Sustainability and Governance: Five Years into the Financial Crisis
White Papers | November, 2013
Following the financial crisis of 2008, the quarter to quarter survival of companies, banking institutions and national governments took the stage from evolving initiatives such as corporate sustainability, management of natural resources and innovation in sustainable business operations. As the global economy moves well into its fifth year of stagnation and record lows in work force participation rates, we have entered a new normal of economic conditions. Given the continued drag on the global economy, DHR International undertook a senior leadership assessment on where sustainability issues fit into corporate governance and strategic priorities today.
To capture the evolving dialogue, DHR International began a series of CEO and non-executive chairmen discussions on corporate governance and sustainability. What began as a conversation with leaders challenged by right to operate issues transformed into a broader survey of nearly 200 CEOS, COOs, non-executive chairman and lead independent directors. In this effort, DHR International set out to determine the current state of governance and sustainability with two key questions in mind:
- Where does sustainability fit in corporate governance, alongside financial audit and other risk management concerns?
- Where does sustainability intersect with innovation, procurement and customer preferences as a strategic business pillar?
In our survey, we found these issues to be central to boardroom discussions of sustainability, and we identified four general outlooks among organizations:
- Sustainability and resource availability is a strategic imperative for operation.
- Sustainability is a matter of business strategy.
- Sustainability is both a right to operate and financial issue.
- Only a small segment of the market and consumers reward sustainable practices and products with a premium.
In this paper, we will present key insights from our survey and share perspectives from business leaders who agreed to participate in an in-depth interview with our research team. We rely on their examples as well as secondary resources to show what levers are driving sustainability in governance and how non-executive directors and senior executives can develop sustainability platforms that make business sense.
I. The Survey Results: Four Key Insights
For our investigation, we created a 14 question survey focused on corporate governance, performance management, accountability and customer demand regarding sustainability and sustainable business practices.
Within our interview and survey group, nearly 25 percent of respondents represented consumer products or retail services businesses; about one-third of respondents represented the engineered materials and infrastructure sector; approximately 20 percent of executives and directors surveyed represented durable goods or products manufacturers and nearly 10 percent of respondents represented financial services banking and professional services sectors.
After a thorough analysis of the survey results, we identified four key insights regarding sustainability and governance:
- Sustainability is a key governance issue for companies that require significant resource intensity and necessitates active board and management involvement. Water and energy availability and development were viewed as two strategic imperatives for nearly 80 percent of respondents.
- Suppliers and companies in nearly every category can find and produce niche sustainable products as a segment of their overall customer offer. On this nearly every executive surveyed agreed and the profitability of such products when constrained to real demand is quite high. More than 85 percent of respondents agreed this is an ongoing topic in the board room as well as the leadership team.
- Sustainability reporting is becoming a greater part of corporate governance and the annual sustainability report requires the same level of diligence and oversight as the annual financial report. Less than 5 percent of companies responding to the survey fail to complete an annual sustainability report that is approved by the board of directors.
- Accountability for sustainability performance resides with the CEO and direct P&L leaders. Customers, regulators and shareholders do not view this as a “staff responsibility.” While monitoring and reporting may be performed by staff leaders and outside auditors, actual performance results are imbedded with business leaders. The analogy was drawn much the same way as financial performance in which the CFO measures financial performance but the CEO owns it. Nearly every CEO interviewed and all non-executive chairman (seven where role separated) held the CEO directly responsible for sustainability performance, not the CSO or senior environmental executive.
