Commentary

Sustainability is an Investment not a Cost

Richard Howitt, Senior Advisor at Frank Bold, surveys the path to acceptance of the business case for sustainability.

The traditional ‘business case’ for sustainability reporting has been put in manifold business conferences, research studies and by sustainability professionals for more than twenty years.

This ‘business case’ for what was formerly called corporate social responsibility has always argued that spending (and reporting) on the environmental and social impact of the company pays itself back in terms of direct cost reductions, better risk management, improved reputation, employee and customer loyalty.

Yet sustainable business has sometimes been perceived as an industry in its own right, where such arguments have had limited impact beyond ‘preaching to the converted’.

Today, both the sheer volume of the evidence which is now assembled and new thinking about economic models in the face of the size and urgency of sustainability challenges faced by companies, have created a fundamental shift in the way businesses perceive the positive benefits of sustainability and its reporting.

Measurable enterprise value creation

The most powerful evidence to support the economic case for sustainability reporting, comes in what is now a widespread series of studies, which all show a positive correlation between companies who achieve better ESG performance and who achieve higher financial returns at the same time.

Investors DWS Group (then known as Deutsche Asset Management) showed by combining the results of different studies on this question (a ‘meta-study’), that in over 60% of cases, positive ESG and better corporate financial performance go together. 

This has been described as ‘ESG alpha’ – the idea that adopting sustainability policies and transparency, can help the company to achieve higher returns compared to the market average.

The size of the financial advantage was calculated in a similar study by Nordea Equity Research, the largest financial services group in the Nordic region, showing that companies with the highest ESG ratings outperformed the lowest-rated firms by as much as 40%.

A further similar exercise by global asset management firm Arabesque in conjunction with the University of Oxford found that 90% of 200 studies analysed conclude that good ESG standards lower the cost of capital; 88% show that good ESG practices result in better operational performance; and 80% show that stock price performance is positively correlated with good sustainability practices.

The same consistent results have been shown in numerous equivalent studies including by the world’s biggest investor, BlackRock, in the work of George Serafeim at the Harvard Business School, in research published in the World Economic Forum and in a study published under the succinct title ‘Sustainability Pays’.

Indeed the evidence is overwhelming: sustainability pays. Breaking this down in to how this pays for the company also yields concrete results.

There is a 20:20 effect, with results showing that sustainable companies can charge 20% higher price premiums and expect up to 20% increases in sales revenue.

Better company results

These results for better performing ESG companies are also reflected by individual companies in adopting the new methodologies for ESG calculation.

German-based technology corporation SAP has calculated that a 1% increase in its Employee Engagement yields EUR 35-45 million revenue to the company.

French-based food services company Sodexo says its gender balance programme has increased the retention of not only employees by 8%, but also clients, by 9%, and boosted operating margins, by 8%.

Swiss-based construction materials company Lafarge Holcim uses an ‘integrated profit and loss statement’, in which it calculated value creation for the company’s operations at €3.6 billion, but combined value creation for the company’s triple bottom line (including social and environmental impact) at €5.3 billion.

The evidence shows that this is not just about sustainable performance of the company, but crucially the reporting of that performance too.

Sustainability reporting pays

There is now widespread recognition that sustainability is crucial to better risk management. Around half of all companies now report on climate risk in their financial reporting, according to global accountancy firm KPMG’s authoritative biannual survey of sustainability reporting, increasing significantly in the past two years in particular. Larger European companies lead globally in these results, with 60 percent report in line with the recommendations of the Task force for Climate-related Financial Disclosure (TCFD). [See KPMG survey graphics here]

Another KPMG survey of business in Germany, found that 75% of the costs of sustainability reporting would be incurred by the companies in any case (the ‘business as usual calculation’) and that the benefits of the reporting exceeded the costs by four times, generating a €750 million gain per year for German business overall. In 13 out of 15 future scenarios analysed, sustainability reporting beat ‘break even’ to provide positive benefits to the company.

Research from Australasia shows that where companies not simply embrace corporate purpose but communicate this effectively to investors, it can lead to a 1.6% increase in stock valuation. The quality of the reporting is similarly found to impact investor behaviour in research by management consultants, KKS Advisors.

It would be possible to continue citing even more results.

But what is suggested by this now overwhelming wave of evidence – in Europe and beyond – is that the ‘tipping point’ has indeed been reached whereby the business case for sustainable business and its reporting has now been won.

Why has the business case not been accepted earlier?

All of this begs the question as to why these financial as well as non-financial benefits have not been more generally accepted before?

