Environmental, social and governance (ESG) factors have become central principles in the capital allocation process for both providers of capital, or investors, and users of capital, or corporations. While initial rounds of ESG investments have largely received praise from shareholders and stakeholders alike, most organizations fail to articulate the value proposition of ESG investments and assess whether such investments have created value or are No.
These shortcomings are perpetuated by the prevailing view that ESG considerations are non-financial in nature, and therefore such a goal cannot be met or even attempted.
But this approach fails to recognize that ESG is not non-financial information, but pre-financial information.
The ESG represents the factors that assess the long-term financial resilience of an enterprise. Given the nature of ESG investments, the analysis needs to temporarily set aside specific return metrics, such as EBITDA, profits and cash flow, and instead focus first on how ESG affects value creation. This is the key to making a significant connection between investment and returns in ESG.
In the short term, the emphasis on value creation will bring much needed financial discipline to ESG investments and increase the information value of sustainability reports and disclosures. In the long term, such a focus could help accelerate the transition from a market-driven event to the ESG’s standard principles-based framework.
The link between ESG and intangible value creation
As the world economy continues to transition from one driven by intangible value, this has made clear the inability of “earnings” to capture value creation through investment. For example, in The end of accounting and the way forward for investors and managers, Author Baruch Lev and Fang Gu Examine the explanatory power of reported earnings and book value for market value between 1950 and 2013. They find that R2 Fell from about 90% to 50% in this period. Recent evidence suggests that the global pandemic has accelerated the trend.
As the ESG represents an effort to fill this value creation gap in financial reporting, it is no surprise that as value creation continues to move into the intangible, so does the rise and adoption of ESGs.
To assess ESG value formation, we must first acknowledge that ESG is not a one-size-fits-all approach. Value creation opportunities for ESG investments are largely a function of the industry in which an enterprise operates. In order to generate economic value from an ESG investment, or any investment, an enterprise must generate returns in excess of what is required for tangible assets and the financial capital employed. Opportunities for ESG value creation are greater for companies with a differentiated, value-added and high-margin business model than for companies with commoditized, tangible-asset intensive, low-margin business models.
In view of the above, it becomes clear that ESG value creation is manifested in the creation and maintenance of intangible assets. But which of the E, S and G generates the intangible asset? Answering this question is necessary to clarify the value proposition of ESG investments for enterprises. The following figure begins by providing a framework for answering this question by examining specific groups of intangible assets, including brands, human capital, customer franchises and technology. It examines the value creation lifecycle through three distinct phases:
- Direct Assets: Intangible assets that are directly affected by an E, S or G investment.
- Indirect Assets: Intangible assets that benefit from the price increase of the direct intangible asset(s) that were targeted with E, S, or G investments.
- Scalable Value Creation: The final stage of the lifecycle recognizes that intangible asset value creation through ESG investments is scalable as a result of interconnection with other intangible assets. Such characteristics are because the value created from an ESG investment may have little to do with the investment amount.
Given that intangible asset value drivers are well documented and understood, and now armed with a better understanding of how E, S and G investments result in intangible value creation, we are looking at ESG investments among enterprises. Some characteristics can be identified to assess the expected relative value creation of . Here are six such features with a brief description:
- Rely on the strength of the brand/brand: The greater the reliance on brand and reputation for an enterprise, the higher the expected return on ESG investment.
- Dependence on Human Capital: The greater the reliance on human capital for an enterprise, the higher the expected return on ESG investment.
- Value Added Business Model: The higher the potential to generate the enterprise valuation premium, or enterprise valuation premium, on tangible assets and capital, the higher the expected return on an ESG investment.
- Nature of Customer Relationship: The greater the connection or exposure to the end customer, the higher the expected return on ESG investment.
- Tangible Asset Intensity: The more a business model relies on tangible assets, the less is the potential value to be created by ESG investments.
- Market-leading technology: Proprietary technology can create consumer demand that is less elastic to the value of other intangible assets, so the more the business model relies on proprietary technology, the less potential value is created by ESG investments.
The following chart analyzes these six criteria for five enterprises from different industries. The greater the area involved, the higher the expected value creation of ESG investments.
While the above are certainly the 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, a focus on intangible value creation can bring greater financial discipline to ESG investments and strengthen sustainability reports to go beyond endless lists of statistics and overly qualitative narratives.
In the long run, a focus on intangible value creation can help move toward a financial reporting system that captures intangible value creation. The primary goal of developing a standardized principles-based framework is to ensure the usefulness and relevance of financial statements. However, the current accounting framework is not only failing to provide relevant information on value creation, but it is also actively hindering efforts to fully implement value-creation ESG priorities.
In a recent article,Constrained by Accounting: Examining How Current Accounting Practice is Disrupting Net Zero Transitions, “The authors analyze BP’s commitment to become carbon neutral by 2050 in the context of the current accounting model for ESG and intangible assets and liabilities. They argue that the current accounting model unfairly penalizes and demotivates companies because This need is expressed more succinctly than in the authors’ analysis of both technology and brand abstractions, the latter of which are discussed below:
“We believe that when an organization does not control the environment, its employees or other stakeholders, it has control over its relationships with those entities, through the alignment of its decisions with societal norms, with respect to its reputation. It follows that the definition of an asset should be applied to an entity’s reputation or its social license to operate, resulting in the capitalization and proper valuation of these assets. This treatment of liabilities to social obligations Balances the need to be recognized as such and minimizes the punitive treatment of costs related to compliance with societal norms. Such costs can be seen as an investment in reputation and the risk to the organization from such investment. Potential profits will be capitalised.
These constraints are not just limited to brands and technology, but also exist to human capital. In “The Two Sigma Effect: Finding Untapped Value in the Workforce, ” the authors note how current accounting drives behavior that limit opportunities for value creation for human capital. The authors explain:
“Private equity has seen labor as a line-item to reduce rather than a place of investment, resulting in a huge blind spot for the industry. What if there was another, more useful way of looking at workforce issues? was the way?”
These examples highlight the inextricable link between ESG and the efforts of accounting standards setters exploring opportunities to systematically address intangible value creation. The limitation of the accounting framework for systematically addressing intangible assets is not due to a lack of acceptance about the importance of intangibles, but a lack of a practical, objective and universally applicable viable framework.
The focus on value creation will allow the best ideas, concepts and frameworks to emerge from ESGs to inform the ongoing debate about how to better communicate value creation through accounting and financial reporting processes. Based on the initiatives shown with ESG, investors can help guide the way towards a solution.
If you liked this post don’t forget to subscribe enterprising investor.
All posts are the views of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.
Image Credits: © Getty Images/SimpleCreativePhotography
Vocational Education for CFA Institute Members
CFA Institute members have the right to earn self-determination and self-report vocational education (PL) credits, including material enterprising investor. Members can easily record credits using their online pl tracker.