Environmental, social and governance factors (ESG) are now mainstream points of discussion and a strategic priority across board rooms large and small.
In the words of KPMG Head of ESG, Sue Bonney, “ESG isn’t something you do. It’s everything you do and how you do it. Businesses not taking ESG seriously will lose customers, employees and financing.”
In a LinkedIn poll recently conducted by KPMG, 54 percent of respondents said ESG is now involved in every or most strategic deal making decision, with only 18 percent saying ESG wasn’t part of their key criteria.
So what’s driving the rise in ESG and what does it mean for corporate strategies?
ESG in deal making
For some organisations, ESG is an essential part of their vision and fiduciary duties. For others it is about returns, risk mitigation, or a framework to build public image and long-term value to the firm and society.
Undoubtedly, a strong ESG proposition can help create value and drive deal activity – and this will only increase in the coming years. Many of the world’s largest companies already include sustainability data in their annual reports.
Greg Jackson is the CEO and founder of Octopus Energy, a sustainable green energy supplier. He says the company made a strategic decision to build ESG into the business from the very outset. While the energy industry itself may struggle with its public perception, Octopus’s approach has opened a much wider pool of potential talent to recruit from. At the same time, its ethos plays well with increasingly ESG-aware consumers.
ESG factors have also been – and continue to be – a key consideration in Octopus’s investment decisions. The business has walked away from potential acquisitions because, beneath a veneer of ESG, the under-lying ethos and culture did not fit. It has also turned down significant third-party investment for the same reason.
“They weren’t committed to the vision of the world we have. ‘Vision collision’ is one of the key reasons that acquisitions fail, and when we spot it, we run a mile. I don’t think you can really compromise on that,” says Greg.
More than lip service
To bring real value to a deal, ESG needs to be incorporated into the DNA of the business. Although precisely what it means will vary, it’s up to every business to think about what it means for them, and then act on it.
“ESG is used as a lens to create additional business value. It helps to strengthen the proposition, improve governance, and drive down costs, as well as having a positive impact on society and the environment,” says James Holley, Head of ESG at Bridgepoint.
Bridgepoint has a firm-wide responsible investment policy and an ESG framework it applies to all its investments. This sets out minimum standards that companies are expected to follow and is an integral part of both the due diligence process and post-acquisition stewardship.
Deal teams are responsible for integrating ESG into the investment process and that includes making sure the appropriate analysis is done to focus on what’s materially relevant to the business.
One of the challenges in ESG due diligence is the broad scope it can cover and, as a result, the spread of expertise and the time required to undertake it. Multiple specialist consultancies may be required to report on different aspects of ESG, each producing its own, often very technical report.
“Bringing all that together promptly to make sure you cover the right issues and ask the right questions during the deal can be tricky,” says James.
ESG adding value to financing opportunities
Recent investments trends suggest there is a growing appetite for transactions with a strong ESG element. There was a record level of ESG financing in 2020 and it is expected to increase further in 2021
KPMG Debt Advisory regularly evaluates and enhances potential ESG financing options, identifying possible lenders and preparing companies for market. So how is the rise of ESG reflected in terms of financing opportunities?
The term ‘ESG financing’ actually covers a wide range of opportunities. It used to be the preserve of investment-grade corporate borrowers only, but is now accessible to a much wider range of borrowers, such as larger mid-market corporates and PE-backed businesses.
Borrowers are increasingly making commitments around social and governance issues in their loan agreements to take advantage of these opportunities, such as having a more diverse board in ‘X’ number of years, or helping vulnerable tenants into employment.
ESG factors are also important for unlocking capital and debt capital. Some banks are reportedly even prioritising ESG considerations above EBITDA, P&L and performance when reviewing credit submissions. There are debt pricing benefits, too. Although marginal currently, in terms of accessing capital and aligning the corporate ESG strategy with the financing strategy, the opportunity is only going to grow.
Optimising ESG implementation
The ability to leverage ESG to capitalise on financing or transaction opportunities, however, relies on robust, transparent data and metrics. This point was picked up by Kate Bowyer, CFO at The Crown Office Estate, which among other things manages a £14 billion investment portfolio, largely focused on commercial property, and the UK seabed.
While ESG disclosures may be strong and stimulate discussion around the transaction table, they have tended to stay in the reporting space, says Kate. If ESG is really going to make a tangible, long term difference in the areas it seeks to address, those data and metrics needs to be much more visible and embedded into the rest of the business.
“If we really want to move the dial on ESG activity, you need a clear line of sight through your strategy, your targets, your decision-making on the ground and all the outcomes that flow from that,” she says.
The Crown Estate recently published its commitment to achieving net zero by 2030. In drawing up this strategy, the organisation has been developing a value creation tool that considers ESG factors when evaluating potential investments.
It also uses its influence to encourage its tenants and supply chain to embrace ESG within their own businesses. It does this through formalised development sustainability principles covering design, construction and ongoing operation.
“These principles are a way of encouraging our supply chain to step up to the challenge and deliver something differently for us,” says Kate.
In terms of how ESG impacts valuation, perceptions are changing. Organisations are recognising the value that ESG can add – or lose. It is being seen as a strategic risk issue, rather than just a CSR or disclosure issue. A development that has been given further impetus by the pandemic, which is often seen as a possible precursor of the climate crisis.
Says James, “It’s vital that companies embrace this. Not in silos, but by opening it out to their organisation and working with departments to understand what’s relevant, then using those insights to build out a meaningful ESG programme.”
The need for a holistic ESG approach in deal making:
Going forward, it’s vital that organisations recognise how ESG factors could affect their businesses and build it into their scenario modelling and long-term planning. This could include running ‘what if’ scenarios, not as forecasts, but to understand the potential impact of ESG. Climate change, after all, is expected to lead to the biggest economic transformation since the industrial revolution. Very few businesses will be unaffected, and this should be reflected in their models and their valuations.
As stakeholders, including investors, employees, customers, new talent and regulators, pay an increasing level of attention to ESG in the coming months and years, there is an opportunity to use it as a catalyst to drive value creation. If the opportunity is missed, however, the pressure on value will be heading in the opposite direction.