Globally, the focus on environmental, social and governance (ESG) considerations has been gathering momentum. Indeed, given increased scrutiny from consumers, regulators and market players, companies can no longer push ESG matters to the backburner or have it as an ancillary topic under the ambit of corporate social responsibility.
ESG is a complex topic and encompasses a broad range of issues. Environmental factors include climate change, biodiversity, pollution and resources. Social factors include customer responsibility, health and safety, human rights and community and labour standards. Governance factors include anti-corruption initiatives, corporate governance, risk management and tax transparency.
Arguably, the climate-related aspect of ESG is most well-understood among companies. According to the fourth EY Global Climate Risk Barometer released in September, companies globally are investing more in producing climate-related disclosures.
It is important for companies to recognise that embracing ESG is more than just disclosures and reporting. ESG reporting is merely the outcome of business actions. ESG must be an integral part of the corporate strategy. This entails determining the ESG elements that matter most to stakeholders, the areas that are most material to the industry and aligned with the business and its purpose, and developing the blueprint for driving the right behaviours and KPIs to measure impact on ESG goals.
Impact of ESG on cost of capital and operations
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Various research has found that there is a clear link between ESG and financial performance and attractiveness to investors. For some time, investors have been seeking out companies that are also ESG leaders. Research from the 2020 EY Climate Change and Sustainability Services Institutional Investor survey found that the majority of investor respondents were moving toward a more disciplined and rigorous approach to evaluating companies’ non-financial performance and that non-financial performance played a pivotal role in investment decision-making. This suggests companies that embrace ESG and demonstrate tangible success would likely have easier access to funding and lower cost of capital.
Further, companies that adopt ESG principles for their corporate strategies may see improvements in their performance. According to EY analysis, value-creation-linked metrics such as operating margins or return on invested capital may move favourably as companies undertake a journey to ESG leadership. While companies may see a drop in net margins, the aggregate result of the movements in other metrics — including the cost of capital — will likely lead to an increase in corporate valuation.
A strong ESG strategy does not only impact capital. According to a study by Oxford University, From the Stockholder to the Stakeholder, 88% of the reviewed sources found that companies with robust sustainability practices demonstrated better operational performance, which ultimately translates into cash flows. As well, 80% showed that good sustainability practices positively influenced stock price performance.
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There are many reasons for the positive performance. For example, the increasing influence of ESG factors on consumers’ purchasing decisions has allowed sustainable companies to charge higher price premiums on their products and services. The EY Future Consumer Index found that consumers are showing increased loyalty to brands that demonstrate a clear commitment to their purpose and ESG principles. The Index found that the majority of consumers will pay more attention to the ESG impact of what they purchase. Hence, companies that want to serve these consumers need to transform to meet these new expectations.
With the focus on ESG, companies also seek to pursue operational and process efficiencies, eliminating waste, simplifying supply chains and cultivating an innovative culture that proactively advocates reinventing existing processes to achieve true circularity. These enhanced efficiencies can also contribute to profitability.
Focus on what matters
While it is clear that companies should be incorporating ESG considerations into their corporate strategy, given the wide-ranging aspects to focus on, it is not a straightforward exercise. Further, there may be trade-offs that are hard to quantify, making the process of incorporating ESG concerns into strategy complex, contradictory and even confusing.
Investors are looking for focus. Companies that direct their efforts in a concerted manner on the most material ESG aspects for their sector have historically demonstrated a higher alpha than peers that do not. Choosing the ESG considerations that companies should focus on based on the sector they operate in will be critical.
To galvanise the organisation’s stakeholders to partake in the company’s ESG journey, business leaders need to communicate clearly their ESG commitment. Achieving results is not merely a matter of investment but also a matter of clear and thoughtful communication of the company’s ESG commitment to all stakeholders, including the capital markets.
By leveraging the long-term value creation metrics identified by the World Economic Forum’s International Business Council, businesses can better demonstrate their contributions toward sustainable, long-term value creation across the full ESG strategy development process from vision definition to execution.
Vikram Chakravarty is EY’s Asean strategy and transactions Leader. The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organisation or its member firms