We thought it would be interesting to share the common approach to integrating corporate governance (CG)  into investment decisions that 34 DFIs have adopted. DFIs cover emerging markets around the world, including Africa, Latin America, the Caribbean, Asia, Middle East, North Africa, Europe and Central Asia, with total assets of more than $850 billion. DFIs investin equity, debt and mezzanine deals.

What does it provide?

The corporate governance framework establishes a common approach for evaluating governance practices in the due diligence phase of a deal and subsequently improving the corporate governance of investee companies.

While not designed as a one-size fits all approach that can easily result in undesired tick-the-boxes behavior, a unified approach makes it more predictable for investee companies what to anticipate in terms of corporate governance expectations by investors. By signing on to the framework, the DFIs hold themselves accountable to actively implement the common approach. In addition, the framework initiative provides a set of corporate governance tools such as corporate governance assessment methodology and guidebooks that are ready to be used. It also establishes incentives for investee companies to embark on governance reforms.

The signatories of the framework undertake to:

1. Integrate Corporate Governance (“CG”) in its investment operation

a. Adopt CG procedures and tools in line with the Framework’s methodology;

b. Where considered appropriate, conduct CG assessments of investee companies and develop CG action plans;

c. Monitor progress of the implementation of CG action plans.

2. Ensure internal responsibility

Identify and assign an internal function that is responsible for the implementation of the Framework.

3. Provide or procure training

Ensure capacity building and knowledge transfer to staff for the implementation and further development of the Framework.

4. Collaborate with other signatories

a. Share experience and resources in training and implementation

b. Contribute to developing case studies and progress reports on the above.

5. Report on implementation

Report annually to the other signatories on the internal implementation of the Framework.

What can private investors in emerging markets learn?

The take-away for private investors is at least two-fold.

1. Coordination of efforts can be effective.

We don’t expect private investors to share their evaluation methodologies any time soon, but the increasing focus big private investors such as Black Rock put on governance and sustainability issues can ha e a significant impact on company behavior and efforts. Coordination efforts by pension funds in some emerging markets such as Chile, where the Administradoras de Fondos de Pensiones (AFP), the country’s private pension funds, operate a shared data base for independent directors show that cooperation can take many different and fruitful forms.

2. Emerging market companies want to improve their governance.

The DFI experience over the last decade shows that there is appetite by emerging market companies to implement corporate governance reforms. If investors provide additional incentives to their investee companies, governance reforms are even more likely to be initiated.

Nigeria to roll out National Framework of Corporate Governance

We find that the index setup and methodology chosen should serve the CGRS well in achieving its goals. After the test phase in 2014, participation for all listed companies will be mandatory. This will give the rating credibility since companies cannot pick and choose to participate. The chosen rating criteria are an adequate blend of Nigerian and international standards, with the explicit aim of evolving over the years to make them progressively harder to meet. In addition, the CGRS has developed a unique three-component rating setup, consisting of a corporate compliance, a director fiduciary awareness and a corporate integrity component. With the explicit addition of a focus on actual company practices and corporate integrity, of special importance in the Nigerian context of course, the CGRS setup is unique in the international context. The plans for the setup of the CGRS also contain a well-thought through selection process for the evaluators engaged in the CGRS rating process which should  – in theory – work well to prevent conflicts of interest and protect the integrity of the rating process. The proposed governance structure with one steering board and three specialized committees is elaborate when compared to other corporate governance indices, but seems appropriate to ensure the credibility, transparency and integrity of the rating system.

In our previous studies of corporate governance indices we have noted the critical importance of transparent communication about an index’s setup and results. Given the complex CGRS setup, including the incorporation of non-public information in the corporate integrity rating component and the generally negative perception of Nigerian business practices, a very high level of index transparency is crucial for the CGRS. The planned comprehensive disclosure of the full methodology and rating results on a singular website would put the CGRS ahead of all existing corporate governance stock exchange indices by a wide margin. In fact, of the currently existing six stock exchange indices based on rating corporate governance, none discloses the individual company rating results.

The success of the CGRS hinges on the successful implementation of its well-conceptualized setup. We are looking forward to see the completion of the pilot phase with volunteering companies later this year and the subsequent launch of the CGRS. An increasing number of stock exchanges is in the process of launching indices incorporating corporate governance factors, often as part of a sustainability index also factoring in environmental and social factors. The Moscow Stock exchange is still planning to launch Novy Rynok some time in 2014 and the Santiago Stock Exchange in Chile has just commissioned a feasibility study for a sustainability index.  In what is a growing number of stock exchanges with indices incorporating corporate governance factors, the CGRS has the potential to stand out for the transparency of its setup and the attempt to measure implementation.

