Green Value

The art and science of ESG assessment

Evaluating efforts to improve ESG credentials, and the effect they have on future earnings, is an embryonic science. Some ESG initiatives are for compliance only; others to improve returns – and others still will add value indirectly, through reputation ratings, for example. Even those with positive downstream returns will inevitably require initial investment that lowers returns in the short term. Investors face the dilemma of how to profile investment opportunities to take account of the risks of not investing in green improvements, versus the likely dilution to earnings both in the short term (from the impact of written-down investment costs), and the longer term (from the likely impact of additional green requirements and costs within the business operation). This is where ESG ratings agencies play a growing role in business valuations. The science behind the ratings is still evolving from subjective qualitative frameworks to more objective quantitative structures, but those ratings are already playing a part. For instance, we can already see that the difference between having an ESG strategy and not having a strategy has an impact on investor appeal, as it conveys a sense that the company’s management team has looked ahead to consider the best future shape of the organisation.

Further downstream, the impact of ESG on valuations is harder to evaluate, and will vary between sectors. Energy markets demonstrate this well. Early alternative energy sources required policy and novel financing structures to make investment attractive enough – particularly to institutional investors such as pension funds and insurers. But now that path has been proven, the next wave of investment in innovative methods to address environmental issues should have a smoother ride – not least because of emerging additional factors such as the security of energy, water and food, in the light of recent geopolitical events. This also means that investment houses will be drawn into environmentally driven investment opportunities, which in turn should improve valuations associated with ESG-fuelled endeavours, albeit on a case-by-case basis.

Decisions

A single greening decision by the board of a listed company could result not only in cash flow changes, but also in market confidence changes that are not entirely predictable. The decision could result in:

1. no impact on value – as the market anticipated the decision;
2. a negative impact on value – perhaps due to risks perceived by investors and analysts; or
3. an uplift – as the decision reduces risks and/or improves potential future earnings.
   

Early green-investing businesses are more likely to have softened the cash demands on the business vs. those playing green catch-up, but another risk is that they may have invested too early for optimal returns – for instance, due to subsequent improvements in technology. It’s a question of balanced and well-timed decisions, and is very sector specific.

Decisions about how to manage green operating costs for those who extract or consume scarce resources (e.g., non-renewables), and those who emit unwanted waste products (e.g., CO2, plastic, nitrogenous agricultural waste, other pollutants) are significant. For industries that consume fossil fuels and emit CO2, including traditional heavy manufacturing and transport, the financial impact is already major, and the future looks tougher still. In some industries, that financial burden will find its way into consumers’ pockets – as we have witnessed both in the energy markets and the travel industry – particularly aviation. Not all of the costs of ESG improvements can be passed on, however, and that additional cost burden will push many companies to the brink of survival.

So, what can be done? Fortunately, some nations and even regions are intervening to shore up companies, industries and economies through the green transition. That intervention addresses the capital investment hurdle to adapt to, or to survive, the payback lag between investments and return. For large-scale industrial transformations, the support can even extend beyond national boundaries, such as through the Carbon Border Adjustment Mechanism.
What’s clear is that ESG assessment measures and their consequent effect on cost structures, cash flows, valuation and viability are key factors for leaders and investors to consider – across individual companies, whole industries, and national and regional economies.