The ROI of ESG

Prioritizing nonfinancial activities can boost company reputation and performance—and reinforce investor expectations.

April 12, 2024

Is environmental, social, and governance (ESG) worth it? Investors say yes. Sustainability investment assets accounted for more than $30 trillion in 2022, according to the Global Sustainable Investment Alliance.¹ And ESG investments around the world are predicted to have quadrupled from 2020 to 2030,² solidifying their role in capital allocation across global markets.

As issues such as climate change and resource scarcity gain prominence, nonfinancial risks are becoming critical factors in investment decisions, and it’s imperative for business leaders to make ESG an essential lens for assessing investments’ broader landscape. By aligning their strategy with ESG principles, companies can create shared value across stakeholders, including communities, employees, governments, customers, and investors.

Applying an ESG framework helps businesses monitor and report on their management of global-scale issues to help make decisions that protect potential profits from emerging threats. But they also use this framework to head off common issues that concern stakeholders, demonstrating the company’s commitment to doing the right thing—even if there’s a short-term financial sacrifice.

Those initiatives can range from taking significant steps toward achieving net-zero carbon emissions to promoting diversity, equity, inclusion, and belonging (DEIB) within the workforce, ensuring a broad range of perspectives inform decision making. To elevate governance initiatives, a company might actively engage with their shareholders, fostering a stronger sense of ownership and responsibility. This could include emphasizing ethical business practices to safeguard a company’s reputation and brand value.

The return on investment (ROI) for prioritizing ESG is vast. Strong ESG performance can reduce talent turnover and help attract those seeking purpose-driven workplaces. And by addressing environmental and social risks, businesses can preserve reputations and save themselves from costly marketing mishaps. Safety is another critical ESG factor: When managed effectively, it reduces safety reserves and insurance costs, boosting the bottom line.

ESG initiatives can also generate direct revenues. For instance, a food company can create an organic product line that increases sales and market shares. Or a manufacturer can leverage tech innovations like AI to optimize energy use and resource consumption, reducing operating costs at factories.

Meeting Demands and Standards

As ESG activity escalates, investors are starting to demand more reporting transparency. But that visibility requires reliable data. Although vast amounts of information are available, interpreting ESG data remains subjective, making it a dynamic market driver. As access to usable data increases, investment managers can incorporate sustainability variables into their processes. Each manager’s reading will influence their investment decisions, inevitably creating a diverse range of approaches. As understanding of ESG data improves, the integration of sustainability into investment strategies will evolve.

Traditionally, ESG has been used to identify and quantify underappreciated or over-appreciated nonfinancial risks that affect a company’s operations. However, ESG is now being redefined to encompass broader investment analysis frameworks like sustainable and impact investing. And as standards change, sustainability reporting and assurance will need to shift accordingly. Spoiler alert: It’s already happening.

The U.S. Securities & Exchange Commission (SEC) adopted new rules³ in March 2024 that will shake up compliance requirements. According to a PwC analysis,⁴ the revised standards require companies to disclose climate-related risks that could have a material impact on business strategy, operations, or financial condition. Although many of the final rules are in line with concepts from the Task Force on Climate-related Financial Disclosures (TCFD), some differ from regulations and standards set by the European Union, International Financial Reporting Standards (IFRS), and the State of California. For instance, the SEC won’t require emerging growth or smaller reporting companies to report greenhouse gas (GHG) emissions, and all companies will be exempt from reporting GHG emissions by value chain partners they don’t own.

Although these new rules won’t take effect until 2026, companies need to start preparing for these requirements now, as they will influence financial reporting under Generally Accepted Accounting Principles (GAAP) and IFRS. Companies must understand their inventory of GHG emissions and embed climate risk into their governance, strategy, risk management, metrics, and targets for effective ESG reporting.

According to a PwC survey,⁵ nearly three-fourths of global investors expressed a desire for standardized ESG reporting, and 85% of CFA members reported incorporating at least one of the three factors into their decision-making process. However, no standard framework exists to quantify a private company’s ESG performance. The International Valuation Standards Council (IVSC) ESG Working Group continues to work on creating a framework, and in the interim, the IVSC published a perspective paper that provides a few suggestions.

Where to Start?

Assess how the company performs on ESG factors. For now, this might require evaluating the self-reporting of objective and subjective factors by company management.

Environmental

For environmental factors, characteristics could be tied to future financial performance. For example, companies with existing or planned manufacturing facilities within a flood-prone area could experience significant disruption to company operations, production, and subsequent revenue levels. One standardization effort proposed by the TCFD is a two-degree scenario analysis. This includes considerations for a two-degree rise in the Earth’s average temperature, and how a company would deal with water usage or carbon pricing, for example.

