It has been a while since companies viewed sustainability as a source of expenses for corporations or, in the best of cases, as a source only of gains in terms of reputation. It was also believed, for some time, that companies that invested in sustainability where doing it for ideological reasons or to stand out in a specific market niche, one that still encompassed a small share of consumers who were engaged and worried about the future of the planet. This outlook has rapidly changed over the last decade.
The change in the understanding and the vision regarding sustainability in corporations has come to transform cost into gain, market niche into global stance, sustainability and social responsibility (which, for a few years, were separate departments/business units that were kept apart form the strategic management core of companies) into ESG – Environmental, Social and Governance strategy. And, when the ESG window opened for corporations, they realized that this was a view into a new world – and into a new type of investor market.
➔ The terms ESG refers to a body of environmental, social and governance practices which, when integrated and internalized, from the strategy stage, up to the operation of corporations, act upon future needs, risks and opportunities, of the corporations, as well as upon the environment ant society, aiming at generating shared value and guiding prosperity.
Little by little, this new investor market started to integrate the ESG agenda of corporations into their parameters of investment. In a more pragmatic than idealist way, investors noticed that ESG practices generate value to corporations.
➔ An analysis of the ESG agenda is able to establish the stance of the corporation in relation to its material matters that are priorities to the prosperity of the corporations, as well as to the environment and the society in which it operates.
A corporation with robust and well-established ESG practices is more efficient, responsible and sustainable in its use of natural resources, in the development of human capital and in the management of innovation. This, in turn, makes the corporation maintain profitability and competitiveness in the long term. If this corporation has a purpose that is connected to the impacts it generates – searching to maximize positive impacts and minimize negative ones – and to a more sustainable operation, it attracts more customers and talent, widening both its consumer base and enlarging the team that will lead it to a sustainable growth.
This is an organization that also engages and pushes its different stakeholders forward, sharing, boosting and adding value to all different parties involved. It is, therefore, a company that has a significant potential to generate shared value, something that fosters the development of suppliers and the general community. Adding to this, corporations that have a robust ESG agenda, also systematically manage their corporation and operational risks that may generate financial and social-environmental impact. In this way, the potential to generate long-term cash flow, together with a consistent risk and opportunity management, bring more resources for investments and make it easier to obtain financing, thus allowing for expansion and innovation of their business. So, such practices generate better results and positive long and short term impacts.
The growing interest for Green Funds and Bonds is the embodiment of this process. Sustainable investment funds gather stocks form companies that use the ESG criteria as part of their strategy. These funds have been progressively generating higher gains to investors. Green bonds, on the other hand, are fixed income titles used to raise funds in order to finance sustainable projects in corporations.
Research and studies have shown more clearly how practices connected to ESG lead to better results and, consequently, how the stocks of sustainable companies tend to gain more value than companies of similar profile that have weaker ESG strategies.
The elaboration of a compliance system in the company is an example of a governance practice -applied to the business – that investors have perceived as a fundamental strategy, as it shows a concern of the business with the fiscal and financial health of the corporation, in addition as being viewed as a form of action against corruption and bribing. Practices linked to the affirmative action and gender equity, especially in leadership positions in corporations, also have an effect on operating results and, consequently, on the valuation of companies. Research carried out by Credit Suisse, published in 2020 in Forbes magazine, shows that companies with one or more women on their boards presented higher levels of innovation and better financial results than companies of similar profile, but which only have men on their boards.
➔ Globaly, USD 30 trillion has been reached in sustainable investment – an increase of 68% since 2014 and ten times over 2004 figures.
An article published by The Journal of Management Portfolio, from MSCI, has analized, from the investor perspective, the influence of the incorporation of ESC aspects in corporations.
The article highlights the three main goals of the investment in ESG: 1. ESG Integration – aimed at improving the profile of portfolio returns; 2. Investment based on values – it seeks to align the portfolio to specific beliefs and ideals; 3. Investment on impact – capital used to speed up social and environmental change, such as, for example, removing carbon from the economy.
The article focuses on the first aspect: ESG as a way to obtaining higher financial results in the management of investor portfolio, and it looks into three pathways for this to happen.
