Module 6: Integrated Management for Capital Markets and Strategy: Value vs Values

Learning Outcomes

By the end of this lesson, students will be able to:

1. Define Smart Beta and Factor Investing

2. Differentiate Sustainability Investment Methods
3. Enumerate the Impact and Challenges of Integrated Reporting

Introduction

As the conversation around sustainability strategy has mostly focused on combining financial and
non-financial data, a quiet shift has been taking place in the financial world. New methods, like smart beta
analysis, are being used to better understand the risks linked to a company’s strategies and leadership. Since
sustainability is now a major part of asset management, companies need to rethink how they plan and
operate to meet the growing expectations of active and engaged investors. At the same time, they must
adopt a more connected way of managing sustainability strategies.

For ESG (environmental, social, and governance) reporting to be truly effective, it needs to go
beyond just being a box-ticking exercise. Instead, companies must ensure that their external reporting aligns
with internal decision-making processes. This means ESG reporting should play a real role in setting goals,
tracking progress, and holding leadership accountable.

To keep up with these changes, businesses need to focus on two key areas (see Figure 1). First,
they must meet the growing data demands of rating agencies and asset managers, who use advanced
techniques to analyze ESG risks and opportunities. Instead of just providing one-way reports, companies
need to actively communicate with investors and stakeholders about their key sustainability goals and
actions. Second, businesses must bring together financial, strategic, and sustainability goals into a single,
well-organized framework. This will help different teams within a company stay focused, work towards
shared objectives, and improve reporting and feedback systems to show real value creation across the
organization.

This chapter begins by looking at how capital markets are evolving and what that means for
businesses today.

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 Figure 1. Double Loop Model

New Developments in Sustainable Investment

The demand for sustainable investments has been growing, mainly driven by institutional investors. As
a result, more investment options are now available across different industries, regions, and strategies.
Research shows that these investments often perform as well as, or even better than, traditional investments
in terms of risk and return. Beyond financial benefits, sustainable investing also helps investors focus on
three key areas:

1. Supporting companies with sustainable business practices.

2. Meeting external sustainability regulations and internal policies.
3. Improving overall risk management and financial performance.

However, as sustainable investing grows, companies must improve how they communicate and manage
relationships with investors. Regulations are also becoming stricter, and shareholders are demanding more
involvement in company decisions, such as voting on executive salaries. At the same time, stakeholders—
including NGOs and institutional investors—are putting pressure on businesses to improve governance and
responsible management. The challenge for companies is to balance environmental, social, and governance
(ESG) responsibilities with financial success.

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The Role of ESG in Financial Investment

Investors now use ESG data to analyze companies and make stock recommendations, which can
affect share prices and market stability. Understanding how ESG factors influence business performance,
investment risk, and financial returns is essential.

Traditional financial theories, such as the Fama-French three-factor model, suggest that
investment returns are based only on financial risks that cannot be diversified away. This creates a challenge
for sustainable investing: avoiding certain industries or stocks for ESG reasons might reduce portfolio
diversification and increase risk. However, ESG investments can still be beneficial when they help manage
risks related to governance, environmental impact, and reputation.

Why ESG Factors Matter in Investing

1. Good Governance Improves Financial Performance

o The agent-principal problem occurs when company leaders (agents) prioritize their own
interests over those of investors (principals). Strong corporate governance helps ensure
leadership decisions align with investor interests, leading to better financial outcomes.
Research supports the idea that well-governed companies tend to have higher returns.

2. Environmental and Social Responsibility Can Reduce Risk

o While improving environmental and social practices may initially increase costs,
companies that fail to do so could face legal penalties, regulatory fines, and reputational
damage. If investors consider these risks, companies with strong ESG policies may see
better long-term financial performance.

3. Reputation and Business Success Are Linked

o Companies with high employee and customer satisfaction often experience stronger stock
performance. If financial markets do not properly account for these factors, businesses that
prioritize social responsibility could generate better returns than expected.

