ESG Consequences May Be Closer Than They Appear

by Robert McConnaughey

An authentic ESG strategy can be an effective tool for connecting with all shareholders, building brand affinity, attracting and retaining top talent, and positioning companies for future challenges.

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Human beings tend to make decisions with an overemphasis on more immediate rewards and risks versus processing the longer-term complexities.  This phenomenon has been deeply studied by psychologists as well as behavioral economists and is largely attributed to “hyperbolic discounting” of the future.  This very human challenge is one of the primary obstacles for corporate leaders in establishing a robust and authentic ESG strategy for their business. 

Leaders might rationalize that arduous paperwork and disclosure requirements, potential hurdles from dissenting Board members and other, more immediate business priorities  preclude focusing on ESG in a meaningful way.  Unfortunately, as with many of our decisions, that procrastination can come at a real opportunity cost. We are at a singular time as a society, where real momentum on environmental, social and governance issues can translate into a strategic business advantage.

A Turning Point for ESG: The COVID Pandemic and Social Unrest

The events of the past year have reinforced the high value of a robust ESG/Sustainability effort for public corporations.  A global pandemic and tumultuous politics around the world have accelerated the need for business leaders to establish (and constantly work to improve) a disciplined stakeholder management process that is well-integrated into all aspects of the business.  The evidence strongly points to the benefits of proactively approaching issues rather than reacting when the consequences of “long-term” risks arrive on your doorstep. 

At its heart, ESG strategy is a way in which to manage a firm’s long-term relationships with its relevant stakeholders, including customers, employees, regulators, and the society in which it operates.  It offers a clearly defined and measured process with which to formally optimize decision-making around those crucial relationships.  Having seen a series of major “100-year flood” or “black swan” events in just the last dozen years (global financial crisis, global pandemic, global populist election surprises and unrest), it’s only prudent to devote time to building plans for resilience and sustainability around one’s brand and organization.

The ESG Journey Develops More Structure and Urgency

Our research at Corbin Advisors, a strategic consultancy that works with publicly traded companies on ESG strategies and value realization, confirms that an accelerating number of executive teams are embracing this and embarking on a more formal ESG journey.  In a broad poll earlier this year, 63% of companies said that ESG was a Very Important or Critical factor in their company’s long-term success, up from 36% when asked the same question two years ago.  A parallel Corbin research survey of investors representing more than $11 trillion in AUM reinforced this view as almost 60% of respondents stated their belief that companies choosing to integrate ESG into their business strategy will outperform those that don’t over the long term. 

The direction of travel on ESG implementation for corporations that want to be viewed as innovative leaders and excellent operators is clear. While companies may be at different stages in their ESG journeys, we see the majority of industry-leading leadership teams making sincere efforts to methodically distill down the most material sustainability issues for their business’s key stakeholders and establishing integrated processes to deliver measurably impactful results into those critical business areas of focus.  The rapidly growing cohort of companies going down this path are doing powerful fundamental work to enhance franchise value.

The Growing Importance of Intangible Assets 

Today’s S&P 500 companies’ total assets are comprised of roughly 90% intangible assets such, as brand value, patents, customer data, and software.  That number was only 32% in 1985, when vastly more value was embedded in physical assets, such as factories and hard product inventories.  As a result of this shift, protecting and reinvesting in key stakeholder relationships is of the utmost importance in maximizing the intangible elements of brand value and related overall business valuation.  Related, a comprehensive 2019 study conducted by Institutional Investor’s Custom Research Lab found that 98% of investors are seeking more transparent disclosures regarding intangible assets.  Thoughtfully constructed ESG policy and outcomes disclosure does not explicitly value those intangible assets, but is certainly relevant to informing that work for potential investors.

Understanding Your Stakeholder Base

So, who are these “stakeholders” beyond investors that a business should prioritize looking after?  Here’s a look at three crucial stakeholder groups served by strong ESG efforts.

