Creating Shared Value through ESG Portfolios
Summary The concept of Creating Shared Value (CSV), first introduced as an idea to align competitive advantage and financial returns with corporate social responsibility (CSR), can be applied effectively through a portfolio-based approach to risk management. Operating companies and related stakeholder groups face a variety of environmental, social, and governance (ESG) issues that pose non-technical risks as well as opportunities for sustainable and responsible corporate behavior. Managed properly, a company s ESG activities can provide both financial return and mutual benefit to stakeholders. Successful companies increasingly view sustainability or CSR activities as business investments that must be handled with the same decision and management processes applied to other operating efforts. With this founding assumption in place, these investments must be carefully planned, executed, and monitored over time to ensure sufficient returns. As with other investment types, diversification is a key element of risk management; identifying and selecting the optimal portfolio of ESG activities is the best way to create and capture shared value. This paper defines shared value as the value created through effective alignment of sustainability or CSR activities. It can be realized as cost-sharing, increased efficiency across the value chain, alignment of stakeholder objectives for the reduction of conflict, and so on. The shared value generated by these efforts is missed when such efforts are not properly optimized and monitored. With sustainability and CSR representing a multi-billion-dollar annual spend, missing out on shared value means significant financial loss for operating companies and their partners. 2
Introduction Recent years have seen widespread acceptance of the concept that doing well financially and doing good in social and environmental terms are not mutually exclusive goals. Changes in investor behavior, particularly the rise in demand for responsible investments, has spurred significant growth in funds comprising companies that pursue sustainability through environmental, social, and governance (ESG) activities. Indeed, the private sector s access to financing is increasingly tied to the demonstrated corporate responsibility; exclusionary screening and other measures are restrictive to industries and companies that fail to meet public demand for such behavior. The private sector has responded to these macro-level changes by acknowledging the need to handle sustainability or corporate social responsibility (CSR) activities in a manner consistent with other business decisions. Treating sustainability or CSR activities as business investments, and managing them accordingly, is rapidly becoming the norm for industry leaders and first movers. Doing so requires careful planning, execution, and performance monitoring, done in a transparent manner and with the interests of all relevant stakeholders in mind. Once disparate topics such as stakeholder engagement, environmental conservation, biodiversity preservation, inclusive economic development, government capacity, social license to operate, and others are more connected than ever before. Understanding the interplay among these, and using those connections as a means to create value and improve returns on investment, are critical to long-term success. All this change is driven by numerous factors, including unprecedented access to information and global connectivity. Public demand for transparency and responsible action, coupled with the magnitude of spending tied to sustainability and CSR, mean that failure to meet expectations carries a high cost. Companies risk not only diminished returns from current efforts, but also future penalties such as limited access to capital due to reputational challenges. This paper offers an approach to sustainability and CSR activities and is designed to address ESG issues both as non-technical risks to be properly mitigated, and as opportunities to create shared value that may otherwise be missed. Obtaining this shared value via a portfolio of ESG investments allows operating companies and relevant stakeholder groups to identify, select, execute, and monitor an optimal set of activities within their particular context. An optimized ESG portfolio allows for investment project cost-sharing, stakeholder objective alignment, efficiencies across the value chain, and other benefits that directly increase ROI while also satisfying sustainability or CSR requirements. 3
Sustainability and CSR as Investments According to McKinsey Global Survey, conducted annually with more than 3,000 companies, the three most popular reasons for addressing issues of sustainability are alignment with business goals, mission, or values; reputational preservation or improvement; and cost control (McKinsey, 2016). Each of these factors clearly characterizes sustainability activities as investments, and while it is difficult to put a finite number on the related spending, there is no question that such activities represent tens of billions of dollars annually. The Fortune 500 alone spend more than $15 billion on CSR, which can be construed as a subset of the broader sustainability behaviors required for successful operations. In an interview with Yale Insights, Unilever CEO Paul Polman (2017) noted that, societal problems may be costing the economy, and thereby individual companies He continued with the idea that, it is cheaper to attack the issues and invest in solving them than to deal with the costs. Companies with strong corporate responsibility reputations experience no meaningful declines in share price compared to their industry peers during crises. McKinsey further punctuates the importance of sustainability and CSR activities with research suggesting that, The value at stake from sustainability issues can be as high as 25 to 70 percent of earnings before interest, taxes, depreciation, and amortization (EBITDA) (Bonini and Swartz, 2014). Whelan and Fink (2016) make a comprehensive business case for sustainability by connecting specific factors including stakeholder engagement, risk management, and innovation with outcomes that include improved financial performance, customer loyalty, and employee engagement. The compelling, data-driven arguments support the view that sustainability and CSR must be viewed as central to business success. A few statistics and conclusions worth highlighting: In a meta-analysis of 200 studies, 90% conclude that good ESG standards lower the cost of capital; 88% show that good ESG practices result in better operational performance; and 80% show that stock price performance is positively correlated with good sustainability practices. 90% of analyzed studies conclude that good ESG standards lower the cost of capital. Between 2006 and 2010, the top 100 sustainable global companies experienced significantly higher mean sales growth, return on assets, profit before taxation, and cash flows from operations in some sectors compared to control companies. During the 2008 recession, companies committed to sustainability practices achieved above average performance in the financial markets, translating into an average of $650 million in incremental market capitalization per company. Additionally, companies with superior environmental performance experienced lower cost of debt by 40-45 basis points. 4
