The Investor Relations Officer for a Net Zero World

Companies are facing a brutal assault from many fronts:

  1. Activist investors like Engine no. 1 has brought oil majors to its knees.
  2. Large institutional investors like BlackRock, Vanguard are pushing companies to up their ESG game.
  3. Customers are up in arms and are pushing companies through their role as shareholders in making their products and services more sustainable.

At the same time, the demand for non-financial data is increasing by leaps and bounds.

In this context, the role of the investor relations officer (IRO) becomes crucial. As a direct link between analysts and investors and the company, the IRO plays a critical role. How analysts and investors perceive a company is also contingent on how the investor relations department responds. A proactive IRO can build constructive relationships with stakeholders helping the company mitigate many risks from investor activism. With sustainability and ESG actions cutting across departments and functions, the IRO needs to link up with many departments rather than just the finance department, as was the case in the past. The IRO should also understand the company’s long-term strategy and thus needs to be included in board and strategy meetings.

Photo by Charles Deluvio on Unsplash

There are many ways in which the IRO can add value in the net zero world:

Articulate the company strategy: With ESG increasingly getting integrated into a company’s strategy, the IRO (along with the CEO) is thrown into articulating the strategy and its impact on shareholder value. The strategy articulating also needs to keep the increasing sceptical long term investors in the loop on company plans and actions.

Gathering intelligence: Investors, now have far greater access to information and data than they previously did. The role of IRO now shifts from being a disseminator of information to that of constantly scanning the environment and stakeholder sentiments. The IRO needs to gauge the stakeholder mood (from social media posts, talks in various fora, rumours within the company etc.) and craft the company’s response before matters precipitate. These actions are likely to impact a company’s strategy, capital allocation, incentive systems, etc.

Attracting the right investors: Investors need to share the company’s philosophy. The IRO can play a crucial role in attracting the right kind of investors who relate to the company’s approach and action on financial and non-financial issues. In addition, with CEOs having to spend a significant chunk of their time with external stakeholders, the IRO can cultivate and keep the stakeholders informed and reduce the pressure on the CEO.

Tooting the horn: The IRO needs a good understanding how the sophisticated investors operate and what issues are becoming a concern to them. The IRO needs to sound the alarm before things get messy. There is a need to constantly scan analytical models and whitepapers on the company and issues of concern to the stakeholders. The IRO is like a radar that forewarns a company of impending storms.

The role of the IRO needs to change from

  • Disseminator of information to proactive articulation of company’s strategy and how it will create competitive advantage for the company.
  • From having limited interaction with the board (typically in an observer role) to articulating the changing landscape and what long term value creation to the board
  • From focussing primarily on sell-side analysts to addressing a cross-section of stakeholders
  • From focussing on financial to having a dotted line to heads of all functions on matters related to talent, compensation, ESG and capital allocation.

With changing relationships between companies and investors, the role of the IRO is also changing. The shift to the net zero world is increasing stakeholder activism, market changes and competitive disruptions. The new IRO has a critical role in navigating the turbulent seas and supporting the CEO in steering to the right course.

The Evolution of Materiality: Double to Dynamic

Materiality is a fundamental concept in accounting. A piece of information is material if it influences someone’s decision. According to the US SEC, if the information on a company is material, it should be disclosed if a reasonable person considers it important.
Information that is material in one setting may not be material in another. Typically, the company decides what is material and what is not.

Sustainability reporting has its origins in Global Reporting Initiative (GRI), where a stakeholder perspective is used. Here the concept of materiality is different. Materiality is based on whether a company’s actions have a positive or negative impact on the world. This is irrespective of whether investors think it is important or not.

Companies typically perform some stakeholder assessment to gather stakeholders’ views on what the stakeholders believe is important. Companies sometimes provide a “Materiality Matrix.” One axis is how important an issue is to the company from a value creation perspective. The other axis is how important this issue is to aggregate stakeholder values sentiment.