Measuring ESG Impact on Investments

A key challenge in sustainable investing is determining how ESG factors affect stock prices. Some
studies suggest that companies with high ESG ratings perform better than those with lower ratings.
However, opinions differ on whether ESG-focused funds consistently outperform traditional funds.

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 One proposed solution is to focus only on material ESG factors—those that directly impact a
company's financial performance. The Sustainability Accounting Standards Board (SASB) provides a
framework to help companies and investors prioritize ESG issues that are most relevant to specific
industries. Aligning ESG assessments with internal business policies ensures that sustainability efforts lead
to meaningful improvements.

The Future of ESG Investment and Regulation

Sustainable investing is evolving alongside new regulations. For example:

• The European Commission has introduced policies to create standardized ESG investment
guidelines, improve transparency, and compare the carbon footprints of different investments.

• China has implemented stricter environmental policies and set pollution reduction targets.
Companies that fail to comply may face production restrictions or penalties, impacting their
financial performance.

Additionally, research shows that integrating ESG factors into investment strategies can enhance
returns under the right conditions. Some studies suggest that ESG investments outperform traditional ones,
but the extent of this advantage is still debated.

Smart Beta and Factor Investing

Investment strategies generally fall into two categories:

1. Active investing, where investors build portfolios based on their analysis of stock prices and
market inefficiencies.

2. Passive investing, which involves replicating the structure of a market index, assuming that stock
prices already reflect all available information.

Smart beta combines the advantages of both strategies. It aims to improve returns, reduce risk, and
enhance diversification at a lower cost than active investing but slightly higher than passive investing. Smart
beta integrates passive market efficiency with active value-investing techniques, using factor-based
strategies that help identify market inefficiencies.

This approach has gained popularity among investors due to its transparency and ability to analyze
market risks systematically. One significant development in smart beta investing is its growing integration
of Environmental, Social, and Governance (ESG) factors, allowing for more responsible and sustainable
investment decisions.

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The Role of ESG in Smart Beta Investing

Smart beta strategies use specific factors to construct portfolios, such as volatility, liquidity, value,
size, quality, and momentum. ESG factors are increasingly being incorporated into these models to better
assess risks and opportunities related to sustainability.

By applying smart beta techniques, investors can:

• Identify companies that align with sustainable business practices.

• Manage risks associated with poor governance, environmental damage, or social issues.
• Make better-informed decisions by analyzing financial, business, and ESG data together.

Companies that ignore ESG-related risks might face reputational damage, legal challenges, or financial
losses, making ESG a critical component in investment strategies.

Challenges in ESG Data and Reporting

Despite its importance, assessing ESG performance is complex due to inconsistencies in data
reporting. Studies show that financial reports and sustainability reports often highlight different risk factors,
making it difficult for investors to get a clear picture of a company’s true risk profile.

Key challenges include:

• Lack of standardization: Different rating agencies use varied methodologies, making ESG scores
inconsistent.
• Transparency issues: Some ESG ratings lack clear explanations of their scoring methods, making
them hard to validate.
• Data overload: The increasing demand for ESG data has resulted in a vast and sometimes
confusing set of information for investors.

To address these issues, companies should align their financial and ESG reporting, ensuring that the
information shared with investors is consistent, transparent, and accurate. This will not only improve
investor confidence but also support companies in meeting sustainability goals.

Understanding Smart Beta and ESG Integration

Smart beta and sustainability reporting have traditionally been separate fields, but recent trends
show they can be effectively combined. Over the last 15 years, asset managers have offered ESG-focused
investment products, evolving from ethical motivations to a more strategic integration of ESG factors with
smart beta techniques. This combination helps investors balance sustainability concerns with financial
performance.

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 While individual investors initially drove ESG-based investing, the growing recognition of
sustainability risks and opportunities has attracted institutional investors. Asset managers now use smart
beta strategies to align ESG exposure with financial risk premia, ensuring that sustainable investments
remain competitive.

