Once an underresearched entity in the workplace, ESG integration has become an increasingly valued topic in the discussion of a company’s future financial performance. Although the financial performance of a company is an important topic of conversation, the other values measured in a company affected by ESG integration are more qualitative than quantitative, and have just as much importance.
“ESG integration is simply the implementation of proactive measures to meet changing conditions in the socio-economic environment,” says Sarah McPhee, Chairwoman and director of AP4. “Companies that work with ESG are more likely to be sensitive to strategic future scenarios, and more likely to be able to meet competitive challenges.”
As the future of ESG integration becomes strategically implemented in more organizations, being able to meet the competitive challenges at hand will allow for a company to keep on pace with global growth. However, part of the understanding of ESG integration is recognizing that not all assets are going to be obtained or used by physical means.
“For want of a more appropriate term, we talk about intangible value, but in the grand scheme of things such value drivers can be very tangible,” says Susanne Stormer, VP of Corporate Sustainability at Novo Nordisk. “For many companies, up to 90% of their market cap is attributable to factors beyond material assets. But what if there’s even more value to be derived, if only we had better metrics? This is where ESG analysis comes in.
“Done well, it does two things: It identifies risks related to environmental, social and governance aspects of a company’s performance and it identifies potential upsides, ‘alpha’, where companies manage such issues better than their peers, and brings them to the attention of investors – and indeed to the company’s management.”
The transgression of ESG integration proves its value alone. Once a public relations issue, ESG integration has worked its way up to being one of the top concerns from boards and management.
“Today, ESG is a business imperative,” says Ulrika Hasselgren, the Managing Director and Global Head of Responsible Investment Strategy & ESG Integration at Institutional Shareholder Services. “It has moved from the public relations department through to management and the board with the backing of a growing number of mainstream investors.”
Data from ISS shows how board members with responsible and sustainable investment experience is increasing in companies as well.
“According to our data, a full 33% of the S&P 500 have at least one director with Corporate Social Responsibility/Socially Responsible Investment experience on the board — that’s a powerful figure,” says Hasselgren. “Our data also shows that 21% of the companies in the Financial Times Stock Exchange All World Developed index are signatories to the UN Global Compact, meaning that their CEOs have committed to implement universal sustainability principles and take steps to support UN goals.”
Organizations from around the world are showing their interest in manifesting a sustainable practice, and how ESG integration can affect their value and other issues as well.
“These companies’ management are examining the impact of climatechange, the implications of a rising middle class and the entry of women to the work force and tackling the financial impact of the shifting influences,” says McPhee. “Obviously, companies with proactive strategies are more likely to increase in value.”
Taking a proactive strategy allows for a company to keep up at the competitive pace of ESG integration, and it’s should be of particular interest companies looking to attract investors.
“The integration of ESG can be a key differentiator for companies competing to attract or retain long-term capital while, conversely, not complying with ESG principles is likely to be viewed as a risk investors do not want to take,” says Hasselgren. “So, without ESG integration, a company will not achieve the highest possible valuation.”
A company’s relationship with investors is directly related to its integration of ESG practices. The more integration a company shows, the more dynamic it is in its practices.
“From a management perspective, integration of ESG dimensions of performance makes a company more resilient in an increasingly more complex, interconnected and dynamic business environment,” says Stormer. “This is what investors will look for when they make investment decisions.”
While the value cannot always be measured by capital gains, it can certainly be measured by other qualitative factors.
“It may still be difficult to do valuation in financial terms, but there is ample evidence that companies who do well on ESG dimensions are better managed and do outperform peers, measured by share performance,” says Stormer.
The increase in ESG integration is being pushed forward by investors, and the number of investors moving ESG forward is increasing as the valuation of integration increases as well.
Says Hasselgren, “Given that ESG development is driven by an increasing number of investors, who want to see that companies incorporate ESG standards into their business strategies and operations, one can argue that corporate executives and boards who do not deal with ESG from a strategic business perspective have not firmly attached themselves to their owners and investors.
“In light of this, we see companies creating board-level committees that focus on the environment, social responsibility, ethics and culture. In fact, our data shows that at least 38 companies in the S&P 500 have these board-level committees; PepsiCo, Goldman Sachs and Sysco are some of the names on this list.”
Unfortunately, the conclusion that ESG integration increases financial performance is still hard to make. The evidence is not embedded or soundly supported in a lot of data. “But for sure,” says Stomer, “good ESG management can help attract certain investor profiles with a focus on long-term value creation.”
