Accounting for natural capital on financial exchanges

Maliau Falls in Borneo. The global economy depends on natural capital such as freshwater. Photo by: Rhett A. Butler.

Last month, Norway’s stock exchange, the Oslo Børs, introduced a way for investors to use their money to promote sustainability. A new list by the stock exchange highlights green bonds, financial products issued by companies to raise capital for environmentally friendly projects. Notably, the list requires that issuing companies obtain and publicize outside opinions on the projects’ environmental features. Børs executives said they expect the new list to attract investors and make companies aware of opportunities arising from green projects.



Norway’s green bond list is the first of its kind in the global financial system, but it is part of a broader trend. Momentum to incorporate information about usage of natural capital—air, water, land, and biodiversity generating valuable ecosystem goods and services—into standards for publicly listed companies has been building for years.



“You can no longer just turn a blind eye to the fact that [natural] resources are dwindling and you don’t have an unlimited supply of these things to use for business free of charge,” said Evan Harvey, director of corporate responsibility at Nasdaq.



Proponents of the effort seek to ensure that investors have access to complete information, companies have sustained access to resources they need, and more of the world’s money is put to work for social and environmental outcomes. Forbes recognized Sustainable Stock Exchanges—a public-private effort to advance sustainability reporting by publicly listed companies—as one of the best financial ideas of 2011. But others still dismiss the idea of natural capital as outside the scope of the financial system.



The financial exchange landscape




Peat forest in Sumatra. Peat forest store massive amounts of carbon, but are being destroyed by logging and agricultural companies. Photo by: Rhett A. Butler.

A financial exchange is an institutional marketplace in which buyers (any entity with funds, from individuals to banks to governments) and sellers (such as companies, banks, and governments) make trades based on current needs and anticipated future payouts. A company or government raises funds to finance projects from institutions and individuals in exchange for a financial instrument, either a share of ownership in the company (a stock), a reliable future payout with interest (a bond), a physical resource for use in production (a commodity), or the guarantee or right to buy or sell a security at a later date (futures and options). In efficient markets, securities are priced to reflect their fundamental economic value, with such prices incorporating all relevant public information as soon as it becomes available.



Such marketplaces facilitate and drive much of the economic activity in the world. There are approximately 65 financial exchanges globally. The New York Stock Exchange, the largest equity exchange in the world, lists 1,867 companies collectively worth $16.613 trillion. Most exchanges require listed companies to issue regular financial reports that provide important information and prove a company is not fraudulent. These requirements are part of a set of standards for company participation called listing standards.



But some investors are now calling on exchanges to add listing standards that include natural capital criteria. They are also demanding regulators require such standards. An example would be requiring every company on an exchange to report its greenhouse gas (GHG) emissions and its strategic plan for decreasing emissions in line with scientific guidelines.

Critics of the current system say the market cannot accurately price securities when companies don’t publicly disclose information about resource use and sustainability. A major barrier to this, however, is that many firms do not measure sustainability issues at all, so this information is not even available to internal managers tasked with long-term planning.



The rise of sustainability listing standards?



Listing standards tied to environmental, social, and governance (ESG) reporting could close this information gap. ESG are a set of factors that convey information about a company’s impacts, such as ethics, workplace safety, international operations and human rights, produce impact, water use, GHG emissions, community relations, indigenous peoples’ rights, gender and board diversity, and executive compensation. In other words, ESG describes aspects of a company’s operations that can profoundly affect its financial and non-financial outcomes.



Investors can use ESG reporting to evaluate whether investments can avoid negative impacts or create positive impacts around the world while achieving competitive returns. Measuring ESG issues also gives investors a more complete picture of a company’s or financial index’s sustainability profile—according to supporters, not only its environmental, social, and governance-related sustainability, but its financial sustainability as well.




School of black trevally. Many of the world’s fisheries have collapsed due to overexploitation and poor management. Photo by: Rhett A. Butler.



“I don’t understand why anyone wouldn’t want more ESG information about companies. If they’re finding ways to outperform their competitors in these areas, you can be darn sure they’re outperforming their competitors in other ways,” said Harvey.

