Here is an excerpt from an article written by Sean Brown and Robin Nuttall for the McKinsey Quarterly, published by McKinsey & Company. To read the complete article, check out others, learn more about the firm, and sign up for email alerts, please click here.
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Sean Brown: What role are investors playing in this push for more balanced capitalism and what do they want to see?
Rupert Younger: The interesting development is that shareholders are in the vanguard of the movement for purpose, and certainly for ESG adoption. Last year, we convened 31 asset owners and managers, some of the biggest names in the world, to help us think through these issues. Five big themes emerged. The first is having clarity on what matters. Investors are not interested in frothy statements but in understanding how purpose is material to the performance of the business. The second is evidence of metrics. Investors want businesses to be much clearer on why purposeful activity produces business outcomes. They also want to see how senior-executive teams are aligned through their incentive systems to deliver purposeful activity. The fourth area is how purpose informs capital allocation decisions, both financial and human capital. The final concern is standardization of reporting. There has been an explosion of different reporting mechanisms, which is not necessarily helpful, but as in any new frontier, you will start to see coalescing around the most powerful and easy-to-adopt standards.
Sean Brown: How exactly do purpose and ESG interrelate?
Robin Nuttall: We think about it as a grid with two axes. On one axis is whether you have strong or poor ESG performance and on the other is your purpose that sets your “North Star.” You need to make sure that your ESG commitments deliver on the goals your purpose sets. The pitfall is that you may state a purpose but have no plan to deliver on it, or you may have a plethora of ESG programs, but nothing ties them together in terms of that North Star.
Sean Brown: How does that alignment influence financial performance? Rupert, you and your Oxford University colleagues have looked at the links between ESG and value creation.
Rupert Younger: We looked at companies on the NYSE and Nasdaq that had strong ESG records at the start of the pandemic, both when markets started to collapse and from March 23rd onward, when the markets began to recover. In both of those periods, companies with better ESG records outperformed those with low records. We did the usual regressions, even accounting for changes in ownership and optimality levels, and saw the same outperformance, both in falling and rising markets. The work done by George Serafeim at Harvard and by others also strongly links purposeful activity with productivity and performance improvements driven by employee engagement. The point is that purpose does not come at the expense of profitability but, in many cases, drives outperformance.
Sean Brown: What is behind this higher capital-markets performance by ESG-focused companies?
Robin Nuttall: We talked about topline growth and customer preferences, whether that is consumers or businesses or governments—you increasingly need sustainable business models to win government contracts. There is also an advantage of having better relationships with regulators if you articulate your societal impact clearly. You can also gain higher resource efficiency. A green supply chain is often a lean supply chain as you remove redundancy and waste. Finally, as Rupert mentioned, you attract better talent and raise productivity. All this can translate into an advantage in the capital markets.
Sean Brown: Companies have to make trade-offs to create more sustainable practices, whether that is making investments or forgoing business opportunities. How do you find them approaching those?
Robin Nuttall: In the near term, there are very real trade-offs. We have developed a model that can help executives and boards with these decisions. It revolves around what we call the 5Ps. First, do your portfolio and products reflect your purpose? CVS Pharmacy famously stopped selling tobacco as it adopted a health-oriented purpose. Number two, people and culture: are you aligning your recruiting and promotion decisions? Thirdly, processes and systems: are you embedding purpose into your supply chain and capital allocation?
Then you have performance metrics and, lastly, positions and engagement. What is your external position? Some oil and gas companies recently withdrew from trade associations whose positions did not reconcile with the companies’ new purpose statements.
We are starting to see industries take an end-to-end view through these lenses. Some energy companies have fully adopted the 5P model. It starts with the portfolio strategy where they divest high-carbon assets and shift toward renewables. They have started embedding purpose in their people and culture, in how they attract and retain talent. They are driving out methane emissions from their operational processes and applying metrics that fit with their purpose, such as greenhouse-gas targets wired into manager incentives. And, as I mentioned, their purpose affects their external affiliations.
Sean Brown: What role are boards playing in fostering this focus on purpose in the organizations?
Rupert Younger: Purposeful activity needs to be well governed. The Enacting Purpose Initiative has put forward a framework called the SCORE model to help boards oversee purpose, and it comprises five simple questions [exhibit]. First, is your purpose simple enough to be understood by everyone? Organizations often overcomplicate. If purpose is to be meaningful, it needs to connect to every level and function in the organization. The second is how does it connect to your strategy? If boards think of purpose as a marketing or cultural driver, that will not deliver its full value. Purpose has to drive strategy and connect why you exist as a company to the choices you make. The third question is about ownership. How is purpose lived, owned, and brought to life within the organization, and who owns it?
The fourth area covers the reward system, and not just in terms of financial rewards but also promotion and opportunities to work on teams and projects. The final area, which emerged out of our meetings with senior board directors and investors, is the power of storytelling. The human race has long built connections through stories. When people talk about purposeful activity around the watercooler and share examples throughout the organization, that can be a powerful way of turning purpose intent into purpose action.
Sean Brown: How are companies aligning executive rewards and incentives with the corporate purpose?
Robin Nuttall: A recent study found that 29 percent of companies now include various ESG metrics in their incentive plans, up from 22 percent a year ago. So just as COVID-19 has accelerated sustainable investing, it has accelerated action on this topic. The areas with the strongest focus are social metrics, such as diversity and inclusion, with more than 88 percent of companies linking compensation to social and people metrics.
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Here is a direct link to the complete article.
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