Outlook 2018: Sustainability

Global equity markets and corporate profits hit new highs in 2017 but beneath that apparently placid surface, tensions in the real economy are setting other records which point to growing challenges in the years ahead. For example:

• The world's average temperature hit a new high and Hurricane Irma became the strongest storm the Atlantic Ocean has seen[1]
• Across developed economies, median real wages continued to stagnate, while Forbes reported the largest jump in billionaires on record [2].
• Trust in government sank to record lows[3], while more CEOs than ever report concern about lack of trust in business[4]

None are new challenges; we could have made similar points for several years. However, it is clear that companies face challenges growing larger and changing faster than ever before. Against this backdrop, the rules for investors and for companies have got harder and rewards for success larger.

The growing detachment between the corporate world and the societies to which companies belong has created challenges across a range of areas.

Licence to operate costs high, and increasing…

While Angela Merkel's success in Germany's 2017 elections may have provided a respite from the stream of upsets by unconventional politicians, disenfranchisement with the traditional order seems more entrenched - and increasingly empowered - than ever. Multinational companies are an easy target for the growing backlash against inequality and globalisation, as well as the social tensions that are changing the political agenda.

Despite the anti-globalisation movement, there is a trend for policy initiatives introduced in one region or sector to be adopted by others. A global consensus appears to have emerged that by coordinating activities like consumer protection, labour standards and governance standards, political leaders can strengthen standards to everyone's benefit.

It is important that companies move to the highest common denominator to future-proof their operations. The US already has clear rules on the disclosure of payments to lobby groups and we expect more scrutiny globally. Modern slavery legislation, adopted in the UK to bring some much needed scrutiny to supply chains, has been co-opted in Australia and other countries are investigating similar approaches. Banks have been forced to adopt stricter guidelines for responsible lending; auto finance looks like it will be next.

Workforce pressures are especially stark. On the one hand, policymakers are putting pressure on corporates to provide 'decent' employment, bridge skills gaps and make progress on gender diversity. On the other, opportunities for automation make headlines every day and laggards in replacing people with capital may face growing competitive difficulties. Walking a line between those competing pressures will be vital.

While investor activism has been increasing for some time, the upcoming revision of the UK Corporate Governance code, the grandfather of global codes, will turn pressures into explicit practices and requirements. This already happens in the Netherlands and less explicitly in Japan. Meanwhile China has been clear about the role it expects the Communist party to take in decisions. A tipping point has been reached; shareholders will be on the pitch rather than spectators.

...and climate change remaining in focus

It is official: the concentration of greenhouse gasses has reached all-time highs and global temperatures have set new records. President Trump's withdrawal from the Paris Agreement on climate change (COP 21) appears to have strengthened the resolve of US companies, cities and states as well as other countries to take action.

Our Climate Progress Dashboard shows that political ambition is lagging action, and we expect this gap to begin to close. 2017 saw announcements of policies aimed at the phasing out of internal combustion cars in countries including the UK, France, Netherlands and India. Traditional energy companies are far from prepared.

The climate challenge will reach every corner of the global economy and investment sector. Plans already agreed will put a price on 25% of the world's carbon emissions. The next step will be for those prices to ratchet to levels at which they have a meaningful impact on business models and corporate strategies.

Whereas company planning for tougher climate action has been a luxury, failure to understand the impacts of moving to a low carbon global economy will impact business models and is looking increasingly irresponsible. The Task Force on Climate-related Financial Disclosures (TCFD) initiative, led by Bank of England Governor Mark Carney, reflects financial markets' growing demand for more and more useful information to assess those risks.

And now moving to investment

A climate of greater scrutiny is not only the province of companies. As Environmental, Sustainability and Governance (ESG) integration becomes more mainstream, with everyone from the largest pension fund in the world down endorsing the Principles of Responsible Investment, we should expect more scrutiny on the outcomes and impacts of all this activity.

Too many asset managers have viewed ESG investing as a marketing platform and opportunity to sell more products, rather than as an investment driver to define, measure and manage.

We believe that the real goal of ESG integration is better capital allocation and investment decisions.

Conclusion

There is an irony in writing a 12-month outlook for sustainability, which has at its heart a long term perspective. There is ample evidence that environmental and social challenges and tensions continue to grow and many of their impacts are likely to accelerate in 2018. However, the closing gap between social and political scrutiny of the corporate sector's role in addressing those challenges is of more significance to us.

Examining companies without considering the social and environmental backdrop that will define future leadership is becoming untenable.

We believe the winners of the future will be those management teams, boards and investors who realise that both the cost and value of a social licence to operate is rising. These winners will adjust their business models to build, identify and support those actions which will create true business sustainability.