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By Nicolai Lundy
Nicolai Lundy is the Sustainability Accounting Standards Board Foundation’s Director of Education and Partnerships, where he identifies opportunities for financial reporting/accounting professionals, investment analysts, sustainability professionals, and securities lawyers to benefit from SASB’s research on material ESG factors across 79 industries. In doing so, he leads the membership, conference, and education programs as well as licensing and the SASB Navigator.
During an 18-month span from May 2011 to October 2012, U.S. truck engine manufacturer Navistar International Corp.’s share price collapsed from nearly $70 to $19—a 73 percent drop—while its two industry peers, Cummins Inc., and Paccar Inc., enjoyed revenue growth as they captured market share. Can the difference between these three competitors be explained based on their sustainability performance? And if so, are there broader implications about the importance of material sustainability information for efficient capital markets?
To answer the first question, consider what happened in 2010 in the U.S. heavy-duty diesel engine market. New U.S. Environmental Protection Agency (EPA) rules took effect, limiting the emissions of Nitrogen Oxides (NOx), among other pollutants. To meet these requirements, Cummins Inc., and Paccar Inc., as well as most other engine makers, opted to use a combination of two of the leading technologies for reducing NOx emissions. Navistar International Corp. implemented just one of those technologies with the stated belief that it would benefit customers. When the new EPA requirements took effect, emissions tests proved that Navistar’s strategy didn’t work. Its engines’ NOx emissions were more than twice the emissions of its two competitors’ engines and well above the EPA emissions limit. EPA is the source of the image below.
The emissions test failures didn’t impact Navistar immediately, but they soon dragged the company down. Navistar was allowed to sell its engines because of previously banked emissions credits and through paying penalties levied for every non-compliant engine sold as it worked to lower NOx emissions. Eventually, the company was running out of credits, and as warranty claims and penalties rose, market share dropped. After a $320 million GAAP pretax profit in FY 2011, Navistar posted a $1.1 billion loss in FY 2012 and its CEO resigned in August 2012. By Oct. 1, 2017, Navistar’s share price still hadn’t fully recovered, sitting at $44, and the stock hadn’t surpassed $45 since early 2012.
For the second image, key: CMI = Cummins; NAV = Navistar, PCAR = Paccar.
The different approaches Navistar and its competitors employed to manage performance on a sustainability-related issue—NOx emissions—had significant consequences. Navistar’s decision proved to be a risky one while Cummins’s and Paccar’s strategy became an opportunity to strengthen their business and grow their market share. This is not an isolated example. Every industry faces sustainability risks and opportunities, and how companies manage them can have material financial impacts.
Sustainability, in this case, is not recycling or composting or replacing light bulbs in your office. The Sustainability Accounting Standards Board (SASB) views sustainability in terms of environmental, social, and governance (ESG) factors that impact the ability of a company to create value over the long term. These factors vary from industry to industry, based on how companies create value.
SASB is funded in part by Bloomberg Philanthropies, and Michael Bloomberg, founder of the global business, financial information and news leader Bloomberg L.P., sits on SASB’s oversight board. Bloomberg BNA is an affiliate of Bloomberg L.P.
For truck engine manufacturing companies, management of factors such as engine emissions and fuel efficiency can impact growth projections. In the restaurant industry, management of factors such as food safety (think Chipotle’s recent e.coli and noro virus cases) and nutritional content are innately tied to business models and future cash flows. In the casino industry, management of factors such as detecting and preventing money laundering activities influences the equity risk premium.
Companies can and do manage their performance on these sustainability factors just as they manage sales performance and profitability. The difference is that performance on sustainability factors can’t always be easily or effectively quantified in financial figures. How could an investor understand a company’s food safety record by just looking at financial data? If two companies spend the same amount on food safety programs, that doesn’t tell the market whether one company has a higher food illness incidence rate.
Thanks to the growing recognition of the value of sustainability information in understanding a company’s performance, there has been a proliferation of sustainability data in the market. For example, 81 percent of the S&P 500 reported sustainability information in 2016, according to a report by the Governance & Accountability Institute, and the Bloomberg Professional Services provides sustainability data on more than 11,000 companies. While the volume of data has increased, the number of institutional investors who say they consider some level of sustainability information when analyzing companies, voting their proxies, and/or in their corporate engagement efforts, has soared. For example, over 1,700 investment firms, with $68 trillion assets under management, have signed the UN Principles for Responsible Investment. Recently, Bill McNabb, Chairman and CEO of Vanguard, published a letter to all directors of public companies encouraging them to embrace “disclosure of sustainability risks that bear on a company’s long-term value creation prospects.”
While a range of investors are increasingly interested in sustainability information, there are significant concerns about the availability, comparability, and quality of the data. In a 2017 EY report, only 12 percent of investors surveyed felt that companies adequately disclose sustainability risks; often the data isn’t available because it’s not reported. When companies report sustainability information, they don’t always use the same metrics, making it difficult or impossible to compare industry peers. In a 2016 PwC report , 92 percent of investors surveyed were dissatisfied with the ability to compare peer companies based on disclosed sustainability data. And companies and investors looking at the same data come to different conclusions about the quality of that data. In the same PwC report, 100 percent of companies were confident in the quality of sustainability information they report but only 29 percent of investors were confident in the quality of sustainability information they receive from companies.
The data availability, comparability, and quality problems have led to an inefficient market for companies and investors. Without a market standard for material sustainability information, companies indicate that they are bombarded with investor questionnaires and different reporting requests. In 2014, General Electric Co. responded to over 650 sustainability data requests, involving more than 75 people, with “virtually no value to [GE’s] customers or shareholders.” Companies are left to either pick and choose some data to report or not report at all and wait for a standard to emerge. This dynamic leads to data gaps, inconsistent metrics, and uncertain data quality, all of which hinders investors’ ability to analyze companies’ current performance and project future performance.
A market standard would establish the rules of the game. Companies would know what they should report and how to report it, and investors could use the reported data to compare industry peers. When companies and investors can agree on a market standard, each can focus on what they do best—companies can focus on managing limited resources to deliver shareholder value and investors can analyze material information to allocate capital effectively.
For a market standard to deliver on its potential, it needs to identify metrics that yield material information that is decision-useful to investors and cost-effective for reporters. These are the hallmarks of SASB’s standards, which are designed to solve today’s sustainability data problems. To identify what is decision-useful and cost-effective, SASB develops the standards based on market feedback; thousands of individuals and hundreds of companies, industry associations, and investors have provided feedback since 2012.
History shows us that the emergence of the Financial Accounting Standards Board (FASB) in the U.S. and the International Accounting Standards Board (IASB) internationally enabled consistently available, comparable, and high-quality financial data in the capital markets; SASB standards can do the same for material sustainability information by providing a standardized way for companies to comply with existing disclosure requirements for material information.
Looking back at our initial example of Navistar, Cummins, and Paccar: only one of the three companies disclosed emissions test results in the fiscal year 2010 Form 10-K: Navistar. The provisional SASB standard for the Industrial Machinery & Goods industry was not released until 2015, but if it had been in place at the time, and all three companies had reported on the SASB standard for NOx emissions, investors might have had a better window into the different approaches the companies took to managing performance in this area.
The consequences of today’s inefficient market for sustainability performance data are not limited to the past. Just look at the 2016 EPA fuel economy and CO2 emissions requirements: Ford and other automakers are struggling to meet those requirements.
Companies and investors will continue to face challenges to make informed decisions until they embrace a market standard for the sustainability factors that help companies deliver shareholder value over the long-term.
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