The market recognizes that companies with high ratings for environmental, social and governance (ESG) factors are lower risk than other companies and the market rewards them accordingly. In the hierarchy of factors that count with investors and markets in general, governance is ranked highest and then environment, followed closely by social factors. A recent scandal involving Volkswagen cheating U.S. diesel emissions tests sent company shares plunging and exposed Volkswagen to potentially up to $18 billion in federal fines. As a result, the trust of Volkswagen’s customers and the public has been undermined and the company will now face intense legal scrutiny. Despite numerous instances of proven corporate disregard, there has been a notable rise over recent years in attention to the management of ESG issues. However, a common challenge for many companies is whether managing ESG issues really help create value and how to quantify the value of ESG initiatives?
“Companies that are considered leaders in ESG policies are also leading the pack in stock performance by an average of 25%.” —Goldman Sachs
The responsible investment strategy that many companies embrace today is based on the view that the effective management of environmental, social and governance issues is not only the right thing to do, but is also critical to value creation. Responsible investors believe that companies which are successful in avoiding ESG risks while capturing ESG opportunities will outperform over the longer term. When it comes to environmental issues, for example, environmental challenges can present opportunities for value creation (i.e. generation of incremental revenue from new technologies, products and markets such as sustainable products and services). Investors also share the view that ESG issues have the potential to materially impact the valuation of investments over the longer term. According to a survey of the private equity industry conducted by PricewaterhouseCoopers, environmental and social issues are considered to some extent during investment appraisals. The survey results further reveal that while there has been progress in developing and implementing responsible investment strategies over recent years, there has been lack of a policy on ESG issues and systems in place to measure value created from ESG initiatives (particularly for initiatives addressing environmental and social issues).
So, what motivates companies to pursue a responsible investment strategy? Some of the most common drivers include risk management, interest from investors, opportunities for cost savings and operational efficiencies, direction from upper management and regulation. Reputation and competitive differentiation also drive a responsible investment strategy, but the importance of these drivers will dissipate eventually given that the need for managing ESG issues has been arising.
Considering the importance of ESG factors, why is it many companies still lack a policy on ESG issues and don’t have systems in place to measure the impact of ESG initiatives on their business? The reason can be lack of internal capacity and expertise. Hiring an in-house team with specialized knowledge can be cost prohibitive, especially for smaller companies, and not sustainable given fluctuations in business and economic cycles. Many investors continue to view ESG only as a means of de-risking their investments and sideline environmental and social points as niche issues rather than being integrated into core business strategy. Measuring ESG performance and assigning financial value to ESG factors remains a challenge, especially considering the availability of ESG relevant financial data. Other reasons include limited ESG reporting requirements in the private sector.
When it comes to measuring value from ESG activities, it can be difficult to quantify how much value is tied to ESG factors. While it is difficult to quantify the extent to which strong ESG management contributes to a good valuation, companies recognize that a sound approach to ESG issues can enhance both earnings and multiples and can improve salability of the company or the asset. The challenge has been identifying ESG metrics and developing an effective measurement framework for ESG activities. Some companies have begun to attach a financial value to ESG initiatives by tracking their direct benefits. These include cost savings achieved from eco-efficiency initiatives or revenue growth achieved from more sustainable products. However, fewer companies have been able to quantify the indirect value achieved from ESG activities (i.e. customer loyalty, brand value or protection against reputation risk). There are a number of challenges in valuing the indirect benefits of ESG initiatives, since there is no market price for the intangible assets and the fact that their value to one company may be completely different to another. Despite difficulty in measuring indirect value achieved from ESG activities, some companies adopted strategies of using non-financial and qualitative indicators to measure ESG factors. Such approaches allow companies to track progress on ESG issues year over year. One of the approaches is to score company performance on key ESG issues (i.e. environment, workplace, and community), against pre-defined ‘maturity levels’.
At Quist, we work with companies across the full lifecycle of their businesses from start-up stage through growth to eventual exit. Our Management Insights™ tool is designed to engage company leadership teams, board members and investors in a more robust value creation and risk management process. Quist Management Insights™ tool poses questions for management teams to assess direct and indirect valuation drivers to help companies determine where they can improve and create financial value.
 Goldman Sachs – Goldman Sachs Global Investment Research, “Overview: Introducing GS SUSTAIN,” July 2, 2007.
 Responsible investment: creating value from environmental, social and governance issues. PricewaterhouseCoopers International Limited. March 2012.