Aligning ESG Benefits – What is the secret of selling executives on using sustainability strategies? Show how the benefits of those strategies help them achieve their existing priorities on which they are already being measured. Executives are juggling way too many key focus areas to welcome adding another one like “sustainability” to the batch.Executives Juggling priorities
That means sustainability champions need to align the set of benefits that are yielded by smart environmental, social, and governance (ESG) / sustainability strategies with executives’ top priorities, even venture philanthropy.
Aligning ESG Benefits with Executives’ Top 10 Priorities
A survey done by Forrester in Q4 of 2010 provides us with a helpful list of executives’ priorities. A cross-section of 2,691 business senior executives in Europe, North America,and Asia were asked to name their top two priorities for 2011.
The “% Selecting” column shows how many respondents included each selection among their top two choices. At first glance, the list is disappointing to sustainability champions: improving ESG / sustainability is ranked 10th–lowest on the list, trumped by revenue growth, efficiencies, innovation, and employee engagement issues.
But wait …
The phrase “Sell the sizzle, not the steak” is an old sales adage. When we buy a light bulb, we don’t really want a light bulb, we want the light it provides. When selling sustainability-related strategies to for-profit companies, we need to ensure we are selling the business benefits that they enable, more than the co-benefits they provide for the environment and society.
As the Forrester survey results suggest, corporate decision makers will be more inclined to embrace sustainability strategies because they help attain their other top nine priorities, more than to “improve corporate environmental sustainability and social responsibility” per se.
To entice companies toward Stage 4 on their sustainability journeys (see my July 27, 2010 blog,The 5-Stage Sustainability Journey) we need to show how ESG-related strategies align with their existing, high priority, business goals.
The slide opposite matches the benefits of ESG strategies with the categories of priorities from the Forrester study. This is the magic of the sustainability sale — it’s not about sustainability.
It’s about helping companies achieve their business priorities. Sustainability is simply the means to those ends.
To make it easy for executives to see the relevance of sustainability-related strategies, we need to map their benefits against frameworks with which executives are already comfortable.
This week, we mapped them against executive’s priorities. Over the next few weeks, we’ll look at three more business frameworks to consider using:
1. The standard income statement framework
2. The standard business case framework
3. The standard value chain framework
Aligning ESG Benefits with the Income Statement
We need to make it easy for CEOs, CFOs, and others in the C-suite to see how embedding sustainability strategies into the company’s strategies and operations will contribute to the firm’s success.Aligning ESG Benefits with the Income Statement
That is, we need to connect the dots between typical financial statements and the benefits that can be realized from smart environmental, social, and governance (ESG) approaches and programs. Aligning ESG benefits with income statement elements helps executives see the relevance of sustainability initiatives to their current financial priorities.
The sidebar shows the basic elements of an income statement, also known as a profit and loss (P&L) statement. It’s pretty straightforward, even for financially-challenged sustainability champions.
It takes the top-line revenue that the company makes from its sales and subtracts the labor and material costs of producing those sold goods (COGS) to calculate the gross profit.
Then it subtracts the overhead, staff, operating, and selling (SG&A) expenses to arrive at the EBITDA earnings—a bit of a tongue-twister of an acronym.
Net income, or profit, is what’s left on the bottom line after subtracting the interest, tax, depreciation, and amortization expenses.
Each of the seven benefits associated with smart ESG strategies can then be arrayed beside the elements of the income statement that it most benefits. “Increased Revenue and Market Share” is easy to position beside Revenue. The next three areas of benefit—“Reduced Material and Waste Expenses,”
“Reduced Energy Expenses,” and “Reduced Water Expenses”—apply to both COGS and SG&A expenses, as do “Increased Employee Productivity” and “Reduced Hiring and Attrition Expenses.” The brackets in the slide beside these five benefits suggest that they are partly helpful in reducing COGS and partly helpful in reducing SG&A. A manufacturing company would realize the biggest savings in COGs since that’s where its labor, energy, water, and material costs to produce their goods are recorded.
A non-manufacturing company would see more of those savings in the SG&A line, since its COGS would be much less significant for a company not manufacturing its goods.
