While more than 95 percent of S&P 500 companies issue a sustainability report,1 very few fully integrate environmental, social, and governance (ESG) into their equity stories. The lack of a clear link between sustainability and strategy can make it difficult for investors to understand how a company’s efforts affect financial performance and, crucially, intrinsic value.
How intrinsic investors look at ESG initiatives
If the classic Monty Python sketch about wanting to buy an argument were placed in the present day, it might be about the performance of environmental, social, and governance (ESG) funds: Do these funds outperform the market, or don’t they? Finance professionals, including academics, sharply disagree.
But what about decisions by traditional, nonpassive equity funds, which don’t operate under a specific ESG remit, when it comes to investing in an individual company? How do these sophisticated investors assess the impact that ESG can have on financial performance and company value?
In our survey, most respondents do not rank ESG at the top of their list of factors that drive long-term value creation. ESG is not named as the most important factor, or even the second most important, for companies in any industry. It ranks as the third-most-important investment consideration in only two industries—energy and materials, which clearly face ever more pressing challenges to manage the net-zero transition. Yet even while the participants typically cite other levers (such as cost optimization and capital productivity) as being significantly more important than ESG in their investment decisions, some investors report that they are considering reducing their exposure to entire sectors because of ESG concerns (Exhibit 1). This is particularly evident in more resource-intensive sectors, such as energy, materials, and logistics.
The group also takes a business-model perspective on the impact of ESG: they assign greater or lesser importance to E, S, or G and elements that fall under each dimension depending upon a company’s specific sector (Exhibit 2). The chief investment officers we surveyed report, for example, that for capital-heavy industries, environmental issues are the most crucial dimension; in the pharmaceutical and medical industries, social issues matter most; and for financial and insurance companies, governance is the most important.
When asked to rank different elements among E, S, and G categories, chief investment officers identify climate change and greenhouse-gas emissions as most important, followed fairly closely by governance structure, material use and waste, and labor practices. But the importance of those individual elements, again, vary depending on industry and company context. It’s crucial for chief investment officers to understand the company’s unique equity story, and for the company to make clear how its ESG initiatives tie into and enable its strategy.
The result is less of an argument and more of a conversation: whether and to what extent elements of ESG matter to a company—and an investor’s decision to allocate capital to that company—depends on the circumstances and strategy of the company itself. Just as they do in other aspects of investment decisions, intrinsic investors will wade into the details, and identify the granular drivers that are most important to the company to create and sustain value for the long term.
Our recent survey of chief investment officers suggests that while major investors believe that ESG is important, they need greater clarity about the ESG value proposition (see sidebar, “How intrinsic investors look at ESG initiatives”). Sustainability aspirations or metrics on a page, without context, are not sufficient to link initiatives to cash flow. That lack of clarity presents an opportunity for companies to make the ESG-to-value case more clearly.
The investors’ view
Long-term-minded investors—whom we call “intrinsic investors”—have an outsize effect on stock performance over time. These investors recognize that ESG will affect value,2 but they always want to dig deeper. They seek out granular information about how specific ESG initiatives can be a source of growth and which risks are most material to a specific company and its broader industry—and the extent to which distinct ESG actions can mitigate those risks.
The quest for clarity
About 85 percent of the chief investment officers we surveyed state that ESG is an important factor in their investment decisions. Sixty percent of respondents review their overall portfolio for ESG considerations, and about 80 percent assess individual company positions in the context of how ESG affects forecasted cash flows. Strikingly, a significant majority are prepared to pay a premium for companies that show a clear link between their ESG efforts and financial performance (exhibit).
Yet surveyed investors say that companies’ current ESG communications fall short in significant ways. Respondents want clearer methods to measure long-term value, greater certainty about regulations, and practicable ESG-related frameworks.
Surveyed investors are also eager for clearer ESG standards. They understand that ESG scores today, unlike financial ratings, don’t correlate fully among ESG score providers. While financial ratings correlate at around 99 percent among providers, ESG ratings can correlate at less than 60 percent because of the different elements and weighting each agency assigns to various ESG metrics.
