When deciding whether to pursue a project, a company’s CEO and CFO are likely to ask, “what’s the expected return on investment?” (Note: to head off the emails that statement might generate, we acknowledge that the preferred approach is to compute a project’s net present value, but we’ll leave it to corporate finance textbooks to explain why).
We can think of ROI purely in terms of bottom-line profits—for example, if an initiative would cost X and is projected to generate 2X in after-tax profits, it’s probably worth pursuing. We can also consider the ROI resulting from risk mitigation, or money spent to prevent bad things from happening, such as modernizing equipment or enhancing products to defend market share. Using some reasonable assumptions, we can estimate an ROI for both of these types of investments (pursue new good things or prevent bad things) in an Excel spreadsheet.
What does this have to do with sustainability and environmental, social, and governance (ESG) issues? Investing in sustainability is, of course, investing, and companies and their shareholders can understandably expect a return on ESG-related investments. But how can we show that spending money to improve a company’s E, S, and G practices actually pays off?
Fair question. Let’s take a look.
ESG benefits performance through “mediating factors”
Corporate finance teams talk about things like ROI, EBITDA, and free cash flow. That’s their language; it gets their juices flowing (we know—we have first-hand experience in that world). Sustainability teams talk about things like reducing carbon emissions, using “green” packaging, and sponsoring diversity initiatives that feel right (and look good in a Corporate Social Responsibility report). While finance teams are often skeptical of the cost/benefit case for ESG-related investments, sustainability teams can be prone to prioritizing the impact of an initiative on the world over the bottom line. The issue is whether and how these two different perspectives can work together.
The article “How to Talk to Your CFO About Sustainability” published in the Harvard Business Review argues that ESG initiatives can and should get buy-in from the finance side of the business. By conducting in-depth industry analyses the authors concluded that sustainability strategies can boost corporate performance through the following nine drivers: innovation, operational efficiency, sales and marketing, customer loyalty, risk management, employee relations, supplier relations, media coverage, and stakeholder engagement.
They call these performance drivers mediating factors because they are the go-betweens in connecting investments in sustainability to improved performance:
The HBR article goes on to say that while any type of good management can improve financial performance through one or more of these mediating factors, doing a good job of managing sustainability risks and opportunities is “one of the most powerful ways to do so.”
The study’s authors cite the automotive sector as a compelling example. In their research, they found 16 sustainability strategies and related changes in business practices, such as reducing carbon emissions, that boosted one or more of the mediating factors. Those strategies and changes contributed to “astonishing” (their word) returns by generating new revenue, reducing costs, or both.
Measuring Return on Sustainability Investing
The HBR article lays out a five-step process for measuring the Return on Sustainability Investing (called the ROSI analytic method). At the risk of offending the authors at the NYU Stern Center for Sustainable Business, the process seems so straightforward it’s almost disappointing – there’s no complicated math, no algorithms, no fancy statistical technique involved.
To do this well does require careful thought and knowledge of how a business operates. Here are the five steps, with summaries of the detailed explanations in the article:
- Identify current sustainability strategies. Companies should explicitly identify the sustainability issues that are most relevant for the business, both in terms of the company’s impact on an issue (vastly different for, say, a mining company versus an apparel manufacturer), and which issues most significantly impact the business.
- Identify related changes in operational or management practices. Next, a company should identify changed practices regardless of financial impact. For example, the authors identified dozens of new practices in the apparel sector, including the use of more sustainable materials, certifying fair labor practices in supply chains, reducing packaging, and “circular economy” efforts such as returning and repurposing garments.
- Determine the resulting benefits. The authors say companies should first look at the non-monetary benefits of sustainability efforts by examining how changed practices contribute to the mediating factors. Things like reducing energy, waste, or delivery vehicle miles driven typically generate operational efficiencies. Some less obvious benefits may include more engagement with stakeholders that increases acceptance of a project, speeding the regulatory approval process and reducing a project’s timeline.
- Quantify the benefits. The next step is to quantify the financial value of the non-monetary benefits from Step 3. The authors cite an example that any CFO would love: An auto company that had implemented a program to recycle solvents collected data on how much solvent it recycled, the cost of reclaiming and recycling, the cost of new solvent, and the cost of water-based substitute solvents—information that had never previously been analyzed.
- Calculate the monetary value. This will require making assumptions, such as the time horizon, costs involved and benefits achievable each year, and any ongoing capital investment required (see, we speak finance). The authors did this for an effort to reduce volatile organic compounds in the automotive industry and came up with a yearly benefit of $88 million, or $440 million over five years. Discounting that at a rate of 10% produced a five-year ROI of $334 million.
By totaling the financial value created or lost by each practice implemented in pursuit of a given strategy, companies can identify which ones generate the most value and where it may want to focus its resources.
Keep in mind that ESG initiatives are not just about reducing carbon emissions, water usage, and wasteful packaging. In other words, companies can find positive ROIs beyond the “E” pillar of ESG, by using the five steps outlined above.
Consider the boost to profitability that can come from improving corporate governance practices. The Nasdaq states that good corporate governance promotes “a stable growth model” and “enables boards and management teams to establish a controlled environment” which is important in executing strategic plans, and allocating resources and capital effectively. Translation: good governance can improve profitability.
Our article, Poor Governance – The Common Thread Of Corporate Blunders describes how a lack of good governance leads to costly problems. But how can boards use governance to enhance performance? Way back in 2016, which is almost a generation ago in terms of the evolution of ESG practices, the Deloitte – Nyenrode Research Program published a meta-analysis of academic research showing how certain governance variables contribute to corporate performance. The authors found that six corporate governance variables have a clear link to performance, as summarized in this table (shortened from the original article).
|Variable||Impact on performance|
|Board independence||A higher number of independent board members improves the board’s objectivity and ability to represent multiple points of view. However, increasing the size of the board may slow decision-making.|
|Board diversity||Diversity has a positive impact on performance. However, when enforced by regulation (“quotas”) there is no such effect.|
|Remuneration||Remuneration such as CEO stock options can boost performance by aligning interests between shareholders and management. The effect differs based on whether times are good or bad for the company.|
|CEO characteristics||Having a powerful CEO (e.g., one who is both the CEO and board chair) has a positive effect on performance but leads to more risky decision-making.|
|Oversight||Active oversight on the part of owners and boards has a positive effect on performance; however, owners and boards tend to become less attentive during times of prosperity.|
|Ownership structure||Institutional ownership enhances the quality of strategic decisions made by the board, by actively engaging and adding an outside perspective.|
The Deloitte-Nyenrode study focuses on the board’s role in corporate governance and concludes that yes, it does impact financial performance. The implications of this study, and the examples of leveraging ESG initiatives in a way that is consistent with driving positive ROI in general, are significant to finance teams and all stakeholders.
OWL ESG’s extensive dataset can be used to link a company’s sustainability initiatives to the mediating factors described in the HBR article, and to the corporate governance practices identified in the Deloitte-Nyenrode study. Contact us to learn more.