When it comes to offering value to shareholders or investors, companies are fixated on profits and economic growth as a significant indicator that they are living up to the fiduciary obligations that they have to these vital role players.
While this was sufficient in the past, the landscape has changed significantly. Consumers and investors have become so fixated with environmental and social governance (ESG) that it is a deal breaker in many instances. Companies with a firm eye on ESG often outperform those who pay no heed to it or are not genuinely invested in it.
The fixation on ESG is increasingly forcing investors to compel companies to prepare reports regarding the value of sustainability.
The investors’ view
The McKinsey article points out that long-term-minded investors—whom we call “intrinsic investors”—have an outsize effect on stock performance over time. These investors recognize that ESG will affect value, but they always want to dig deeper.
They seek out granular information about how specific ESG initiatives can be a source of growth and which risks are most material to a specific company and its broader industry—and the extent to which distinct ESG actions can mitigate those risks.
The quest for clarity
The article adds that about 85% of the chief investment officers we surveyed state that ESG is an important factor in their investment decisions. Sixty percent of respondents to a McKinsey Survey pointed out that they review their overall portfolio for ESG considerations, and about 80% assess individual company positions in the context of how ESG affects forecasted cash flows. Strikingly, a significant majority are prepared to pay a premium for companies that show a clear link between their ESG efforts and financial performance.
Yet surveyed investors say that companies’ current ESG communications fall short in significant ways. Respondents want clearer methods to measure long-term value, greater certainty about regulations, and practicable ESG-related frameworks.
The article points out that surveyed investors are also eager for clearer ESG standards. They understand that ESG scores today, unlike financial ratings, don’t correlate fully among ESG score providers. While financial ratings correlate at around 99% among providers, ESG ratings can correlate at less than 60% because of the different elements and weighting each agency assigns to various ESG metrics.
A significant majority of chief investment officers are prepared to pay a premium for companies that show a clear link between their ESG efforts and financial performance.
The importance of sectoral differences
The article points out that an important part of achieving greater ESG clarity, investors reveal, is understanding industry differences. For example, our survey shows that with respect to ESG in the energy sector, investors prioritize capital productivity and cost optimization. We observed similar trends for the industrials, materials, and consumer sectors. While investors rate the elements of E, S, and G roughly equally in importance when summing across all industries, that isn’t the case within each individual industry. Investors find that excellence in different pillars is required based on a company’s sector. For companies in the industrials and energy sectors, for example, surveyed investors seek out ESG initiatives in the environmental dimension. For companies in the technology; pharmaceuticals; and travel, logistics, and infrastructure sectors, investors consider social initiatives to be the most important. And for those in the financial and insurance industries, investors rank governance concerns the highest.
Notably, for some industries, the absence of a clearly defined ESG strategy leads surveyed investors to consider decreasing their exposure to or to divest from some industries entirely. That holds particularly true for investments in the energy; materials; and travel, infrastructure, and logistics sectors. But in most cases, ESG is part of a broader set of detailed investment factors they consider.
The compelling opportunity for a more value-focused ESG story
The article adds that investor demand for greater detail and nuance suggests a compelling opportunity for companies to provide a clearer ESG-to-value case. In other words, what is the relevance of ESG for the business? How do ESG initiatives tie to value creation? What are the key levers and value drivers?
Consider, for instance, how CEOs and CFOs provide context for quarterly and annual earnings, especially in their accompanying presentations: publicly filed reports are the start, but not the sum, of investor communications. Similarly, managers should not rely on formulaic ESG reporting to provide a comprehensive picture. Just as reports filed under generally accepted accounting principles are not full descriptions of strategy, carbon disclosures and other presentations of ESG metrics do not provide, without more context about the company’s unique business model, sufficient descriptions of strategic impact.
An important value horizon
This will only increase in the future as communities become increasingly active participants in the financial future of companies.
Turnaround Talk recently published two articles which discuss the future of renewable energy in South Africa, with one article describing this future as similar to that of the gold rush on the Witwatersrand in the late 1880s. Communities will be significant role players in this renewable energy boom as they will be the major benefactors of jobs and industries that are created to support this boom.
Ensuring that communities and the environment share an equal benefit of profits and investment has major benefits and is increasingly becoming a vital value horizon. Will ignoring ESG investing become a future root cause of financial distress?