Understanding the financial implications of sustainability

THERE has been growing evidence in recent years that companies with a strong environmental, social and governance (ESG) proposition tend to benefit from superior financial performance. This link became even more evident during the pandemic, a crisis that reinforced the need to foster a more inclusive form of capitalism.  “In general, most metastudies of the relationship between ESG factors and operating performance show that companies which invest in a focused way – that is, based on materiality – in ESG tend to do better in key metrics such as profitability and return on assets,” says Konstantinos Dimitriou, associate partner, Strategy and Transactions at EY Corporate Advisors.  “Quite importantly, these firms also generally tend to enjoy a lower cost of capital across both debt and equity, which means they often enjoy a valuation premium,” he adds. 

Demonstrating a commitment to sustainability driven by ESG factors creates value for businesses in a variety of ways, from internal cost reductions to improved stakeholder relationships. For one, firms that execute their ESG strategy successfully can combat rising operating expenses, while improving operational efficiencies.  “Such companies are likely to be more aware of the true cost of raw materials and resources, such as water and electricity. By lowering energy usage and transiting to sustainable means of operations and production, both emissions and overall energy  expenses for the business can be reduced,” explains Cherine Fok, partner, KPMG ESG, and a member of CPA Australia’s ESG committee in Singapore. 

A robust ESG proposition also allows companies to win new business, as they meet compliance and other requirements. For instance, firms with a proven sustainability record that provide business-to-business services may be more likely to be awarded  contracts, as ESG becomes a priority for both public and private sector organisations.  End consumers, too, are increasingly favouring brands that have a strong commitment to sustainability, and are showing their preference by voting with their wallets. “From a consumer perspective, customers and end-users are becoming more ESG-conscious. The need to satisfy customer demands will drive companies to implement ESG initiatives to remain competitive in the marketplace,” says Giam Ei Leen, Sustainability & Climate leader, Deloitte Southeast Asia.  Putting ESG in the core of business strategy also helps with the attraction and retention of talent amid a tight labour market. According to a 2021 Deloitte survey, some 30 per cent of respondents said they would consider switching jobs to work at a more sustainable company. From a capital perspective, investors today are convinced that companies performing well on ESG are less risky and better positioned for the long term. As such, ESG factors are now commonly included within credit underwriting decisions, as well as investment analysis and decisions.  On the flip side, sustainability-related risks such as climate change can have a negative financial impact on businesses, from monetary penalties for not adhering to increasingly stringent reporting obligations to reputational damage for not taking the climate crisis seriously. These, in turn, can result in reduced demand and revenue. In the longer term, companies could also face the prospect of higher insurance premiums and supply chain disruptions due to unpredictable and extreme weather events.  “Climate-related risks have a huge potential to affect the operations of businesses and their relationship with consumers. Resulting macro effects on the local and global economy also create financial risks and opportunities that companies must be cognisant of,” says Fok.  Strengthening ESG To beef up their ESG value proposition, companies need to think about sustainability beyond compliance, and focus on how such factors can enhance business resilience while identifying new business opportunities.  This involves developing a clear vision of what ESG means to their organisation, and how to incorporate relevant initiatives into their business strategies. This should be guided by a firm’s overarching purpose, and cascaded across business and operational priorities. “Companies should not try to do ‘everything’, but focus on material ESG issues which are aligned to the defined purpose, material to their business and relevant to their stakeholders,” says Giam, who is also a member of CPA Australia’s ESG committee in Singapore.

It is also important for there to be “buy-in” from every level, from interns to the C-suite, for a company’s ESG efforts to bear fruit. Furthermore, companies should develop a framework to measure the impact of their sustainability efforts, regularly assess its impact and commit to transparency in reporting.  Dimitriou notes that linking individual management incentives to ESG targets may also be required to drive commitment. “In practical terms, this means establishing ESG targets on the most material topics, in collaboration with multiple internal and external stakeholders, and then setting annual financial targets that are consistent with those targets,” he says.  One starting point could be to establish a “house view” on carbon cost curves to price the organisation’s emissions. These cost estimates can then be used to begin driving carbon efficiency into the organisation’s supply chain in a structured and quantified way, that leads to specific, positive-ROI initiatives with financial and non-financial targets, explains Dimitriou. Beyond ticking boxes While ESG practice and disclosures are often seen as a listed company phenomenon, experts argue that sustainability should be a priority for all businesses. In recent years, the Singapore Exchange has been a key driver of such disclosures for listed entities with its comply-or-explain guideline on sustainability reporting. In the near future, the regulator will incorporate International Sustainability Standards Board standards into the listing rules as mandatory disclosure requirements for listed companies.  Dimitriou believes that private companies are likely to be brought into the ESG fold by the financial system. “The world’s leading providers of capital, including most major global investment houses and banks, are increasing their ESG requirements and performing more due diligence on all their products. Even though they are not funded by public markets, many private companies rely on such capital providers and will, therefore, sooner or later have to establish their own ESG strategy and reporting,” he says.  Giam notes that all companies should recognise that embedding ESG into corporate strategy should not be only about meeting compliance obligations. “ESG is simply good business. It can help attract new customers, attract and retain talent, minimise risk and potential reputational damage. A company’s ability to respond to critical environmental and societal expectations may ultimately affect its social license to operate.”