Companies with strong corporate responsibility reputations experience no meaningful declines in share price compared to their industry peers during crises versus firms with poor CSR reputations whose reputations declined by 2.4-3%; a market capitalization loss of $378M per firm. The 2015 EY Global Institutional Investor Survey found that 59.1% of institution investor respondents view nonfinancial disclosures as essential or important to investment decisions, while, 62.4% of investors are concerned about the risk of stranded assets (i.e. assets that lose value prematurely due to environmental, social, or other external factors). Nearly two-thirds of consumers across six international markets, and 82% of respondents in emerging markets, believe they have a responsibility to purchase products that are good for the environment and society. Numerous studies have found higher employee morale in companies with strong sustainability programs. The takeaways from these various reviews are that (1) sustainability and CSR activities, done properly, must be viewed as ROI-generating investments rather than costs; (2) increasing public demand for ESG reporting and disclosure requires that companies be smarter and more transparent with regard to such activities; and (3) companies that properly engage stakeholders and maintain ESG standards experience financial competitive advantage relative to industry peers. In short, failing to properly manage ESG considerations equates to leaving money on the table. Companies with superior environmental performance experienced lower cost of debt by 40-45 basis points. Shared Value Portfolio It is a given in the world of investing that a diversified portfolio reduces risk and improves returns over the long-term. Yet, this mentality is often not applied to the types of investment activities inherent to sustainability and CSR efforts. Instead, many companies focus too narrowly on specific types of impacts, or treat sustainability or CSR as one-off projects unconnected to a larger body of work. Not only does this approach limit the returns generated by these investments, it can also deal inefficiently with the ESG risks in play. Viewing sustainability or CSR in terms of a connected portfolio is a superior method to achieving sufficient financial returns while also making a broader and more lasting ESG impact for all stakeholder groups. A portfolio approach necessarily begins with effective stakeholder engagement and comprehensive assessments that collect and analyze relevant data. Comprehensive information informs good decision-making; situational assessments viewed in a given company s operational context allows for the identification of possible ESG activities. Each of these activities serves a standalone investment. An operating company may partner with local or regional governments, communities, and other stakeholder groups to build a school, improve healthcare, train a skilled workforce, or support economic development among small businesses. More critically, the collection of investments, properly integrated and managed creates even more shared value than that produced by the individual components. 5
Workforce Development Governance Health Education Resource Project Supply Chain SME* Environment *Small and Medium-sized Enterprises Figure 1: A Shared Value Portfolio identifies the complex and integrated relationships among potential investments to optimize ROI and positive impact. Resource Project Financials Impact Project Financials Portfolio Shared Value As represented in Figure 1, a shared value portfolio is constructed and managed by: Identifying all possible investment activities through comprehensive assessments Understanding how the various activities relate to and connect with one another Selecting the combination of investments that integrate to form the portfolio with the best balance of financial return and ESG impact Executing those investment activities Monitoring their performance over time to validate the portfolio s ROI 6
The first set of steps, applied through scientifically rigorous data collection and analysis, can demonstrate the complex relationships among multiple ESG activities and the company s own operations. For example, when mapped out, it is possible to see the relative potential impact on the project financials of commercial operations (represented as Resource Project ) of investments that might otherwise be misunderstood or underestimated. Improved educational programming leads to more vocational skills; connected to a workforce development effort, this generates a higher quality local workforce which may reduce supply chain and staffing costs. Layering in small and medium enterprise development can create a circular economy that improves local standards and quality of life, and so on. In other examples, an improved healthcare system may reduce days missed of work, directly affecting the bottom line. A road, already required for supply and distribution, can serve multiple purposes by facilitating power grid construction, travel for local workforce, and improved capacity for government service delivery. Each individual investment activity is impacted, and ideally enhanced, by the others, and collectively they form an ESG portfolio greater than the sum of its parts. Moreover, the network of investment projects diversifies risk in a manner similar to a diversified stock portfolio. Political upheaval, natural disaster, or some other change could dramatically impair a single project, but a network of efforts has a better chance of maintaining continuity and effectiveness over time. Functionally, engaging in a portfolio of ESG investments has natural benefits. Projects may be able to share common costs, particularly around management and administrative issues. Outcomes of one project may be leveraged to improve the results of another; for example, access to healthcare is positively related to improved educational outcomes, so improving a school system may yield greater benefit when done in conjunction with healthcare reform. A suite of projects is also more likely than individual, standalone efforts to have a network effect across the value chain; by integrating sustainability measures, companies can see benefits from pit to port. Example: A road required for the movement of supplies and products may have unintended consequences that increase non-technical risks. As a vector for disease transmission, a byway for crime, and potential source of accidents, that road is far more than just a transportation route. Planning and constructing it as part of an investment portfolio that pairs the road with improved access to healthcare, capacity-building for crime prevention, HSE training, and stakeholder engagement addresses and mitigates these risks while also allowing for high-impact investments in regional communities and infrastructure. This turns the risks presented by a standalone roadway into significant potential ROI across a portfolio of ESG investments. 7
