25 July 2018 by Daniel Godfrey
A sustainable, long-term approach to wealth creation has the potential to safeguard the future
Stewardship and sustainability. Environmental, social and governance – or ESG for short. Buzzwords that are increasingly frequently heard but where there is no commonly accepted definition. And we love to complicate things, ending up with good concepts that just scratch the surface of their potential.
We can be sure that whatever the codes, rules or laws introduced in an attempt to change behaviour, it is business that will drive outcomes. By definition then, boards and management need to use these concepts as a jumping-off point for thinking about their strategies and how they are going to be accountable for results.
Frameworks created by legislators, regulators or capital markets should ideally act as a blueprint for the board’s agendas and thinking, rather than a straitjacket. This ensures each board determines and articulates in their own way: the purpose of the company, their strategy for fulfilling that purpose, their objectives, targets and milestones, and the governance that they put in place to succeed. And that they are properly accountable to stakeholders for delivery.
Stewardship is the management of assets with the purpose of creating wealth sustainably for all stakeholders and of leaving those assets to the next generation of managers in better shape than they were found. In this definition, sustainability is implicit within the concept of stewardship and applies equally to asset owners and asset managers as it does to boards and executives.
The structure and accountability of the management of those assets defines the governance. Within that governance structure, management can have benign or malign impacts on environmental and social issues.
However, this is not new. Even several hundred years ago, farmers knew the importance of leaving fields fallow. Although they could have created more wealth that year by planting that field, it would come at a greater cost to the future. In the same way, there is controversy about many share buy-backs that may increase short-term earnings and share prices, in a way that feeds through to executive remuneration but may come at a cost to long-term investment and innovation.
“There needs to be universal recognition that the purpose of investment is sustainable wealth creation”
The focus and noise around stewardship, ESG and sustainability that we see and hear today reflect existential threats for humanity and could not be more important. If business is unable to manage assets to avert the worst climate change outcomes, humanity faces famine, disease and war.
If business in western democracies is unable to pay a fair living wage, improve living standards and provide opportunity to the majority, we face populism and reduced acceptance of the rights of others.
In the case of either or both, the likely consequence is a risk of massive depopulation events. This might remove the negative impact of human life on the rest of the biosphere but the quality of human life left behind would more like that in Mad Max than a new age of enlightenment.
It is all very well to paint a scary picture of the future, but boards and capital markets participants need to determine how they can play their part in creating a better one.
A necessary but insufficient first step is for there to be universal recognition that the purpose of investment is sustainable wealth creation, which has very powerful and positive benefits for the providers of capital. With over $30 trillion in global pension funds, the ultimate beneficiaries and providers of a big proportion of global capital are workers.
For individuals, sustainable wealth creation, brought about by good stewardship is extraordinarily beneficial. It enables them to ride out unexpected financial shocks with obvious benefits for reduced stress, wellbeing and the quality of their relationships; it enables them to buy and to do the things they dream of; and it provides them with a decent standard of living as they get older, crucially, in a world that is worth living in.
At the same time, stewardship that is successful in creating wealth sustainably has profoundly positive impacts on society. It backs enterprises that care about the environment, communities and suppliers, invest in human capital, innovation and R&D, focus on optimising long-term total return, and reduce pay inequality and pay a fair share of tax.
The only way to improve productivity is through long-term investment – whether in people or innovation in the broadest sense. Improved productivity leads to improved profits, GDP growth and to tax revenues that underpin education, infrastructure and the welfare state.
The problem is that while the purpose of investment might objectively be sustainable wealth creation, it is not the prevailing purpose of the investment and capital markets.
The big prizes are not awarded based on measures of the amount of sustainable wealth created over the last decade and more. The measure of sustainable wealth creation is long term, cumulative and absolute total return. However, because this is not the operating mode for investment and capital markets, the business environment has become infected with success being measured by short-term and/or relative return incentives.
Focus on short-term relative, rather than long-term absolute, means we have a dysfunctional capital and investment market that carries a significant opportunity cost to long-term, absolute, cumulative returns. Investors could do so much better and so could society.
This is absolutely not a trade-off, exchanging a little lower return for a better world. It is illogical to think that optimising over a sequence of short terms can have a better long-term outcome than a focus on the long term in the first place.
This problem is affecting the whole investment chain from the point at which capital is committed by or on behalf of an ultimate beneficiary to the point at which it’s deployed by business. Although every link in the chain tends to recognise the imperfection of where we are, they rue their lack of agency to change things on their own.
Boards complain about asset managers and sell-side analysts only caring about the next quarter. Asset managers complain about ‘greedy’ executive management, short-term investment consultants and asset owners who talk the talk but who always have ESG at the bottom of the agenda at meetings. And asset owners complain that asset managers will not do the stewardship job properly. In reality, everyone is to blame.
The answer to this issue is time horizons. The ultimate beneficiaries of all this activity are going to be accumulating and living off this capital for many decades. If the investment chain could realign its operating model around those objective long-term interests of the beneficiaries, then focusing on stewardship would become central to everything, rather than the veneer it so often is today.
“Stewardship that is successful in creating wealth sustainably has a profoundly positive impact on society”
Passive managers cannot sell, so they need to use their considerable clout to work with boards to help companies focus on long-term sustainable wealth creation. Some already do great work but even they could do more.
Active managers need to break free of the tyranny of objectives that are defined relative to an index benchmark. Over long periods of time, beating an index should be a consequence of the way they deploy and steward investor capital, but the objective should be to identify great opportunities and to steward them well. As soon as the objective is defined relative to an index, focus necessarily becomes short-term price, at a cost to long-term value.
Finally, both capital market participants and corporate executives should break the system of performance-related pay. If people were just paid salaries and given shares every month, restricted for ten-years plus, their incentives would be aligned to long-term stewardship outcomes.
This would then allow boards and managers to retake accountability for performance management through discussions of progress on strategy, measures, milestones and targets. These would be the correct starting point for the performance conversation, not an arbitrary precipice for success or failure.
Successful, sustainable wealth creation has the potential to change the world for the better. We will not avert catastrophic climate change without it, nor will we generate the productivity growth needed to share wealth more fairly without long-term investment and hard work.
Unfortunately, no single link in the chain has the agency to go it alone. Yet every link can take responsibility for standing up and telling their clients and suppliers they are willing and eager – if they are permitted to do so.
From the perspective of boards, this means formulating long-term strategy in the context of long-term sustainable wealth creation, eliminating focus on short-term financial metrics and selling it to asset owners and asset managers.
Being willing to see some shareholders sell down if necessary and to find new ones who share the vision, and, ultimately being willing to fall on their sword if they cannot generate sufficient support for the vision in which they believe.
Boards, capital markets and the investment chain have the power quite literally to save the world.