II. Approaches to Sustainability: Three Perspectives
Our survey results suggest that resource availability, business strategy and accountability are at the heart of boardroom discussion. Furthermore, we identified three distinct ways that corporations choose to engage with the sustainability:
- Amongst a significant subset of respondents, many company board and executive teams viewed sustainability as a “cost of doing business” in a dynamic regulatory environment. They expressed frustration with policy and regulatory regimes that have no implementation orthodoxy or fail to acknowledge technology gaps that render renewable energy targets, carbon emission reduction targets and material recycling objectives as unachievable with underlying technological and systemic solutions. In this challenging economic climate, their frustration has only grown. Jeff Greene, CEO of Consolidated Container (a leading consumer packaging provider and supply chain partner) captured the view of many executives and directors in this subset:
“Sustainability efforts must consider all factors related to package design and its performance in the field, to fully capture the intended benefits and succeed. Business boards and executives must guard against unintended erosion of economic value that can result from secondary consequences not considered. We have had customer’s comply with their customers’ requests for incremental improvements that have led to serious issues, such as a reduction in packaging shelf life. The remediation efforts associated with outcomes such as this had far greater negative one-time impact than the best case benefits projected over the life cycle of the entire product category.” - Jeff Greene, CEO, Consolidated Container
- Our second subset of respondents approached sustainability as a business strategy rather than a governance priority. They focused on consumer preferences and specifications, what customers are willing to pay for and procurement mandates for being able to sell and market products based on content and consumption data. They find mixed results. With consumer goods and big ticket durable goods items, affluent customers have an imbedded price point for “sustainable” features, but in many cases they confuse terminology. Organic food, for instance, isn’t necessarily sustainable but many consumers seem to equate the two. Jim Twining , CEO of Southern Tide (a leading branded apparel manufacturer and marketer) reflected the view of many executives who have done detailed analysis on customer preference and pricing in sustainable and “homegrown” product marketing as a strategic initiative:
“Consumer preference is challenging with regards to issues such as sustainability and ‘Made in the USA.’ While very emotive, the actual market for products designed with this as a key selling point represents a single digit part of the market. And we have to be careful. In many cases best use and greatest benefit are not as advertised due to unintended consequences. Using fiber or materials for one product at the expense of a more effective solution or preventing use in other products can be far more damaging than the expected benefit.” - Jim Twining, CEO, Southern Tide
- A third subset of respondents emphasized the strategic imperative of being able to operate with challenging future resource constraints. Nearly all respondents in this overlapping group concluded that energy and water were going to be key business drivers over the next decade and in almost all cases had created sustainability or stewardship committees on the board to address this issue from a strategic and management oversight perspective. In dealing with this specific concern, boards either mandated or approved specific management structures and compensation measures to incentivize sustainable business metrics and performance. Ward Nye, CEO of Martin Marietta Materials (an industry leader in building and construction materials) provided key insights reflective of this group:
“For our team at Martin Marietta Materials the challenges faced during the economic downturn have been extraordinary. Housing starts dropped from a peak of over 2 million to less than 1 million in a rapid descent; commercial construction followed housing into the abyss. These two end-uses together normally comprise around 45% of our annual aggregate volume. Thus, sustainability for us has been about maintaining and enhancing our core business operations. By doing so in a safe and disciplined manner, we continued to be financially profitable during this challenging period. But in the final analysis, without profitability a business cannot survive to provide the supporting benefits to its surrounding communities. That is what sustainability means for Martin Marietta — today and for the future.
- As we look to the next decade, water supply and overall logistics will be critical components as we make market decisions. To be clear: without our capabilities and those of our sector, key infrastructure, roads, and development simply cannot occur. As a business and society, we must be vigilant in maintaining logistics efficiencies and water supplies. If society arrives at a philosophical place where efficiently moving goods, services and people are no longer viewed as an imperative, our U.S. economy is going to continue to suffer mightily.” - Ward Nye, CEO, Martin Marietta Materials
By examining several case studies and reviewing the latest research on finite resources, green business strategy and corporate accountability, we will see how our key insights and these approaches to sustainability play out in real businesses.
III. The Strategic Imperative of Finite Resources: Energy and Water
Projections of energy and water use, technological advancement and the political dimensions of finite resources weigh heavily on companies like MasTec, a multinational infrastructure engineering and construction company with more than 13,000 employees in North America. As COO Bob Apple explained, “We continue to see the challenges facing sustainable growth being driven by a lack of National Energy Policy and a failure to understand the implications of energy and water use with goals for changes in consumption patterns and sources not tied to actual technology capability. This is a significant strategic business challenge facing the board room and the operating business for us directly and nearly all of our business partners.”
Bob Apple’s comment speaks to three elements of resource sustainability:
- Business growth demands an adequate flow of natural resources at an affordable price
- Environmental policy may fail to acknowledge the current state of technology
- Domestic and international politics can dramatically affect both of the above elements
On an international scale, demand and access to energy varies greatly. According to the International Energy Agency (IEA) 2012 report, global energy demand is set to rise by one-third between 2010 and 2035, and demand is driven primarily by non-OECD countries. India’s energy demands will more than double over this time period while China will see 60 percent growth. In contrast, OECD demand is only expected to grow by three percent. So far, this dynamic has produced unusually high volatility in international hydrocarbons markets and has accelerated the development of enhanced recovery techniques like hydraulic fracturing, or ‘fracking’.
On a country-by-country basis, the energy squeeze has varied effects. China, for instance, has coordinated foreign policy with the interests of national energy companies to secure and develop fossil fuel reserves in Central Asia and Africa. In contrast, many experts suggest that through coordinated efforts to boost domestic fossil fuel production, introduce more renewable energy and improve efficiency, a coordinated US National Energy Policy could relieve American businesses from the volatility and political insecurities China fears. As a result of evolved technologies in hydraulic fracturing (‘fracking’) the US should overtake Saudi Arabian oil production by 2020 and become a net hydrocarbons exporter by 2030.