Finally, “Reduced Interest on Borrowed Capital” can be an important benefit. The potential benefit of a few basis points lower interest rate on borrowed capital affects the “I” (Interest expense) in “ITDA.”
By aligning ESG-related benefits with the income statement framework, it becomes evident how and where each benefit contributes to a more positive profit. Using financial language improves sustainability champions’ credibility. Being able to relate the so-what’s of ESG benefits to the income statement enhances that credibility further.
Aligning ESG Benefits with the Standard 2-Part Business Case
There are only two reasons a company changes: to avoid risks and / or to capture opportunities. They go for the upside, and / or run from the downside. They are attracted to the carrot, and / or want to duck the stick; the yin and / or the yang. Trying to convince a company to fully embed sustainability into its strategies and operations requires a very compelling business case. The standard business case is made up of these same two parts, shown in the figure below.Aligning ESG Benefits with the Standard 2-Part Business Case
The status quo is very difficult to change. A company’s carefully crafted strategies, operational processes, current product lines, and organizational culture have served it well. There have to be very good reasons to mess with success, or the proposal will fail. Sustainability champions need to show what the company will gain if it embraces sustainability-related strategies, and the threats to the company if it does not.
We like to think that the appeal of new opportunities will be adequate to convince companies to embrace smart sustainability strategies. We size potential benefits, show how they contribute to a more robust bottom line, and wonder why companies don’t leap at the chance to be more profitable.
My research has shown that typical small companies can improve their profits by at least 66% within five years by embracing smart sustainability strategies; for typical large companies, that potential profit improvement is 38%. It looks like embracing sustainability opportunities is a no-brainer.
Unfortunately, a company has to change how it does things – it has to innovate – in order to reap the sustainability benefits, and the status quo needs a wake-up call. That’s where the risk of not changing is a helpful, essential part of the business case. The burning-platform theory of change says that things need to get hot before we decide to jump into new waters. The downside of not changing is often more motivating than the upside of doing things differently. The fear factor normally trumps the hope factor.
Later on, when leaders explain why they are doing the right things now, they often deconstruct the drivers and emphasize the opportunities that they wanted to capture by instituting new environmental, social, and governance (ESG) strategies and procedures. The risks that they wanted to avoid are often unspoken, but they were usually critical motivators. As sustainability champions, we need to gently help point out those threats up front and quantify their potential impact, to ensure the business case is compelling.
The adjacent slide aligns the seven benefits that can be reaped from smart sustainability strategies with the Capture Opportunities part of the business case. The benefits of avoiding the risks are noted against the Avoid Risks component. The risks are sized by quantifying the potential impact of the threat and factoring it by the probability of the risk occurring within the scenario planning timeframe.
Don’t let the 7:1 ratio of benefits to risks fool you. The ratio of their weighting in the decision-making process may be the reverse.Business case aligned ESG benefits
To make it easy for executives to see the relevance of sustainability-related strategies, we need to map their benefits against frameworks with which executives are already comfortable. This week, we mapped them against the standard 2-part business case that is behind all business decisions. This is the fourth of a portfolio of four frameworks that improve the relevance of the sustainability business case to business leaders. The other three were:
- Aligning ESG Benefits with Executives’ Top 10 Priorities
- Aligning ESG Benefits with the Income Statement
- Aligning ESG Benefits with the Value Chain
Now we have four arrows in our quiver. Let’s go for the credibility bulls-eye!
As usual, the above slides are from my Master Slide Set.
Responsible Investing Incorporating ESG Factors
Investments that pay heed to environmental and social factors can be very lucrative. Responsible investing offers an unparalleled opportunity as the world increasingly comes to grips with the harsh realities of the destructive nature of the old economy. The trend towards greener investments can be expected to continue as the planet’s resources become ever more scarce and renewable energy is increasingly mainstream.
Responsible investment is about far more than ensuring that a company is contributing to the green economy. To be truly sustainable there must also be a dimension of social responsibility that includes far-ranging factors including everything from fair wages to ensuring there is no child labor involved.
Responsible investment requires investors and companies to take a wider view, longer term view that acknowledges the full spectrum of risks and opportunities facing them. This approach enables them to allocate capital in a manner that is aligned with the interests of their clients, the environment and people.
