With so much discussion around Environmental, Social and Governance (ESG), some PE firms may view it with skepticism. Isn’t ESG just a buzzword—one that represents an uncomfortable trade-off between profitability and sustainability? Below we discuss how ESG is not just a buzzword but drives value creation.
It is important to distinguish between ESG and sustainability. ESG applies to areas such as supply chain management, people management, diversity & inclusion, anti-bribery & corruption, compliance, and tax strategies—which are critical elements of doing business. Sustainability refers to making a positive impact in the community. This includes efforts that support the 17 Sustainable Development Goals (SDGs) of the United Nations, such as reducing global carbon emissions, improving access to education, and eliminating world hunger. When viewed in this light, the previous dismissive characterization falls away and reveals what smart firms have already discovered: ESG drives value creation.
Research compiled by McKinsey shows that a strong ESG proposition correlates with higher equity returns. With ESG practices, value can come in several forms. For example, lower energy consumption and reduced water use can lead to cost reductions, and productivity can improve as top talent gravitates toward companies with a sense of greater purpose.
With this in mind, PE firms are focusing more staff on responsible investment matters: In a PwC survey from 2019, 35% of respondents reported having a team dedicated to responsible investment (up from 27% in 2016). As their portfolio companies create value through ESG practices, GPs are demonstrating the importance of those outcomes through reporting, strategic reinvention, and business transformation.
Investors, stakeholders and regulators seek more transparency in all aspects of business, and ESG is no exception. Detailed reporting helps satisfy that scrutiny, and it reveals specific ways that ESG initiatives benefit portfolio companies. For example, as the size of a company’s carbon footprint changes, that impact can be tracked on financial statements. Standardized reporting is needed for comprehensive measurements to maximize ESG's usefulness as a value driver. In a recent PwC survey, executives cited “lack of reporting standards” as a top barrier to ESG peer comparison effectiveness.
Although it’s important to measure ESG progress with the right tools for data-gathering and reporting, metrics are only useful if you’re tracking the right thing. Firms need to establish Key Performance Indicators (KPIs) that reflect and support ESG goals. In a PwC survey of PE firms, 72% of respondents said they already use or are currently developing KPIs to measure the performance of their responsible investment policy. KPIs help GPs track progress toward ESG goals—but to monitor that performance, they need to find methods for frequent, accurate data collection from portfolio companies (such as software that automates data collection).
When firms refine their approach to ESG reporting and underlying goals, it also creates an opportunity to reevaluate strategy. Are current business priorities aligned with desired ESG outcomes or competing with them? A number of scenarios could prompt that reevaluation, whether it’s stakeholder scrutiny, changes in regulatory requirements, mitigating climate risk or green growth opportunities. Instead of pursuing initiatives that undermine ESG, GPs need to formulate strategies with ESG factors in mind.
For example, suppose a firm sets a net-zero goal for emissions. It could construct a plan for divesting traditional power sources and reevaluate design and construction methods for new facilities to reduce emissions.
When ESG is an integral part of strategy instead of an afterthought, it can lead to meaningful business transformation. If a firm decides to work toward the decarbonization of an entire investment portfolio, it may quickly discover that most of the carbon footprint comes from the supply chain. That can lead to digital transformation within portfolio companies—for example, putting an entire supply chain on a cloud-based ERP system, as a critical initial step to help suppliers report and reduce their carbon impact. ESG goals can facilitate collaboration within an organization’s value chain to identify and maximize opportunities such as a business model grounded in recyclable design. Because dramatic change is never easy, GPs may want to think about how incentive structures support transformation within a portfolio company’s workforce.
As ESG plays a growing role in investment decisions for both GPs and LPs, it reflects a mindset shift within the industry. Once viewed as a cost center, initiatives addressing human rights and supply chain issues are now recognized as value drivers. Barriers to adoption and concerns about “greenwashing” accusations will begin to disappear as the industry moves away from proprietary assessment methodologies and continues to adopt standardized reporting for ESG practices. GPs can also take steps to communicate their efforts more clearly with investors, whether through stand-alone ESG reports, a website page dedicated to ESG reporting, or the inclusion of ESG clauses and considerations in Limited Partnership Agreements.
Although the industry has plenty of room to improve the way ESG shapes investment decisions, ESG provides a healthy way to create sustainable value.
Sanne offers access to ESG advisory experts with strong experience in ESG strategy development, regulatory gap analysis, materiality analysis, reporting frameworks, data strategies and data analysis.
Using an online ESG reporting platform, Sanne offers independent verification of ESG reporting and compliance, providing clients and their investors with expert data analysis, governance, and education tools.