Companies often push aside investment in social factors in favor of profit, but environmental, social and governance (ESG) initiatives have been shown to intrinsically promote sustainable earnings and facilitate long-term success. Tucker Ellis’ Tod Northman and Savannah Fox discuss.
Recently, the Rock Center for Corporate Governance at Stanford University and ValueAct Capital teamed up on a case study, The Business Case for ESG (ESG Case Study). Environmental, social and governance (ESG) factors include a wide variety of influences conventionally excluded by investors and boards from the financial analysis of a company.
For example, ESG may include how a company responds to climate change, how it treats employees, what health and safety policies it has in place or even how the company responds to news that its CEO was involved in a scandal.
Though many critics contend that these factors are soft and perhaps unmeasurable, The Business Case for ESG argues that, despite their flimsy veneer, ESG factors hit hard in today’s world.
What is ESG? Environmental, social and governance refers to a company’s operational standards that socially conscious investors may use to determine whether to invest in a company. ESG looks at how a company performs as a steward of the earth, how it treats employees, suppliers, customers — and even the communities where it does business. Governance refers to management, the Board, executive pay, audits, internal controls, and shareholder rights.
ESG Acceptance Grows
Support for companies to embed ESG factors in business decision-making began in 2005, when Ivo Knoepfel argued that ESG led to sustainable markets and externalities that benefited society. Shortly after that, the United Nations Environment Programme – Finance Initiative reinforced this idea when it published a report that proved ESG was relevant for financial valuation.
Critics initially resisted applying ESG factors, fearing they would be ineffective and distracting. Instead, these critics, mostly investors, fixated on short-term profits. By 2013 and 2014, critics slowly warmed up to ESG after multiple studies showed that corporate sustainability produced good financial results. Today, as proposed by the Rock Center and ValueAct Capital, a framework exists that further validates the practicality and long-term sustainability of profits that accompany ESG integration.
According to the ESG Case Study, focusing on the durability of earnings and downside risk inherently incorporates many concepts associated with ESG. Analysis of ESG factors provides an effective risk-management structure, sheds new light on strategy development and growth opportunities and addresses the demands of customers, employees and investors.
ValueAct adopted a three-step framework to incorporate ESG factors in the decision-making process and to strengthen engagement with portfolio companies on these issues. The three steps are:
- Identify relevant stakeholders and factors
- Isolate and evaluate potential risks
- Support companies as they invest in their businesses to increase returns
The first step helps companies understand which ESG factors are most important to their operations based on the values of customers, suppliers, employees, regulators and society. As an example, ValueAct applied this framework to the private student loan industry. To reach long-term success, private student loan lenders must consider the goals of all stakeholders, including students, parents, colleges, government regulators, U.S. taxpayers and shareholders.
The second step evaluates and quantifies the company’s position and associated risk for each ESG factor. This step requires active engagement from investors with significant stakes and a long-term perspective. Here, participation can encourage risk mitigation and justify management decisions targeted toward the broader investment community.
In the private student loan example, ValueAct considered the role of the federal government as both a competitive lender and a policymaker. It questioned whether private loans provided better value than federal loans, what policy changes might affect both programs and how multiple-lender borrowing affects schools and students. These questions focused private student loan providers on the factors its stakeholders valued the most: accessibility, quality and affordability.
The third step requires senior business leaders to consider material ESG factors in their development of strategy. As the authors of the case study argue, ESG factors create positive reactions that build atop one another and “create a powerful flywheel effect.” For example, a company’s investment in sustainable supply chains can promote volume growth and premium pricing through loyal customers, which in turn attracts talented employees to the company and may even reduce costs.
In the private student loan context, investments targeted toward improving student outcome can reduce the number of defaults while at the same time enhancing the perception of the company by customers, employees and regulators.
ESG and Institutional Investments
In addition to the role of ESG in business decision-making, ValueAct also suggests that there is an opportunity for institutional investors to support companies where sustainability is at the heart of the investment thesis or whose business models promote solutions for certain environmental and social problems.
AES, a global power company, illustrates a company shifting the focus of its business model to address a societal problem – in this case, carbon emissions. In 2018, AES divested assets primarily tied to coal plants and publicly promised to reduce carbon intensity. It ramped up its environmental impact reporting and changed its mission statement to reflect its commitment to a “safer and greener energy future.”
These changes attracted new talent, which resulted in increased productivity and innovation. At the same time, AES’s price-to-earnings multiple jumped from 9x to 14x in just over a year while its stock price outperformed industry indexes.
Similarly, one of the largest for-profit education companies in the U.S., Strategic Education, repositioned itself for long-term growth based on a business model that contributes to positive social change. With costs and student debt rising, Strategic Education saw an opportunity to make higher education more affordable.
Through investments in artificial intelligence, student-outcome measures, competency-based learning and non-educational degree offerings, Strategic Education improved the student experience and retention rates. As a result, operating margins, profits, enrollment and graduation rates increased. Most importantly, Strategic Education’s focus on ESG factors set it apart from competitors, many of which collapsed or experienced declines in revenue and profits.
ESG is here to Stay
The Business Case for ESG makes clear that the incorporation of ESG factors is more than a fad. It is necessary to create long-term value and generate returns in industries that face significant environmental and social challenges.
Despite its initial lukewarm reception, societal changes and increased transparency have solidified ESG’s place in financial valuation. It has become easier to measure the impact of ESG factors through an increase in available data. With the added development of industry benchmarks, like the recently opened S&P 500 ESG Index, investors will come to expect ESG initiatives as an indicator for a sustainable profit and minimized risk.
 The Business Case for ESG, Rock Center for Corporate Governance, May 23, 2019, available at papers.ssrn.com/sol3/papers.cfm?abstract_id=3393082.
 Who Cares Wins, The Global Compact, December 2004, available at https://www.unglobalcompact.org/docs/issues_doc/Financial_markets/who_cares_who_wins.pdf.
 A legal framework for the integration of environmental, social and governance issues into institutional investment, UNEP Finance Initiative, October 2005, available at https://www.unepfi.org/fileadmin/documents/freshfields_legal_resp_20051123.pdf.
 From the Stockholder to the Stakeholder, University of Oxford and Arabesque Partners, March 2015, available at arabesque.com/research/From_the_stockholder_to_the_stakeholder_web.pdf.
 First U.S. ETF Tracking S&P 500 ESG Index Draws $25 Million, Wall Street Journal, June 27, 2019, available at https://www.wsj.com/articles/first-u-s-etf-tracking-s-p-500-esg-index-draws-25-million-11561645763?mod=searchresults&page=1&pos=1.