Do companies that ignore long-term environmental or social costs in the pursuit of near-term profits pay another price in foregoing potentially long-term sustainable profit opportunities? The Business Case for ESG, from the Rock Center for Corporate Governance at Stanford University, authored by Stanford academics and representatives of ValueAct Capital, considers a framework for incorporating sustainability or ESG (environmental, social and governance) factors into corporate strategy and decision-making. The prevailing theory is that the failure to take sustainability into account is a component of short-termism, “leading to decisions that increase near-term reported profits at the expense of the long-term sustainability of those profits. The costs of those decisions are assumed to manifest themselves as externalities borne by members of the workforce or society at large.” The paper cites investors like Laurence Fink of BlackRock and innovative approaches like The New Paradigm as examples of efforts to encourage companies to take into account stakeholders other than solely shareholders. The paper suggests that, properly analyzed, sustainability can affect not only externalities, but can also benefit the business itself—there is a business case for ESG.
According to the paper, the first step in the framework is to “map the ecosystem of stakeholders”—customers, suppliers, employees, regulators, the community and general public (including environmental impact), shareholders and competitors—and analyze what their goals might be and their various interests lie. The paper indicates that the map should reveal which ESG factors are most relevant: “Certain factors, such as governance and human capital, might be applicable broadly while others, such as environmental footprint, might be more limited.”
With that analysis in hand, under the framework, the company next evaluates its own position and risk related to each of the identified factors. The paper suggests that engaging a substantial investor with a long-term perspective can help to elevate the discussion of risk with the board, encourage corporate investment to mitigate risk and champion the decision among other investors.
However, the paper asserts, ESG has relevance well beyond risk reduction:
“ESG factor analysis can lead to the identification of investments or activities by the company that increase long-term returns. For example, a company’s investment in a more sustainable supply chain can deepen relationships with customers (thereby promoting volume growth and premium pricing), attract talent to the organization, and perhaps reduce costs….These positive effects can build on one another and create a powerful flywheel effect. To identify and capitalize on opportunities such as these, senior business leadership must consider material ESG factors as core inputs into their strategy development.”
While ESG factors can be integrated into the strategies of all companies, the paper maintains, some companies are able to put ESG “at the center of the investment thesis,” or to develop business models that “are core to the ultimate solution for specific environmental and social problems.” One example of these companies discussed in the paper benefited from adopting a long-term investment horizon, transitioning its decades-old business by making “an up-front investment in order to increase long-term value.” The case study involved a mature power company that provided capacity to utilities globally, relying on coal as its primary energy source. But the company was able to recognize that there were costs to that reliance and began to reposition its business to renewable sources. It then accelerated that transition through a major reorganization, divesting primarily coal plant assets, and entering into joint ventures to build capacity for energy storage and development of renewables. Through various public sustainability reports and public commitments to substantially reduce its reliance on coal, the company made clear the seriousness of its transition to green energy.
The paper identifies a number of ripple effects from these actions, including galvanizing the company’s culture, helping it to attract talent, increasing workforce productivity and innovation, attracting positive recognition from NGOs, attaining relief from shareholder pressures regarding sustainability and securing new investments from green-oriented investors. Significantly, during this period of investment, “the company’s price-to earnings multiple expanded from approximately 9x in January 2018 to 14x by March 2019, and its stock price outpaced industry indexes.” Through this transition, the company was able to turn an environmental challenge into a long-term profit opportunity, creating value and generating returns by fundamentally changing its business model to one that addressed stakeholder concerns regarding sustainability.