The Forum for Sustainable and Responsible Investing reported that as of 2014, roughly one in six dollars invested in the U.S. is employing sustainable, responsible, and impact (SRI) investing principles, including funds divested from the “sin stocks” of alcohol, tobacco, and firearms. From 2012 to 2014, the number of ESG mutual funds increased from 333 to 456 and assets represented doubled to $1.93 trillion. Still, only three percent of the world’s largest listed companies, those worth $2 billion and more, report on basic sustainability measures including employee turnover, energy, GHG emissions, injury rate, payroll, water consumption, and waste.



Linking access to capital markets with ESG standards—whether requiring companies to simply disclose ESG data or actually meet specific goals—would raise the profile of sustainability issues as material concerns, those relevant for a company’s bottom line. Currently, reporting on governance is the most sophisticated and prevalent among public companies, while environmental metrics are growing in use and reliability, and social metrics are the least developed, according to Harvey.



Greater transparency on these issues would provide investors with a more complete understanding of the risks, including the non-financial risks, facing a company, according to a report by the United Nations Environment Programme (UNEP), the Global Reporting Initiative (GRI), KPMG, and the Centre for Corporate Governance in Africa. In 2010, the U.S. Securities and Exchange Commission recognized climate change as a material concern and issued guidance requiring publicly traded companies to disclose climate-related material risks.



Disclosure and financial performance



Natural capital issues concerning air, water, land-use, and biodiversity provide particularly fertile soil for ESG standards implementation. Voluntary disclosure can only go so far, as companies bear the full cost of disclosure and conservation efforts while the burden of environmental harm is broadly distributed – regardless of who is responsible for causing it. Today, only 39 percent of the world’s largest listed companies report on GHG emissions and only a quarter report on water usage. On average, six percent of an exchange’s listed companies report on raw material usage.



Evan Harvey notes that although some companies ignoring ESG criteria may profit in the short term, the lack of integration will harm them in the long term. Investors that believe in the long-term success of a company will enable that company to weather a bad quarter, he said.




Green bright-eyed frog (Boophis viridis) in Madagascar. Scientists have been warning for decades of a looming possible mass extinction if business as usual continues. Photo by: Rhett A. Butler.



On the other hand, Harvey said, “if you court short-term investors by constantly producing and promoting short-term values, you get what you deserve.”

The data suggests that Harvey is correct. There is evidence that disclosure correlates with superior financial performance. The Carbon Disclosure Project (CDP) found that S&P 500 companies that rank highest in transparency and active planning for climate change enjoy 50 percent less volatile earnings than peers who do not set similarly high standards. They also generate 18 percent higher return on equity (ROE) than these peers and 67 percent higher ROE than companies that do not report to CDP.



Existing ESG listing standards



Listing standards that compel companies to account for natural capital usage already exist. There are 180 policies on sustainability disclosure in 45 countries and regions around the world, 72 percent of which are mandatory. But as of yet, there remain no universal standards for disclosure of natural capital on exchanges. Different laws and standards apply to different types of financial vehicles, from publicly traded equities to corporate or government bonds, derivatives, and commodities.



A report by Corporate Knights Capital, an investment advisory firm focused on corporate sustainability, ranked the Helsinki Stock Exchange as the stock exchange that most incorporates sustainability. Of its 23 large listings, 21 disclose payroll data, 20 greenhouse gas emissions, and 19 energy use.



Most of the top ten ranked exchanges are European, but the Johannesburg Stock Exchange (JSE) —the only emerging market exchange in the top ten—ranks third. This ranking can be linked, at least partially, to South Africa’s 2009 King Code of Governance (King III), which requires all institutions, including all JSE-listed companies, to comply with certain standards of sustainability and corporate governance and emphasize all stakeholders, not just shareholders. Since 2004, the JSE has also offered a Socially Responsible Investment Index, reviewed annually to meet rigorous ESG and climate change standards.




Haze from a forest fire in Australia. As global warming ramps up scientists warn of increased droughts and forest fires. Photo by: Rhett A. Butler.



