Introduction
Shareholder preeminence theory
Business case for ESG
Do companies that ignore long-term environmental or social costs in the pursuit of near-term profits pay another price in foregoing potentially long-term sustainable profit opportunities? The Business Case for ESG, from the Rock Center for Corporate Governance at Stanford University, authored by Stanford academics and representatives of ValueAct Capital, considers a framework for incorporating sustainability or ESG (environmental, social and governance) factors into corporate strategy and decision-making. The prevailing theory is that the failure to take sustainability into account is a component of short-termism, "leading to decisions that increase near-term reported profits at the expense of the long-term sustainability of those profits. The costs of those decisions are assumed to manifest themselves as externalities borne by members of the workforce or society at large." The paper cites investors like Laurence Fink of BlackRock and innovative approaches like The New Paradigm as examples of efforts to encourage companies to take into account stakeholders other than solely shareholders. The paper suggests that, properly analyzed, sustainability can affect not only externalities, but can also benefit the business itself—there is a business case for ESG.
Shareholder preeminence theory
Although the shareholder preeminence theory still largely holds sway in the U.S., it has recently come under more critical scrutiny—and from what might otherwise seem unlikely sources. For example, in his last two annual letters to public companies, Laurence Fink, the Chair and CEO of BlackRock, has advocated that companies recognize their responsibilities to stakeholders beyond just shareholders—to employees, customers and communities—as part of an overall focus on the long term. In his 2018 annual letter, Fink suggested that governments have just not been up to the task of addressing the many challenges afflicting society, with the result that "society increasingly is turning to the private sector and asking that companies respond to broader societal challenges…. To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate." [Emphasis added.]
According to the paper, the first step in the framework is to "map the ecosystem of stakeholders"—customers, suppliers, employees, regulators, the community and general public (including environmental impact), shareholders and competitors—and analyze what their goals might be and their various interests lie. The paper indicates that the map should reveal which ESG factors are most relevant: "Certain factors, such as governance and human capital, might be applicable broadly while others, such as environmental footprint, might be more limited."
With that analysis in hand, under the framework, the company next evaluates its own position and risk related to each of the identified factors. The paper suggests that engaging a substantial investor with a long-term perspective can help to elevate the discussion of risk with the board, encourage corporate investment to mitigate risk and champion the decision among other investors.
However, the paper asserts, ESG has relevance well beyond risk reduction:
"ESG factor analysis can lead to the identification of investments or activities by the company that increase long-term returns. For example, a company's investment in a more sustainable supply chain can deepen relationships with customers (thereby promoting volume growth and premium pricing), attract talent to the organization, and perhaps reduce costs….These positive effects can build on one another and create a powerful flywheel effect. To identify and capitalize on opportunities such as these, senior business leadership must consider material ESG factors as core inputs into their strategy development."
The footnotes to the paper make clear, however, that the research literature is not entirely positive on the financial benefit to companies that have jumped on the sustainability bandwagon:
"Some research finds that companies that embrace ESG principles perform better, although the results are mixed. [A paper from 2017 found] that during the financial crisis, high-ESG firms experienced greater returns, profitability, growth, and sales per employee relative to low-ESG firms. [A 2013 paper looked] at value creation from mergers, showing that high ESG acquiring firms experience significantly more positive returns from acquisitions than low-ESG firms. [A 2016 paper provided] evidence that well-governed firms that suffer less from agency concerns engage more in ESG activities, and that a positive relation exists between ESG and firm value. However, [a 2011 paper found], in a meta-analysis of 251 studies from 1972 to 2007, that the 'overall average effect [of ESG…] across all studies is statistically significant, but on an absolute basis it is small.'"
Nasdaq, which has just released a new voluntary ESG Reporting Guide, contends that a "range of studies have found correlation between companies with good ESG practices and a lower cost of capital, lower stock price volatility, and better valuation over the long term. Nasdaq itself is persuaded that a correlative exists, and it seems to exert positive influence for listed companies." According to Nasdaq, the notion that ESG factors should be characterized as "non-financial" is itself controversial: "how a company manages them undoubtedly has financial consequences [and] many believe that ESG information is no less relevant or useful to an investor in assessing the financial prospects and operational performance of a company than information channeled through traditional accounting practices."
While ESG factors can be integrated into the strategies of all companies, the paper maintains, some companies are able to put ESG "at the center of the investment thesis," or to develop business models that "are core to the ultimate solution for specific environmental and social problems." One example of these companies discussed in the paper benefited from adopting a long-term investment horizon, transitioning its decades-old business by making "an up-front investment in order to increase long-term value." The case study involved a mature power company that provided capacity to utilities globally, relying on coal as its primary energy source. But the company was able to recognize that there were costs to that reliance and began to reposition its business to renewable sources. It then accelerated that transition through a major reorganization, divesting primarily coal plant assets, and entering into joint ventures to build capacity for energy storage and development of renewables. Through various public sustainability reports and public commitments to substantially reduce its reliance on coal, the company made clear the seriousness of its transition to green energy.
The paper identifies a number of ripple effects from these actions, including galvanizing the company's culture, helping it to attract talent, increasing workforce productivity and innovation, attracting positive recognition from NGOs, attaining relief from shareholder pressures regarding sustainability and securing new investments from green-oriented investors. Significantly, during this period of investment, "the company's price-to earnings multiple expanded from approximately 9x in January 2018 to 14x by March 2019, and its stock price outpaced industry indexes." Through this transition, the company was able to turn an environmental challenge into a long-term profit opportunity, creating value and generating returns by fundamentally changing its business model to one that addressed stakeholder concerns regarding sustainability.
For further information on this topic please contact Cydney Posner at Cooley LLP by telephone (+1 415 693 2000) or email ([email protected]). The Cooley LLP website can be accessed at www.cooley.com.
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