Keynote speech given Wednesday 23 June 2015 at the Private Equity international, Responsible Investment Forum in London England by Keryn James, Global Director of Operations, ERM
When ESG is mentioned in financial circles and particularly in the context of value creation, it is usually on a continuum somewhere between “ESG is a differentiator” to “I think I see it, but I can’t quantify it” to “I don’t get it at all!” I believe that many in the investment community have moved on from “I don’t get it all/it adds no value”, however, notwithstanding the number of people in this room and the shift we have seen in demand from clients, there are still concerns about how to create, quantify, articulate and extract value.
It is our view at ERM:
- That ESG is material to value creation (or erosion if not done properly);
- That there are certainly some challenges and barriers to realising this value (otherwise we wouldn’t be discussing this and everyone would have done it); and
- That with an effective approach these challenges can be overcome and value can be created.
This view has been formulated from our experience as the world’s leading sustainability consultancy working around the world across the full transactions lifecycle with all of the players – from the banks, to the PE houses and institutional investors. With 5000 people on the ground, we have advised on ESG issues for more deals and portfolio business reviews than any other consultancy. And, as some of you are aware, ERM is also a PE portfolio company, so we can reflect on the issues from that that perspective. The culmination of these experiences provides the background and context to the observations and insights I want to share with you.
What I intend to do in my brief remarks is:
- Provide some evidence for my assertion that ESG is value creating and that this is material.
- Provide some thoughts on the critical barriers and challenges which prevail currently.
- Describe some of the common success factors in building an effective approach to ESG value creation.
So, what evidence is there that ESG is value creating?
Value can be created in a number of ways at both a transaction and portfolio management level – and I am going to highlight four of them:
The first is the most obvious – value can be created by improving the asset valuation process, thereby creating commercial negotiation opportunities. As an example – a PE firm we have worked with bought an industrial company at a discount through significant price chips after identifying some major ESG issues (which put off some other buyers) however through an in-depth understanding of these issues they were able to find effective solutions to the problems during ownership and then sell the business at a significant premium with the price chip issues addressed during ownership (saving in the order of $30million). An in-depth understanding of the issues, the process and cost for addressing them, as well as the upside that could be created, created significant value.
The second way of creating value is through enhancement of risk identification and hence mitigation post-acquisition. For example, for one particular manufacturing business we were able to review and assess health and safety issues and help the business avoid cost and business interruption. By reducing LTIs by 68% through a series of H&S interventions the business avoided costs in the order of $8million – which, even when using an EBIT multiple of 5 results in a $40million value impact.
Thirdly, value can be created by identifying upside opportunities associated with business improvement through efficiency, human capital management or innovation - for example:
- On a project in the US we evaluated a power generation portfolio for energy efficiency and sustainability opportunities. This resulted in the identification of savings associated with reduced operational costs and increased output/revenue valued at $23m per annum, for the test pilot site.
- In regards to human capital management there is an opportunity to improve organisational structure and customer service. As an example, we worked on assisting a client to identify and implement improvements to an Airport Management Centre, resulting in an increase in on time departures from 35% to 86%.
- At a product level, it is worth considering the example of GE’s ecomagination products – you can quantify the impact in terms of annual revenues at $25 billion at 20%+ growth rates.
Finally, value can be created through reputation enhancement or management. Demonstration of a commitment to respond to changing societal expectations around social and environmental issues and managing potential reputational risks can deliver real returns for the portfolio business and for the investor. For example a portfolio asset review project that we undertook involved a seafood restaurant chain with a substantial supply chain in Asia. The review of ESG issues resulted in the identification of potential reputation risk issues associated with the presence of IUCN listed critical and endangered species on restaurant menus. We were able to help the investor identify the issue and put in place supply chain monitoring and management to remove the risk from the portfolio.
While it can be challenging to quantify the value of good ESG management it is clear from what we have seen, the firms that explicitly consider ESG issues are realising both financial and non-financial benefits during ownership and at exit. This view has been reinforced in a recent Harvard Business Review article (Digital article April 14, 2015) presenting the results of a study on the types of socially responsible investments that make firms more profitable. In this article, George Serafeim concluded that “firms making investments and improving their performance on environmental, social and governance (ESG) issues exhibit better stock market performance and profitability in the future”. He further suggested that for investors, there is therefore substantial value to be gained from analysing non-financial data and incorporating it into decisions.
So what are the challenges and barriers that might prevent you from capturing this value?
