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.
ESG is deeply integrated into business operations, with its components interconnected. Social criteria intersect with environmental and governance factors when companies adhere to environmental regulations and sustainability principles. While our emphasis is primarily on environmental and social aspects, governance cannot be isolated. Effective governance entails not only adhering to laws but also understanding their intent, such as proactively addressing potential violations and fostering transparent communication with regulators instead of solely relying on formal reports to convey compliance.
ESG-oriented investing has experienced a meteoric rise—global sustainable investment now tops $30 trillion.
The proactive consideration of ESG has become increasingly urgent. A statement by the US Business Roundtable in August 2019 underscored businesses’ commitment to a wider array of stakeholders beyond shareholders. This shift aligns with the surging popularity of ESG-oriented investing, which has seen remarkable growth, now exceeding $30 trillion globally. This trend reflects heightened societal, governmental, and consumer focus on corporate impact, as well as recognition among investors and executives that robust ESG practices are vital for long-term success. The substantial investment in ESG indicates its enduring significance, beyond a passing trend or superficial gesture.
Moreover, empirical evidence overwhelmingly supports the notion that companies prioritizing environmental, social, and governance factors do not hinder value creation; instead, they often enhance it. Robust ESG performance is associated with higher equity returns, as well as reduced downside risk, evidenced by lower loan and credit default swap spreads, and higher credit ratings.
Five links to value creation
1. Top-line growth
A robust ESG strategy enables companies to access new markets and enhance their presence in existing ones. When regulatory bodies trust corporations due to their strong ESG performance, they are more inclined to grant them access, approvals, and licenses, opening up avenues for growth. For instance, in a recent major infrastructure project in Long Beach, California, for-profit companies were selected based on their sustainability track record, showcasing the tangible benefits of superior ESG execution. Similarly, in the mining sector, companies with proactive social engagement activities enjoyed smoother resource extraction processes and achieved higher valuations compared to their peers with weaker social capital.
A strong ESG proposition helps companies tap new markets and expand into existing ones.
ESG considerations also influence consumer preferences. Research indicates that a significant portion of consumers are willing to pay a premium for environmentally friendly products, with many expressing a willingness to pay up to 5 percent more for green alternatives that offer comparable performance. Companies have recognized this trend and seized business opportunities by incorporating sustainability initiatives into their operations. For example, Unilever’s introduction of Sunlight, a water-saving dishwashing liquid, resulted in sales growth exceeding category averages in water-scarce markets. Similarly, Neste, a Finnish company initially focused on petroleum refining, now derives a significant portion of its profits from renewable fuels and sustainable products, reflecting the commercial viability of sustainability-focused initiatives.
2. Cost reductions
ESG initiatives can significantly reduce costs for companies, offering various advantages including mitigating escalating operating expenses such as raw material costs and environmental impact. McKinsey research highlights that effectively implementing ESG measures can counteract the impact of rising operational costs, which can affect operating profits by up to 60 percent. By analyzing resource efficiency relative to revenue, the research identified a strong correlation between resource efficiency and financial performance across sectors, with companies that prioritize sustainability often demonstrating superior financial results.
A major water utility achieved cost savings of almost $180 million per year thanks to lean initiatives.
Companies that excel in ESG implementation have realized substantial cost savings. For example, 3M’s proactive approach to environmental risk through its “pollution prevention pays” program has resulted in savings of $2.2 billion since its inception in 1975. Similarly, a major water utility achieved annual cost savings of nearly $180 million by implementing lean initiatives focused on preventive maintenance, inventory management, and energy consumption reduction. FedEx has made significant strides in reducing costs and environmental impact by transitioning its fleet to electric or hybrid engines, resulting in a reduction of fuel consumption by more than 50 million gallons.
3. Reduced regulatory and legal interventions
A robust external-value proposition can provide companies with more strategic flexibility and help alleviate regulatory pressures. Across various industries and regions, evidence suggests that a strong performance in ESG can reduce the risk of unfavorable government actions and may even garner government support.
The potential impact of regulation on corporate profits is substantial, with our analysis indicating that approximately one-third of corporate profits are vulnerable to state intervention. However, the extent of this impact varies depending on the industry. In sectors such as pharmaceuticals and healthcare, the at-risk profits range from 25 to 30 percent, while in banking, where regulatory provisions are particularly significant, this figure can be as high as 50 to 60 percent. Similarly, industries like automotive, aerospace and defense, and technology, which often rely on government subsidies and interventions, face similar levels of potential profit vulnerability, reaching up to 60 percent.
4. Employee productivity uplift
A robust ESG proposition is a powerful tool for attracting and retaining top talent, boosting employee motivation, and enhancing overall productivity. Research by Alex Edmans from the London Business School revealed that companies listed on Fortune’s “100 Best Companies to Work For” achieved significantly higher stock returns over a 25-year period compared to their peers.
Positive social impact correlates with higher job satisfaction—when companies “give back,” employees react with enthusiasm.
