Willem Schramade, Sustainability and Valuation Specialist in Robeco’s Global Equity team, recently published an article on ESG integration in the Journal of Applied Corporate Finance. In this article, he explains how true ESG integration can help both investors and companies become more successful and may even lead to a more sustainable form of capitalism.
Most large corporations believe sustainability has the potential to have a significant effect on their revenue and profits. Also, studies have shown that sustainability concerns and corporate programs to deal with them can end up affecting stock returns. Nevertheless, both investors and corporate managers continue to struggle to incorporate sustainability into their financial decision-making.
However, sustainability can and should be integrated into both of these kinds of financial decision-making. Corporations and asset managers alike can accomplish this by linking sustainability to business models, competitive positions, and value drivers, such as sales growth and profit margins. A way to do this is the ‘value-driver adjustment’ (VDA) approach. This approach starts with the recognition that the pursuit of sustainability in business can not only help address social and environmental problems, but can also be an important source of strategic or competitive advantage.
At first glance, the success of sustainability investing (also known as Socially Responsible Investment, or SRI) looks quite impressive given the growth in assets under management that are labeled as such. But it’s questionable what these numbers really mean. The problem is twofold. First, it is typically not very clear what’s under the SRI label. SRI includes both ESG integration and ethical investing, which are two very different approaches. ESG integration is about taking ESG issues into account in investment decisions, with investment performance as the main goal. In contrast, performance is a secondary concern in ethical investing. And this difference in philosophy and methods shows up clearly in the results. A recent study provides persuasive evidence that profit-oriented SRI strategies (i.e., ESG integration) actually outperform mainstream strategies, whereas values-oriented SRI strategies (i.e., ethical investing) underperform on average.
The second problem is that many ESG integration approaches are actually quite superficial. The more advanced asset managers tend to have the following elements: being a signatory to UNPRI and similar initiatives; voting and engagement activities; screening and exclusion; dedicated ESG staff. But although these are all very useful, true ESG integration goes much further. The European Sustainable Investment Forum (Eurosif), the leading pan-European organization dedicated to promoting sustainability in financial markets, has defined ESG integration as involving “...explicit consideration of ESG factors alongside financial factors in the mainstream analysis of investments. The integration process focuses on the potential impact of ESG issues on company financials (positive and negative), which in turn may affect the investment decision.”
Such a process clearly goes well beyond screening and engagement, and implies the use of ESG information in all stages of the investment process, including the investment case and the valuation models used in investment decisions. But, of course, very few of today’s asset managers are actually doing this.
In our view, there are three things that are key to successful ESG integration:
1. Management commitment
Management actually allocates resources to ESG integration and puts effective incentives in place.
2. A focus on materiality
An issue that is material from an investment perspective means that it can change an investor’s investment decision, since it has a decent probability of seriously affecting the company’s value drivers and valuation. Materiality is critical to establishing the link between sustainability and valuation. This, in turn, is key to getting analysts and portfolio managers engaged.
3. Solid ESG integration frameworks
Our Value Driver Adjustment (VDA) approach ties into traditional valuation approaches by linking ESG factors to value drivers through their expected effects on business models and competitive positions. The underlying conviction is that if a company derives a competitive advantage from its ability to manage an ESG issue, that advantage should become visible in its value drivers. That is, the company should in the end have higher sales growth, higher margins, more efficient use of capital, or lower risk. These value drivers in turn drive the ROIC (return on invested capital) and valuation of the firm.
Lots of corporations claim that sustainability is important to them, but only a few have proven capable of showing that it’s an important business driver. To succeed first in identifying internally, and then demonstrating to outsiders, that sustainability is an important business driver, companies will need to make use of the same ingredients as asset managers: management commitment; a focus on materiality; and solid frameworks. The latter two seem particularly problematic and missing in most companies.
As they are important business drivers, top management needs to incorporate material sustainability issues into its strategy. This means that management must have a thorough understanding of how sustainability issues affect the corporation’s competitive position and the ability to achieve its strategic objectives. Management should ensure that the firm’s strategic objectives are consistently operationalized into targets, resources, and methods that middle management can use across all functions.
There are three keys to successful ESG integration into a company’s strategy:
1. Apply traditional finance and valuation methods in a more thoughtful way by treating sustainability issues as indirect financials and analyzing their link to the value drivers.
2. Complement these traditional methods with some that are focused on strategy and sustainability. This provides a company with estimates of ‘nonfinancial’ factors and the risks associated with them. This helps management to prioritize focus areas, quantify the business case, and better navigate trade-offs.
3. Recognize that this is a change process and act accordingly. Getting new methods adopted takes time, effort, and patience.
Corporate sustainability reporting (CSR) often amounts to telling the world the good things the company does for local communities and society at large, in a way that is largely separate from conventional financial reporting. This is old school CSR: too easy, no targets, and limited accountability. It’s also a missed opportunity. Just as analysts and portfolio managers aren’t interested in hearing about immaterial issues from their sustainability counterparts, they also aren’t interested in hearing about that from corporate managements. Instead, they want to know how management expects the company’s key intangibles and material sustainability issues to affect its long-term value.
When laymen think of investing, they often associate it with casino scenes or The Wolf of Wall Street. And admittedly, it is often a very detached business, with huge companies being reduced to a few financial metrics. A more engaged type of ownership would be most welcome, both from a social point of view and from an alpha generation stance. Therefore, our main ESG integration improvement efforts are focused on engagement.
Our investments will become more concentrated and focused on those companies that can show they have a sustainable business model, and that are eager to keep on improving on both material sustainability issues and the value drivers. We think this is part of a growing trend. Moreover, as both investors and corporations become better at integrating sustainability into their investment decisions, their relationships are likely to strengthen. Average holding periods will increase, short-term tendencies on both sides will abate, relations will deepen, and commitment will increase. The road is long, but the financial and corporate sectors can become better at performing their key roles of allocating capital to the most productive resources, including social costs. And over time, we might actually get a more sustainable form of capitalism.
This is a summary of an article that was published in Journal of Applied Corporate Finance, Spring 2016, Vol. 28, Number 2, 17-28