Emerging Markets / July 22, 2019

ESG Investing: The Business Case for Sustainability

In the four decades since the UN General Assembly’s Brundtland commission defined sustainable development as “development that meets the needs of the present without compromising the ability of future generations to meet their own needs,” sustainability has become a key buzzword across industries. For some, sustainability goes no deeper than products free of chemical dyes wrapped in burlap to justify an uptick in price. But for companies and industries willing to do the hard work of evaluating their processes from a cradle-to-cradle, systems-based perspective, sustainability is far more than an adjective. It is the key to maximizing profits and maintaining security. A growing body of research demonstrates that ESG investing (investing that priortizes the importance of environmental, social and corporate governance), offers significant long-term advantages.

ESG Investing: The Business Case for Sustainability


Risk
Perhaps the most obvious advantage of ESG investing is the ability to mitigate risk. While the “Tragedy of the Commons” is the ease with which destructive actions can be externalized, at some point, the scales will balance and the impact of externalized costs will ripple through the supply chain. In the long term, these externalities represent major sources of risk.

Arabesque Partners and the University of Oxford collaborated on the report From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance, which details the significant liability unsustainable actions create. “Another risk for companies may be external costs (externalities). These can affect production processes either directly or through disruptions in the supply chain which may depend on unpriced natural capital assets such as climate, clean air, groundwater and biodiversity,” the report explains.

One of the most dramatic examples is BP’s Deepwater Horizon oil spill in 2010. Two years before the spill the company received severe criticism of their poor performance in ESG categories including environmental pollution, occupational health and safety, and adverse impact on local communities and labor forces. Following the spill, BP’s share price dropped 50% from April 20 to June 29th, and in the following five years their share price underperformed peers by 37%, per Arabesque.

Certainly not all poor ESG performers experience such a detrimental event, but the risk potential is there whenever costs are externalized.

Performance
Waste is a message. It communicates a design flaw. As Michael Porter and Claas van der Linde describe for the Harvard Business Review, “When scrap, harmful substances, or energy forms are discharged into the environment as pollution, it is a sign that resources have been used incompletely, inefficiently, or ineffectively. Moreover, companies then have to perform additional activities that add cost but create no value for customers: for example, handling, storage, and disposal of discharges.” To test this, the pair examined waste production in chemical plants and found that of 181 methods to reduce waste in the plants, only one resulted in increased costs. The inverse lesson being: 99.5% of the time, implementing a more sustainable design increased profits.

This is the basis for William McDonough’s cradle-to-cradle design model. When viewing the natural world, the waste of one process becomes the fuel for the next. To maximize the profit potential of sustainability, this should be true of industrial processes as well as the management of natural processes. As the Demeter Biodynamic® Farm Standard describes:

“[In] day-to-day practice, the goal is to create a farm system that is minimally dependent on imported materials, and instead meets its needs from the living dynamics of the farm itself. It is the biodiversity of the farm, organized so that the waste of one part of the farm becomes the energy for another, that results in an increase in the farm’s capacity for self-renewal and ultimately makes the farm sustainable. This requires that, as much as possible, a farm be regenerative rather than degenerative.”

Again, sustainability is not a costly marketing tool. It is the impetus for improved design and maximized performance and profitability. As Oxford and Arabesque confirmed in a review of over 200 sources regarding the business case for sustainability, “80% of the studies show that stock price performance of companies is positively influenced by good sustainability practices.”

Reputation
In their global survey “Sustainability’s Strategic Worth,” McKinsey & Company reported, “Year over year, large shares of executives cite reputation as a top reason their companies address sustainability; of the 13 core activities we asked about, they say reputation has the most value potential for their industries. However, many of this year’s respondents say their companies are not pursuing the reputation-building activities that would maximize that financial value.” Additionally, “[Executive respondents] are also most likely to say that among these activities, reputation management has the highest value-creation potential for their industries over the next five years.”

This sentiment has also been echoed from the consumer side. In the 2018 Edelman Trust Barometer, 64% of respondents agreed that “CEOs should take the lead on change rather than waiting for government to impose it.” And 56% responded that “companies that only think about themselves and their profits are bound to fail.”

ESG investing is not about willingly paying more (or accepting lower returns) to ensure best practices. It is about implementing best practices because they ultimately yield the best results: risk mitigation, profit, and reputation.