KPMG released a publication in 2012 entitled Expect the Unexpected: Building business value in a changing world, which identifies ten sustainability “megaforces” that are projected to impact business across all industry sectors in the coming decades.  In today’s global economy, such megaforces as water scarcity, population growth, and urbanization will all shape the way business is conducted.  The report posits that the process of “decoupling human progress from resource use and environmental decline [will be] the central challenge of our age,” and businesses that emerge successfully through this transition will be more resilient and therefore protected against risks.  The concept of decoupling is an accepted way to reconcile the disparity between our planet’s apparent finite resources and thus far infinite (and virtually exponential) economic growth: economic growth can be possible without relying – at least as much – on natural resources or raw materials.  Waste elimination, recycling, and other methods of increasing operational efficiency will all provide ways for businesses to expand their output and economic growth while shrinking their ecological footprints.

The KPMG report goes on to discuss different industries by sector and explore which may be the most vulnerable to these sustainability megaforces.   As per the Industry Classification Benchmark (ICB) system, KMPG identifies the following 11 industry sectors:

• Airlines
• Automobiles
• Beverages
• Chemicals
• Electricity
• Food Producers
• Industrial Metals and Mining
• Mining
• Marine Transportation
• Oil and Gas
• Telecommunications and Internet

In order to effectively analyze and evaluate these sectors, KPMG used a data set created by the independent environmental research agency Trucost that translates environmental impacts into monetary values and is therefore a measure of an industry’s environmental sensitivity.  One important measure of environmental sensitivity is environmental intensity, which conveys the environmental cost of potential profits. Trucost’s data set indicates that environmental costs are rising very quickly, but since it puts a price tag on environmental externalities, those “off balance sheet” costs have not yet necessarily translated into financial impact.  KPMG points out that calculating these externalities is becoming more commonplace, as “businesses will be most motivated to act on sustainability when the costs of environmental and social impacts can be shown on financial statements.” (Expect the Unexpected)

This analysis reveals good news and bad news for different industries.  The Industrial Metals, Marine Transportation, and Mining sectors all showed a reduction in earnings exposure to environmental cost, or an improvement in environmental intensity, though this is largely the result of profits in those sectors growing more rapidly than their environmental impact, rather than a real reduction in these industries’ environmental impacts: in other words, this juxtaposition between economic growth and environmental cost likely cannot be contributed to decoupling.  Conversely, the Automobile, Chemicals, and Electricity sectors show signs of decoupling.  Their environmental costs are growing at a lower rate, or even shrinking altogether, while they are simultaneously improving their environmental intensity.

The Food Producer and Beverage industries, conversely, appear to be facing particularly devastating changes resulting from the sustainability megaforces.  Not only is their environmental intensity actually increasing, but the “environmental costs of the Food Producers sector could outweigh their entire earnings.” (Expect the Unexpected)  Beverages have significant exposure to these megaforces, with high exposure to water scarcity, food security, climate change, population growth, ecosystem decline, and with partial exposure to energy and fuel, deforestation, and urbanization.  Similarly, Food Producers will be highly exposed to climate change, water scarcity, ecosystem decline, population growth, wealth, energy and fuel; and potentially exposed to urbanization.

While decoupling is clearly a necessary process for all industry sectors to explore, it is worth further exploring just what this may mean.  Author Jackson of “Prosperity without Growth” stresses that there are actually two types of decoupling, relative and absolute.  Relative decoupling relies on increased efficiency to accomplish its goal: lowering the ecological intensity of industry activity relative to the GDP (Jackson).  With continuously growing GDP, however, ecological intensity may still ultimately rise even when employing relative decoupling.  Absolute decoupling means that the absolute ecological impact declines, regardless of what is happening with the economy.  Jackson proposes some potentially radical methods by which we may achieve absolute decoupling, including curbing economic growth.  While those ideas aren’t tenable in today’s economy, it is certain that now is the time to be making ecological investments in carbon reduction, infrastructure changes, and ecosystem protection among others (Jackson).  Furthermore, the KPMG report shows a stark future ahead for industry sectors that fail to reduce their environmental intensity in some form or fashion.  Creativity and innovation has always been vital for businesses, but will be increasingly so as they pivot to meet the coming sustainability challenges.

