With the increasing awareness of the 17 Sustainable Development Goals (SDGs) with 169 targets set by the United Nations and worldwide collaboration to achieve the goals, Environmental, Social and Governance (ESG) factors have become increasingly important not only due to the regulatory frameworks, but also changing priority of banks, institutional and retail investors.
ESG factors become more and more crucial aspects in the investment consideration process as well as capital allocation for both capital providers (shareholders and creditors) and users of capitals (corporations).
Sustainable finance or green finance plays an important role in driving the sustainable transformation of the economy, encouraging companies’ management to redesign their business models to incorporate ESG framework into their capital budgeting process, supply chain management and sustainability reports to their stakeholders to mitigate ESG risks and achieve sustainable financial performance. Financial sector players that consider ESG aspects in their decision-making processes increase long-term investments in sustainable activities and business projects, significantly contributing the mobilization of capital necessary to achieve the SDGs.
ESG ratings have been necessary tools for assessing ESG risks in investors’ investment assessment processes, and have been growing in importance as investors, asset managers, financial institutions and other stakeholders increasingly rely on ESG assessment and rankings. As opposed to traditional credit ratings which assess companies based on financial factors using well-defied ratios, ESG ratings are considered based on non-financial data with a variety of indicators and less structured assessment criteria, which mostly focus on the broadly defined E, S and G areas, to evaluate a corporate ESG strategy.
Although the general perception is that ESG disclosures are typically non-financial in nature and that they do not have a financial impact, this view fails to recognize that ESG represents a multitude of factors to assess the long-term financial viability and sustainability of an enterprise. According to the International Valuation Standards Council (IVSC), ESG is better characterized as pre-financial information and should be incorporated in the valuation practice and standards in a systematic approach.
While this emerging trend is becoming more mainstream, there is still a degree of opacity on the relationship between ESG performance and company value; namely which ESG elements have the biggest impact on value, and whether companies with strong ESG performance attract a premium.
The lack of global ESG reporting standards has resulted in a lack of standardization when calculating and reporting on ESG performance although the developments for standardization are still underway, including the development of global ESG reporting standards under the International Sustainability Standards Board. Meanwhile, ESG ratings provided by various third-party agencies provide a useful proxy to understand and compare companies’ ESG performance. However, each of these third-party agencies utilize their own proprietary methodologies and lack alignment. Researches found that the average correlation of ESG scores for seven of the largest ESG rating providers is only 0.45, compared to an average of 0.99 for credit ratings by major agencies. Despite their shortcomings, ESG ratings are now widely used by a range of stakeholders to assess ESG performance.
In a recent publication by Deloitte (“Does ESG impact company valuations? An Australian perspective”, April 2022), in relation to the Australian market, Deloitte analysis of companies in the ASX200 (as a proxy for the Australian listed market) over a three-year period from 2019 through 2021, has highlighted the following key insights:
- There is a ‘size effect’. Larger companies have better ESG ratings, despite similar reporting scope coverage.
- There seems to be a reasonable positive correlation between total shareholder returns (TSR) and improvements in ESG scores over a three-year horizon. This holds for excess (industry-adjusted) as well as absolute TSR.
- Improvements in ESG scores also correlate positively with improvements in valuations multiples (EV/EBITDA, EV/Revenue and P/E) over this horizon.
Of the three ESG pillars, the Environment or ‘E’ score seems to be the most persuasive when it comes to excess TSR, whereas the Social or ‘S’ score is most closely matched with earnings multiple improvements.
Despite survey evidence suggesting a decrease in the cost of capital for companies that improve their ESG metrics, with evidence of a greater weight of capital seeking ‘ESG friendly’ investments, Deloitte analysis of the Australian listed market does not show such relationship.
So, what can companies do to improve their ESG performance to drive increased value? The question remains as to whether ESG-linked outperformance represents a market inefficiency that will eventually disappear over the longer term horizon. However, in the interim, it is vital that corporate and private equity companies prioritize the following:
- Have an informed understanding of the ESG issues relevant to their business and/or portfolio companies, value chain and key stakeholders
- Disclose performance data relating to material ESG issues in a transparent and consistent manner
- Prioritize investment in ESG initiatives that align with these material issues and the strategic priorities of the business and/or portfolio companies.
In summary, ESG frameworks and sustainable finance are inevitable. Companies can use their ESG risk assessment and data to carry out sustainability initiatives, enhance performance and attract capital. Investors expect active and responsible ESG approach from their investees and are more interested in financing the ones that demonstrate good ESG performance. Like other market participants, for valuers to successfully incorporate ESG framework into valuations, they need a reliable ESG metric reporting that is consistent between companies, across geographies, and over time.