The importance of sectoral differences
An important part of achieving greater ESG clarity, investors reveal, is understanding industry differences. For example, our survey shows that with respect to ESG in the energy sector, investors prioritize capital productivity and cost optimization. We observed similar trends for the industrials, materials, and consumer sectors. While investors rate the elements of E, S, and G roughly equally in importance when summing across all industries, that isn’t the case within each individual industry. Investors find that excellence in different pillars is required based on a company’s sector. For companies in the industrials and energy sectors, for example, surveyed investors seek out ESG initiatives in the environmental dimension. For companies in the technology; pharmaceuticals; and travel, logistics, and infrastructure sectors, investors consider social initiatives to be the most important. And for those in the financial and insurance industries, investors rank governance concerns the highest.
Notably, for some industries, the absence of a clearly defined ESG strategy leads surveyed investors to consider decreasing their exposure to or to divest from some industries entirely. That holds particularly true for investments in the energy; materials; and travel, infrastructure, and logistics sectors. But in most cases, ESG is part of a broader set of the detailed investment factors they consider.
The compelling opportunity for a more value-focused ESG story
Investor demand for greater detail and nuance suggests a compelling opportunity for companies to provide a clearer ESG-to-value case. In other words, what is the relevance of ESG for the business? How do ESG initiatives tie to value creation? What are the key levers and value drivers? Consider, for instance, how CEOs and CFOs provide context for quarterly and annual earnings, especially in their accompanying presentations: publicly filed reports are the start, but not the sum, of investor communications. Similarly, managers should not rely on formulaic ESG reporting to provide a comprehensive picture. Just as reports filed under generally accepted accounting principles are not full descriptions of strategy, carbon disclosures and other presentations of ESG metrics do not provide, without more context about the company’s unique business model, sufficient descriptions of strategic impact.
Know your audience
“Know your audience”—a key tenet of communications in any context—is critical for corporate communications on ESG. Too often, the media tend to refer to “investors” as a homogenous group with similar interests and needs. Seasoned CFOs, however, know that different shareholders have different strategies, and that no widely held company can satisfy every investor. A clear segmenting exercise can help senior leaders understand who their target audience is and what to emphasize in their investor communications.
In prior articles, we’ve suggested a practicable way to segment investors: intrinsic investors, traders, indexers, closet indexers, and retail investors.3 Our research suggests that intrinsic investors drive long-term share prices and should be the primary audience in mind for crafting strategic communications that lay out the long-term value creation of the company (as opposed to next quarter’s performance).4
ESG can be a compelling part of this intrinsic value story. From a top-down perspective, we now see some investors use rankings or other rules to screen out companies. For example, some investors simply avoid oil and gas companies. They seem to be in the minority, however, and there is usually little a company can do when individual investors apply an industry-wide embargo.
Intrinsic investors who do not dismiss industries out of hand because of ESG considerations can be grouped into two basic segments:
- Long-term investors who consider ESG an important consideration and use it to add a layer of additional analysis and judgment for their decisions. For example, rather than screening out oil and gas companies, these investors might differentiate among such companies based on their rates of reduction in carbon emissions and invest only in those they deem most able to reduce emissions.
- Investors who focus strictly on the economic impact of ESG initiatives, particularly on cash flows and value creation. For example, these investors might avoid oil and gas companies with a higher chance of having stranded assets, or real estate companies with a greater risk of having their properties flooded based on the assets’ geography. These investors might also consider whether the company is well positioned to create value from new opportunities created by the energy transition (for example, capabilities in hydrogen or in carbon capture, utilization, and storage). Our survey suggests that many investors seem to fall into this second category.
For purposes of crafting an ESG equity story and investment case, the two categories are sufficiently similar that a clear story about how ESG links directly to sustained financial performance and long-term value creation should satisfy both intrinsic investor segments. As a company conveys its ESG initiatives into its equity story, it should bear in mind that its target investor audience is sophisticated, long-term oriented, and relentlessly focused on sustainable competitive advantage.
Getting to the ‘how’ of sustainability communications
How then should companies incorporate ESG into their equity stories and strategic communications? Part of the “how” is relatively easy: CEOs and CFOs should communicate that they recognize what is happening in the market and spell out what the company is doing about it.
Of course, if ESG communications were that easy, one would expect that more companies would do it well. They don’t. Part of the challenge is that market and societal forces develop rapidly; there are many unknowns, and companies can fall back on vagueness and platitudes to try to cover multiple potential outcomes. But clear strategy is marked by decisive choices. Effective equity stories acknowledge competitive and macroeconomic changes; they address how the company’s strategy will enable it to benefit from the changes, and they address the risks. Experienced senior leaders will explain why the strategy works, and only then will they proceed to targets and risks.