Source: https://www.sasb.org/blog/double-and-dynamic-understanding-the-changing-perspectives-on-materiality/

In 2011 SASB started looking at materiality. It classified materiality based on the industry. For example, the material issues for the iron and steel industry are GHG emissions, air quality, energy management, water and wastewater management, waste and hazardous materials management, employee health and safety, and supply chain management. The material issues for the commercial banking industry are data security, access and affordability, product design and lifecycle management, business ethics, and systemic risk management.

The EU Commission first introduced the concept of double materiality in 2019.

Double materiality is an extension of the financial concept of materiality. Double materiality means that topics can be material from both a financial and a non-financial perspective. Thus, topics that are material from an ESG perspective may have a financial impact over time. There is a continuity between financial and non-financial perspectives. It may appear as if there are two definitions of materiality. However, that is not the case. A topic can be material from either one or both perspectives.

A more recent approach to materiality is dynamic materiality. The concept of “dynamic materiality” was first introduced by the World Economic Forum (WEF) in early 2020 and gained traction. Dynamic materiality is based on the fact that the materiality of an issue can be dynamic, changing based on foreseen or unforeseen events. For example, take the case of a product that has negative externalities. Society may tolerate these externalities for some time. They may not be material at that point. However, with time, society realises the importance of these externalities, and they become material. Since dynamic materiality is forward-looking, it involves stress-testing ESG issues against a set of future events to figure out which issues are likely to be material. This also gives an indication of which issues are more sensitive to future shifts.

Companies need to keep abreast of the evolving concepts of materiality. This will enable them to report their sustainability actions more accurately and provide an impetus to their net-zero efforts.

Linking Executive Compensation and ESG: Navigating a Minefield

Photo by Alexander Mils on Unsplash

ESG issues are shaking up boards and CEOs. As a result, companies are increasingly considering tying CEO compensation to ESG issues. Some of the marquee companies that link executive compensation to ESG include Apple, McDonald’s, Rio Tinto, Royal Dutch Shell, and Unilever.

European and British companies have taken the lead. According to a survey by Pay Governance, 90% of UK and European companies included ESG metrics in their incentive compensation plans. Compare this to the US, where only 21% of the companies linked ESG metrics to CEO compensation.

With shareholders and consumers making ESG issues a priority, companies are being forced to respond by linking executive compensation to ESG targets. The push for tying CEO compensation to ESG metrics also comes from activist investors willing to punish companies that do not tie ESG targets to executive compensation.

There are two compelling arguments for linking pay with ESG performance. First, many believe that good ESG practices will boost a company’s bottom line. Thus an incentive to improve ESG performance will improve financial performance. Second, it is commonly believed that rewarding performance is the best way to ensure performance.

Although linking CEO pay to ESG performance is on the rise, many issues need to be addressed:

  1. Many companies try to deflect attention from poor performance by highlighting executive compensation linked to ESG factors. For instance, Shell has underperformed the S&P 500 by a wide margin and its profits have been weak and even amde a loss last year.
  2. What percentage of the compensation is linked to executive pay? If only a small fraction is linked, the CEO may not worry too much about ESG actions and yet receive significant compensation.
  3. ESG factors linked to executive compensation may be easy wins that enable the CEO to still take a fat pay packet. For instance, targets may be linked to diversity measures which can be easily achieved by hiring the right mix of candidates. Or, they may be linked to carbon reductions that are achieved by simply buying carbon offsets, whose genuineness is often questionable. Alternatively, recycling targets can be achieved by outsourcing recycling activities. The tougher can of long term carbon emissions get kciked down the road.
  4. ESG actions have a long term impact, whereas CEO tenures tend to be relatively short – median CEO tenures are around five years. This creates a mismatch – with results of ESG actions coming well beyond the CEO’s tenure. Most CEO’s will baulk at such long term goal setting.
  5. Some focus on a few KPIs, whereas others design multidimensional scorecards covering a wide range of focus areas. It is often easy to mistake the woods for the trees. The challenge lies in creating a scorecard that is sufficiently comprehensive to cover a range of ESG priorities and at the same time remain manageable.
  6. Finally, the benefit of linking pay to ESG performance lies in measurement. With imperfect measures and data gaps in ESG, it often becomes difficult for goals to be set.  

