Environmental, social and governance (ESG) factors have become central tenets of the capital allocation process, both for providers of capital, or investors, and for users of capital, or companies. While early rounds of ESG investments have received widespread praise from shareholders and stakeholders, most organizations fail to articulate the value proposition of ESG investments and assess whether and how these investments have created value.
These shortcomings are perpetuated by the prevailing view that ESG considerations are non-financial in nature and therefore such a goal cannot be achieved or should not even be attempted.
But this view fails to recognize that ESG is not non-financial information, but rather pre-financial information.
ESG represents the factors that assess a company’s long-term financial resilience. Given the nature of ESG investing, analysis should temporarily set aside typical performance measures, such as EBITDA, earnings and cash flow, and focus instead on the impact of ESG on value creation. This is the key to creating the essential link between ESG investments and performance.
In the short term, the focus on value creation would bring much-needed financial discipline to ESG investing and enhance the informative value of sustainability reports and disclosures. In the long term, such guidance can help accelerate the transition of ESG from a market-driven phenomenon to a standardized, principles-based framework.
The link between ESG and intangible value creation
As the global economy continues its transition to an economy driven by intangible value, she has clarified the inability of “profits” to capture value creation through investment. For example, in The End of Accounting and the Way Forward for Investors and Managersauthors Baruch Lev and Feng Gu examine the explanatory power of reported earnings and book value relative to market value between 1950 and 2013. They find that the R2 fell from around 90% to 50% over the period. More recent evidence suggests the global pandemic has accelerated this trend.
Given that ESG represents an effort to fill this value creation gap in financial reporting, it is no surprise that value creation continues to shift towards intangibles, along with the rise and adoption of the ESG.
To assess ESG value creation, one must first accept that ESG is not a one-size-fits-all approach. The value creation opportunities for ESG investments largely depend on the sector in which a company operates. In order to generate economic value from ESG investments, or any investment, a company must generate returns in excess of those required from the tangible assets and financial capital employed. Opportunities for ESG value creation are higher for companies with a differentiated, value-added, high-margin business model than for companies with a commoditized, asset-intensive, low-margin business model.
Given the above, it becomes clear that ESG value creation manifests itself in the formation and maintenance of intangible assets. But which of E, S and G generate which intangible assets? Answering this question is necessary for companies to articulate the value proposition of ESG investing. The following figure begins to provide a framework for answering this question by looking at specific groups of intangible assets, including brands, human capital, customer franchises, and technology. It examines the value creation lifecycle through three distinct stages:
- Direct assets: Intangible assets that are directly affected by the investment E, S or G.
- Indirect assets: intangible assets that benefit from the increase in value of the direct intangible assets targeted by the investment E, S or G.
- Scalable value creation: The final phase of the lifecycle recognizes that the value creation of intangibles through ESG investing is scalable due to interconnection with other intangibles. These attributes explain why the value created from ESG investments may have little correlation to the amount of investment.
Since the value drivers of intangible assets are well documented and understood, and now armed with a better understanding of how E, S and G investments drive the creation of intangible value, we can identify certain characteristics to assess the relative value creation expected from ESG investments between companies. . Here are six of those features, along with brief descriptions:
- Brand Reliance/Brand Strength: The more a company relies on a company’s brand and reputation, the greater the expected return on ESG investments.
- Dependence on human capital: The more a company relies on human capital, the higher the expected return from ESG investing.
- Value Added Business Model: The higher the company’s valuation premium relative to tangible assets and capital, or the ability to generate a company’s valuation premium, the higher the expected return from ESG investing.
- Nature of customer relationships: The greater the connection or exposure to the end customer, the higher the expected return from ESG investments.
- Intensity of tangible assets: The more a business model relies on tangible assets, the lower the potential value created by ESG investing.
- Dominant technology on the market: Proprietary technology can create less elastic consumer demand with respect to the value of other intangible assets. Therefore, the more a business model relies on proprietary technology, the lower the potential value created by ESG investing.
The following table analyzes these six criteria for five companies in different industries. The larger the area covered, the greater the value creation expected from ESG investments.
While the above are certainly six key criteria for ESG value creation, such a framework is not limited to just six criteria, nor does it require the use of these specific criteria.
What is the way forward for ESG?
In the short term, focusing on intangible value creation can bring more financial discipline to ESG investing and strengthen sustainability reporting to go beyond endless lists of statistics and overtly qualitative narratives.
In the longer term, a focus on intangible value creation can facilitate the transition to a financial reporting system that captures intangible value creation. The primary objective of developing a standardized principles-based framework is to ensure the usefulness and relevance of financial statements. However, the current accounting framework not only fails to provide meaningful insights into value creation, it also actively limits efforts to fully implement value-creating ESG priorities.
In a recent article,Constraints by accounting: examining how current accounting practices limit the transition to net zerothe authors analyze BP’s commitment to becoming carbon neutral by 2050 in the context of ESG and the current accounting model for intangible assets and liabilities. They argue that the current accounting model unduly penalizes and demotivates companies when they attempt to make such investments. This need is no more succinctly articulated than in the authors’ analysis of both technology and brand intangibles, the latter of which is discussed below:
“We posit that if an organization does not control the environment, its employees or other stakeholders, it controls its relationship with these entities, linked to its reputation, through the alignment of its decisions with social norms. It It follows that the definition of an asset must apply to an entity’s reputation or social license to operate, which results in the capitalization and fair valuation of those assets. requirement to recognize social obligations as liabilities and reduces the punitive treatment of costs related to meeting social standards Such costs could be viewed as an investment in reputation and the potential benefit to the organization from such an investment would be capitalized .
These constraints are not limited to brand and technology, but also exist for human capital. In “Impact Two Sigma: Finding Untapped Value in the Workforcethe authors note how current accounting drives behavior that limits value creation opportunities for human capital. The authors state:
“Private equity has tended to view labor as a job to cut rather than a place to invest in, which creates a big blind spot for the industry. What if there was another, more fruitful way to approach labor issues? »
These examples highlight the inextricable link between ESG and the efforts of accounting standard setters exploring opportunities to systematically address the creation of intangible value. The limitation of accounting frameworks in systematically addressing intangibles is not due to their lack of recognition of the importance of intangibles, but rather the lack of a workable framework that is practical, objective, and universally applicable.
The focus on value creation will allow the best ideas, concepts and frameworks emerging from ESG to inform the ongoing debate on how to best convey value creation through accounting and financial reporting processes. By leveraging the initiative shown with ESG, investors can help lead the way to a solution.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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