Other leaders are emerging from around the world: Bovespa, the Brazilian stock exchange and the largest in Latin America, became the first exchange to sign the UN Global Compact in 2004 and commit to ten human rights, labor, environmental, and anti-corruption principles. It was the first Latin American exchange to introduce a Corporate Sustainability index in 2005. Bovespa’s Novo Valor initiative promotes sustainability internally and in the capital markets.



The Australian Securities Exchange (ASX), ranked tenth in the Corporate Knights Capital report, requires all listed companies to disclose their efforts to manage sustainability risks—including environmental, social, and economic—or explain why they have not undertaken efforts to do so.



The Singapore Exchange (SGX) also has a “comply or explain” policy and makes companies’ boards of directors responsible for “holistic integration of environmental, social and governance considerations in the company’s strategy.”



Organized efforts to promote ESG integration



Globally, part of the effort to advance ESG criteria as fiscally sound policy are industry working groups and other public and private institutional efforts. The UN Sustainable Stock Exchange Initiative
convenes financial exchanges, policymakers, investors, regulators, and companies to voluntarily commit to sustainable business practices and responsible investing. It promotes corporate transparency and financial performance—already established goals in the realm of financial exchanges—but also emphasizes long-term financial sustainability stemming from investments that are safe because they incorporate ESG standards. Sixteen stock exchanges have elected to join the SSE Initiative to work together on developing sustainability reporting that makes sense for each exchange. As of 2014, those 16 exchanges include 17,000 companies representing $36 trillion.



The Climate Disclosure Standards Board (CDSB)
a group of businesses and environmental organizations working to promote corporate recognition of environmental issues, grew out of the 2007 World Economic Forum meeting. The CDSB is working on creating an “international reporting framework for the integration of climate change and environmental information into mainstream corporate reports,” aiming to standardize ESG disclosure in light of the lack of international agreements on the issue.



The Ceres Investor Network on Climate Risk (INCR),formed in 2003, connects more than 100 institutional investors representing $13 trillion to mitigate risks and take advantage of opportunities arising from climate change through changing internal practices and practicing shareholder advocacy.



The most recent significant addition to this field is the World Federation of Exchanges’ Sustainability Working Group, formed in March 2014. Representatives of dozens of global exchanges convene to build consensus around how they should address ESG issues.




Oil palm plantation worker. The oil palm industry has been hit by allegations of poor working conditions. Photo by: Rhett A. Butler.



“Most regulators have not addressed this issue effectively,” said Harvey, who is also the chairman of the Working Group. Financial exchanges “are going to be part of the solution,” he added. “We need to act now together to find a way for public companies to be better corporate citizens.”



According to Harvey, the group is considering every possibility “to get more valuable, more vetted ESG standards into the hands of the investing public,” including voluntary standards, requirements, and comply or explain. He emphasized the importance of looking beyond quarterly deliverables.



“We’ve moved past the era now of just evaluating financials,” he said. “You need to look at more measures of company health than just the financial health. Oil companies look great right now, but what’s that going to look like in 20 years?”



The Sustainability Working Group will publish recommendations for exchanges this year. Harvey said, however, that ESG standards can be more effective when mandated by large-scale and institutional investors instead of stock exchanges. A public company has the option to list on a different, less regulated exchange, but it is always beholden to its investors.



Future prospects



Eighty percent of companies are not effectively incorporating sustainability criteria into operations and reporting, according to Harvey. Some of these companies, he said, have “clung on to this ridiculous mythology” that ESG reporting is too costly or time-consuming. The 20 percent that see ESG as integral to a successful future, however, include “hugely influential companies [that] tend to be able to drive change,” noted Harvey.



The growing call to action argues that incorporating apparently non-financial issues into companies’ decision-making processes will actually yield better financial outcomes. Concerned citizens might push for the adoption of ESG standards because they care about forest preservation or stopping human trafficking – or because they see that the futures of their investments are tied to a company’s access to natural capital. But this issue is not just the purview of activists.



Global institutions, national and local governments, and established corporations are recognizing that in order to deliver expected financial returns in the long run, all the factors that affect a company – from the coastal land its corporate headquarters are on to the people that work in its factories – must be taken into account. The debate about the relevance of ESG standards to a company’s bottom line is inextricably linked to efforts to do so.

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