Boards and executive compensation committees can counter some of these issues. Unfortunately, many boards and executive compensation committees come from an earlier generation and lack an appreciation for ESG issues. This lets many CEOs get their way on ESG linked compensation.

A good system to link CEO compensation to ESG factors involves:

  • A value driver analysis will help companies understand which ESG factors have a short term impact value and which ones have long term value.
  • Create a methodology by balancing various metrics (both leading and lagging) to determine nonfinancial metrics linked to ESG. 
  • These metrics can then go into executive compensation measures. Programs can be designed to align with value drivers enabling the company to go from point A to B.

Corporations are at a crossroads. Boards and CEOs are debating what their fiduciary responsibilities should be in a world where the focus on ESG is continually growing from the society. Although establishing and achieving the ESG goals is the right thing to do, connecting executive pay and ESG needs to be done with care and thought. It’s challenging but doable.

Net Zero and Jevons Paradox

Achieving net zero requires a shift to renewable sources of energy. There is another way that not many people talk about – energy efficiency. Unfortunately, improving the energy efficiency of products is not sexy enough (unlike a solar power plant!) to be talked about but is a crucial lever for net zero.

There have been gradual improvements in the inefficiency levels of many products. Our cars guzzle lesser fuel. Our refrigerators, air conditioners, washing machines, dishwashers use less electricity. All this should lead to lower carbon emissions. But it doesn’t. Why? As the fuel cost decline, we compensate it by buying larger cars. Instead of using one air conditioner, we use two. We use larger refrigerators and higher capacity washing machines.

This phenomenon is attributed to the Jevons paradox. The theory, named after the 19th-century British economist William Stanley Jevons, posits that efficiency gains often increase demand.

One possible way to manage the situation is communication and bringing in a culture of sustainable consumption. 

Climate Bad Banks for Stranded Assets

Stranded assets are becoming a reality. Take the case of thermal coal. It is widely recognised that thermal coal is no longer a growth opportunity. This is coupled with the fact that debt financing grew sharply and leverage ratios have skyrocketed. A bulk of financing for thermal power plants has come from debt. With thermal power plants being rapidly replaced by renewable energy plants, many power plants will become defunct. Given that there is a large amount of debt associated with these plants, the lenders are in a quandary.   

Image by jwvein from Pixabay

So, what happens to these power plants? Creating a climate “bad bank” could be better than running down these power plants.   

The idea of a bad bank has gained currency with the Non-Performing Assets (NPA) of Indian banks. A ‘bad bank’ is a bank that buys the bad loans of other lenders and financial institutions to help clear their balance sheets. Over time, the bad bank resolves the bad assets. Like the concept of bad banks, there can be climate bad banks that cater to assets impacted by climate issues.  

There are four ways in which resolution can occur:  

On Balance Sheet Guarantee: Here, the bank protects part of its portfolio against losses, typically with a second-loss guarantee from the government.  

Internal Restructuring unit: A separate unit is created in this scheme, and the assets are placed within it. This ensures sufficient management focus and incentives are aligned to the restructuring of assets bringing about efficiencies.  

Special Purpose Entity: This is an off balance-sheet solution. Here the unwanted assets are offloaded into a special purpose entity (SPE). This way the assets are taken off the balance sheet.   

Bad Bank Spinoff: In the spinoff, the bank shifts the assets off the balance sheet and into a legally separate banking entity.  

Creating a bad bank is desirable action. Without a bad bank, the fossil fuel assets may be sold off to opaque unlisted entities. These entities may have little or no intentions of running or responsibly closing these assets.