However, projections of global energy use assume future improvements in energy efficiency. The BP Energy Outlook 2030 predicts that global energy intensity will be 31 percent lower in 2030 than 2011 — without this advancement though, the report says that global energy supply would have to double, rather than increase by 36 percent to meet demand.
In other words, energy security for the global economy requires technology that does not yet exist. At the same time, new technologies like hydraulic fracturing have generated sharp opposition. Public advocacy groups have raised significant concerns regarding fracking techniques and potential contamination of fresh water reserves and the water table. For multinational companies, the global pressure on energy supplies, dependence on innovation and the risk of regulation is less than comforting.
With regard to fresh water supply, American corporations may face even greater uncertainty. Globally, by 2030 the Water Resource Group expects demand for fresh water to exceed supply by 40 percent. The United States will not be immune to this pressure.
The scale of water use and depletion in the U.S. is staggering. From 1900 to 2008, the US Geological Survey estimates that U.S. groundwater reserves dropped by 264 trillion gallons and the rate of depletion was three times higher than average between 2000 and 2008. The Ogallala Aquifer, which supplies 30 percent of the nation’s irrigated groundwater, could be depleted by 2060. Furthermore, researchers found that farmers in California’s Central Valley, considered the nation’s “fruit and vegetable basket,” used enough water during the 2006-2009 drought to fill Lake Mead, America’s largest man-made reservoir. As with fossil fuels, the country has yet to see a coordinated national policy or serious effort to address this issue.
As Bob Apple suggests, the future of energy and water create a great deal of uncertainty in the boardroom. American self-sufficiency in energy appears to be on the horizon, but how soon? Will carbon emissions regulation precede the availability of technology that can improve efficiency? With political instability in the Persian Gulf and volatility in hydrocarbon prices, can organizations expect to purchase energy at an affordable price? If certain American watersheds begin to fail, can organizations bring water from more reliable sources? These questions remain at the center of boardroom discussions.
IV. Sustainability as a Business Strategy: Earth Choice Paper
While resource constraints turn sustainability into a strategic imperative for some organizations, others can make sustainability a business strategy. By producing niche goods for a sustainable use, socially conscious and typically affluent market, businesses can in fact profit from sustainable product development and marketing.
The Earth Choice paper brand, produced, marketed and sold by Domtar Corporation, is a current example of how companies can align sustainability and financial performance. Earth Choice is a category leader in uncoated, free sheet paper for office, home and commercial printing.
Unlike most natural resources based industries, forest products and paper makers have two incredible resource advantages. First, the majority of their raw materials are made from trees and other crop fiber sources such as cotton, all of which are crops and can be harvested and regrown, unlike metals, earth or rock. Second, an intensive industrial and consumer recycling campaign for paper products has been a phenomenal success across nearly every economy, creating a virtual closed-loop supply chain for a significant portion of the industry.
Unfortunately, no industry has been less successful in marketing the renewable resource message and sustainable product value proposition than the forest products industry. Over the last 20 years, the industry found itself in conflict with special interest groups over competing certification standards for renewable forestry products. Strategically, Domtar adopted a middle ground Forest Stewardship Council (FSC) standard and partnered with the World Wildlife Fund to pioneer product introduction that segmented 100 percent FSC certified paper products, 100 percent FSC certified and post-consumer waste paper products and 100 percent recycled paper products all at different price points. This segmentation and pricing strategy has given businesses and consumers a choice in how they purchase paper, and Domtar stock skyrocketed from $7 a share to $75 a share during the economic crisis.
Not only did Domtar create a sustainable products platform, but just as importantly, they created a world-class education and awareness program involving internal employee champions called Earth Choice Ambassadors. Moreover, they created an online education program for school students called the Forest Academy, which provides an authentic message about stewardship and sustainability in the forest products industry.
Domtar wove sustainability into its products and its entire business approach. At “The Sustainable Paper Company,” all employees are measured and held accountable to performance in sustainability and revenue.
In the words of John Williams, the chief executive officer brought in to reshape Domtar in 2008, “Sustainability isn’t just about environmental issues for Domtar. Sustainability is about maintaining and evolving a sustainable and profitable business enterprise with how we operate and what we sell as a key driver in our Vision, Values, and Business Strategy.”
V. Sustainability Reporting and Performance Measures
When business leaders across industries stress the importance of sustainability reporting and the importance of holding business leaders accountable for sustainability performance, the boardroom must ask two questions:
- What metrics and issues are worth reporting?