Public-Private Partnerships and the Role of Government It is important to note that this approach is neither designed nor intended to place undue burden on the private sector when it comes to development work. While improvements in infrastructure, government capacity, and service sectors like healthcare and education may be critical elements of the ESG portfolio, it is not the sole responsibility of the private sector to conduct or fund this work. The portfolio approach necessarily involves the coordination of public-private partnerships (PPPs) that allow entities on both sides to play vital roles. In this way, operating companies can bring to bear expertise and resources that may not be available via other means while still allowing governments and other public sector stakeholders to remain responsible for service delivery and public works. Proper identification and coordination of PPPs facilitates effective outcomes for both sides, and serves as an additional method of stakeholder engagement over time. Operating companies, their shareholders, and other providers of capital should view PPPs and related activities as part of the investment process; returns will stem, in part, from the improved public services and social infrastructure resulting from these arrangements. Validating ROI through Performance Monitoring and Impact With stakeholders actively engaged and impact portfolio options explored and selected, companies are well positioned to create additional value through maximized ROI generated by meaningful impact investments. Once created, this value must be maintained and protected through continuous performance measurement and evaluation. The first step is to ensure appropriate monitoring and validation. For some investments, this calculation is straightforward, but for ESG activities it can be more difficult. Credible resources, such as the International Finance Corporation s Financial Valuation Tool (IFC FV Tool) are freely available to calculate a probable range for the net present value (NPV) of individual investment projects. For example, Kate Sharum, Corporate Responsibility Manager of the New Forest Company reports We are using the FV Tool to kick-start an evaluation of our projects so that we can make decisions on which are most sustainable for communities and deliver the highest value (IFC, 2017). With a proper ESG portfolio in place, however, validation takes on an added layer of complexity. The value of each investment project remains part of the calculation, but the interplay among the portfolio projects generates additional ROI. As shown in Figure 2, this final bit represents significant return that is often missed or ignored entirely; failing to engage in a portfolio approach necessarily means that the financial benefit derived from integrating projects cannot be realized. 8
Figure 2: Shared Value from ESG Portfolio Admittedly, the question of how to fully assess shared value concept is still a work in progress. Impact valuation is an active and growing field at the intersection of ESG and financial considerations. As described by the World Business Council for Sustainable Development (WBCSD) Impact Valuation Roundtable, impact valuation is a new, innovative concept to identify, understand, improve, and demonstrate the benefits and costs of business to society (WBCSD, 2017). As described in Figure 3, continuously monitoring Shared Value generation makes it possible to transition from simply recording inputs and associated outputs to more accurately identifying and validating outcomes and their associated value. Consistent and appropriate measurement and evaluation not only protects the initial investments by quantifying positive impact, but also serves as evidence for future business case development and access to financing. Companies that demonstrate the ability to implement effective ESG portfolios are better able to articulate the value they create, telling the story of their positive impact and financial returns in a manner that resonates with shareholders and stakeholders alike. 9
Figure 3: Protecting shared value enables companies and stakeholders to realize and grow benefits. From WBCSD Operationalizing Impact Valuation (WBCSD 2017) Planning, executing, and tracking the performance of optimized ESG portfolios is the best way to attain a level of value that has been missed by previous approaches. By quantifying this value in terms of financial ROI and ESG benefits across stakeholder groups and regional value chains, companies can understand and report on exactly what their impact investments are able to achieve and how they perform. In this way, the approach yields greater financial outcomes while also meeting transparency and disclosure requirements demanded in an increasingly connected world. 10
References Bonini, S., and Swartz, S. (2014). Profits with purpose: How organizing for sustainability can benefit the bottom line. McKinsey & Company Insights. mckinsey.com IFC Comm Dev (2017). IFC launches revamped Financial Valuation Tool website. Retrieved from https://www.commdev.org/ifclaunches-revamped-financial-valuation-tool-website/ McKinsey & Co. (2016). McKinsey Global Survey Results. mckinsey.com Polman, P. (2017). Should companies lead on sustainability? Yale Insights. Retrieved from http://insights.som.yale.edu/insights/ should-companies-lead-on-sustainability Porter, Michael E. and Kramer, M. (2011). Creating Shared Value. Harvard Business Review. Retrieved from https://hbr.org/ 2011/01/the-big-idea-creating-shared-value Whelan, T., and Fink, K. (2016). The comprehensive business case for sustainability. Harvard Business Review. Retrieved from https://hbr.org/2016/10/the-comprehensive-business-case-for-sustainability World Business Council for Sustainable Development (2017). Operationalizing Impact Valuation: Experiences and recommendations by participants of the Impact Valuation Roundtable. Retrieved from http://docs.wbcsd.org/2017/05/ IVR_Impact_Valuation_White_Paper.pdf 11