Perhaps this is because sustainability has largely existed in a ‘bubble’ within the company, not fully accepted by its finance function, senior executives or Board. The study published by the Alliance for Corporate Transparency revealed that in the EU, only 14% of companies out of 1000 provided insights on the integration of sustainability in core business strategy, Board discussions, and performance incentives. Sustainability has been largely absent from management education and perceived as part of all reporting being seen as a compliance exercise, not recognised as relevant to a company’s business model and strategy.

Meanwhile, sustainability reporting methodologies, indicators and frameworks were often seen as immature and lacking credibility.

However, it now appears that the breakthrough moment has been reached and surpassed, whereby costs and risks associated with not pursuing sustainable development for the business, are now accepted to be higher than being prepared to do so.

What has changed?

The biggest mindset change on this question in past years, has been the increasing recognition that systemic risk presents the major threat to the business.

The TCFD was a key tipping point for sustainability to be treated as a financial issue within companies. Predicted resource shortages have built recognition about companies’ dependency on finite social and natural capital. The Covid pandemic has exposed how social developments can very quickly lead to very significant business dislocation. Extreme weather events have become not just more numerous, but inflicted deep economic damage.

To quantify this change in perception of business risk in the face of catastrophic climate change, the Commission on the Economy and Climate further described this as the equivalent of moving from one fatal aircraft accident every three million flights, to 300 fatal accidents each day.

This new understanding has led to fundamental change not simply in business, but within the investor community too, where for the first time ESG investment is predicted to overtake conventional investment in Europe, by as soon as 2025.

The EU sustainability finance strategy will give such concerns a very material form by a robust framework of hard law requirements, incentives and benchmarks which will enter into force by 2025, with the aim to channel a staggering EUR 850 billion of new bank loans and private investments annually into the transformation of the European economy to a sustainable model.

For companies who want better access to capital and at a lower cost, there is a clear incentive to pursue sustainability and to report it clearly.

For European businesses, the concrete pipeline of European Union regulation is already projected in the European Green Deal and as part of the European Commission’s most recent Sustainable Finance package. These include tightening rules for banks, investors and insurers to ensure sustainability requirements from business; extending the ‘taxonomy’ or what is considered to be environmentally sustainable to social issues too; expansion of its Emissions Trading Scheme alongside an expected rise in the price of carbon and strengthening transport, waste, buildings and land use legislation.

Business must prepare for such changes in the very near future. Sustainability cannot be marginalised any longer, but will now be understood to be central to the strategic challenges for the business overall.

In pure economic terms too, conventional financial accounting is now accepted as failing to address the importance of intangible assets in the valuation of the company. Covering elements such as brand, reputation, knowledge, research capacity and data, leading financial services company Ocean Tomo now assesses these to represent 90% of the value of the largest listed companies.

Businesses now recognise that they cannot afford to limit their financial management and reporting, to what encompasses only 10% of the true value of the company.

Companies also share the concerns of retail investors about the volatility of stock markets, based on short-term fluctuations which do not reflect the real economy, but have a direct effect on company valuation too. This has begun to lead many companies to move from simply calculating profitability to new measures of value creation – value for the enterprise and for its stakeholders.

Measures including the EU Taxonomy, scenarios analysis according to the TCFD, climate transition plans to achieve Net Zero and science-based targets have all introduced much greater precision to sustainability strategy and reporting.

At the same time, experimental methodologies for calculating social and environmental cost and impact have been seen to become more mature. These include examples such as the concept of multi-capital accounting being developed by organisations in the Value Accounting Network, the ‘Prosperity’ metrics in the World Economic Forum’s Common Metrics for Stakeholder Capitalism and the concept of the Sustainable Competitive Advantage Period, whereby an ESG and stakeholder-centric business can prolong the longevity in its lead over its competitors. Each of these is based on economic assessments and valuations.

Long-standing calls for the convergence of conflicting sustainability reporting frameworks have also now made significant progress, generating action from regulators – led by the European Union’s CSRD and sustainability reporting standards – to make this seem possible for the first time.

System benefits

Perhaps most of all, the arguments about externalities, which used to be about companies allegedly avoiding social and environmental costs so that they are borne by society in general, have suddenly been reversed.

In the new era, growing markets for sustainable products and services and lower costs for sustainable production methods are not created by individual companies in isolation, but by a combination of actions by multiple businesses, which fundamentally change cost-benefit calculations from the outside. This is the scale of the sustainability transition in the system directly impacting on the business.