Srtrong ESG profile ➪ More competitivenes ➪ Higher profits ➪ Higher dividends
Corporations that have a strong ESG profile are more competitive than their peers. The competitive advantage may be due to an efficient use of resources, a better development of human capital, or a better management of innovation. Companies that are best rated by their ESG, typically develop good long-term business plans and incentive plans for senior management. Competitive advantages generate a good return on investment, which leads to greater profitability. Higher profitability results in more dividends.
It is important to note that investors focused on sustainability, in general, have a long-term investment horizon. In the long-term performance, the contribution of dividends to the return on investments was greater as the forecast investment time increased.
Strong ESG profile ➪ Better risk management ➪ Lower risk of serious incidents ➪ Lower tail risk
Corporations that have a strong ESG profile typically have above-average risk control and compliance standards. By having better risk control standards, these companies suffer fewer incidents such as fraud, embezzlement, corruption or litigation, that can seriously impact the company’s value and, consequently, their stock price.
When incidents that lead to risks are less frequent, the company has fewer sudden falls in share price due to specific and unforeseen events (tail risk). Research has shown that the best-rated companies in terms ESG presented statistically lower rates of risk of stock decline such as volatility, moments of partial downs and losses in worst case scenarios.
It is important to note that the management of a company needs to be in accordance with the level of risk exposure it faces. A company with a high degree of risk associated with ESG factors, needs to have a robust and proactive risk management, while a company that has limited exposure may have a more modest management.
Strong ESG profile ➪ Lower systemic risk ➪ Lower capital costs ➪ Higher valuation
Corporations that have a strong ESG profile are less vulnerable to systematic market shocks. Therefore, they demonstrate less systemic risk. For example, companies that operate under regimes of greater energy efficiency or reduced resource/commodity consumption are less vulnerable to changes in energy or commodity prices. In this way, the appreciation of its shares tends to demonstrate less systemic market risk. This translates into lower cost of capital for the company. And the lower cost of capital directly leads to a higher valuation.
On the other hand, companies with a profile that is less focused on ESG aspects have a relatively smaller investor base, for two reasons: 1. Investor preferences, either because of risk aversion, or because they are socially aware and avoid exposure to companies with low ESG standards; 2. Information asymmetry, as companies with little ESG focus are not as transparent with their stakeholders (including investors), in particular with regards to their exposure to risk, risk management, and governance standards
While the impact of ESG on a company’s investment base and valuation is difficult to measure in practical terms, there are good reasons why large investors are excited to integrate ESG into their portfolios. Consequently, it is hoped that this movement will motivate organizations to go further, by including ESG aspects in their operations, products and services, in the way they do business, and in ESG-related disclosure to their stakeholders. Improved standards of competitiveness, resilience to risk, a more conscientious and transparent management, are factors that certainly have an impact on the company’s valuation and this benefits both investors and companies. All this still brings invaluable benefits to society and the future of our planet.
In order to capture these invaluable benefits, it is important for corporations to improve their ESG agenda, with the understanding that it will be a Journey. It will, therefore, be a trajectory that will involve actions in the short, medium and long terms, aimed at adapting organizational goals, business models, processes, structures and policies, for the generation of sustainable and shared value.
For corporations that are starting their journey now, the first step, after making the organization’s leadership aware of the importance of this agenda, is to define the organization’s material issues as well as the current situation of each of them. The assessment of management maturity in ESG is also part of this diagnosis, given that Management is the main link connecting the strategy with the areas, at the tactical and operational levels, in their initiatives and routines. Based on this diagnosis, strategic ESG ambitions should be outlined and more importantly, implemented through a consistent roadmap that involves different areas, levels and Stakeholders, in order to deliver the expected value and ensure the perpetuity of the new desired ESG practices and culture.
Make an initial evaluation of your company with our ESG Management meter. Using this self-assessment tool, you will know the level of maturity of your business in ESG Management. You will also get our recommendations about how to progress on your journey of evolution in terms of ESG parameters.
¹ Source: Global Sustainable Investment Review 2018, Global Sustainable Investment Alliance, 2018, gsi-alliance.org.
² Foundations of ESG Investing: How ESG affects equity valuation, risk and performance, by Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltán Nagy, and Laura Nishikawa – The Journal of Portfolio Management, Volume 45, number 5.