Businesses sometimes assume sustainability reporting and progress distract from value creation rather than adding to it. The relevance to their core business is not always immediately apparent. When companies consider sustainability a “nice to have” add-on rather than integral to their core business, they may lose out on important value-creation opportunities.
When comparing the results of over 2000 studies, 63% show a positive correlation between performance across sustainability environmental, social, and governance (ESG) criteria and equity valuation, while 8% showed a negative correlation.
Investors have expressed interest in sustainability information because they see it as both a driver of financial risk and opportunity. According to BDO’s U.S. Private Capital Survey in 2022, “94% of fund managers state that they assess their target companies’ ESG potential as part of their due diligence review.”
Companies would benefit from understanding how investors link sustainability dynamics to business value. We share a framework for considering how sustainability impacts translate from the real world to the balance sheet.
Consider your industry as a first step
Identifying relevant sustainability issues is the first step. Indeed, sustainability looks different across different industries. This is why the Sustainability Accounting Standards Board, now led by the International Financial Reporting Standards, developed a set of principles focused on financial materiality of sustainability information.
SASB’s conceptual framework is useful for understanding how sustainability-related resource use, impacts, and responsible activities link to value creation. It outlines some direct channels of financial impacts such as risks and opportunities.
Sustainability can drive revenues
Sustainable products and services can lead to higher revenues based on:
- Quality. Sustainable products factor in product safety and management in a comprehensive way. The resulting higher quality of products can lead to higher revenues.
- Pricing. Consumer interest in sustainable products can drive higher revenues and create an opportunity for companies to price their products and services at a premium.
- Value creation inputs. Sustainable companies are often more interested in preserving environmental inputs for their products, such as energy, water, forested products, or harvested agricultural products. By developing a long-term strategy for ensuring supplies of these inputs are sustainable, companies can safeguard their long-term value creation opportunities.
Sustainability and cost reduction
Costs linked to sustainability issues show up in numerous ways. While direct operating costs such as energy, water and waste are the most obvious, additional indirect costs can also shape a company’s sustainability analysis. Here are ways companies can lower costs directly by managing their business sustainably.
- Energy and water efficiency. Operating your business more efficiently can lower energy and water costs, while also reducing CO2 emissions and water withdrawals compared to a company’s economic activity.
- Renewable energy generation. For achieving absolute reductions in CO2 emissions, transitioning to renewable energy is a great opportunity that can also reduce long-term energy costs by feeding energy back into the grid.
- Waste reductions and diversion. Costs linked to landfilling or properly managing hazardous waste are high for most industries. Reducing waste can directly lower these costs.
- Circular economy strategies. Evaluating resource use for opportunities to rent, maintenance and repair, reuse, remanufacturing or recycle key resources in your operations can lead to lower costs related to waste disposal or equipment replacement.
Asset and liability valuations: links to sustainability
It’s essential to remember that there are different approaches to asset and liability valuations. One of the most common approaches, using the discounted cash flow analysis for companies, which can also apply to assets, suggests that companies continue in perpetuity. Therefore the short-, medium- and long-term perspectives linked to sustainability issues can directly impact the selection of the discount rate for a business.
Sustainability factors that impact asset valuations are linked to insurance, mortgages, and permitting or tender opportunities for new projects. If a business is seen as unlikely to comply with sustainability-linked policies or transition in time to meet expectations related to climate change, this can affect how different financial institutions value the company. On the flipside, innovation linked to sustainability could send a positive signal that a company will access new markets or technologies seen as low risk in the energy transition or adaptations to minimize the impacts of climate change to buildings or facilities can add long-term value to a company. Additional factors such as management decisions linked to external systemic sustainability changes can also influence how a company’s value is assessed.
In extreme cases, certain assets have the potential to become stranded assets. In this case, social sustainability factors come to the fore to ensure workers in these industries have viable alternative career paths as part of a “just transition.”
Risk management and cost of capital
One of the most important ways of considering sustainability is from a risk-based lens. COSO has created a framework for integrating sustainability risks into a standard risk management approach.
Companies may choose to do so, because investors and lenders are increasingly savvy about how sustainability risks integrate into a company’s long-term performance. Some risk factors are dependent on external systemic circumstances, while others relate to how well companies manage their environmental risks, which can help investors and financial institutions.
Climate risk. Strategies to consistently lower a business’s carbon footprint in line with science-based targets can signal lower potential transition risks linked to regulatory changes and litigation. Climate change also presents direct physical risks to assets in the built environment. These physical risks can directly damage buildings at an increasing rate over time, based on the regional exposure to climate change impacts. Insurance companies are increasingly integrating these physical risks into their policy rates and insurance may become unavailable in areas at great risk from damaging climate-linked events. Awareness of these changes is critical for businesses to develop strategies for lowering emissions and adapting their assets to more extreme environments.
Risks linked to pollution. Support from local communities is integral to the support for any business endeavor. When polluting industries cause health impacts to local communities or environments, public outcry and punitive action from municipalities and regional governments can lead to direct costs to remedy the situation. In extreme cases, operations can be shut down at a specific plant or facility. Examples include oil spills, chemical releases into the environment from factory malfunctions, mining pollution, and air pollution caused by burning hazardous materials.
Risks linked to brand reputation. When brands gain a reputation for unsustainable activities, consumers can choose different brands and shift to more sustainable products. Changing market preferences can create reputational changes suddenly based on a single high-impact event or slowly over a long-term period due to shifting preferences and generational differences. These consumer-related perceptions and risks should be tracked and monitored within a sustainability strategy.
ESG Ratings and Scores provided by Sustainalytics, MSCI, and Refinitive are one popular way lenders and investors can quickly assess a company’s ESG performance relative to other companies in its industry. While many of these scores have proprietary algorithms that vary from provider to provider, companies can report their sustainability performance to help improve their ratings.
Adding sustainability insights to business analysis
By assessing the relationship of sustainability factors to these key channels of financial impact:
- Revenues linked to products, services, and value-creation inputs
- Cost structure
- Assets and liabilities valuation
- Cost of capital and risk management
Companies can start integrating sustainability based on the issues relevant to their industry. This helps them to fine-tune their business strategy and identify potential areas they may have missed. Sustainability offers a more comprehensive value-creation approach to business. Today’s sustainability analyses incorporate broader perspectives when defining a strategy:
- Considering value chain risks upstream and downstream from operations, including Scope 3 emissions
- Considering the short-, medium- and long-term time horizons
- Assessing the likelihood of sustainability risks and opportunities, and defining whether they are occurring or potentially in the future
- Assessing the overall magnitude of financial impacts from sustainability issues and whether this is due to a one-time event or from a creeping accumulation of financial effect
SASB has identified metrics it deems applicable for different industries to track and measure that can directly influence these channels of financial impact. These metrics are compiled across different sustainability pillars: environmental; human resources; social (including human rights); business model and innovation; and leadership and governance.
For businesses that genuinely want to optimize their value creation opportunities, sustainability reporting and data collection offer plenty of insights.
