ESG is the “name of the game” that will define the next decades for all institutions. So let us start by breaking down the ESG term (Koller & Nuttall, 2019):
E: Stands for environment, and every company uses natural resources, that affects and is affected by the environment. The managing and handling of these natural resources (water, energy, waste, etc.) have consequences on the environment, including the surrounding ecological life.
S: Stands for social, and it addresses the relationship between a company and the internal and external community. This includes labor relations, gender equality, and diversity inside an organization, as well as the communities where an organization operates and does business.
G: Stands for governance, and it includes the compliance with laws, regulation, and shareholder requirements i.e., the procedures that a company adopts to comply with legal requirements, to operate in a certain area and sector.
Integrating ESG elements has always been considered a burden especially for profitable institutions, that sometimes are unable or unwilling to integrate it into their core strategy, nor properly tabulate it in their financial statements. Many profitable institutions lobbied against ESG integration, as it will change their operations, processes, and sometimes products, causing extra cost that is deemed unnecessary without realization of profits. The rise of pressing issues especially climate change, Covid-19, and economic recessions forced governmental institutions to pressurize many industries to integrate more ESG aspects into their organization. After all, some of the pressures listed above are from the beginning due to many of these big companies’ direct activities, and human practice of high consumerism.
Nevertheless, companies that have strong ESG programmes realized high benefits internally and externally, both from a material and non-material perspectives. These companies were dynamic by nature allowing them to adapt to socioeconomic and environmental changes. Furthermore, they are keen to discover strategic opportunities, foster innovations, and new revenue streams.
At an organizational level, ESG requires more research and specificity to decision-making processes, thus allowing more informed investment, and upgrading the style of management. It also attracted and retained talents, who are more loyal, passionate, and adaptable to company activities. From an outreach perspective, ESG integration resulted in more strategic partnership, as a company is seen more concerned in the next decades than with quarterly profits. This also resulted in more stock liquidity as more money was invested into companies with strong ESG integration as they are seen more sustainable, ethical, and futuristic (Winters, 2022).
On the other hand, companies who integrated ESG with a weak strategy, or just as a façade for marketing purposes, created an unfamiliar extra cost that was not properly managed causing financial problems, and trust issues for employees and clients.
Whether because it is a carrot or a stick, it is not just a matter of following a trend or obeying laws, success is matter of both values and strategy. Given the paradigm shift that is happening worldwide, it is not a question on whether we need ESG integration but rather what framework should be put in place to ensure ESG is done efficiently, while at the same time adding value to the organization. Such a framework will definitely have an ad hoc criteria that is dependent on the industry, market trends, and investment style. Nevertheless, there are common practices that are essential to ensure ESG integration is a success from a strategy and financial prospective.
Corporate Strategy
An ESG strategy should identify all the risks associated with their activities and processes, while setting mitigation measures to address these risks. Furthermore, setting metrics that can be tracked and reported, via the right monitoring and evaluation methods. Such strategy must also consider the tools and personnel needed to integrate ESG factors across all levels.
For example, installing new water and energy technologies in the agricultural industry, should be accompanied by the right monitoring and evaluation tools, while also mitigating the behavioral responses that leads to more water usage, to fully assess the gains form an environmental perspective.
From a social perspective, a good example could be adjusting HR manuals to address gender integration for prospective hires in areas/projects where there is lack of gender diversity. Another example is adjusting health and safety manuals to address new governmental regulations from a governance perspective. Setting all the above with measurable data will provide key insights into where are the benefits and setbacks, and where to enhance in the short and long run.
The ESG generated data is very important not just for internal use, but also provides investors with crucial transparent information and measurable data regarding a company’s operational efficiency and future direction. Furthermore, it provides information regarding social impact and brand value to field prospective partnerships based on trust and similar goals.
Corporate Finance
A company’s valuation models including dividend discount model, discounted cash flow model, and/or adjusted present value model must be adjusted to reflect ESG integration. Across the financial statements a firm should consider:
Income Statement: ESG components must be reflected in the company’s sale growth showing future operating costs, thus reflecting new opportunities or new risks associated with ESG integration. This will allow decision makers at the company or investors to either adjust the operating cost directly or adjust the operating profit margins (Principles for Responsible Investment, 2022).
Example: An organic products company could have higher operational cost, due to change in regulations related to crop quality, thus operational cost or profit margins must be adjusted to meet the new regulations.
Balance sheet: The anticipated cash flow and associated net present value must be accounted for when integrating ESG components. Revaluating assets could result in higher or lower future earnings, affecting operating and investment cost and a company’s fair value (Principles for Responsible Investment, 2022).
Example: The future cash flow of an agricultural equipment company may be less than the estimated future cash due to insufficient demand for pesticides, or regulatory change in that domain.
Cash flow: ESG integration will increase or decrease future capital expenditure, thus decision makers and investors should adjust the formula linking capex to revenue, or applying absolute cost adjustment to the forecasted cashflow statement (Principles for Responsible Investment, 2022).
Example: New waste legislation could cause a company to have a waste management plan affecting the overall capital expenditure of the company but having a plan that includes selling waste materials could mean a new revenue stream.
A scenario analysis should be made, one with ESG integration and one with a baseline valuation, the difference between the two scenarios reflects the magnitude of ESG integration on company performance.
Example
A good example of strong ESG integration is Worthington Industries, ranked number 1 on Investor’s Business Daily (IBN, 2022). The industrial manufacturing company of steel processing, construction products, and consumer products remained committed to generate returns for their stakeholders as their first goal, even in their Corporate Citizenship and Sustainability Report (2022). Therefore, Worthington aimed to leverage all ESG aspects into their financial benefit, and company expansion.
From an environmental perspective, the company enhanced their water and energy efficiency, as well as their waste management plan, this approach did not just reduce the company’s overall cost but allowed them to expand to new markets such as energy solution, since they became familiar with the energy sector problems, and have the complementary assets to create solutions for these problems. Moreover, from a social aspect, their moto is treating their employees and every stakeholder the way one would want to be treated, with diversity and inclusion, being embedded in their team structure. This made the Worthington workforce more coherent, and as a result the company appeared on FORTUNE’s 100 best companies to work for in the US list. Finally, their corporate governance is directed from the company’s board, allowing big decisions to come from the top of the hierarchy, thus providing more compliance and transparency with regulations (Worthington Industries, 2022). The overall result of such sustainability mindset made Worthington Industries worth 2.2 billion in the fiscal year of 2022, “generating $1.3 billion in sales and adjusted EBITDA of $340 million, an increase of 47% compared to the $232 million of adjusted EBITDA generated during fiscal year 2021” (GlabalNewsWire, 2022).
One strategy worth mentioning is that Worthington will split its business into two public-traded companies by 2024. One company will include their steel processing, and the other is for their fast-growing markets of consumer and construction products, as well as their energy solutions. This will allow each company to focus on distinct markets, while also considering tailored business strategies and flexibility to utilize capital towards specific targets, including ESG integration (GlabalNewsWire, 2022).
To conclude, ESG integration is now a must-do that all companies would be well-advised to adhere to. For ESG integration to be successful, it should be met with a strong framework that possesses both qualitative and quantitative angles. This framework should include a strategy aspect upon which measurable KPIs are set, and transparent data are generated, allowing decision makers and investors to monitor this data and develop the corporation’s operations further. Furthermore, it must include financial adjustments tabulated in the financial statement, showing increased risk-adjusted returns and long-term viability of the corporation.
