ESG investing is an investment practice where private equity investors analyze Environmental, Social, and Governance (ESG) criteria to gauge the material risks and growth opportunities of specific companies and industries.
The corporate world is now reaching a tipping point where businesses can no longer afford to ignore ESG-related material risks that threaten the stability or profitability of its operations. Investors and stakeholders alike expect companies to take responsibility for the impact of their activities, and to meaningfully contribute to the global challenges of our time. ESG analysis is therefore becoming just as crucial as the essential financial factors that every investor must consider when vetting potential investments.
This article simplifies ESG investing, divulges its relevance in the changing investment landscape, and offers proven practices on how to evaluate ESG criteria in your investment portfolio.
Since the 1972 United Nations meeting in Stockholm, there’s been a shift in focus towards a more sustainable human environment. Thirty-two years and three Secretaries-General later, under the watch of SG Kofi Annan, the UN sold the ESG idea to 50 CEOs of major financial institutions and the International Finance Corporation. This marked the beginning of the ESG criteria in the corporate world.
The UN urged governments to encourage ESG investing after the adoption of the 17 Sustainable Development Goals (SDGs) in 2015 – a set of global targets focused on achieving sustainable development, social and ecological wellbeing, and the eradication of poverty worldwide. Although the U.S. government has yet to formally announce its advocacy for ESG investing, corporate shareholders have dramatically scaled up their support for sustainable investing in the last few years.
While the practice of embedding ESG criteria into the corporate value equation may have started in the public markets, in recent years the private sector has been pulled into the sustainability conversation as well. Companies are starting to realize that the benefits of a good ESG strategy extend beyond good PR and marketing– if done right, taking a sustainability lens can help future-proof a business while also positively affecting the bottom line.
In terms of disclosure, private equity has traditionally remained ‘private’ and has not reported non-financial issues. That stance is evolving rapidly, owing to a combination of pressures both from the top-down (socially conscious investors and shareholder activists) and from the bottom-up (consumers, employees and other stakeholders). While clear regulatory guidelines are still being established in Europe and the U.S., many PE firms have sensed the inevitable shift in investor expectations around ESG and are proactively incorporating those values into their long-term business strategies.
Despite conflicts over the sustainability of “sustainable investing,” PE firms have seen good reason to fight the good fight. Below are some of the key reasons.
According to the Journal of Private Equity, seeking new investments in this ESG-focused era requires PE investors to consider the social criterion. Now, in line with the UN’s goal of curbing global poverty, businesses are becoming more community oriented and diverse. And markets are opening up to these businesses. Companies that engage in social activities are more welcomed by communities, increasing the ease of doing business and exploring new markets or opportunities in those communities.
Considering the environmental criterion of ESG investing, 75% of Millennials are eco-friendly. Many innovative startups, founded by Millennials, are focused on sustainable solutions to help mitigate the consequences of global problems like climate change. This is opening up new markets that private equity investors can capitalize on, while simultaneously addressing some of the most critical global challenges of our time.
Consumers are “going green” – and they don’t mind paying to do so. Over 70% of consumers are willing to pay 5% more for existing products if they are certified to be more eco-friendly. Therefore, the possibility of an increased bottom line by simply implementing ESG models in their business is driving entrepreneurs to build more sustainable products.
For investors, the inclusion of ESG criteria in analyses of risk and opportunities helps to identify existing businesses with the potential to expand and serve more environmentally conscious consumers.
Businesses lose over $120 billion annually on wasted plastic packaging that comes around to bite us in the rear. The Great Pacific Garbage Patch is an obvious example.
However, incorporating sustainable businesses in your portfolio makes for reduced costs. By reducing waste, recycling used materials, and paying more attention to metrics such as their water consumption and carbon footprint, businesses and their investors can save significantly on operational cost.
The challenge isn’t only focused on plastic recycling. High energy consumption is also considered an environmental issue. In more recent times, energy intensive businesses are having a hard time keeping up with the climate change goals that countries are pursuing. For one, China has stripped itself of high energy consuming Blockchain miners, an industry that’s received over $12.2 billion in funding from VCs and PE investors since 2016.
In the healthcare industry, hospitals can save over $15 billion in operational cost by simply reducing energy consumption and wastes. As energy efficiency targets become more aggressive as a result of ever-increasing climate risk, businesses will need to either adapt and innovate or risk fading away into irrelevancy.