As explained by PRI:
“Responsible investment is an approach to investment that explicitly acknowledges the relevance to the investor of environmental, social and governance (ESG) factors, and of the long-term health and stability of the market as a whole. It recognizes that the generation of long-term sustainable returns is dependent on stable, well-functioning and well-governed social, environmental and economic systems. Responsible investment can be differentiated from conventional approaches to investment in two ways. The first is that time-frames are important; the goal is the creation of sustainable, long-term investment returns not just short-term returns. The second is that responsible investment requires that investors pay attention to the wider contextual factors, including the stability and health of economic and environmental systems and the evolving values and expectations of the societies of which they are part. Looking to the future, these issues will be increasingly key.”
Responsible investing is also known as impact investing, it consists of investment choices that offer social and environmental benefits. The new emerging economy, including Renewable energy sources and battery technology require elements like gallium, indium, germanium and lithium. This makes those companies which mine the key components of the new green economy a very good investment.
There are a wide range of responsible stocks and mutual funds. Extraordinary returns await those who factor ESG into their investment strategies.
For more information see the United Nations’ Principles for Responsible Investment.
Aligning ESG Benefits with the Value ChainSustainability Chain
Executives are continuously looking for ways to make the company’s value chain more robust and resilient. Smart environmental, social, and governance (ESG) strategies and programs can help.
As pointed out in my last two blogs, we need to make it easy for CEOs, CFOs, and others in the C-suite to see how embedding sustainability strategies into the company’s strategies and operations will contribute to the firm’s success. We have shown how ESG benefits relate to the executives’ 2011 priorities (Aligning ESG Benefits with Executives’ Top 10 Priorities, May 17, 2011) and to the income statement (Aligning ESG Benefits with the Income Statement, May 29, 2011). This week, we’ll show how ESG benefits help strengthen key links in the value chain.
The sidebar shows the links in the standard value chain. Reading from left to right, the company takes guidance from the market and develops its vision, goals, values, strategies and systems that will enable its success. If it is a manufacturing company, it makes quality products from raw materials, energy, and water. Companies in every sector want to attract, retain, and engage talented employees to deliver its services and support customers.
An unfortunate byproduct of the company’s operations is waste. On the other hand, if the company’s products and services delight customers, the resulting revenue stream leads to the goal—bottom-line profits.
Each of the seven benefits associated with smart ESG strategies can then be arrayed beside the links in the value chain it most benefits. The first three areas of benefit—“Reduced Material and Waste Expenses,” “Reduced Energy Expenses,” and “Reduced Water Expenses”—help improve the efficiency of links throughout the company’s operations. “Increased Revenue / Market Share” is easy to position against the Revenue link.Value Chain aligned esg Benefits
“Increased Employee Productivity” and “Reduced Hiring and Attrition Expenses” help the engaged employee link. Finally, “Reduced Interest on Borrowed Capital” can be an important benefit that helps a higher proportion of the revenue flow through to the bottom line instead of being diverted to pay interest on borrowed capital.
By aligning ESG-related benefits with the value chain framework, it becomes evident how and where each benefit strengthens important links. Using relevant frameworks improves sustainability champions’ credibility. Being able to relate the so-what’s of ESG benefits to the standard value chain enhances that credibility further.
As usual, the above slides are from my Master Slide Set.
Please feel free to add your comments and questions using the Comment link below.
Video: Sustainability at Unilever – The Value Chain
Unilever is dedicated to making a profit while reducing its impact on the environment. The value chain lets Unilever see where their biggest impacts are. This video makes the point that we all need to grow our businesses but not at the cost of the planet. Unilever is teaming up with suppliers, customers and consumers to see how they can all reduce their impact on the world.
A Practical Proposal to Erase Externalities
As the global economy grows, it expands into pristine habitats, interferes with critical ecosystems, consumes more resources, and emits more pollutants. Many activities that fall under the banner of economic growth are undercutting the planet’s ecological systems. At the heart of this tragedy are pollution damages that are imposed on society but not factored into company costs. These damages are called externalities because they are externalized by the businesses generating them.