Practical Methodology for ESG-Smart Beta Integration

A structured three-step approach is commonly used to integrate ESG with smart beta:

1. Controversy Screening: Excludes industries with significant ESG concerns.

2. ESG Scoring: Eliminates the bottom 30% of companies within each industry based on ESG
performance.
3. Smart Beta Allocation: Applies factor-based techniques to construct a diversified and risk-
optimized portfolio.

This approach ensures that ESG considerations are embedded in investment decisions while
maintaining financial stability. However, industry-wide exclusions can reduce investment diversification,
making it necessary to balance ESG goals with overall market exposure.

Challenges in ESG Data and Reporting

Despite its advantages, integrating ESG into smart beta strategies presents challenges:

• Inconsistent ESG Ratings: Different agencies use varied methodologies, leading to inconsistent
ESG scores.
• Transparency Issues: Many ESG rating systems lack clarity on their scoring criteria.
• Industry Bias: Excluding entire industries based on ESG concerns may overlook improvement
opportunities within companies.

Investors must carefully evaluate ESG data sources and methodologies to make informed decisions.

The Role of Integrated Reporting

As ESG considerations gain prominence, companies face increasing pressure to improve

transparency in financial and sustainability reporting. Traditional financial reports often fail to capture long-
term sustainability risks, leading to the rise of Integrated Reporting (IR). IR combines financial, social, and
environmental performance metrics, helping investors assess a company’s long-term value creation.

The International Integrated Reporting Council (IIRC) introduced a framework emphasizing:

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 • Holistic Value Creation: Companies should report on financial, intellectual, human, social, and
environmental factors.
• Breaking Internal Silos: Integration across business functions improves decision-making.
• Stakeholder Considerations: Beyond shareholder returns, businesses must consider broader
stakeholder impacts.

Challenges in Integrated Reporting

Despite its potential, Integrated Reporting faces several issues:

• Limited ESG Focus: Critics argue that IR still prioritizes financial performance over sustainability.
• Analytical Misalignment: ESG analysts and fund managers use varied methodologies, creating
inconsistencies.
• Lack of Standardization: Companies struggle to align ESG performance with financial reporting
frameworks.

For Integrated Reporting to be effective, businesses must actively align ESG data with financial
performance metrics, ensuring transparency and consistency.

Integrated Management: Operationalizing Sustainable Strategy

As managers realize that Environmental, Social, and Governance (ESG) factors are becoming
crucial in financial risk analysis for investors, the next step is to integrate ESG considerations into internal
and external business strategies. This shift is called "Integrated Management," distinguishing it from
Integrated Reporting. Integrated Management emphasizes aligning both financial and non-financial goals
across the entire organization. This alignment goes beyond communicating with investors to incorporating
ESG metrics directly into planning, forecasting, and performance monitoring processes.

The Role of Performance Management

Ferreira and Otley (2009) argue that performance management, which includes strategy design,
execution, and monitoring, is a multi-disciplinary concept. It combines business policy, accounting,
leadership, and behavioral change. This approach uses systems thinking, incorporating dynamic models
and feedback loops to adjust and influence performance. A well-known model for this is Kaplan and
Norton’s Balanced Scorecard (1996), which focuses on how companies execute their strategies, not just
design them.

Challenges with ESG Reporting

While Integrated Reporting uses "six capitals" to represent value creation (e.g., financial, human,
social), it lacks detailed insights into the interactions between these capitals. By focusing only on material
risks without considering the broader business context, it can obscure the dynamics of a business model. A

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materiality approach that focuses on risks identified through stakeholder and business relevance can miss
the strategic relationships and dependencies between various topics, limiting its usefulness in developing a
sustainable strategy.

