars on its behalf.)
Inventiveness. Prolific innovation confers competitive advantage. It shows up at the shoe company Allbirds, which has encouraged Amazon to steal its approach to sustainability. You see it at Roche, which has been alone among the big pharmaceutical companies in spending more on research and development than on marketing. Or think Apple, which spends more on R&D than it does on nearly anything.
A willingness to pivot… quickly. Companies built for resilience build on a foundation of data they can make sense of and act on quickly. Consider Square, which has configured itself to harness and act on information and speed decision-making. Since the start of the pandemic, that ability has enabled Square to swipe small-business deposits from banks.
A diverse culture. Companies gain a human capital advantage by building a culture that puts people first with diversity and inclusion at its core. Five years ago when Asana had 175 full-time employees, the software maker became one of the first tech companies of its size to create and fill a job for the head of diversity and inclusion. Or as the team at Ellevest, an investment platform for women, has noted, “fun stuff only matters when employees’ other needs are already being met — needs like feeling safe and valued, and understanding how their work fits in with the company’s priorities.”
Alignment with stakeholders. Companies that maintain resilience over the long-term pay attention to the role stakeholders play in their success. The shares of companies that acted to keep employees and workplaces safe during the pandemic, showed their commitment to suppliers, and repurposed products and services to address the needs of customers outperformed their industry peers, according to researchers at State Street and Harvard Business School. Now think of Wells Fargo and Boeing. If you’re aligned with customers, there’s no way you open fake accounts or put people on planes whose safety you have reason to question.
In the face of unknown unknowns, it may feel prudent to call for even more ESG disclosure. But companies that invest in reporting engines only create wealth for the information brokers. Investment in human capital, and climate programs, and innovation creates wealth for stakeholders and shareholders alike.
Resilient companies create resilient portfolios. Which is what long-term investors really need.