Every day, producers of myriad products impact the biosphere in ways unknown to customers, investors, and policy makers in both host and home countries. By not undertaking the measures necessary to protect ecosystems, these companies avoid responsibility for the damages. And because they have failed to account for the true costs of their businesses, they can sell their products at lower prices than more ecologically responsible companies, gaining an unfair advantage and reaping undeserved profits.
The consumption patterns in many product markets would change if the true costs of production were reflected in the prices of the products, or even if customers, investors, and policy makers had better access to accurate information. There are many possible paths to full internalization of these externalities, but there is no clear map of the territory.
As the United Nations Environmental Programme puts it, “in the current absence of sufficient and comparable company disclosures on the environmental impacts of operations and supply chains,” it is difficult to puzzle our way out of the dilemma. In fact, it is virtually impossible to achieve a sustainable economy unless something is done about pollution externalities.
A true-cost economy would align our economic system with nature’s life support systems. Biologists teach us that each living system has feedback loops that allow it to adjust and operate within carrying capacity limits. The human economy is no exception, but we’ve short-circuited an important feedback loop by letting companies externalize the costs of their pollution. The time has come to adopt systematic rules that add pollution costs to the prices of goods and services. Such rules would provide critical information that is necessary to keep the scale of the economy within the planet’s carrying capacity. A true-cost system would solve real problems, but how can we put such a system in place?
The mission of the U.S. Securities and Exchange Commission (SEC) is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Although the SEC requires public companies to disclose certain financial information, it does not require them to disclose information about their health and environmental externalities. Changing the requirements could produce widespread positive impacts.
Public companies are responsible for as much as one-third or more of all pollution externalities. By requiring these companies to track and report the costs that they typically externalize, we would not only set a legal precedent, but we would also begin to instigate the much deeper social and cultural changes needed to achieve a true-cost economy.
If we can compel the largest and often most intransigent corporations to disclose how they are impacting the planet, truth and honesty can begin to displace “dark costs” and secrecy. With such a cultural shift, we will perhaps no longer be talking about imposing disclosure requirements, but rather enjoying increased cooperation and forthrightness.
In the meantime, the transition to a true-cost economy calls for mandatory, annual disclosure of externalities — ecological impact disclosures — by every company that falls under SEC jurisdiction (effectively all U.S. public companies and some foreign issuers as well). Adoption of ecological impact disclosures can be done by successfully petitioning the SEC, passing federal legislation, or both.
CERES (a prominent nonprofit organization), religious groups, and pension funds have pushed for shareholder resolutions and achieved important successes toward institutionalizing broader disclosures. Other groups have petitioned the SEC to adopt a flexible environmental, social, and governance (ESG) reporting framework, such as that developed by the Global Reporting Initiative. These efforts are worth applauding, but we need a bigger, bolder solution that confronts the magnitude of the problem and paves the way for a sustainable, true-cost economy.
The best route is to empower the SEC to force each public company to provide an annual ecological impact disclosure. Such a disclosure would be more effective than a flexible or voluntary framework — it would require specific data, reported in standard forms. Each reporting company would provide information about its own operations as well as those of other companies in its supply chain. In addition to aggregate, company-wide information, companies would provide site-specific data so that the public can determine where impacts are occurring.
Many investors have been calling for this sort of information to help them make better decisions about where to put their money. But this is precisely the kind of information that has been kept from the public for the past century. Keep an eye on the efforts at Foundation Earth over the next year to remedy this situation.
4 ESG-Friendly Findings about Borrowing Rates
In my last blog, I outlined three concerns that lending institutions have about companies with poor environmental, social, and governance (ESG) track records. First, environmental practices may expose borrowers to expensive legal, reputational, and regulatory risks that could jeopardize their solvency.
Second, lenders want to ensure they are not stuck with the borrower’s current and past environmental liabilities if the borrower defaults on the loan. Third, lenders are wary of risks to their own reputations if the public perceives they are abetting the borrower’s irresponsible corporate behavior.
