Environmental, social, and governance (ESG) issues are receiving increased focus by businesses, investors, customers, communities, and other stakeholders. A recent PricewaterhouseCoopers (PwC) survey found that 79 percent of private equity firms believe investor interest in ESG issues will increase in the next two years. This focus is also increasing in the deals market.
Macro issues and regulation are having an impact on companies’ ESG strategies, in concerns related to the rising prices of natural resources, urbanization, global events, and natural disasters, as well as economic expansion into emerging markets.
As market momentum and confidence in capital markets continue to build, so are expectations about how companies deal with analyst focus on ESG matters. An greater level of understanding is essential to measuring sustainability and quantifying the ESG impacts on investments.
Deals professionals are also noting a rising interest in the financial and non-financial implications and effects that ESG issues can have on initial public offerings, mergers, acquisitions, and divestitures.
Last fall, in fact, PwC conducted a poll during the webcast, “Integrating environmental, social and governance (ESG) issues in deals and valuing their impact,” and found that 38 percent of deals and finance professionals said that investors are the stakeholder group most focused on ESG issues, followed by senior management at 36 percent, boards of directors at 19 percent, and bankers at seven percent.
What Is the Difference between Sustainability and ESG?
ESG management enables companies to better focus their strategies and benefit from understanding the risks and opportunities associated with their corporate activities and initiatives. Companies wondering how to approach ESG can consider the following:
E: The “environmental” aspect of ESG refers to a company’s use of energy, fuel, water, and chemicals and how they impact its value chain and the environment. How are companies using these resources? What are the environmental risks associated with a company’s supply chain? Does a company have a liability that needs to be recognized or disclosed? How can a company use fewer resources and use them more efficiently in order to recognize cost savings and potentially enhance revenue?
S: “Social” issues are becoming more relevant as companies move into emerging markets, where operations or their supply chains can be subjected to a host of entirely new risks. These can include health and safety, working conditions, and employee retention. For example, a factory fire at an offshore vendor can be blamed on a U.S. retailer, with accusations of failing to support safe working conditions. Companies need to understand these risks and get ahead of them by developing risk mitigation strategies.
G: “Governance” refers to management’s responsibility to effectively implement processes and structures that oversee corporate affairs. This includes establishing a framework and implementing controls, management oversight, continuous monitoring, and reporting. The Securities Exchange Commission (SEC) is paying attention to environmental and social issues, as well, and how companies should report them in public filings. This is evidenced by the the SEC’s Dodd-Frank Conflict Minerals rule, climate change disclosures, and financial reporting requirements for environmental liabilities and asset retirement obligations.
Why Does ESG Matter in a Deals Context?
In the same recent PwC poll, 68 percent of those planning divestitures, mergers, or IPOs in the next year said they will evaluate ESG considerations when planning their transactions. Companies are paying more attention to ESG issues, in part because investors are asking more questions. This trend has gained momentum due to a greater amount of data being available on the ESG performance of individual companies that has been provided through various portals, including Bloomberg Terminals and Google Finance.
In addition, environmental and social factors can have an impact on deal value. Environmental exposure continues to have material financial impact on companies, especially in such industries and sectors as metals, energy, chemicals, mining, aerospace, and defense, as well as other industrial product companies. For example, strong, demonstrable performance on ESG factors can enable the seller of a business to validate the asking price during deal negotiations.
Further, environmental liabilities and environmental-related asset retirement obligations come with challenging reporting aspects and implications, which can drive significant costs for a company. In addition, capital expenditures, compliance requirements, operating expenses, and the cost to meet objectives and targets in customer requirements can all potentially affect deal value.
Forward-thinking companies that see the importance of ESG risk management have long been building systems to address environmental and social risks. Companies without extensive experience with these systems can begin by focusing on taking inventory of their ESG risks and ensuring transparent financial reporting and disclosures.
By proactively managing those areas, companies can enhance the quality of their financial reporting, improve their ability to be ready for audits, strengthen their liability valuations, and enhance their financial reporting controls. Ultimately, these types of initiatives can help companies be better positioned when it comes to deal negotiations.
What’s the Risk for Not Focusing on ESG in the Deal Process?
When companies — particularly those in the industrial product sectors that may be subject to long-term environmental remediation obligations — fail to adequately address environmental vulnerabilities, buyers can potentially end up with inaccurate valuations regarding liabilities and consequently be poorly positioned for negotiations. Reputational risk can also be a concern, in terms of how a company may be perceived regarding overall financial risk management.
On the whole, the investing public is getting smarter and more focused on ESG issues: On several occasions, public companies have lost significant value (e.g., stock price, reputation, etc) as a result of supply-chain failures or environmental concerns that received media attention and public scrutiny.
Buyers are now integrating ESG concerns into their diligence processes, which means that sellers must be more mindful of ESG issues. Companies are expanding the breadth and the depth of their diligence exercises by looking more comprehensively at the potential for risks and opportunities and how to quantify them. What kind of impact could existing or emerging ESG issues have in the future? There is a greater emphasis on understanding the direction of trends and valuation impacts.
Dedicating resources to assist in the evaluation of ESG may not only minimize risks but also maximize opportunities. Based on a company’s internal rate of return, cost savings and revenue-generating initiatives (e.g., reduction in energy usage; use of green packaging, renewables, and eco-products; etc) can impact both bottom- and top-line results.
Where Should ESG Evaluation Begin?
Companies should first ask themselves how ESG issues are relevant to their business and prioritize the material risks identified. Quantifying risks that can turn into liabilities — and thus depress future earnings — is critical in deal negotiations. Augmenting the traditional due diligence approach to include a focus on ESG issues will help accurately estimate liabilities and identify new opportunities for operational efficiencies, cost reductions, and value creation in the deal.