Sources

Jackson, Tim. Prosperity without Growth: Economics for a Finite Planet. London: Earthscan, 2009. Print.

KPMG. “Expect the Unexpected: Building Business Value in a Changing World.”Building Business Value in a Changing World. N.p., n.d. Web.

The investors’ guide to corporate governance in Latin America published by BNamericas looks at the ownership concentration and a lack of minority shareholders’ rights that have defined the landscape for many years.

This week BNamericas spoke with the report’s author, Andreas Grimminger, founder and managing director of PGS Advisors international, a policy and corporate governance consultancy, to take a pragmatic look at the level of corporate governance standards in the region and gain a better understanding as to the role of capital market development in encouraging better standards.

The full report can be found here.

BNamericas: How do corporate governance standards compare between Latin America and other emerging markets?

Grimminger: Most emerging markets face very similar corporate governance issues, as concentrated ownership is a prevalent feature across markets. Asian markets, as well as some Latin American markets, are further characterized by significant cross-shareholdings and sometimes pyramid structures, which make related-party transactions an issue of particular importance.

Corporate governance practice standards and their integration into law and regulation have improved significantly in both developed and emerging markets over the last decade, but the distinguishing factor lies in their implementation and enforcement and in developing a culture of good corporate governance that is part of the business fabric.

For sound corporate governance practices to become truly engrained in the business culture, I believe a balanced mix between regulatory and private initiatives is essential. Latin American markets, especially Brazil, compare fairly well to other emerging markets in this respect.

Corporate governance reforms in Brazil have been to a large degree driven by private actors, such as the Brazilian institute for corporate governance (IBGC) and self-regulatory initiatives such as the Novo Mercado segment on BM&F BOVESPA.

On the other hand, initiatives in Malaysia, which can be considered a regional corporate governance leader in Asia, have been top-down, driven by the Malaysian Security Commission.

In contrast, investor groups like the Brazilian association of capital market investors (AMEC) are private investor initiatives. This is not to say that the Brazilian securities regulator CVM is not playing an increasingly important role in corporate governance reforms, but many initiatives have come from the private sector.

Other Latin American markets like Colombia and Peru and especially Chile, on the other hand, are predominantly driven by regulatory initiatives in their corporate governance reforms. So there is room for more private sector initiative, even though Chile can already count on three corporate governance institutes.

BNamericas: Can you differentiate the role of foreign investors from local investors when it comes to pressuring companies to follow certain standards?

Grimminger: Given the low liquidity of most equity markets in the region and the AFPs’ preference to invest locally, AFPs are clearly the dominant institutional investors and minority shareholders in the region. For minority investors, whether they are AFPs or foreign investors, securing representation on the board and obtaining the disclosure of relevant company information to protect their rights are the most important issues.

AFPs certainly have a leg up on foreign investors as they usually fill the few seats for independent directors, but there are already many successful examples of cooperation between AFPs and foreign investors and, ultimately, the growing influence of AFPs is beneficial to all minority investors.

This increased influence can, to a degree, be tracked to the introduction of regulatory requirements forcing AFPs in Colombia, Chile and Peru to vote their shares, nominate directors, actively consider corporate governance and report on all these issues.

BNamericas: What is required for the pace of improvement in corporate governance practices to speed up?

Grimminger: Good corporate governance practices are important for companies for two principal reasons. First, to assure outside investors that their investor rights are respected. Second, sound corporate governance structures, such as diverse and independent boards of directors, benefit any company regardless of its capital structure as they improve decision-making and risk management.

In order for reforms to continue or even accelerate in the region, two developments are necessary. First, liquidity needs to increase so outside investors become more relevant and companies more likely to listen to their governance demands. And second, companies’ awareness needs to be further raised with respect to the many economic benefits of good corporate governance.

We see both occurring, albeit at a slow pace. However, improved corporate governance practices, in particular when it comes to the disclosure of company information in the region, are critical for the continuous development of the regional economies and capital markets.

BNamericas: With the rise in cross-border consolidation within the region, do you foresee new issues arising with regards to standards of corporate governance and regulations?

Grimminger: Regional integration initiatives such as MILA and the rise of the multilatinas will not lead to the rise of new issues, but – in my opinion – to the intensification of already existing ones.

