How Your Sustainability (ESG) Credentials Impacts Your Valuation
ESG – Environmental, Social, and Governance – refers to a set of criteria by which companies are evaluated, which considers the broader impacts of company operations on key stakeholders.
E in ESG, stands for environmental criteria, including the energy your company takes in and the waste
it discharges, the resources it needs, and the consequences for living beings as a result. Not least, E encompasses carbon emissions and climate change.
Social criteria, addresses the relationships your company has and the reputation it fosters with people and institutions in the communities where you do business. S includes labor relations and diversity and inclusion.”
Governance, is the internal system of practices, controls, and procedures your company adopts in order to govern itself, make effective decisions, comply with the law, and meet the needs of external stakeholders.”
At a time when climate change is viewed as “the defining issue of our generation”, and social issues such as diversity, equity, and inclusion top the corporate agenda, ESG performance has become a central lever for driving value. 2020 was a pivotal year for environmental, social and governance (ESG) integration and particularly ESG investing, with record inflows into ESG products rising 140% in 2020, per Moody’s Investors Service. The pandemic has had a profound impact on ESG goals, as there is now a heightened sense of awareness and urgency to combat climate change and social inequality.
From 2016 to 2018, ESG integration increased by 69% across global public and private markets, according to the 2018 Global Sustainable Investment Review. The trend reflects a larger shift—in business, consumerism, and investing—toward greater awareness of impact. As consumers are making more socially and environmentally conscious choices, investors are also looking to support the funds and companies that drive positive change.
Global sustainable investment now tops $30 trillion—up 68 percent since 2014 and tenfold since 2004. The acceleration has been driven by heightened social, governmental, and consumer attention on the broader impact of corporations, as well as by the investors and executives who realize that a strong ESG proposition can safeguard a company’s long-term success. The magnitude of investment flow suggests that ESG is much more than a fad or a feel-good exercise.
But even as the case for a strong ESG proposition becomes more compelling, an understanding of why these criteria link to value creation is less comprehensive. How exactly does a strong ESG proposition make financial sense? According to a McKinsey Report, ESG links to cash flow in five important ways
Facilitating Top-Line Growth
A strong ESG proposition helps companies tap new markets and expand into existing ones. When governing authorities trust corporate actors, they are more likely to award them the access, approvals, and licenses that afford fresh opportunities for growth. ESG can also drive consumer preference. McKinsey research has shown that customers are willing to pay to “go green” and the pay-offs are real. Unilever’s Sustainable Living (Purpose-Driven) Brands are growing 69% faster than the rest, delivering 75% of the company’s growth. Finland’s Neste, founded as a traditional petroleum-refining company more than 70 years ago, now generates more than two-thirds of its profits from renewable fuels and sustainability-related products. Neste also recently announced that it is aiming for 100% renewable electricity use globally by 2023. In a time when sustainability has become a critical differentiator for businesses, strong ESG performance creates a variety of competitive advantages for companies.
ESG can also reduce costs substantially. Among other advantages, executing ESG effectively can help combat rising operating expenses (such as raw-material costs and the true cost of water or carbon), which McKinsey research has found can affect operating profits by as much as 60 percent. Consider 3M- the company has saved $2.2 billion since introducing its “pollution prevention pays” (3Ps) program, in 1975, preventing pollution up front by reformulating products, improving manufacturing processes, redesigning equipment, and recycling and reusing waste from production. FedEx, for its part, aims to convert its entire parcel pickup and delivery fleet to “zero-emission electric vehicles” by 2040; to date, more than 20 percent have been converted. They have already saved jet fuel consumption by more than 1.43 billion gallons since 2012.
Reduced Regulatory and Legal interventions
A stronger external-value proposition can enable companies to achieve greater strategic freedom, easing regulatory pressure. In fact, in case after case across sectors and geographies, we’ve seen that strength in ESG helps reduce companies’ risk of adverse government action. It can also engender government support. The value at stake may be higher than you think. By our analysis, typically one-third of corporate profits are at risk from state intervention.
Upliftment of Employee Productivity
Instilling a strong sense of purpose with an effective ESG proposition can help companies enhance employee motivation, and increase productivity overall. Employee satisfaction is positively correlated with shareholder returns. For example, Fortune’s “100 Best Companies to Work For” list generated 2.3 percent to 3.8 percent higher stock returns per year than their peers over a greater than 25-year horizon. It has long been observed that employees with a sense not just of satisfaction but also of connection, perform better. Just as a sense of higher purpose can inspire your employees to perform better, a weaker ESG proposition can drag productivity down.
Investment and Asset Optimization
The attention given to environmental, social and governance (ESG) issues has never been greater in the investing world. According to EY’s Global Private Equity Survey 2021, over two-thirds of investors point towards looking at ESG risks and opportunities very seriously for their investment decisions. Moreover, an International Finance Corporation report suggests that India has a US$ 3.1 trillion climate investment opportunity by 2030. A strong ESG proposition can enhance investment returns by allocating capital to more promising and more sustainable opportunities. Recently, Legal & General announced it would divest from four companies over their failure to address climate risks, and BlackRock supported 75% of climate and social proposals in the first quarter of 2021. Black Rock has even threatened to vote its shares against any portfolio company that doesn’t fall in line with carbon reporting. Investors now see inaction on climate change as a key material risk to the business.
When it comes to ESG, it’s important to bear in mind that a do-nothing approach is usually an eroding line, not a straight line. Continuing to rely on energy-hungry plants and equipment, for example, can drain cash going forward. While the investments required to update your operations may be substantial, choosing to wait it out can be the most expensive option of all. The rules of the game are shifting: regulatory responses to emissions will likely affect energy costs and could especially affect balance sheets in carbon-intensive industries.
Being thoughtful and transparent about ESG risk enhances long-term value—even if doing so can feel uncomfortable and engender some short-term pain.
Companies that perform poorly in environmental, social, and governance criteria are more likely to endure materially adverse events. Just in the past few years, multiple companies with a weak ESG proposition saw double-digit declines in market capitalization in the days and weeks after their missteps came to light.
It’s a crucial time for companies to prioritize their ESG goals. For the ones who don’t it could threaten the very survival of business, while the ones who do could see exponential growth and new opportunities.
“Climate change has become a defining factor in companies’ long-term prospects. Awareness is rapidly changing, and I believe we are on the edge of a fundamental reshaping of finance.”
– Larry Fink,
Chairman and CEO, BlackRock, largest money manager in the world