Internal vs. External Focus

Material topics (i.e., ESG issues) are usually selected through interviews or questionnaires, often
without enough input from key internal management teams. These topics often don't reflect detailed
industry-specific data or consider dependencies between them. Without a deep analysis of strategic goals,
companies may end up with fragmented strategies instead of a unified, sustainable approach.

Building an Integrated Management Approach

To operationalize a sustainable strategy, a more comprehensive approach is necessary. This
involves actively modeling the strategy, using frameworks like the "sustainable strategy map" (see Fig. 6.2),
which clearly shows dependencies across different capitals. The map also summarizes current and future
objectives, integrating available data for a coherent internal overview. This framework should be applied
consistently across business units, ensuring alignment with both corporate and business unit goals.

Aligning Corporate and Business Unit Strategies

In large organizations, managers must align corporate-level strategies with those at the business
unit level (Wunder, 2016). While business units might have different goals, the overall strategy should be
integrated and cohesive. This alignment, combined with feedback loops from business units, helps refine
corporate strategy. Cascading strategy throughout the organization can be challenging, but it’s critical for
creating synergy and ensuring that sustainable practices are embraced at every level.

Setting Integrated Targets

It’s important to establish clear and measurable ESG targets that are aligned with leadership
behavior and existing incentive structures (see Fig. 6.3). Managers should be given the authority to act and
be held accountable for outcomes. The more standard these indicators are across the organization, the better
they support strategic alignment. However, some flexibility is needed at the business unit level to adapt the
strategy as necessary.

Support from Corporate Leadership

Corporate management plays a crucial role in supporting the implementation of sustainable
strategy. This includes ensuring that resources are available for key initiatives, with a distinction between
corporate-level and business-unit-level support. A small number of corporate-wide initiatives, funded by
headquarters, can provide a strong foundation for raising awareness and setting the stage for broader
integration of sustainability topics across the organization.

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Leadership Behavior and Performance Management
Integrated Management requires changes not only in performance measurement but also in
leadership behavior. Leaders need to move from simply communicating sustainability goals to fostering a
culture where sustainable strategy is seen as everyone’s responsibility. Introducing Integrated Management
is a phased process that starts with aligning internal and external measures, and progresses into a model
where leadership supports sustainable strategy at all levels of the organization.

Figure 2. Sustainable Strategy Map

Figure 3. Integrated Management Process

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Conclusion

As sustainability becomes a key part of business and financial practices, companies need to rethink
how they lead strategic and organizational changes. To keep up with the growing demands from investors,
organizations must make sure that their sustainable strategies are integrated into their overall management.

Currently, there aren’t comprehensive rules for combining non-financial (like ESG) and financial
reporting, and external investors are increasingly demanding more transparency. Companies need to stop
just reacting to these demands and start being more proactive. By using advanced investment techniques,
such as Smart Beta (which focuses on identifying material ESG factors), businesses can better align the
way rating agencies evaluate them with their own internal strategies. This means improving their
understanding of what data investors and agencies need and ensuring that they communicate these insights
clearly. Organizations should also be more open and willing to discuss how they collect, analyze, and share
data. This will help companies keep up with growing demands for accurate, reliable information and ensure
that they are not just collecting data for the sake of it, but doing so in a thoughtful and strategic way.

Another important action is making sure that both internal and external reports are connected. This
will give a more complete picture of the company’s objectives, performance, and strategies. Companies
need to make sure that both their financial and non-financial goals are aligned, and they shouldn’t create
unnecessary barriers between them. If a company fails to do this, it will lead to confusion and poor
performance. To succeed, management must be able to respond to external challenges and ensure that
strategies are clearly communicated and followed throughout the organization. This requires a change in
the way processes and systems work, and strong leadership from the top that helps guide the company in
the right direction.

In short, businesses must take more control of their sustainability strategies by better aligning
reporting, improving communication, and ensuring that leadership supports this process throughout the
company.

Reference:

Wunder, T. (2019). Rethinking strategic management: Sustainable strategizing for positive impact.
Springer.

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