Why Environmental, Social, and Governance (ESG) matters when times get tough

It’s hard these days not to consider the possibility of near-term economic downturn. Yes or no? If and when? How long and how deep? There are no sure answers to those key questions at present. This level of uncertainty inevitably leads to conversations about how best to staunch an organization for changing conditions. Those discussions are happening in any institution that manages budgets, including households, businesses, and governments.

Concurrently we are experiencing an explosion of activity in the market related to management and disclosure of Environmental, Social, and Governance (ESG) risk. Much of the ESG momentum focuses on climate related risk and energy dependency, and for good reason. There is an increased sense of urgency driven by stakeholder awareness of the real consequences of climate change and the volatility of the energy economy. Investors are demanding data to understand how climate related risks, a company’s carbon intensity, and/or the transition to a low carbon economy could hinder returns or present opportunities.

Interest is intense enough that three major institutions are separately seeking to finalize updated standards for climate related disclosures, including the International Financial Reporting Standards (IFRS), the U.S. Securities and Exchange Commission (SEC), and the European Financial Reporting Advisory Group (EFRAG). The good news is that, while there are differences, all three efforts are influenced by the Task Force on Climate Related Disclosure (TFCD) and GHG Protocol approaches that provide important commonalities necessary for consensus, compatibility, and decision making.

Its not just Climate Risk

Stakeholders are also applying pressure to companies to disclose how the company’s business activities impact communities and ecosystems and how labor and safety practices impact the workforce in order to reveal risks to the company’s license to operate, access to natural resources, and threats to the stability of the labor force. Further, there is demand for transparency related to how a company is managed, how executives are incentivized, how a company confronts risk, and whether the organization operates legally and complies with regulations. All of these elements matter to investors and other stakeholders because any one of them could potentially impact an organization’s ability to create value and adapt to changing market conditions. The upside is that ESG metrics also represent opportunities for innovation, enhanced competitiveness, supply chain reliability, adaptation, operational efficiency, and cost controls.

Companies are responding, with varying levels of enthusiasm, by investing in identifying risks and exposures related to their environmental liabilities, social impacts, and governance practices. As with any investment, money, mindshare, and time are required inputs in order to benefit from the effort. The investment horizon for ESG projects can be short, medium, or long term. For example, a simple energy efficiency initiative may see return within 12-18 months, but it may take several years to bring an innovative new product to market. Typically, the more complex the risk the longer the investment horizon. Appetites for short term gains are much stronger, but the rewards of long-term investment in ESG performance are often what it takes to effectively transition to a more favorable economy.

ESG investments should always address carefully considered material issues in order to yield meaningful returns. Material issues are those issues reasonably likely to have a significant effect on the operating condition or market valuation of a company. Therefore, well-executed investments in ESG-related material issues should position an organization to better weather tough times. This is critically important to keep in mind in the face of economic uncertainty. Tim Cook, CEO of Apple, has famously said: “We believe in investing during downturns.” That strategy has certainly paid off for Apple investors. ESG is not simply window dressing, or even just the right thing to do. Sustained investment in and focus on ESG material issues could be the difference between thriving or failing in a time of recession.

The Upside

Even in downturns some companies thrive. There are endless examples of innovative companies pivoting to fill unmet market needs, or whose practices avoid supply chain disruption or who are able to reduce costs because their optimized operations minimize reliance on scarce natural resources or third-party energy, or because their investments in people and communities encourage loyalties that pay dividends even in the harshest economic conditions. All of these opportunities can be revealed using well managed ESG metrics.

• During the Great Depression Martin Guitars employed a number of strategies to stay afloat including investing in innovative designs that allowed them to drive demand with revolutionary guitar styles, such as the Dreadnought and the 14-fret neck.
• One of the very first products brought to market by Panasonic founder Konosuke Matsushita was an electric plug that was built using recovered screws from used lightbulbs. This circular approach helped Panasonic survive the devastated Post-WWII Japanese economy. At that time, it was extremely difficult to source raw materials due to scarcity, expense, and restrictions. Many companies failed. But Panasonic’s inherent approach to resource preservation during manufacture and collection of used material for incorporation in new products allowed Panasonic to thrive.
• Another ESG success story is Texas Roadhouse. The hospitality industry was hit hard by the Covid-19  pandemic. In 2020 the late Kent Taylor, CEO of the steakhouse chain, donated his salary and bonus, around $800,000, along with an additional $5 million to an emergency fund the company already had in place to help employees. Mr. Taylor was known to say, “we are a people company that just happens to serve steaks.” Not only did the company survive the downturn but they are thriving in a still difficult environment. First quarter 2022 revenues were about $13 million over analyst projections despite raising prices 3.2%. This success has been attributed to customer loyalty: a direct result of the emphasis on the customer experience delivered by motivated frontline staff. Kent Taylor demonstrated the truth of Larry Fink’s observation that: “Stakeholder capitalism is not about politics. It is not a social or ideological agenda. It is not ‘woke.’ It is capitalism, driven by mutually beneficial relationships between you and the employees, customers, suppliers, and communities your company relies on to prosper. This is the power of capitalism.”

A Business Model for Resilience

ESG seems to stir up controversy in some circles. It has been used lately as a headline grabber with dramatic claims that ESG is at best a distraction and at worst a threat to prosperity. Others may feel that investment in ESG performance is a ‘nice to have.’ But the truth of the matter is that the businesses that are best positioned to weather downturn and build long-term enterprise value have ESG performance woven tightly into their business model. Those organizations have data-driven governance structures that consistently confront risk, reward innovation, ensure compliance, demonstrate accountability, and value transparency. They effectively identify and manage environmental and social risks and capitalize on opportunities. They create metrics to track performance, quantify exposures and measure returns. Companies who meaningfully invest in addressing ESG material issues are simply well-run businesses with vision-based leadership and an appetite for innovation, and they are positioned to thrive in dynamic and challenging conditions.

If you are interested in exploring the opportunities a robust ESG program offers your organization please reach out to Connie Prostko-Bell Director, ESG & Sustainability Practice at Cprostko-bell@all4inc.com  610-422-1110.