Getting your environmental, social, and governance (ESG) proposition right links to higher value creation.
Your business, like every business, us deeply intertwined with environmental, social, and governance (ESG) concerns. It makes sense, therefore, that a strong ESG proposition can create value. In this article, we provide a framework for understanding the five key ways it can do so. But first, let's briefly consider the individual elements of ESG:
The E in ESG, environmental criteria, includes 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. Every company uses energy and resources; every company affects, and is affected by, the environment.
S, 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. Every company operates within a broader, diverse society.
G, 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. Every company, which is itself a legal creation, requires. governance.
Thinking and Acting on ESG in a proactive way has lately become even more pressing. The US Business Roundtable released a new statement in August 2019 strongly affirming business's commitment to a broad range of stakeholders, including customers, employees, suppliers, communities, and, of course, shareholders. ESG-oriented investing has experienced a meteoric rise. 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 suggest that ESG is much more than a fad or a feel-good exercise.
Five links to value creation
The five links are a way to think of ESG systematically, not an assurance that each link will apply, or apply to the same degree, in every instance. some are more likely to arise in certain industries or sectors; others will be more frequent in given geographies. Still, all five should be considered regardless of a company's business model or location. The potential for value creation is too great to leave any of them unexplored.
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. Superior ESG execution has demonstrably paid off in mining, as well. Consider gold, a commodity that should, all else being equal, generate the same rents for the companies that mine it regardless of their ESG proposition. Yet one major study found that companies with social-engagement activities that were perceived to be beneficial by public and social stakeholders had an easier go at extracting those resources, without extensive planning or operational delays. These companies achieved demonstrably higher valuations than competitors with lower social capital. ESG can also drive consumer preference. McKinsey research ha shown that customers say they are willing to pay to "go green". McKinsey found that consumers would be willing to pay an additional 5 percent for a green product if it met the same performance standards as a non green alternative. In another study, nearly half (44 percent) of the companies of the survey identified business and growth opportunities as the impetus for starting their sustainability programs. The payoffs are real. When Unilever developed Sunlight, a brand of dishwashing liquid that used much less water than its other brands, sales of Sunlight and Unilever's other water-saving products proceeded to outpace category growth by more than 20 percent in a number of water-scarce markets. And Finland's Neste, founded as a traditional petroleum-refining company more than 70 year ago, now generates more than two-thirds of profits from renewable fuels and sustainability-related products.
Cost reductions ESG can also reduces 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. In the same research finding, there is a significant correlation between resource efficiency and financial performance. The study also identified a number of companies across sectors that did particularly well - precisely the companies that had taken their sustainability strategies the furthest. As with each of the five links to ESG value creation, the first step to realizing value begins with recognizing the opportunity. Consider 3M, which has long understood that being proactive about environmental risk can be a source of competitive advantage. 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. Another enterprise, a major water utility, achieved cost savings of almost $180 million per year thanks to lean initiatives aimed at improving preventive maintenance, refining spare-part inventory management, and tackling energy consumption and recovery from sludge. FedEx, for its part, aims to convert its entire 35,000-vehicle fleet to electric or hybrid engines; to date, 20 percent have been converted, which has already reduced fuel consumption by more than 50 million gallons.
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, it is found 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. Typically one-third of corporate profits are at risk from external engagement intervention. Regulation's impact, of course, varies by industry. For pharmaceuticals and healthcare, the profits at stake are about 25 to 30 percent. In banking, where provisions on capital requirements, "too big to fail", and consumer protection are so critical, the value at stake us typically 50 to 60 percent. For the automotive, aerospace and defense, and tech sectors, where government subsidies (among other forms of intervention) are prevalent, the value at stake can reach 60 percent as well.
Employee productivity uplift A strong ESG proposition can help companies attract and retain employees, enhance employee motivation by instilling a sense of purpose, and increase productivity overall. Employee satisfaction is positively correlated with shareholder returns. For example, the London Business School's Alex Edmans found that the companies that made 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. Moreover, it's long been observed that employees with a sense not just of satisfaction but also of connection perform better. The stronger an employee's perception of impact on the beneficiaries of their work, the greater the employee's motivation to act in a "prosocial" way. Recent studies have also shown that positive social impact correlates with higher job satisfaction, and field experiments suggest that when companies "give back", employees react with enthusiasm. For instance, randomly selected employees at one bank who received bonuses in the form of company payments to local charities reported greater and more immediate job satisfaction than their colleagues who were not selected for the donation program. Just as a sense of higher purpose can inspire your employees to perform better, a weaker ESG proposition can drag productivity down. The most glaring examples are strikes, worker slowdowns, and other labor actions within your organization. Farsighted companies pay heed. Consider General Mills, which works to ensure that its ESG principles apply "from farm to fork to landfill". Walmart, for its part, tracks the work conditions of its suppliers, including those with extensive factory floors in China, according to a proprietary company scorecard. And Mars seeks opportunities where it can deliver what it calls "wins-wins-wins' for the company, its suppliers, and the environment. Mars has developed model farms that not only introduce new technological initiatives to farmers in its supply chains, but also increase farmers' access to capital so that they are able to obtain a financial stake in those initiatives.
Investment and asset optimization A strong ESG proposition can enhance investment returns by allocating capital to more promising and more sustainable opportunities (for example, renewables, waste reduction, and scrubbers). It can also help company avoid stranded investments that may not pay off because of longer-term environmental issues (such as massive write-downs in the value of oil tankers). Remember, taking proper account of investment returns requires that you start from the proper baseline. 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-intense industries. And bans or limitations on such things as single-use plastics or diesel-fueled cars in city centers will introduce new constraints on multiple businesses, many of which could find themselves having to catch up. One way to get ahead of the future curve is to consider repurposing assets right now - for instance, converting failing parking garages into uses with higher demand, such as residences or day-care facilities, a trend we're beginning to see in reviving cities. Foresight flows to the bottom lines, and leaning into the tailwinds of sustainability presents new opportunities to enhance investment returns. Tailwinds blow strongly in China, for example. The country's imperative to combat air pollution is forecast to create more $3 trillion in investment opportunities through 2030, ranging across industries from air-quality monitoring to indoor air purification and even cement mixing.
Who says that a strong environmental, social, and governance (ESG) proposition cannot create value for companies and their shareholders?
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