Once considered a small factor in the overall economic equation, environmental issues now represent a growing financial risk for businesses. Companies that adhere to an environmental, social and governance (ESG) approach quickly discover the business value of the “E” in ESG.
It’s become so important that some argue an “F” belongs at the beginning of ESG, standing for “financially relevant.”
The “E” in ESG takes into consideration how well an organization acts as a steward of its physical environment, including use of natural resources. This includes both the impact of direct operations as well as a company’s value chain, the full scope of activities required to create and distribute a product or service. It also measures how well a company incorporates these factors into financial and business decisions.
Environmental and sustainability issues impact a wide range of business activities. They include the carbon footprint across the complete product life cycle, climate risk management, efficient use of water and land and management of emissions and waste.
More executives and investors than ever realize private business is a potential driving force for positive change. Nowhere is that truer than in environmental sustainability.
An Evolving Position on ESG
Leading financial firms and corporations have in recent years encouraged the movement of more capital investment into activities and strategies that incorporate sustainability into business operations. One of the thoughts behind this movement is that politicians cannot (or will not) make the changes needed to protect the environment on their own.
Another is that businesses in the past have caused much of the environmental damage we see clearly today, putting the leaders of industry in the best position to understand and address the challenges. No one knows the potential environmental hazards of manufacturing more than manufacturers.
One of the keys to this shift is making businesses and investors aware of the positive financial impact of supporting environmental stewardship — or the negative impact of ignoring the issue.
- Investors and other stakeholders need to better understand how a company performs, makes decisions and creates value.
- They also need a clearer picture of the external impact of a company’s actions, both in absolute terms and in comparison to other companies.
- Employees want to understand if their employer drives greater equality, empowerment, better working conditions, as well as safer and more sustainable communities.
As part of attaining these goals, EY advises companies to consider adopting more financially relevant ESG philosophies, what they call FESG. EY writes that linking financials to ESG “enables businesses to deliver change and stakeholders to better understand their full value and impact.”
Why Is This Issue Becoming More Important?
All the reasons needed to understand why organizations have started to focus more on the economics of environmental issues are contained in the latest global climate reports from the United Nations. Released in February 2022, it paints a dire picture of the future if steps are not quickly taken to slow global warming.
The report predicts increases in extreme weather events, illness and death from issues such as heat stress and air pollution, and an increase in poverty and hunger. This will impact people, plants, animals, ecosystems and economies.
The private business community can play a critical role in slowing global warming and the resulting adverse effects of climate change. That’s made the “E” in ESG more relevant to how businesses choose to operate. It’s also influenced some investors to fund companies that offer technologies that reduce both the consumption of energy and the emissions of greenhouse gasses.
It’s not just a matter of principle. It’s a matter of recognizing the exigent risks of environmental damage to entire regions and capital markets. However, experts in finance report that this recognition needs to be more widespread.
Global investment firm Franklin Templeton notes that “we see a sizable disconnect between ambition and action among companies and governments. There needs to be a sense of urgency, and active investor engagement around the adoption, measurement and tracking of key climate-related pledges to accelerate change.”
There are signs this is happening. The value of sustainability-focused index funds has doubled to more than $250 billion, Forbes reports. Morgan Stanley research shows that 85% of U.S. investors expressed interest in sustainable investing, including 95% of Millennials.
Focusing on Sustainability Creates Business Value
Executives can point to taking steps such as reducing carbon emissions and making more efficient use of water resources as successes in helping the environment. But how can businesses quantify sustainability efforts in terms of the value created for the business?
McKinsey & Co. reports that the “overwhelming weight of accumulated research” shows investments in ESG do not create a drag on value creation, but rather lead to higher equity returns. They also result in reduced downside risk, including higher credit ratings.
They list five areas where ESG creates value. Not all will apply to every business or every location, but businesses and investors should consider them when focusing on the “E” in ESG.
1. Top-Line Growth
Companies that demonstrate a strong ESG commitment are better positioned to win the trust of both consumers and government officials. For example, government officials in Long Beach, California, screened potential companies bidding on a public-private infrastructure project based on their past performance in sustainability.
2. Cost Reduction
McKinsey found a strong correlation between companies that practiced the efficient use of resources and improved overall financial performance.
3. Reduced Regulatory and Legal Interventions
A track record of sustainable policies and adhering to laws governing how companies interact with the environment can relieve regulatory pressure on organizations. It also makes them less likely to become embroiled in costly legal actions.
4. Increased Productivity
In the modern workforce, companies that practice ESG attract and retain the most talented employees. Employees who feel a higher sense of purpose within the company culture are also more likely to engage and become more productive.
5. Investment and Asset Optimization
Companies can enhance investment returns by investing in more sustainable opportunities, rather than those that face long-term environmental issues (McKenzie uses the example of massive write-downs on oil tankers).
While the knowledge of the business value of the “E” is growing, some companies still are in a “do nothing” mode because the losses are slow, not fast. By better defining the economic case for investing in sustainable products, executives and investors can help drive the changes needed to lower the impact of business on the environment.