Social

Social factors can be more difficult to quantify. Discussion often relates to establishing a DEIB office and boosting DEIB activities, which influence hiring and retention decisions. Attempts to quantify social factors focus on a company’s reputation, such as how they impact consumer engagement and employee unrest. For example, boycotts against a company’s products could hinder financial performance.

Governance

Governance can be tied to regulatory investigations and subsequent punishments and fines as well as the quality of internal processes and oversight. For example, if a manufacturing facility is polluting excessively, it might face fines or orders to periodically cease operations, impacting a company’s top and bottom line.

In the absence of a formal framework to measure how ESG impacts private company valuations, efforts can be made to integrate ESG considerations into the financial information that is later used in the valuation analysis. The IVSC Perspectives Paper: ESG and Business Valuation⁶ even highlights the importance of characterizing ESG information as “prefinancial” rather than “nonfinancial.”

The Private Valuation Equation

When performing a private company valuation, experts are often provided with a quality-of-earnings (QoE) assessment, or a similar analysis. These procedures examine things like nonrecurring and/or nonoperational business activities and potential value-creating or cost-saving opportunities via synergy. Although ESG factors are not explicitly accounted for within QoE adjustments, they might already fall under nonrecurring costs or cost-saving opportunities. Standards like IFRS and those from the SEC can help map management ESG strategies to different value drivers, including revenues, costs, and capital expenditures.

As ESG reporting becomes more standardized, these considerations can impact both income and market valuation approaches.

Market approach

Assessing relevant ESG factors for a company’s industry and comparing that with their activities is a good place to start. These same ESG factors can be used to select the peer company set by discarding competitors that perform substantially differently. S&P, Moody’s, and Fitch are developing and refining their own alphanumeric scales for the ESG performance of public companies via the S&P Global ESG Scores, Moody’s ESGView, and Fitch ESG.RS tools.

Consideration will then be given in the valuation process for the company’s value compared to others. If everything else is equal, an acquirer might be willing to pay a premium for a company that scores well on ESG parameters, or conversely, might turn away from a company that scores poorly.

Income approach

When using this approach, ESG-related consideration is given to the reliability and predictability of future cash flows. Extremely poor ESG performance can be integrated into the capital asset pricing model via an additional risk premium category for the discount factor.

For example, if a company is operating a factory within a country that is tightening GHG emissions requirements in five years, but cash flow modeling extends past the new requirements without adjustment, a risk premium might be applied to account for potential regulatory action. Such actions could reduce manufacturing capacity while the facility undergoes modernization and/or impact the factory’s profitability thereafter.

Poor ESG performance could also be integrated into the terminal value assigned to a company by reducing the terminal growth rate or even utilizing a rate of decline. All these factors could be used to calculate, and subsequently give weight to, a downside performance case.

The ESG Reward

Indeed, it seems ESG is worth the effort. In markets with mandatory ESG reporting, data shows a positive relationship with higher ESG disclosure scores—and it indicates that investors are willing to pay a price premium. To account for this, a premium should be applied to companies with high ESG scores as part of a valuation analysis. Companies with strong ESG practices also often experience reduced risks, which can be reflected in a more stable customer base and less volatile cash flows, further adding to their valuation benefits. Overall, integrating ESG considerations can lead to both tangible financial gains and intangible advantages that positively impact a company’s valuation. As companies strive to align their operations with ESG principles, they can contribute to global sustainability efforts, enhance their reputation, and open avenues for increased enterprise value. In short, the ESG framework has become an essential component in business strategies, financial reporting, and valuation. Companies with strong sustainability practices tend to reduce risks at the company level, which can translate into more favorable investing decisions.

An ESG Call to Action

There are several ways that finance professionals can embrace ESG and drive sustainable value creation:

Educate yourself. Understand the ESG framework, its evolving landscape, and the impact of ESG initiatives on financial reporting and valuation.
Assess your ESG strategy. Conduct a rapid assessment of your company’s ESG initiatives to identify areas of effort and opportunities for value creation.
Integrate ESG in decision making. Encourage cross-functional collaboration to embed sustainability principles into business strategies, risk management, and financial decision making.
Play by the rules. Start developing a plan to comply with revised SEC disclosure guidelines to ensure your company is ready to comply.
Measure impact. Develop methods to quantify the impact of ESG initiatives on financial performance, including ESG-related adjustments in valuation models.
Be transparent. When it comes to the quality of ESG data and information, consider independent assurance of sustainability reporting to build confidence with investors.
Listen to stakeholders. Engage with stakeholders, including investors, customers, employees, and communities, to understand their ESG expectations and incorporate their feedback into business strategies.