A larger and more diverse investor base will demand better governance standards, such as increased disclosure of company information ahead of the annual general meeting and more say on board nominations.

The current practice that board nominees are not disclosed until the AGM (with the exception of Brazil) will certainly come under increased pressure. We already see the disclosure of at least the names and background of nominees ahead of the board elections at companies needing the votes of outside investors to reach a quorum.

At PGS Advisors we believe that companies across the region will increasingly follow best practices, not only in the case of multilatinas and other blue chip companies, but also more and more in the case of medium-sized and even family-owned companies.

It is important in this context to demonstrate the economic and reputational benefits of good corporate governance and good sustainability practices for all kind of companies. The growing regional importance of ESG (Environmental, Social and Governance) standards for corporations and investors in the region will be an important trend to watch.

Raising C-suite awareness of sustainability benefits is a critical initial step before even creating a roadmap. Some progress can be reported on this issue, as more CEOs are aware of the benefits of implementing corporate sustainability. According to MIT Sloan’s 2012 Sustainability and Innovation Global Executive Study, 48% of CEOs responded that they had changed their business model to incorporate sustainability; of those, 46% reported that sustainability added to their bottom line. However, out of 600 companies surveyed last year by CERES for The Road to 2020 Report, more than half still fall into the Tier 4 “Starting Out” in their Roadmap for Sustainability. In Tier 4, CERES catalogs those companies who are beginning to understand sustainability and which need considerable work to integrate sustainability into overall corporate accountability systems.

Corporate sustainability demands a broad view of issues and impacts, as well as a working understanding of what the company does and how it does it. Embedding sustainability means joining the two together through a series of concrete steps.

1. Understand sustainability and recognize what it means to the company

As a first step, it is important to define what sustainability means for every area in the company and to identify its benefits. From investment decisions, developing new products or services to changing procurement practices, sustainability has an increasingly central role in these decisions. Coca-Cola is one of the companies centering its investment decisions on sustainability. When considering the development and location of new production plants, water sustainability has been now included as a key factor. Sanjay Guha, president of Coca-Cola Great Britain says “potential markets and ease of distribution were once the only key factors. Now it is the long-term supply of water.” In order to understand where sustainability efforts should be concentrated in a company, it is necessary to identify those issues that have the biggest impact and are most relevant to the business and to stakeholders.

 2. Engage with stakeholders

Depending on its line of business, a company’s impact can vary among stakeholders. Generally, companies engage with the most influential groups, keeping close ties and a constant dialogue. However, engagement can happen on different levels and should respond to expectations from both sides. Different levels and methods of engagement bring benefits to both companies and stakeholders and can be translated into more sustainable practices. Bonnie Nixon, Director of Environmental Sustainability at Hewlett Packard explains, “allowing stakeholders to honestly critique us pushes us to improve our programs and helps us develop our thought leadership platforms.” In the same way, Procter and Gamble has benefitted through the engagement with local communities around the world by finding alternative uses for its waste materials. Through employee engagement, Kraft Foods has developed a model where employees contribute with ideas and viable plans to reduce waste while helping to reach the company’s waste reduction targets.

 3. Set goals and commitments

Once key environmental, social and governance issues have been identified and engagement methods for each stakeholder group have been defined, efforts must focus on reducing risks and seizing opportunities around these issues centered on sustainable practices. Whether driven by cost reductions, innovation or improved financial performance, sustainability commitments and goals need to be established.

For Wal-Mart, most of it commitments and goals on sustainability are focused around the use of renewable energy and the adoption of energy efficiency. Initiatives in these areas have resulted in the recognition of Wal-Mart as the largest on-site green electricity generator in the U.S. and have led to cost savings of over $500m USD a year. Another example is United Airlines. The airline aims to reduce its environmental impact through the participation of all its suppliers in its Sustainable Supply Chain initiative.

While companies like Wal-Mart and United Airlines aim for a complete transformation of their businesses, small companies are setting goals and commitments according to their scope of action. Initiatives mainly focus on cost reductions from energy use, waste management and commuting practices, as well as social actions in the community like local development projects and volunteering campaigns.