For these three reasons, laggard companies with poor ESG track records may find they pay a higher rate for their borrowed capital. The Social Investment Forum’s 2010 Moskowitz Prize for scholarly research on socially responsible investing was awarded to Rob Bauer and Daniel Hann for their paper, “Corporate Environmental Management and Credit Risk.” In it, they analyzed 1996 to 2006 data on the environmental profiles of 582 U.S. public companies and their associated cost of debt. They found:
- Companies with low environmental scores pay a premium for debt financing, and consistently have lower debt ratings from agencies like Moody’s and S&P.
- Companies with better scores pay less for debt, but they tend not to be rewarded for their environmental performance by the ratings agencies. The agencies seem to lag individual bond investors regarding the significance of ESG metrics
- The link between environmental performance and credit risk is, in fact, no stronger in “dirtier” industries than it is for the market as a whole. The authors attribute this to the “heterogeneity” of a sector’s risk profile: a belief that every company in a sector like coal mining, faces environmental liabilities similar to its peers in other sectors.
- Perhaps the study’s most intriguing finding is that the link between environmental risk and debt costs has strengthened. For example, bond investors seem to be pricing climate change-related credit risk in anticipation of laws yet to be passed.
So the credit standing of borrowing firms is influenced by legal, reputational, and regulatory risks associated with environmental accomplishments. Companies with weaker environmental performance pay a premium for debt financing and companies with better scores pay less for debt. The study found that spread can be as much as 64 basis points (0.64%) and it is growing.
Interestingly, this is an absolute spread, not a relative one. Regardless of the interest rate, a company may receive as much as a 0.64% lower rate for borrowed capital if they have an exemplary sustainability track record. Rounding the spread to 0.60%, if a company has long-term debt of $1,000,000, the savings on annual interest payments could be $6,000. On debt of $50,000,000, the interest savings could be as much as $300,000.
In times of tight credit, it pays to be a better ESG risk.
3 Reasons Banks Fear ESG LaggardsReasons Banks Fear ESG Laggards
How lenders respond to a company’s request for financial assistance is somewhat driven by the applicant’s environmental, social, and governance (ESG) track record. Borrowers require financial capital in order to purchase equipment or new premises in which to produce its goods or services.
Some of these capital improvements may be for pollution prevention equipment to comply with tougher environmental regulations, with energy-saving retrofits, for water conservation and treatment, or for new green production lines.
Some of the loans may have nothing to do with green projects. Regardless, one cold reality applies to any loan request: Your ESG track record can be a stumbling block.
Access to capital is a challenge. Credit is still tight following the recession. Banks are tightening their requirements for loans and asking for more extensive disclosure about the applicants’ ESG policies, management systems, track record, and stakeholder relationships to help them assess environmental and social risk. There are three primary reasons banks care.
First, environmental practices influence the solvency of borrowing firms and may expose them to expensive legal, reputational, and regulatory risks. Lenders want to know if a borrower might be hit with costly fines, cleanup costs, and business restrictions which could impact its ability to repay outstanding loans.
Second, lenders want to ensure they are not stuck with the borrower’s liabilities. If the borrowing company defaults on its loan, the lender may have to seize the company’s assets that were used to secure the loan. If it seizes them, it owns them and is then directly liable for the cost of cleaning up any of the company’s environmental pollution, remediating contaminated land, and preventing further environmental damage.
Third, lenders are also wary of risks to their own reputations if the public perceives they are abetting irresponsible corporate behavior. This potential guilt by association leads to prolonged due diligence for potential environmental and social liabilities associated with the project or the borrower. This can delay financing for projects that may have significant environmental or social impacts, or render them ineligible for financing. Wells Fargo, Credit Suisse, Morgan Stanley, JPMorgan Chase, Bank of America and Citibank are now leery of lending to coal companies involved in mountaintop removal.
HSBC has curtailed its relationships with some producers of palm oil, which is often linked to deforestation in developing countries. The Dutch lender Rabobank has applied a nine-point checklist of conditions for would-be oil and gas borrowers: the list includes commitments to improve environmental performance and protect water quality.
For these three reasons, laggard companies with poor ESG track records may find they pay a higher rate for their borrowed capital. Exemplary companies may enjoy a preferred rate. In my next article, we’ll explore the size of this spread.