1. Current and Future Customers: It is widely documented that a significant majority of individual consumers express a desire to support brands and products that can demonstrate positive societal impact. However, on average, actual purchasing behaviors show an unwillingness to do so at significantly higher cost, lower quality, or at the detriment of freedom of choice. Organic and sustainably produced food, for example is preferred, so long as it tastes good, looks attractive, and doesn’t cost too much.

Given these preferences, leading consumer-facing businesses such as Walmart are working hard to please their customers with a growing commitment to offering sustainable products while also maintaining core principles such as everyday low prices. They can do so effectively and without sacrificing profits by exerting steady pressure on their supply chain to execute change for them in all aspects of manufacturing and delivering their offerings. This push catalyzes a need for effective ESG actions and communications through a vast web of providers.  Walmart is simply one prominent example of this phenomenon, and we see similar catalytic dynamics rippling out from many other large, customer-facing businesses. On issues from greenhouse gas emissions to diversity and inclusion metrics, we will continue to see pressure on suppliers to get on board or lose market share/revenues.

2. Current and Prospective Employees: Attracting and retaining talent is the lifeblood of any business. Millennial and Gen Z workers express a clear preference to work for ethical and environmentally-friendly companies. Many go so far as to suggest that they would accept a lower salary to work for an ESG-leading employer and these preferences increase with education levels. This age cohort already comprises over 70% of the U.S. workforce. 

In addition, changing national demographics also put an increasing priority on thoughtfully cultivating and satisfying a diverse employee base as a business prerogative. We increasingly hear from clients that they face challenges when sales leaders do not connect naturally to their evolving customer base given distinct perspectives and life experiences influenced by gender, race, and age differences.

3. Government and Regulators: The Biden Administration’s top policy priorities cited after solving the COVID pandemic are “tackle climate change and advance racial equity and civil rights,” and both areas of focus have clear ESG policy implications. In the United States and globally, the public has concerns regarding the concentration of power in corporations. This is leading to rising risk of regulatory challenges for business leaders as politicians address those concerns. Use of government controls to reign in corporate power is not at all an exclusively left-leaning issue either.

Concerns about the power of “Big Tech” and more aggressive anti-trust activities are examples of growing actions with support on both sides of the aisle in the United States. European climate policies are generally more aggressive than American rules, and even in markets like China, environmental regulation is expanding at a rapid pace. The changing regulatory environment presents both risks as well as opportunities and a company’s (or industry’s) best defense against unwanted governmental intrusion is public recognition of good citizenship.

Understanding the Role ESG Plays in Reducing Risks

A growing body of research demonstrates that implementing high quality ESG programs significantly reduces measurable risk.  As one example, a comprehensive 2020 MSCI report analyzed the entire US and European investment grade and high yield bond MSCI index constituency. It found “lower levels of systemic and idiosyncratic risks” among high ESG-rated issuers, after controlling for traditional DTS (credit volatility) factors and style factors, including credit quality. They found a residual effect in explaining credit risk not yet captured by credit ratings. 

In short, even controlling for external credit ratings, strong ESG results (in this case as defined by MSCI ratings) significantly reduced default risk and adverse credit events.  While there is no magic solution to controlling risk, strong ESG policies and procedures can help business leaders materially improve enterprise resilience and reduce the risk of catastrophic downside.

ESG-related risks (and opportunities to gain competitive advantage) will inevitably show up and are growing in both frequency and intensity in the world around us. An authentic strategy can be an effective tool for connecting with all shareholders, building brand affinity, attracting and retaining top talent and positioning companies for future challenges.  Establishing, elevating, and iteratively improving a thoughtful set of ESG/Sustainability policies and practices in order to maximize a business’s chances of making wise decisions around those issues is increasingly the standard for high-quality leadership teams.

Robert McConnaughey is Senior Vice President of the Community Impact Group at Corbin Advisors.