In our experience, a compelling ESG equity story addresses the following issues.
What is changing in the market? This description could be as simple as laying out management’s view on how quickly an already shifting market will move (for example, the share of electric-vehicle sales in five, ten, and 20 years) and the impact those shifts are having. In many energy-intensive businesses, the impact and range of responses can be highly uncertain (for example, the role of hydrogen or carbon capture). Again, a detailed management perspective and explanation are essential: Will the company bet now on a specific scenario (such as a full transition to hydrogen and electricity for refinery energy), or will it seek to keep more options open (perhaps by making some smaller bets, or by testing the waters with joint ventures)? There will also be businesses where the impacts of ESG initiatives are more bounded. For example, while future frying pans might be made out of zero-carbon steel, it’s unlikely that the total number of frying pans sold worldwide will exceed historical demand levels relative to market size. Here, executives will need to explain why they believe an investment now into low-carbon metal is needed (for example, through customer surveys).
What is the company’s strategy? For some businesses, linking ESG strategy to value creation is straightforward at a high level. Many car manufacturers, for example, have announced whether and how quickly they intend to shift to full electric-vehicle portfolios, regardless of whether they will support charging networks or other components of an ecosystem. For businesses that face greater uncertainty (for example, carbon-intensive businesses such as building materials, where companies experiment with solutions but there is not yet clear movement in the overall market with announced strategies to change products), executives should lay out their view on the levers they intend to address. These companies could explain, for example, how much R&D effort is being put into new materials like recycled plastics for construction and less-carbon-intensive concrete, as opposed to decarbonizing existing processes. For businesses with greater exposure across their supply chains, initiatives could be more preliminary (“finding the right suppliers”), or more immediately pressing (“working now with our suppliers to invest in joint ventures to do the following”). All companies in high-emissions industries, however, should be able to articulate the new opportunities that they intend to pursue in order to create value from the energy transition.
How does this strategy create value? Executives should be able to identify the direct link between a company’s ESG strategy and its value creation strategy. To be credible, that connection should not be a checklist recitation of initiatives with a high-minded vision. Rather, companies should be able to walk investors through, in a reasonably granular way, why they chose the ESG initiatives they did, and how they will create value in terms that investors traditionally understand. That is: How will this ESG strategy enhance (or sustain) cash flows, return on capital, and margins; mitigate risks; affect top-line growth; and attract and retain the talent needed to produce these results? Examples of clear communication include a food company that laid out differences in customer demand for sustainably sourced products by region. In another case, an electric utility anchored its strategy on decarbonization and pivoted to renewable energy, showing investors that doing so reduces customer costs and operating expenses in wind- and solar-power generation.
What’s the evidence that the strategy works? Investors want proof points that the ESG strategy is generating desired results. CEOs and CFOs should be able to provide clear facts that their company can “win” in an ESG element. Those details are quantitative as well as qualitative: What specific competitive advantages does the company hold, and how are we managing them for success? Why should investors allocate capital to this multibusiness company instead of to pure plays? Companies can demonstrate links to value creation in various ways. For example, a global consumer-packaged-goods company ties its ESG strategy to financial metrics including earnings growth and cash generation growth from new products. The food company mentioned above, for its part, highlights the rapid sales growth of plant-based food products, as well as sales of affordable, accessible products in emerging markets, as it describes present and future cash flows.
What are the risks—and opportunities? Intrinsic investors are well experienced in approaching valuation based on probability-weighted scenarios, both on the upside in terms of opportunities and on the downside, including risk. An effective equity story improves investor understanding of how the company is using ESG to raise the odds for outperformance and address risk. One technology company, for example, takes a holistic approach to mitigating and managing climate-related risks on its business strategy, including in operations, working with suppliers, and by offering sustainable products. Another company conducts and shares a materiality assessment, based on a 2x2 matrix of the expected impact of opportunities and risks across external and internal stakeholders, in order to sharpen its insight and make its ESG strategy more transparent.
Investors recognize that ESG can be an important factor in choosing whether to invest in specific companies. It may be time for executives to step up and fully integrate ESG into their equity story, making sure to connect ESG to value creation, and differentiate themselves from their peers based on ESG value impact.
