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As stakeholders’ expectations focus more on sustainable development, companies must fully embrace this paradigm shift to create value.


In brief
  • Companies are under increasing pressure to focus on sustainable development and long-term value creation beyond generating profits for shareholders.
  • The correlation between corporate sustainability initiatives and long-term value creation is clearer today than in the past.
  • By embracing sustainability on the strategic and operational levels, companies can realize greater long-term business value.

When the COVID-19 pandemic struck the world, images of clear waters along Venice’s waterways and clean air in many major cities surfaced during the lockdowns. This once again underscored the human impact on the environment and heightened the interest in sustainability and environmental, social and governance (ESG) risks. Such an interest is not new but has been escalating. Investors are paying more attention to how businesses are managing their ESG risks.

The 2020 EY Climate Change and Sustainability Services (CCaSS) fifth global institutional investor survey found that an overwhelming 98% of investors surveyed evaluate nonfinancial performance based on corporate disclosures. Among them, 72% said they conduct a structured, methodical evaluation.

Yet, it appears that ESG considerations have not been adequately addressed. Investor dissatisfaction with ESG risk disclosures has risen since 2018 and 86% of investors dissatisfied with environmental risk information received said it is critical for disclosures in this area to improve.

How to Enhance Long Term Value thru Sustainability

This emphasis on corporate sustainability extends beyond the investor community, increasingly underpinning interactions between companies and their customers, supplier networks, partners and employees.

With the growing importance of sustainability in business, corporate executives are hard-pressed to embrace a paradigm shift away from the sole purpose of generating profits for shareholders toward advocating sustainable development and long-term value creation in their organizations.

In recent years, numerous studies have linked the implementation of corporate sustainability initiatives to improved business and financial performance. Similarly, from a valuation perspective, it is believed that sound corporate ESG practices would increase a company’s value. This can be attributed to the impact of ESG practices on three areas: cash flow accretion, lower cost and better access to capital, and market-specific factors.

Integrate ESG considerations to drive revenue growth and cost efficiencies

The Business and Sustainable Development Commission estimates that achievement of the UN Sustainable Development Goals could result in at least US$12t worth of market opportunities a year for the private sector by 2030.1 This represents about 10% of the global GDP forecast for that year. The opportunities span a multitude of sectors, including food and agriculture, energy as well as health and wellness. Corporate executives who succeed in integrating ESG considerations as a core driver of their corporate strategy and differentiating their organizations within the global sustainability ecosystem will be well-positioned to capitalize on these opportunities and generate new revenue streams for their businesses.

The increasing influence of environmental and social factors on consumers’ purchasing decisions has also allowed sustainable companies to charge higher price premiums on their products and services, commanding a greater share of wallet of existing customers.

At the same time, integrating ESG considerations as part of company decision-making often leads to operational and process efficiencies within the business, thereby helping to improve profitability. This can typically be achieved through better resource management policies to reduce and eliminate wastage, sustainable supply chain management practices to reduce the environmental impact across the value chain and costs, and cultivation of an innovative culture to reinvent existing processes.

 

“Integrating ESG considerations as part of company decision-making often leads to operational and process efficiencies within the business, thereby helping to improve profitability.”

Andre Toh – EY Asean Valuation, Modeling & Economics Leader

This is corroborated by an EY analysis, which measured the profitability of the top sustainable corporations in the world based on Corporate Knights’ 2020 Global 100 ranking2 against that of their respective industry medians. Sustainable companies in the ranking outperformed their industry peers on gross profit, EBITDA, EBIT and net profit metrics (see chart below). These companies recorded higher EBITDA and net profits than their peers for 73% and 61% of the industries analyzed respectively, with the extent of outperformance ranging from 3.1 to 6.3 percentage points.
How to Enhance Long Term Value thru Sustainability 2

Higher ESG-rated companies have also been associated with lower idiosyncratic risks. According to The Journal of Portfolio Management, sustainable companies experienced a lower frequency of large, adverse idiosyncratic stock price moves between 2009 and 2019, compared with those that had a lower ESG rating.3 This could be attributed to better risk management and compliance standards across their operations and supply chain practices, resulting in organizations that are more resilient and less susceptible to the risks of black swan events, including compliance breaches and supply disruptions.

 

Demonstrate strong sustainability commitment to lower financing costs

Another factor linking sustainability to value creation is the impact of corporate sustainability on a firm’s cost of capital. Companies that focus on corporate sustainability tend to be less vulnerable to systematic risks. This, in turn, results in higher risk-adjusted returns for investors.

For example, a company that considers ESG-related metrics in its operations would be cushioned from the impact of increasing regulations due to heightened government scrutiny of the environmental impact of economic activities. Corporate executives in such a company would already have measures in place to mitigate the impact of operations on the environment, thereby reducing the burden of new legislation on the business.

According to Bloomberg, global ESG assets are on track to exceed US$53t by 2025, accounting for more than a third of projected total assets under management for that year.4 Most institutional investors incorporate ESG considerations in their investment framework and apply negative or positive screening techniques to integrate ESG elements with traditional financial analysis. Against this backdrop, companies that demonstrate a strong commitment to sustainability will be viewed more favorably by these providers of capital, and therefore have access to more sources of financing at a lower cost.

Investments in ESG-related initiatives undertaken by companies may also be valued at an “ESG-specific multiple” that is at a premium compared with the rest of the business.

 

Operationalize the sustainability agenda

Despite overwhelming evidence validating the case for corporate sustainability, many companies may struggle to develop a clear business plan that embeds a sustainability strategy. This underscores the importance of putting rhetoric into action.

Embarking on the sustainability journey entails an end-to-end, iterative process. This starts from board-level conversations of an organization’s raison d’être, cascades down to the management decisions on their portfolio strategy and capital allocation, and ultimately influences day-to-day activities.

The Long Term Value Framework, conceptualized by the Embankment Project for Inclusive Capitalism, offers a path forward for companies that are keen to articulate a compelling and actionable sustainable value-creation story to stakeholders. Importantly, this would involve the identification, monitoring and reporting of relevant metrics to communicate the organization’s progress toward its desired long-run outcomes for stakeholders. It would also involve the corresponding augmentation of related IT infrastructure, data collection and analytics capabilities to support such initiatives.

Stakeholders increasingly hold corporate executives accountable for their organization’s role in sustainable development. As the linkages between long-term value creation and sustainability become more apparent, companies are under increasing pressure to act to remain relevant in the business landscape of the future.

Rather than advocating fringe programs with the sole intent of assuaging stakeholders, companies should drive a comprehensive approach to integrate the tenets of sustainability into the firm’s activities to help maximize long-term business value.

 

This article was authored by Andre Toh, EY Asean Valuation, Modeling & Economics Leader, with contributions from Zhiyong Guo, Senior Manager, Valuation, Modeling & Economics, EY Corporate Advisors Pte. Ltd.

The article was first published here.

Photo by Nicholas Doherty on Unsplash.

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