Allocating Capital For Long-Term Returns

Generation white paper highlights key considerations in successful allocation of long-term capital

20 May 2015: The Generation Foundation, the advocacy initiative of independent investment management firm Generation Investment Management, has today published a new White Paper: Allocating Capital for Long-Term Returns. This paper reasserts the ever-stronger business case for Sustainable Capitalism, building on the Foundation’s 2012 report Sustainable Capitalism, and makes a number of recommendations for how the business and financial community can better allocate capital to ensure long term growth and outperformance.

Al Gore, Chairman of Generation Investment Management, commented:

“The importance of sustainability to business and investing has intensified as financial markets are forced to address challenges posed by the realities of natural resource scarcity, the effects of unabated carbon emissions, rapid urbanisation and widening wealth inequality, to name just a few. As the context of business and investing shifts, understanding the economic benefits of a more sustainable form of capitalism has become even more critical. This has significant implications for asset owners, asset managers, corporate executives and other market participants seeking to grow successful businesses and deploy capital today and in the future.”

The White Paper demonstrates how an evolved model for capitalism, in which business and capital seek to maximise long-term value creation, has gained significant momentum, and is increasingly supported by new research and performance metrics. It also highlights the key trends driving global change, their associated risks and investment opportunities, and how they are likely to affect the adoption of Sustainable Capitalism.

In particular, the White Paper highlights three core integrated ideas that investors, asset owners, corporate executives and boards will need to adopt in order to successfully allocate capital for the long-term. The three core ideas are strongly connected to the themes that form the bedrock of Sustainable Capitalism: decoupling prosperity from resource-intensive growth; revising investment time-horizons to target sustained value creation beyond quarterly profits; and integrating sustainability factors into strategic decisions and asset valuations.

1. Assess carbon risk and price carbon in all capital allocation decisions

The transition to a low carbon future will revolutionise the global economy and present significant opportunities for superior investment returns. However, investors must also acknowledge that carbon risk is real and growing. In spite of the impressive leadership emerging within the business community, and the mounting momentum towards a regulated carbon price, carbon largely remains an un-priced externality in financial markets today. Although it is impossible to know the exact timing of the prospective tipping point when financial markets will fully internalise carbon risk, it is critical for investors to prepare for its inevitable impact over the next five years.

Investors should proactively include a meaningful carbon price when allocating capital in order to better manage risk and identify investment opportunities.

2. Use sustainability analysis to enhance investment frameworks

Sustainability is a lens to help investors make better investment decisions. As detailed in the White Paper, both the academic and real-world evidence increasingly demonstrates how the full inclusion of sustainability factors in economic decisions translates into better outcomes.

Sustainable investment starts with an understanding of the drivers of return for a company, a portfolio or an asset class. It requires an investment process that does not forget the fundamentals of finance and business, including valuation analysis. However it needs an analysis of all of the factors that can drive long term performance including product innovation, executive compensation, culture, human capital management, governance, supply chains, selling practices, product life cycles, carbon exposure, resource utilisation, and health and safety. In short, analysing a company’s attitude to these factors can often provide insights into a company’s long-term vision, its strategy for implementing that vision, and the probability of its success.

3. Uphold the full remit of fiduciary duty

Sustainability is an important factor in the long-term success of a business. Therefore, as with any other issue related to the prudent management of capital, investors and companies have a fiduciary duty to include sustainability into decisions.

The commonly held interpretation of fiduciary duty must be updated beyond the mistaken view that its scope is limited to a definition of financial responsibility that excludes sustainability. Principally, there exists a robust business case for incorporating sustainability in investment decisions to maximise long-term financial performance. In addition, new regulation and broader legal reform are compelling reasons for doing so.

The Paper also argues that the active decision to ignore sustainability factors may in fact be a breach of fiduciary duty. This is especially true when assessing the impact of ESG considerations on the financial performance of investments.

David Blood, Senior Partner of Generation Investment Management concluded:

“Implementing the recommendations outlined in this report could radically transform the global economy by 2020. Financial markets would incorporate the price of externalities that are currently treated as nearly free resources, like unabated carbon emissions, and allocate capital accordingly. Asset owners, asset managers and companies would, in the process, adopt a more holistic definition of fiduciary duty – one which incorporates sustainability and shapes investment frameworks as a result. In so doing, investors should successfully build profitable investment positions for long term gain, while helping to mobilise action towards addressing urgent sustainability issues.”

View the white paper here.