 4. Establish systems and processes

Once the goals are established, specific systems and detailed processes need to guide the implementation of each initiative. Throughout the design, processes and policies in place must be taken into consideration and collaboration among areas encouraged. At this point, gaining executive commitment is crucial. The appointment of an internal sustainability champion as the main driver of sustainability and the development of a successful employee engagement model are also good practice. According to the 2012 Report of Sustainability Leaders by VOX Global and Net Impact Berkeley, 78% of respondents say top management was a key contributor to embracing sustainability. However, 81% identified their colleagues across the company as primary drivers of success.

Unilever’s Sustainable Living Plan was launched in 2010. Under the leadership of its CEO Paul Polman, this ten-year sustainability plan has already accomplished considerable progress in its first two years. Under the umbrella of its comprehensive overall sustainability strategy, Unilever is utilizing its wide array of brands to target distinct social issues, invest in sustainable technologies and change consumer behavior. Unilever has also accomplished to fully embed sustainability across the company and to successfully engage external actors. Besides the appointment of a Chief Sustainability Officer in 2012, the company’s management structure includes a Sustainable Living Plan Steering Team, a group of external specialists in corporate responsibility and sustainability known as the Sustainable Development Group and the launch of the “Small Actions, Big Difference Budget” which finances employees ideas based on environmental benefit and financial return.

 5. Track progress, communicate actions and meet expectations

Lastly, it is important to set a system that measures the performance towards each goal. Defining key performance indicators to meet the identified goals will allow to detect areas for improvement and will gather relevant data to track progress. Metrics and indicators are also central for the reporting and communicating activities of the company. Internally, the availability of data contributes to the prioritization of issues and initiatives and to promote employee involvement around sustainability. Externally, collecting data is fundamental for an accountability strategy, to respond to stakeholders’ expectations and interests and to comply with reporting standards.

Companies reporting under the Global Reporting Initiative guidelines have already embraced the development of indicators. In addition to these guidelines, the Sustainability Accounting Standards Board is currently preparing frameworks that will standardize sustainability key indicators per sector. Alongside these efforts, companies are designing their own systems to measure performance, like Wal-Mart’s Sustainability Scorecards, which, among other criteria, ranks suppliers according to their environmental footprint and contributes to Wal-Mart’s performance measurement.

In the end, corporate sustainability needs to adapt to the maturity of the business and the company’s willingness to treat sustainability as a strategic opportunity. These steps are only the beginning of a process that can eventually transform a company’s entire business strategy into a sustainable business strategy.

Due to increases in energy prices, energy is being considered less a cost and more a strategic component of business. As part of sustainability efforts, the efficient use of natural resources, specifically of energy, is becoming a priority for businesses.

Although energy efficiency can be considered a low hanging fruit among sustainability practices, its adoption is not an easy task. Considerable investments are required to transform a company’s operations towards energy efficiency. In the 2011 Survey on Energy Efficiency prepared by the Economist Intelligence Unit, lack of funding was identified as a major obstacle in the implementation of energy efficiency. Most survey respondents believe energy efficiency will play a more important role in their business in the future; however, only large companies are taking aggressive steps to tackle energy use, as they are able to capitalize on economies of scale. In response to funding challenges, governments and other institutions such as energy service companies (ESCOs) are offering incentives and financing schemes to trigger public-private investments towards energy efficiency.

Besides funding, the survey reports proven return on investment as the most important obstacle for integrating energy efficiency initiatives into business strategies. While companies appear to embrace the benefits of energy efficiency, they are still struggling with how to implement energy saving measures. Skepticism and long payback periods – the period it takes for the project to recuperate the investment through savings – around these initiatives is keeping companies from going further than improving lightning or air-conditioning systems. Regarding payback, expectations tend to be for a 1 to 3 year payback timeframe. For energy efficiency projects, depending on the scale of investment, this may not be a feasible time frame.

Strategies on energy efficiency need to be tailored according to corporations’ energy demands. Companies in energy intensive industries such as steel, chemicals, refining or metals require the overall transformation of their processes and equipment. In the same way, corporations in manufacturing and retail incur in considerable investments to renovate supply and distribution chains. However, low energy intensive sectors and services can undertake gradual improvements without compromising a company’s financial situation. Changing habits and adjusting systems, supported by senior management and employee involvement, represent viable options that translate into significant savings.  Even turning off computers at night represent a 10% reduction in energy bills, according to the Carbon Trust.

