Part two: ESG - why now?

Intangibles link ESG to financial performance

The evidence shows that wise social and environmental engagement pays the firm financial dividends. Employee engagement is one of many connecting rods. What are the others, and how do they work?

In 2000, McKinsey & Co analysed international equity markets to show that, of a firm’s market value, an average of 55 per cent represented the market’s evaluation of the firm’s core intangible assets, with the remainder being an evaluation of the firm’s physical assets and financial performance, its continuing net profit after tax and cash flows. The figure varied between industries, being as low as 20 per cent for capital-heavy industries such as mining, and 80 per cent or more for service industries such as media and banking.⁶

These intangible assets are not simply existing intellectual property and contracts. They are four: the firm’s brand and relationships, and the productivity and innovation capacity of their people. These four deliver future financial performance, which is of course of more interest toinvestors than past performance.

More recent studies show that, as our economies become more service-based, the average value of the non-physical assets has risen from 17 per cent in 1975, to 68 per cent in 1995, to 81 per cent in 2009 to 90% in 2020.⁷ This is what happens in maturing economies, where physical goods are commodified, consumers seek brands, services and experiences, and firms depend more than ever on their people to deliver. 

Most CFOs readily accept these figures. It’s then not a stretch to suggest that wise engagement on social and environmental issues can bolster reputations and relationships, and help drive an innovative and productive corporate culture.

Reputation or brand? Yes, solid social and environmental performance helps qualify a firm for more opportunities and a lower cost of capital, attract customers, and be an employer of choice.

Relationships? Yes, engaging on significant social and environmental issues with governments and other firms creates new relationships and strengthens existing ones. As it does personal relationships within the firm. In both cases, there is time to build understanding and appreciation,outside the pressures of purely commercial transactions.

Innovation? Yes, ESG engagement means looking at new problems, from different perspectives. The solving technology is never far away. ESG provides the financial rationale and will. New products, services and markets follow.

And people? Yes, this is the strongest driver. People are satisfied with their job if it gives them a decent income, friends at work and some professional development. But if they’re contributing and developing in other ways, then their productivity and capabilities increase.

What firms do matters

From an historical perspective, a firm’s enlightened ESG engagement and people’s reactions to it make sense.

For better or worse, firms and their markets are the way societies now organise their most powerful productive forces – it’s the way we get things done. If, for whatever reason, we have a social or environmental problem, there is no way it will be resolved without firms being part ofthe solution.

Firms demand a lot from their employees and, of course, give a lot in return. It can be an all-encompassing relationship. If people feel that that relationship is working on the social or environmental issues that matter to them (or at least it’s not against them), they invest more of themselves in that relationship.

These are growing expectations. Consider Maslow’s hierarchy of needs. Once we have basic physical needs and safety in place, we want to belong, and to gain confidence and respect. At the peak of that hierarchy is creativity, problem-solving and, dare one say it, morality.

As a society, we are well aware that social and environmental problems exist, always have and always will. Having invested enormous amounts in education and social stability, what we have now though are many more tools to deal with those issues (and perhaps create more) – innovations in technology, information, and business models.

With these tools, non-government organisations, governments, customers, investors, employees and future employees expect firms to dosomething about those issues that concern them. Those firms that do so have been very pleasantly surprised. No less a student of corporate strategy than Michael Porterhas documented how they have benefited, and the competitive advantage they have earned.⁸

Deciding what to do

If expectations are building for your firm’s ESG performance, and there are benefits from your doing so, what should you do?

It’s not an easy question, for the number of ESG issues that are relevant to your firm are numerous. Research firms that rate the ESG performance of listed companies keep track of over 1,200 different metrics, everything from the independence and diversity of boards, to gigalitres of water, to freedom of association. The most prominent voluntary reporting standard, the Global Reporting Initiative, makes do with 130. Some of these might be relevant, some not.⁹

What matters to your firm are the issues that have a potentially material effect on its business or intangibles. That’s a list still too long to be actionable. Consider then issues your firm can influence, drawing on its particular assets and capabilities.

It helps that your people are interested, more so that an action supports your existing corporate priorities. We’re getting closer. The answers won’t be obvious, but there are ways of working them out.¹⁰

One such way is a valuation tool that can calculate the value at risk from ESG issues, and the potential financial returns from any particular action to address them. If there’s a public good or ‘externality’ your firm relies on, cost it in to your business model and see how exposed that model may be. There are rigorous approaches, but they’re available.

ESG, sustainability, CSR, ‘internalising the externalities’. Call it what you will. It’s worth a closer look.

First published in the Governance Industry of Australia's Keeping Good Companies, May 2012

Notes

1. Morris J and Pell, MB, 2010, 'Renegade Refiner: OSHA says BP has "systemic safety problem", www.iwatchnews.org/2010/05/17/2672/renegade-refiner-osha-says-bp-has-%E2%80%9Csystemic-safety-problem%E2%80%9D [4 April 2012]. That statistic rang alarm bells among some ESG-led investors, but not enough. Similarly, the ESG research firm Invest expressed concern about AAA investments laid over 'ninja' (no income, no job, no asset) loads, nine months before the emperor's clothes came off in September 2008
2. Morningstar, Australian fund performance over one, three, five and seven years to 30 June 2011
3. Through the principles of Responsible Investment, the Equator Principles, the Carbon Disclosure Project, the Water Disclosure, the Enhanced Analytics Initiative, and myriad other investor-led calls for disclosure
4. In the UK, this is now a positive obligation under the Companies Act
5. Superannuation funds are a special case here. Their trustees recognise that they're investing for their beneficiaries over ten to 40 year time frames, and that superannuation contributions are mandated by society through the voice of its legislature. It makes sense then that superannuation fund investments take into account the longer-term social and environmental investments
6. Bruckner K, Leithner S, McLean R, Taylor C and Welsh JF,2000, 'What is the market telling you about your strategy?', McKinsey Quarterly, June
7. Ocean Tomo, 2010, Intangible Asset Market Value Study
8. Porter ME and Kramer MR, 2006, 'Strategy and Society: the link between competitive advantage and corporate social responsibility', Harvard Business Review, December, pp 78-93
9. See also Geraghty L, 2010, 'Sustainability reporting - measure to manage, manage to change', Keeping good companies, Vol 62 No 3, pp 141-145
10. Dowse K, 2006, 'Sustainability measures that count', Keeping good companies, Vol 58 No 8, pp 466-471