UNDERSTANDING ESG

ESG stands for Environmental, Social, and Governance. These factors are often used to evaluate how far advanced countries and companies are with sustainability.

Environmental factors consider how the natural world is conserved, social factors look at how people are treated both inside and outside the company, and governance factors examine how a company is run.

ESG FACTORS: ENVIRONMENTAL

The environmental criterion evaluates how companies utilize energy and manage their environmental impacts.

Environmental factors considered include climate change, energy efficiency, biodiversity, carbon emissions, air and water quality, waste management, and deforestation. Companies that ignore these environmental risks may incur unanticipated financial risks as well as investor scrutiny.

ESG FACTORS: SOCIAL

The social criterion looks at how a company nurtures its people and culture, and the ripple effect of that on the wider community. Social factors include inclusivity, employee engagement, gender and diversity, data protection, customer satisfaction, human rights, privacy, labor standards, and community relations.

ESG FACTORS: GOVERNANCE

The governance criterion examines a company’s internal system of controls, procedures, and practices, and how it stays ahead of violations. Governance ensures industry best practices and transparency, and it includes engaging with regulators.

A clearly-defined corporate governance system can be used to align or balance interests between stakeholders, and it can also serve as a tool to support the long-term strategy of a company.

Governance factors considered include the company’s leadership, executive compensation, board composition, shareholder rights, internal controls, audit committee structure, lobbying, bribery and corruption, whistleblower programs, and political contributions.

ADDITIONAL COMMENTS ON ESG

The individual elements of ESG are inextricably intertwined. For example, environmental criteria overlap with social criteria and governance when companies seek to act in accordance with environmental laws and wider concerns about sustainability.

When talking about sustainability, we focus more on environmental and social concerns, but as every leader knows, governance is equally important; it cannot be hermetically separated. Indeed, to excel in governance requires mastering, not just the letters of the laws but also their spirit. For instance, you need to master how to get in front of violations before they occur.

You can read about reasons to consider ESG when investing here.

HOW DOES ESG CREATE VALUE?

Research has shown that companies that pay attention to ESG concerns do not experience a drag on the creation of value.

From both a tilt and momentum viewpoint, a strong ESG proposition corresponds with higher equity returns. Better ESG performance also correlates with lower downside risk, as evidenced by higher credit ratings, lower loan, and credit default swap spreads. 

Although the case for a strong ESG proposition has become more compelling, the understanding of how these criteria are linked to value creation is still not clearly understood. Below are some of the ways ESG creates value.

1. FACILITATING TOP-LINE GROWTH

Companies may tap into new markets and expand into existing ones with a strong ESG proposition. When governing authorities have faith in corporate actors, there is a greater possibility of them awarding these corporate actors the access, licenses, and approvals that open up fresh growth opportunities.

For example, the for-profit companies that were chosen to participate in a recent, huge public-private infrastructure project in Long Beach, California, were screened based on their previous performance in sustainability.

Consumer preference can also be influenced by ESG. According to a McKinsey research, customers are willing to pay to “go green.” Even though there are significant discrepancies in practice, such as customers who refuse to pay even 1% more, the research showed that upward of 70% of consumers surveyed about purchases in different industries (including oil and gas) said they would pay an extra 5% for a green product if it met the same performance standards as a non-green alternative.

2. REDUCING COSTS

ESG can also help to reduce costs significantly. Among other benefits, effectively implementing ESG can help offset rising operational expenses (like raw-material costs and the true cost of carbon or water).

According to a McKinsey research, operating profits are affected by as much as 60% by operating expenses. In this same report, a metric (the amount of water, waste, and energy used in relation to revenue) was created to examine the relative resource efficiency of companies in various industries. A strong correlation between resource efficiency and financial performance was observed.

3. MINIMIZING REGULATORY AND LEGAL INTERVENTIONS

With a stronger external-value proposition, companies can achieve greater strategic freedom, reducing regulatory pressure. Indeed, strong ESG helps minimize companies’ risk of unfavorable government action. It can also bring about government support.

One-third of corporate profits are typically at risk from state intervention. Of course, the impact of regulation varies by industry. For instance, the profits at stake are higher in banking (usually 50 to 60%) than in pharmaceuticals and healthcare (about 25 to 30%).

4. INCREASING EMPLOYEE PRODUCTIVITY

A strong ESG proposition helps enhance employee motivation by imparting gradually a sense of purpose. It also boosts overall productivity and helps companies to attract and retain top talents.

The satisfaction of employees positively correlates with shareholder returns. Furthermore, it has long been observed that employees perform better when they feel not just a sense of satisfaction but also of connection. 

Recent research has also shown that having a positive social impact is linked to increased job satisfaction. Also, it is observed that employees react with enthusiasm when companies “give back”.

A weaker ESG proposition can push productivity down, just as a sense of greater purpose can inspire better performance. Worker slowdowns, strikes, and other labor actions within an organization are the most obvious examples.

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5. OPTIMIZING INVESTMENT AND CAPITAL EXPENDITURES

A strong ESG proposition can boost investment returns by allotting capital to more sustainable and more promising opportunities (for example, waste reduction, scrubbers, and renewables). It can also help companies in avoiding stranded investments that may not pay off in the long run due to long-term environmental issues.

When it comes to ESG, you need to know that a do-nothing approach is typically an eroding line, not a straight line. For example, when you continue to use energy-intensive plants and equipment, you risk draining cash in the future. While the costs of updating your operations may be significant, waiting it out can be the most expensive option of all.

TO WRAP UP

A strong ESG proposition can create value for companies and their shareholders. Among other benefits, it can help facilitate top-line growth, reduce costs, minimize legal and regulatory interventions, increase the productivity of employees, and optimize capital and investment expenditures.

Consumers and investors prefer to do business with companies with strong ESG performance as compared to companies whose environmental, social, or governance practices may pose a greater financial risk.

Additionally, robust sustainability and ESG strategies help businesses become more resilient and improve company overall performance. The LITH platform will make it easy for businesses to efficiently navigate through the ESG world.