Finance is the new externality. The speed with which digital technologies have spread, how the volume of new investment has shifted from fossil fuels to renewable energy or the expansion of LED lighting, were not predicted in advance but have become today’s reality.

Ground-breaking new improvements in battery charging, the successful development of the hydrogen fuel cell or the development of mass meat substitutes, could all be similar innovations which quickly alter economic assumptions in the very near future.

The London Business School has called this the ‘pie-growing mentality’, the idea that sustainability transition for the company grows market opportunity for businesses overall.

Therefore, static cost-benefit analysis techniques are being replaced by more dynamic and transformative models for financial performance amongst business thinkers, recognising that innovation in sustainable products and services, the rapid growth of new markets, the potential for being left responsible for stranded assets and possibilities for step-change reductions in the costs of production, must be factored in to business planning and decision-making.

This makes it clear that sustainability is indeed an investment not a cost.

One key piece of evidence which demonstrates this shift of thinking within business, is shown by successive Reuters’ Responsible Business Trends Reports, which have found that 54% of companies attribute sustainability to be a revenue driver, compared to 21% who do not.

This underlines that business has now been convinced by what has now become a wealth of statistical evidence, which takes the theoretical benefits that come from sustainability reporting and which has now succeeded in putting hard numbers to prove the argument.

Closing arguments

These two articles started by showing that research undertaken by and on behalf of the European Commission has made an indisputable case that the benefits of its new Corporate Sustainability Directive and associated standards for sustainability reporting, achieve a clear business benefit over the costs entailed.

However, in the past, such a ‘business case’ has not always been well received by business itself.

What has been argued above is that the urgency of sustainability challenges – a ‘wave’ of corroborating evidence about the economic benefits of sustainability and new economic models recognising the dynamic nature of the transition to a sustainable economy – all create a new context in which business is now able to give broad support to these initiatives.

Perhaps we will not need to discuss ‘the business case’ in future years? The argument has been won. Case closed.

Sources:

  1. ESG & Corporate Financial Performance: Mapping the global landscape, Deutsche Asset Management and the University of Hamburg, December 2015.
  2. Strategy & Quant: Cracking the ESG Code, Nordea Equity Research, September 5 2017.
  3. From the stockholder to the stakeholder: How sustainability can drive financial outperformance, Smith School of Enterprise and the Environment at the University of Oxford and Arabesque Asset Management, 2015.
  4. Sustainability: The Future of Investing, BlackRock Investment Institute, December 2020.
  5. Corporate Sustainability: First Evidence on Materiality, Mozaffar Khan, George Serafeim, and Aaron Yoon, HBS, 2015.
  6. “Sustainability and profitability can co-exist. Here’s how,” CP Gurnani, World Economic Forum, January 7, 2020.
  7. Sustainability Pays, Natural Capital Solutions, May 2012.
  8. The Comprehensive Business Case for Sustainability, Tensie Whelanand Carly Fink, Harvard Business Review, October 21 2016.
  9. The Business Case for Corporate Investment in ESG Practices, Matteo Tonello and Thomas Singer, The Conference Board, July 2015.
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  15. Integrated Sustainability Reporting – Quantifying the economical benefits of being sustainable, Marko Lange, SAP Community, March 31 2015.
  16. The value of value creation, Marc Goedhart and Tim Koller,McKinsey Quarterly June 16, 2020.
  17. Integrated Profit & Loss Statement – Annual Results and Assumptions, Lafarge Holcim, 2019.
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  28. Spinning gold: The financial returns to stakeholder engagement, Witold J. HeniszSinziana DorobantuLite J. Nartey, Strategic Management Journal, August 22 2013.
  29. The Inevitable Policy Response, UN Principles for Responsible Investment, March 2021.
  30. The Soaring Value of Intangible Assets in the S&P 500, Aran Ali, Visual Capitalist, November 12 2020.
  31. Joint Statement on Advancements in Value Accounting, The Value Accounting Network, July 14 2021.
  32. Measuring Stakeholder Capitalism: Towards Common Metrics and Consistent Reporting of Sustainable Value Creation, World Economic Forum, September 22 2020.
  33. Sustainability is key for value creation, Dhananjay Phadnis, Fidelity Sustainable Investment Blog, March 2 2021
  34. How great companies deliver both purpose and profit, Alex Edmans, London Business School, October 31 2019.
  35. The Responsible Business Trends Report 2017, Reuters Events Sustainable Business, May 30 2017.

This article was originally published as a part of Frank Bold’s series of 2021 monthly briefings focusing on sustainability reporting. It can also be accessed on the Alliance for Corporate Transparency website.

 

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