The business case for ESG

Bronagh Ward, Senior Associate at KKS Advisors, tells us how companies can act on the business case for ESG.

The ability to quantify a positive link between corporate ESG efforts and financial performance is at the centre of revolutionising the economy and bringing sustainability to the top of the agenda for corporate leaders. Today, we have a much deeper understanding of the financial implications of ESG than we had just a decade ago. In short, we now know that ESG issues are connected to better financial performance (when companies focus on the specific issues most relevant to their business and industry), and that investors use ESG data and company performance rankings to allocate capital, minimise risk and optimise returns. This knowledge is reshaping how senior decision makers think about strategy, competitiveness and value creation. 

A key milestone in the sustainability realm occurred in 2014, when leading academics, including George Serafeim (co-founder of KKS Advisors and Professor at Harvard Business School), demonstrated that a portfolio of companies with better sustainability performance generated significantly higher financial returns over an 18-year period than a similar portfolio with poor sustainability performance (1). This evidence helped challenge the assumption that investors and companies would have to sacrifice returns in exchange for social and environmental outcomes and accelerated interest in ESG in the private sector. 

Companies that have identified the right key issues for their business can start to measure their progress and, over time, drive performance gains

More evidence supporting the idea that ESG is good for business continues to emerge. A recent analysis of the banking industry conducted by KKS Advisors found that firms with good ratings on industry strategic sustainability issues delivered significant financial outperformance over firms with poor ratings on the same issues (2). BlackRock – the world’s largest institutional investor – has weighed in on the topic too, publishing research dispelling the myth that a return sacrifice is needed when adopting sustainable investing, arguing that in fact the opposite is true (3). According to BlackRock, the full consequences of a long-term shift to a more sustainable economy are not yet reflected in market prices, and a return advantage can be gained during the transition. Additionally, early evidence following the outbreak of the COVID-19 pandemic has shown that ESG funds have been more resilient to the market downturn, reinforcing the view that ESG is not a ‘nice to have’ during good times, but is in fact critical to better economic performance even during a market downturn (4). 

If ESG matters to financial performance, then what do companies need to do about it? In our experience of working with clients on sustainability strategies and reporting, a three-step strategy model is needed:
1. Communicate the business case, 2. Prioritise the most relevant ESG issues, and 3. Measure and track progress. 

1. Communicate the business case 

A first key step is to understand the business case and drivers for action, which for many companies begins with looking at the growing demand for ESG from their investor base. It is important to know that companies are being ranked on ESG disclosure by investors and by third-party ESG scoring providers, and that choosing not to disclose certain information will likely hurt your score. State Street Global Advisors, another of the world’s largest institutional investors, has been urging boards of directors to pay attention to ESG scores, noting that “a company’s ESG score will increasingly determine if trillions in global institutional and retail capital will flow toward them or away from them”(5). It is important to note that to generate the level of buy-in needed to integrate ESG successfully across an organisation, the business case should be communicated to key stakeholder groups across the organisation, and it must resonate with each of them. The board, and investor relations and sustainability teams are three groups that will each bring distinct perspectives and respond to different incentives. 

2. Prioritise the most relevant ESG issues 

Once the business case is well understood, companies that are truly committed to ESG will start to drive strategic performance upgrades across their business. To get there, the second step in the process is the identification of the most relevant ESG issues linked to the business model and industry that should be prioritised. Certain issues are more likely to impact financial and operational performance and therefore will be more important to investors. Given the vast universe of ESG issues that exist, it is essential to go through this prioritisation exercise in order to be efficient. For example, a good employee health and safety record is important for mining companies to retain their social licence to operate, while effective systemic risk management is more important for large financial institutions to ensure resilience. Too many companies find themselves lost among the multitude of existing ESG disclosure frameworks and as a result are pulled in many different directions without a guiding compass.  

3. Measure and track progress 

Companies that have identified the right key issues for their business can start to measure their progress and, over time, drive performance gains. Here, it is important to focus on quantifiable metrics which can be tracked and plugged into financial models. Some of the areas where companies typically find value from sustainability include direct costs savings (e.g. from energy efficiency), increased customer loyalty, increased staff retention rates and lower cost of capital. 

Going forward, the trend towards sustainability is set to intensify as investors and regulators step up their oversight of corporate sustainability disclosure and performance. It will be further intensified by pressure from the general public, the scientific community and NGOs, who are raising awareness on key issues such as climate risk – an issue which is projected to have severe impacts on the global economy within the next decade. Yet a simple truth is that many business leaders are currently missing opportunities to derive economic value from ESG. Sooner or later, companies that are proactive in embracing sustainability will ultimately be rewarded by the market. Overall, there can be no doubt that ESG matters and is here to stay.

The Luminous view

As KKS Advisors say, the business case is clear. COVID-19 has escalated ESG adoption, and there is clear evidence that ESG stocks are outperforming the market. Companies large and small must develop a clear ESG strategy.

(1) Eccles, Ioannou, and Serafeim (2014). The Impact of Corporate Sustainability on Organizational Processes and Performance. Management Science, Volume 60, Issue 11. Source: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1964011

(2) KKS Advisors and Global Alliance for Banking on Values (2019). Do Sustainable Banks Outperform? Source: https://www.kksadvisors.com/do-sustainable-banks-outperform

(3) BlackRock (2020). Sustainability: The tectonic shift transforming investing. Source: https://www.blackrock.com/us/individual/insights/blackrock-investment-institute/sustainability-in-portfolio-construction

(4) Financial Times (2020). ESG shines in the crash: legal milestone for ratings. Source: https://www.ft.com/content/dd47aae8-ce25-43ea-8352-814ca44174e3 

(5) State Street Global Advisors (2019). What’s your ESG Score? Source: https://hub.ipe.com/download?ac=83644