Five Ways A Strong Environmental, Social and Governance (ESG) Proposition can Create Value
Your business, like every business, is deeply intertwined with environmental, social, and governance (ESG) concerns. It makes sense, therefore, that a strong ESG proposition can create value—and 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.
Just as ESG is an inextricable part of how you do business, its individual elements are themselves intertwined. For example, social criteria overlaps with environmental criteria and governance when companies seek to comply with environmental laws and broader concerns about sustainability. Our focus is mostly on environmental and social criteria, but, as every leader knows, governance can never be hermetically separate. Indeed, excelling in governance calls for mastering not just the letter of laws but also their spirit—such as getting in front of violations before they occur, or ensuring transparency and dialogue with regulators instead of formalistically submitting a report and letting the results speak for themselves.
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.1 Of a piece with that emerging zeitgeist, ESG-oriented investing has experienced a meteoric rise. Global sustainable investment now tops $30 trillion—up 68 percent since 2014 and tenfold since 2004.2 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 suggests that ESG is much more than a fad or a feel-good exercise.
So does the level of business performance. The overwhelming weight of accumulated research finds that companies that pay attention to environmental, social, and governance concerns do not experience a drag on value creation—in fact, quite the opposite (Exhibit 1). A strong ESG proposition correlates with higher equity returns, from both a tilt and momentum perspective.3 Better performance in ESG also corresponds with a reduction in downside risk, as evidenced, among other ways, by lower loan and credit default swap spreads and higher credit ratings.4
But even as the case for a strong ESG proposition becomes more compelling, an understanding of why these criteria link to value creation is less comprehensive. How exactly does a strong ESG proposition make financial sense? From our experience and research, ESG links to cash flow in five important ways: (1) facilitating top-line growth, (2) reducing costs, (3) minimizing regulatory and legal interventions, (4) increasing employee productivity, and (5) optimizing investment and capital expenditures (Exhibit 2). Each of these five levers should be part of a leader’s mental checklist when approaching ESG opportunities—and so should be an understanding of the “softer,” more personal dynamics needed for the levers to accomplish their heaviest lifting.