- How do we incentivize business leaders to prioritize sustainability?
Choosing what to report is challenging because sustainability is an all-encompassing concept with varying definitions. Thus, it is essential for companies to first define sustainability as it pertains to their operations, customers, societal role and environmental impact. Only then can the board make informed decisions about what to measure and how to do it.
Georgia Pacific is an outstanding example of a corporation that has harmonized a definition of sustainability with reporting practices and business fundamentals. Georgia Pacific defines sustainability as “meeting the needs of society today without jeopardizing our ability to do so in the future.” Jim Hannan, CEO of Georgia Pacific, offered instructive insight into what that means.
“For Georgia Pacific, sustainability is critical to creating long-term value for customers, employees, our shareholders and society. We attempt to integrate sustainability into our business strategies by looking at the social, environmental and economic impacts of our decisions to find those trade-offs that the customers, consumers and end-users value most and which best enrich the communities in which we operate. We believe that consumers and customers making choices among alternatives is the best way to determine what people value the most. Pursuing issues that customers and consumers do not value or which do not in fact reduce cost or risk in an economical manner is just another way of wasting society’s resources and is not sustainable.”
For Georgia Pacific, sustainability must balance the interests of customers, employees, shareholders, society, the environment and the communities in which Georgia Pacific operates with an overarching concept that if it doesn’t create business value it isn’t a truly sustainable solution. Each sustainability initiative must create value for these constituencies otherwise it is not worth pursuing.
This self-determined approach to sustainability helps Georgia Pacific know what should be reported, and company takes painstaking efforts to document its findings. Indeed in 2011, the company launched an entire sustainability website that reports on sustainability in a compelling and transparent way.
For instance, Georgia Pacific provides a detailed profile of the economic impact in each state or province in which it operates. From the number of facilities, people employed and wages paid to the products produced, manufacturing processes and safety certifications, each profile is specific and honest.
The company also openly reports its energy consumption. Impressively, Georgia Pacific generates 60 percent of its energy requirements from biomass, 34 percent from fossil fuel and six percent from purchased energy. But, the company does not merely use reporting to highlight positive performance. Georgia Pacific is also deliberate in its accounting on air and water quality measures and increases in total energy use.
Through reporting, Georgia Pacific is held accountable to its own definition of sustainability, rather than external expectations. Reporting also documents the performance of the CEO and direct P&L leaders, who customers, shareholders and regulators consider responsible for sustainability. The value and visibility of metrics therefore incentivize company leadership to own sustainability.
Five years into the economic downturn, sustainability crosses paths with a diverse set of business, environmental and socioeconomic challenges that boards of directors and senior executives must regard as a critical component of effective corporate governance and risk management. The financial concerns facing all types of businesses have not lessened in the course of the downturn. As leaders and directors face this “new economic normal,” holistic strategic issues such as sustainability require renewed attention in the board room.
For businesses such as MasTec, sustainable business is highly dependent on sound governmental policy towards energy and water as well as the development of technologies that can support the long-term use of finite resources. In contrast, for Domtar sustainability has become the basis for operation and the company’s competitive edge during a tough economy. And as Georgia Pacific demonstrates, sustainability can be a positive force for business growth and wider society when companies reflect on what sustainability means and how it should be measured and incentivized as a business driver.
All corporations, regardless of their dependence on resources or independence from environmental issues, stand to benefit when corporate governance takes the initiative with sustainability. These benefits range from specific financial improvement to risk management and safeguarding of the right to operate in resource intensive industries. Given our examples above, we believe a number of steps in governance and corporate leadership will lead to improved business performance and mitigate business risk:
- Insure sustainability is incorporated into board committee responsibilities or as a standing committee to lead discussion, research and action steps on the most pressing sustainability issues.
- Define sustainability such that it harmonizes the interests of consumers, shareholders, executives, employees and local communities in which the corporation operates with a foundation built on business outcomes.
- Develop specific leadership accountabilities through either a chief sustainability officer or defined responsibilities for sustainability metrics, reporting and messaging — the vast majority of companies are already moving in this direction.
- Set benchmarks of sustainability based on the company’s definition, the mutual interests of company stakeholders and ability to measure and report findings.
- Treat sustainability reporting with the care and seriousness of financial reporting. Be equally transparent about successes and areas for improvement for inclusion in annual sustainability reporting.
The challenges facing board members and senior executives continue to be complex. While financial success and business survival remain at the forefront in a fatigued global economy, sustainability is no longer just an “environmental” issue. As demonstrated in this survey, CEOs and board directors in companies that have created significant business value during challenging times view sustainability as integrated into financial performance, not exclusive from it.