Employees who feel a sense of connection and purpose in their work tend to perform better, as they are motivated to contribute positively to society. Studies have shown that positive social impact is closely linked to higher job satisfaction, with employees reacting enthusiastically when companies engage in philanthropic initiatives. Conversely, a weak ESG stance can lead to productivity issues such as strikes and labor actions.
Leading companies like General Mills, Walmart, and Mars recognize the importance of extending ESG principles throughout their operations. They ensure that ESG considerations are integrated “from farm to fork to landfill,” actively monitor supplier work conditions, and invest in initiatives that benefit both their business and the environment, such as model farms equipped with innovative technologies and increased access to capital for farmers.
5. Investment and asset optimization
A robust ESG proposition can boost investment returns by directing capital towards more promising and sustainable ventures, such as renewable energy and waste reduction initiatives. This approach helps companies avoid investing in assets that may become stranded due to long-term environmental issues, such as declining value in fossil fuel assets.
Taking proper account of investment returns requires that you start from the proper baseline. When it comes to ESG, a do-nothing approach is usually an eroding line, not a straight line.
Inaction in the face of evolving ESG considerations can lead to diminishing returns over time. Continuing to rely on outdated and energy-intensive infrastructure can drain financial resources in the long run. Delaying necessary updates may ultimately prove to be the costliest option, as regulatory responses to emissions and shifts in consumer preferences towards sustainability could significantly impact profitability, especially for carbon-intensive industries.
Adapting to future trends and regulations can present opportunities for businesses. Repurposing assets, such as converting underutilized parking garages into high-demand spaces like residential units or day-care facilities, can help companies stay ahead of changing market dynamics.
Embracing sustainability can unlock new investment opportunities, particularly in regions like China where initiatives to combat air pollution are expected to generate substantial investment prospects across various industries, including air-quality monitoring and indoor air purification.
The personal dynamic
Get specific
Understanding the diverse ways in which environmental, social, and governance factors can generate value is crucial. However, when it comes to inspiring others, the focus should be on what truly resonates with each individual. Different executives may prioritize different causes, making it essential to streamline initiatives and focus on no more than five priority projects.
To determine these initiatives, it’s vital to align them with the company’s overarching mission. For example, a leading agribusiness may focus on addressing hunger by leveraging its expertise to help farmers diversify crops and adopt new technologies, thereby increasing production and fostering stronger ties with communities.
Each company will have a unique ESG profile based on its position in the corporate life cycle. New entrants may have greater potential for growth through ESG initiatives, while established competitors might focus on maintaining community relationships and mitigating risks. Ultimately, it’s the CEO’s responsibility to garner support for initiatives that align best with the company’s mission and values.
Get practical
The CEO’s primary message should center around value creation, as anything else may seem out of tune. When discussing ESG priorities, it’s crucial to demonstrate how they align with value creation and provide concrete metrics to support this alignment, such as output per electricity use or waste cost per employee.
To make a compelling case, thorough analysis of the value chain is essential. Proactive companies conduct detailed research, engage with thought leaders and industry experts, and involve internal and external stakeholders in the process. Publicly presenting these findings, especially to investors, reinforces rigor and encourages actionable steps.
Get real
A candid assessment of ESG acknowledges the significant risk of value destruction if mishandled. Neglecting ESG criteria can lead to adverse events, as evidenced by recent instances where companies experienced substantial declines in market capitalization after ESG-related missteps. Leaders must carefully evaluate the potential impact on value from external engagement and prepare for scenarios that could affect operating profits. In today’s environment, unexpected events, even from a single social media post, can have severe consequences. Ignoring ESG risks is a losing strategy, and failure to address them directly can be disastrous.
Being thoughtful and transparent about ESG risk enhances long-term value—even if doing so can feel uncomfortable and engender some short-term pain.
Conversely, addressing ESG risks transparently can enhance long-term value, despite potential short-term challenges. Dick’s Sporting Goods CEO, Ed Stack, anticipated backlash when the company restricted gun sales in 2018, resulting in an estimated $150 million loss in sales. However, the company’s stock rose by 14% over the following year, demonstrating the positive impact of addressing ESG concerns.
ESG for the long term
A robust environmental, social, and governance (ESG) proposition can indeed create value for companies and shareholders, as recognized even by Milton Friedman, who noted that investing in amenities for the community or improving governance can attract desirable employees and yield other benefits. Research indicates that businesses focusing on long-term investments tend to have less discounted future cash flows, compared to those prioritizing short-term gains like share repurchases. Maximizing shareholder value doesn’t necessarily mean sacrificing stakeholder interests; in fact, building strong connections with stakeholders enhances resilience and long-term value creation. However, conflicts between shareholder and stakeholder interests can arise, as illustrated by legal cases such as Craigslist’s attempt to prioritize community interests over shareholder wealth maximization, which was ultimately rejected by Delaware courts. Executives must navigate these trade-offs by adopting an “enlightened value maximization” approach, where expenditures on any constituency are justified if they contribute to long-term value creation, including ESG investments.
Tran Dung/ATES GLOBAL
Source: Mckinsey
