The importance of the best-in-class approach to sustainability

The best-in-class approach to sustainability investment means investing in companies that are leaders in their sectors in terms of meeting environmental, social and governance (ESG) criteria. An alternative approach, called best-in-progress, involves investing in companies that have demonstrated substantial improvements in their ESG performance over time. The former is the most effective approach to bringing about positive changes.

It is clear that investors think in terms of risks. Investing directly in best-in-class companies is a safe bet because strong ESG performers will deliver not only economic returns but also environmental and/or social returns, especially in emerging markets. The Deputy Director for Global Capital Markets of the Institute of International Finance explained recently that companies with good scores on ESG factors outperformed their peers in emerging markets by 103% during the past decade.

The best-in-class approach allows investors to identify which companies are better positioned for the future and avoid those which are likely to underperform or fail. Leading corporations have understood the value of ESG investing as a tool to increase capital while signaling a long-term commitment to sustainability.

However, it is clear that some investors are more risk-averse than others. The best-in-progress approach seems to be more appropriate for risk-tolerant investors even though it is probably less effective in achieving environmental and social changes. This is partly because best-in-class companies usually have stronger financial arms and greater policy-making influence. They could lead and pave the way for smaller companies to follow. The following are a few examples.

Nestle SA, one of the ESG leaders in the food products industry, can inspire significative changes in areas like supply chain management, operational eco-efficiency, raw material sourcing, and human capital development. Alcoa Corp, one of the leaders in the aluminum industry, could set the example by reducing its footprint, managing its waste management process and improving its water discharge activities. Pirelli & C SpA, one of the leaders in the auto components industry, could play a critical role in improving fuel efficiency and lowering vehicle-generated emissions.

It is important to note that companies with demonstrated improvements in their ESG performance may still be far from being best-in-class. It does not seem fair to reward companies with a very low base at the expense of ESG leaders given that for the latter is increasingly difficult to show significative advances. If the best-in-progress approach prevails, the best-in-class companies will be unfairly castigated.

The best-in-class approach creates good incentives because it encourages managers to improve ESG performance in an integrated way, without overshadowing any dimension. The leading companies pay similar attention to the environmental, the social and the governance criteria. Adidas AG is the current ESG leader in the textile, apparel and luxury goods industry because it scores better than its competitors in areas like supply chain management, risk management, brand management, operational eco-efficiency, environmental policy, product stewardship, occupational health, human capital development, and human rights.

The best-in-progress approach, on the other hand, offers a perverse incentive. In order to attract investors, managers could be tempted to prefer stunning improvements in specific areas instead of steady progress in the three ESG dimensions. That would be a setback in a moment when companies are starting to disclose how they integrate the triple bottom line impacts through a more holistic report of its inputs and outputs.

Unfortunately, the best-in-progress approach may also encourage greenwashing practices. Companies with poor ESG performance could overstate the benefits of specific programs with the objective of demonstrating substantial improvements. It is clearly more difficult to succeed in attracting investors using greenwashing practices if they use the best-in-class approach.

George Kell, Founding Director of the United Nations Global Compact, explained that ESG investing has evolved to the point where it can stimulate market transformation for the better given that corporations and investors have growing influence and power. Unquestionably, the best-in- class approach is the most effective in bringing about positive change in the environmental and social performance of investee companies.