While there are a number of these I could discuss, I am going to focus on three today. The first and most critical of these is related to alignment with business strategy and growth plans. We often see ESG programmes that have not been aligned with and factored into the company’s value realisation and growth plans. It is very difficult then to mainstream these issues and get senior management buy-in and support to achieve the desired outcomes and quite often the opportunity to create value is therefore missed. For example when doing vendor due diligence to support companies in their sale process, in more than 60% cases, we find material ESG issues that were identified during pre-acquisition haven’t always been fully addressed and this is often because the issues are not on the radar of senior management. As I described earlier, this can have a material impact on transaction value.
The second barrier is around the lack of understanding of the potential depth and breadth of value creation. Where companies are working on ESG programmes, they are often focussed on the lowest hanging fruit or the most ‘obvious’ savings opportunity, for example energy efficiency. And while these issues clearly should be addressed, there is an opportunity to broaden the impact of an ESG focus. For example a PE portfolio company that we worked with had achieved very good results in resource efficiency and H&S but had not done anything on the product side and was lagging behind some of the sector leaders in this space. The GE example demonstrates the significant material upside that can be generated in addressing ESG through product development.
The third barrier is the lack of visibility of ESG programmes. Some portfolio companies are running good value enhancement initiatives…but rarely is there board level visibility of impacts of such ESG programmes and public disclosure on such matters is even more limited. In our experience not more than 5-10% of PE portfolio companies have been communicating externally on their achievements on ESG issues whereas, a much higher percentage of companies are probably working on such programmes. This has two consequences. The first is that in areas where value is being created, and could be significantly scaled or expanded across a portfolio of businesses, there is a lack of awareness and therefore support to do so. Secondly the lack of visibility and communication with their customers and other stakeholders may result in a lost opportunity to enhance brand and create a competitive advantage through market differentiation.
So what are the common success factors in building an effective approach to ESG and ensuring that it creates material value?
Firstly I believe it is important to look at ESG management as an upside value tool to investments …not just a risk management tool. But in order to create opportunity as well as manage risk, you need to consider four critical aspects:
- Where you are seeking to enhance the value of a business during a transaction or during the investment cycle you need to ensure ESG initiatives are aligned with the strategic goals of the business. In the same HBR article I referred to earlier, the results of the detailed research clearly indicates that those businesses that focus on ESG issues that are closely related to their strategic objectives, deliver outcomes that contribute to valuation.
- The second key success factor is to ensure that the ESG issues you expend resources on are material. Companies can spend significant resources on ESG issues, but not actually mitigate real risks. A concrete example of this is the Scandinavian investor who withdrew from a Swedish retail company, not due to concerns about water consumption in stores on which considerable effort and focus had been placed, but due to child labour issues in the supply chain, which had not been addressed. This example highlights the importance of understanding that not all issues are equal and so a company’s need to understand what is material to adding value is important. Much of this comes from being informed by ‘on the ground experience’ about how social and environmental issues materialize.
- Thirdly it is important to review and update the strategic priorities on a regular basis. The world is fast changing and there is a risk that investors can end up with stranded assets if they are not attuned to emerging issues. One particular area that is relevant right now is carbon and climate change. As we approach the CoP21 climate change talks at the end of this year in Paris, which have taken on added significance with the participation of the US and China, it is clear from the clients we talk to and the events we participate in, that attitudes to climate change are changing quickly. The fact that the Norwegian Government Pension Fund, one of the world’s largest pension funds –capitalized with profits from Norway’s oil and gas industry - as of last year is now considering “contribution to climate change” as a basis for excluding a company from its portfolio. In addition a number of banks and sovereign wealth funds have pledged not to increase their investment in coal assets. Together these examples show just how far the issue has risen up the investment agenda in recent times and suggests that investors should review the strategy for their assets in light of this changing dynamic.
- Finally, in the context of the above I would suggest that being aware of the opportunities associated with delivering ESG improvements through product development and enhancement is very important. We live in a resource constrained world, and opportunities for eco-designed products that meet sustainability challenges are significant. Regulations that govern product stewardship are emerging rapidly and businesses with products that have a high environmental and social impact are more likely to be impacted. For example, product stewardship regulations place restrictions on hazardous substances in certain products, creating a risk of not being able to place/ship products to some markets or being subject to recalls. If you are aware of emerging trends and regulations and your products contain less harmful substitutes you can create a first mover advantage to increase market share.
I trust that I have provided you with clear evidence that companies that address ESG issues pro-actively, can create value. If you are actively reviewing or considering how to factor ESG issues into transactions or portfolio management, I would encourage you to consider the key challenges and barriers specific to your businesses and develop an approach that is aligned with your strategic objectives. If you do this you can increase the likelihood that material value creation is a reality across your portfolio.