Besides cost reduction, energy efficiency presents other tangible benefits related to brand value, performance and carbon emission controls. “Cutting carbon is a great environmental story, so customers will reward you for having proven low-carbon credentials”, says Harry Morrison, manager at Carbon Trust Standard Company. The carbon footprint also matters to investors in a company. The disclosure of information on carbon emissions and energy use is taking an increasingly central role in investment decisions by investors and shareholders.

There are still considerable barriers that stand in the way of fully adopting energy efficiency measures, and there is a long way to go. Efforts in measuring and monitoring energy usage, promoting energy benchmarking and auditing as well as disclosure on savings will certainly incentivize the adoption of energy efficiency in business decisions.

What is materiality and why is it important?

The concept of materiality has its origins in the auditing and accounting processes of financial reporting. In financial terms, a concept is considered material to the company if its omission or misstatement influences the economic decision of users. In recent years, the concept of materiality has been adopted in sustainability and is increasingly influencing the design of sustainable strategies and reports.

Compared to financial statements, sustainability considers a broader scope of action and covers a multitude of issues- environmental, social, economic and more. This context requires a more comprehensive definition for materiality. The Global Reporting Initiative (GRI) defines as material those issues with “a direct or indirect impact on an organization’s ability to create, preserve or erode economic, environmental and social value for itself, its stakeholders and society at large”.

In simple terms, materiality aims to identify the societal and environmental issues that present risks or opportunities to a company while taking into consideration the issues of most concern to external stakeholders. The process of labeling material topics in a company requires a comprehensive framework that methodologically identifies and prioritizes issues, risks and opportunities, commonly known as materiality analysis.

Materiality analysis

Source: PGS Advisors

When to perform a materiality analysis?

A materiality analysis is a tool that takes into consideration the company’s financial concerns while foreseeing future risks and opportunities around ESG issues. A materiality analysis is especially useful for companies building a sustainability strategy, preparing a sustainability report or looking to explore new business opportunities.

As in traditional enterprise risk management, strategic planning for sustainability requires a deep understanding of the impacts of a company’s operations and a comprehensive stakeholder map. Materiality analysis helps a company tailor its sustainability strategy and stakeholder engagement activities around the issues that are most pressing to their business and sector. It not only identifies issues with significant social or environmental impact for the company but also takes into account the understanding of stakeholders. When preparing reports, the availability of this information guarantees addressing the issues that represent a major concern to stakeholders and consolidates a company’s accountability strategy.

In addition, materiality analysis can provide information to develop products and services with the greatest potential for sustainable business growth and can influence a company’s decision-making process by weighing risks.

How to identify materiality

Generally, materiality varies considerably from company to company. Material topics can be similar within an industry or a sector, but they also respond to particular characteristics of a company such as size, location, time of establishment, level of stakeholder engagement, financial performance, etc. As a result, the practical application of materiality is constantly evolving. Recently, organizations like the Sustainability Accounting Standards Board (SASB) and the GRI have developed tools to consolidate the process of identifying materiality.

The SASB is in the process of building materiality maps for each industry. It has determined materiality according to issues under five categories: Environmental Capital, Social Capital, Human Capital, Business Model & Innovation, and Leadership & Governance. Until now, materiality maps for the healthcare and financial sector have been published. Maps per industry will be available in the short to medium term.

At the same time, the GRI developed a materiality framework to guide sustainability reporting: the Reporting Guidance for Defining Content in the GRI Sustainability Reporting Guidelines. Companies reporting under these guidelines are taking advantage of the materiality analysis beyond reporting and are using the process to target their sustainability efforts.

Common elements in materiality analysis include:

1. Identification of a universe of relevant economic, social, environmental, and governance issues for consideration;
2. Evaluation and ranking of the level of stakeholder concern regarding each issue;
3. Evaluation and ranking of the potential impact on the company of each issue;
4. Presentation of issues prioritization, typically in a matrix format that is subsequently used to inform strategy and reporting.

In addition, the process usually takes into consideration surveys involving consumers and sustainability experts, feedback from stakeholder meetings, engagement events, media scans, internal business impact surveys, corporate risk maps, etc.

Materiality analysis is about setting priorities right. By complementing financial and non-financial performance, materiality helps align a business strategy with a company’s ESG risks and stakeholders’ interests while achieving larger impacts in sustainability. It is quickly becoming the dominant concept in sustainability reporting and it is just a matter of time before companies realize the potential and benefits of a materiality analysis for their overall performance and sustainability in particular.