Theoretically, the future in ESG integration shows that it might be able to fund itself. “The beauty of ESG integration is that it widens the potential investor universe for a company and thereby, should reduce its cost of funding,” says McPhee. “While ESG investors are still a minority, companies integrating ESG factors will attract both ESG and conventional investors.”
However, since the method of analysis for ESG integration is still growing, many companies are asked to self-report through questionnaires. While the information taken from questionnaires is important, it hardly gives a thorough report.
“ESG analysis is still a nascent discipline, and it requires much more qualitative analysis from multiple sources,” said Stormer. “Questionnaires rarely give a full picture. Therefore, ESG analysts will tend to seek more engagement with companies to better understand how they manage these issues.
“This kind of investor queries may be seen as time-consuming, particularly because it is often one-on-one engagements, but in our experience they can also help inform company policies and practices.”
Companies who seek to gain competitive advantage will need to stay at the forefront of ESG integration, and must adapt to the change in policy by having a malleable, but stable, strategic implementation.
“As for future financial performance, ESG integration is just a form of strategic discipline whereby a company accepts changing values of its stakeholders and is concerned about environmental impact,” says McPhee.
Maintaining that discipline is crucial for a number of reasons, such as for identifying what risks are involved during ESG integration. When a company loses strategic discipline, often times a number of problems in a new program start to slip through the foundation of its development.
“It can be difficult, both for the ESG analyst and for the company management, to identify which ESG issues entail the biggest risks, and opportunities,” says Stormer. “In recent years we have seen increasing sophistication in analyses of how climate change may affect a company’s future performance.
“This is a field where there is strong scientific data and a growing consensus on how to quantify impacts. There are other robust frameworks for measuring environmental impacts, such as the Natural Step.”
Strong scientific data that will quantify impacts will help increase transparency in ESG reporting, ergo drawing in a wider range of potential investors from both sides of the integration spectrum.
Says Hasselgren, “I would also say that companies that do not incorporate ESG from a business strategy perspective as well as with high transparency – thus failing to engage ESG investors and stakeholders — can be affected by the risk of a lower valuation.
“This lack of transparency can create skepticism and be interpreted by investors as hidden risks. It can also signal insufficient coordination between the company’s management and its investors and stakeholders.”
Outside of investors, there are many other stakeholders when it comes to ESG integration and development, who expect companies to manage ESG dimensions as effectively as they do financial capital.
“These could be non-governmental organizations, whose job it is to hold companies to account for their performance, authorities who will expect companies to at least meet minimum standards of performance in regards to, for example, respect of human and labour rights, environmental management and climate action, anti-corruption, customers, consumers and of course the company’s employees,” says Stormer.
While strategic implementation should be a concern of organizations, the provision of transparent ESG reporting must be conducted by outside organizations in order to obtain objective evaluations.
Says McPhee, “Exchanges strive to provide transparent and comparable information so that investors will have access to ‘perfect information.’ If every company has its own set of metrics, investors will not be able to evaluate the importance of ESG factors in company valuation.
“Just as exchanges insist on standardized financial information, they will hope to attract better companies with ESG information by increasing comparability, and thereby attract the largest investors. It is really very logical that exchanges should require standardized ESG metrics since these are gradually gaining the same importance as financials.”
ESG dimensions expand to a number of sub-issues, and the strategic implementation of and evaluation of ESG practices heavily impact all of them. Whether it be financial profit, human capital, transparent communications among executives, etc, ESG integration is an evolving process that will continue to have a necessary effect for positive growth in the global economy.
“We have also seen an emerging approach to measuring Environmental Profit and Loss. Much of this is driven by experimentation by academia, analysts and companies. Where there is less focus and rigour is on the social dimensions,” says Stormer. “How can we valuate an engaged workforce, for instance. Or a healthy workforce?
“Some of the barriers may be attributable to the fact that there are many issues related to valuation of human lives, or quality of life. Yet, intuitively, everyone will understand that there is value related to these dimensions, which can — and should — be factored in when assessing how well a company is positioned for the future.”
Vice versa, when companies take a look at their smaller issues and begin to implement positive change, they begin to also lay the foundational groundwork for a stable integration of ESG practices. In turn, this will allow them to increase their value and maintain pace with growth in the competitive landscape.
Christopher P. Skroupa