Economically, investing in green sustainable companies offers private equity investors an opportunity to gain from a large pool of $26 trillion in economic benefits before 2030. According to research, there’s more.
Data shows that employees at sustainable companies are 19% more productive. The motivation that comes from pursuing a purposeful and humanitarian cause is arguably the reason for this productivity boost.
However, it’s not just about the environmental criteria of ESG. Socially responsible companies have also reported higher employee productivity, noting that employees are even willing to work for less at these companies in return for an ethical and sustainable company culture.
More than anyone, investors understand how these heightened employee morales and commitments positively affect a company's bottom line as well as the performance of the entire portfolio.
PE investors, albeit sophisticated in investment assessment practices, are having a hard time evaluating the ESG worthiness of target companies. This section points out the right questions that you should be asking when making non-financial assessments of potential investment opportunities.
There are lots of ways that companies can be environmentally and socially responsible. Often, corporate ESG goals seem vague. Many popular slogans like “save the planet” and “aquatic lives matter” are grossly unspecific.
The question, however, should be focused on what role a company is playing in the salvation of our planet. More quantifiable ESG goals are focused on a specific aspect of our growing environmental and social concerns. For instance, Colgate’s commitment to reducing water wastage by encouraging its consumers to save water while brushing is a pretty specific ESG goal. Unilever’s Water Care Initiative is another good example.
Therefore, when vetting investment opportunities, be sure to understand how their ESG initiatives actively affect the ecosystem. Look for specific and measurable evidence of their impact through ESG-focused efforts, as well as transparency and accountability in their sustainability reporting. This will reveal a lot about the true motives and values of the company’s leadership.
Sustainability is a profitable practice if done right. Simply resolving to adopt sustainability practices to get in line is not the right thing to do. Instead, investors ought to look for businesses that are implementing ESG criteria that significantly impact their company’s value.
From the previous “Colgate” example, encouraging consumers to reduce water wastage while brushing may help save the planet but obviously may not directly impact the company’s bottom line.
On the other hand, Apple’s Environmental Responsibility Program is significantly linked to the company’s bottom line in several ways. According to its 2021 Environmental Progress Report, Apple facilities consumed 13.9 million kWh less electricity than the previous year. With the electricity cost of 19.9 cents per kWh in California, the tech giant saved over $2.77 million in electricity cost alone, all by adopting 100% renewable energy. This combined with the company’s trade-in policies and other eco-friendly practices is one major ESG strategy that’s adding billions to its bottom line.
Yet even Apple's sustainability program doesn't stand up to scrutiny upon examining the bigger picture of their business operations. One could argue that its practice of "planned obsolescence" – intentionally designing a product with a limited useful life to encourage new purchases or replacement gadgets – goes directly against the idea of sustainability and consumer transparency. Planned obsolescence also paves the way for more negative externalities as a result of increased mining for materials.
The example above shows the importance of looking beneath the surface when conducting ESG due diligence. PE investors should ultimately look out for similar value-aligned ESG policies when analyzing investment opportunities – and confirm those policies with quality data and proof of impact.
When it comes to environmental and social responsibility, it’s very likely for company leadership to overdo things. This can make the ESG concept appear as a fad, arousing skepticism in the broader market and negatively impacting the company’s value. Companies and their leaders are free to “talk the talk” all they please – but in today’s era of stakeholder accountability and shareholder activism – they must be ready to “walk the walk” as well.
There's also the risk of not doing enough. This can put companies at huge risk of public contempt and a plummeting market value. McKinsey & Co recorded that poor engagement with the public on environmental and social responsibilities can cost companies up to 30% of their market value.
Therefore, PE investors have to ascertain whether their target companies are hitting the sweet spot in their environmental and social responsibility campaigns as a part of their analyses. Any claims of ESG additionality need to be readily proven with science-based evidence of that impact.
A well-implemented ESG scheme in businesses doesn’t only increase profit. It also improves the quality of lives for employees and the communities that they serve, as well as the health of our planet.
These three benefiting aspects of the ESG (profit, people, and the planet) is what John Elkington described as the Triple Bottom Line, where all three components of a business’s existence wins. When done right, sustainable and ethical practices will lift up not only a business’s shareholders, but all of its stakeholders as well.
Meaning all of us have a path forward, together.