Corporations must be prepared for the introduction of tax and other policy tools and should be aware of the benefits and implications they represent. This post highlights three challenges corporations face regarding the implementation of green policies: 1) identifying relevant policies, 2) understanding their scope and 3) integrating them into the company’s operations.

Identifying relevant policies

The first challenge companies face is identifying and understanding the tools in place and their relevance for their operations. In most cases, companies are aware of relevant penalties but lack information on other instruments’ potential usefulness. Given that the green policies are increasingly focusing on incentives and other tools such as low-interest loans and grants, companies should take advantage of these incentives by reviewing strategies and operations, and evaluating the incorporation of incentives into new or existing projects.

Understanding policies’ scope

Companies often misinterpret the scope of green policy tools. In some cases, corporations believe these instruments are only relevant to companies offering green products or services or to companies who have a long-term sustainability strategy. Fortunately, green policies are addressing multiple topics and can result in the transformation of core strategies, the modification of everyday operations and the increase of the feasibility of projects in the pipeline. For example, the Japanese government is providing subsidies to acquire eco-friendly vehicles and fleets, which will reduce a company’s transportation costs considerably; Australian farmers are selling carbon credits to companies looking to offset emissions and are contributing to more sustainable farming practices in the country; and energy-efficient buildings deductions in the U.S. are representing millions of dollars in potential savings to corporations.

Integrating policies into everyday operations

The adoption of new policies into everyday operations can represent challenges that require leadership and collaboration. In this process, company leaders have to make sure that policies are considered an opportunity and not a threat. As reported in E&Y’s Six Growing Trends in Corporate Sustainability, setting the tone from the top is key to ensure the adoption of sustainable practices. The same approach should be adopted when aiming for the adaptation of green policies by companies.

At the same time, the introduction of new policies will require alignment across areas in both strategy and processes. In order to successfully adopt these, collaboration among areas is essential: the translation of sustainability issues into costs and benefits by financial teams, into project planning tasks by operations departments and so forth. Lastly, the communication of potential benefits and clarity in goals will be key to engage all areas of a company into making the necessary changes to adopt new policies.

Governments have taken steps – however timid – towards addressing environmental challenges. Corporations contribute to these challenges and should play a central role in addressing them too. As companies  incorporate green policy tools and become examples of successful adaption, the private sector’s perspective and experience will be an invaluable source of information for the future design and evaluation of green tax systems. It could be win – win for everybody…

In order to address the challenges of environmental changes, governments are designing and implementing green policy tools ranging from tax incentives to specific subsidies and grants. KPMG International’s Green Tax Index Report analyzes green tax systems from 21 countries. The Index provides information on “which countries are most active in using green tax incentives and penalties to drive sustainability”. It identifies over 200 individual tax incentives and penalties to achieve green policy objectives and categorizes countries into four quartiles according to the degree of tax use (see table below). The ranking of China in the first quartile and Finland and Germany in the third are certainly surprises.

Source: KPMG Green Tax Index Report 2013

The United States tops the ranking with a strong bias towards tax incentives due to its extensive program of federal taxes promoting energy efficiency, renewable energy and green building. Japan comes in second place, ranking higher on green tax penalties than the U.S, with a specific focus on the use and adoption of green vehicles. In third place, the United Kingdom leads on carbon and climate change and presents a more balanced approach between incentives and penalties.

Australia, Germany and Finland, associated with strong environmental policies, are surprisingly constituents of the third quartile. However, this is mainly explained by the wide range of green policies they have implemented, few of which are of the tax variety. Australia (18^th) has focused on non-tax tools such as grants, loans and direct investment to promote green innovation and energy efficiency. Similarly, Germany (17^th) favors low-interest loans and capital subsidies, and Finland (21^st) focuses on grant funding for green innovation.

The emerging economies Brazil, Mexico, Russia and Argentina are located in the fourth quartile. Policy tools in these countries are mainly applied as incentives: Russia leading in promoting energy efficiency and Brazil in green innovation.  However, overall, there are few instruments in place in these countries regarding the achievement of green goals.

Since January 2011, more than 30 green taxes have been introduced around the globe. This trend will continue to drive consumer and business behavior towards more sustainable practices. These policies will certainly contribute to already changing customers’ perceptions on greener businesses and products. Corporations must be prepared to benefit from these policies and to adopt them into their everyday operations. In another post we will discuss some of the implications these policies represent for corporations and their sustainability goals.