Environmental, social and governance (ESG) aspects have change into central principles within the capital allocation process, each for providers of capital (investors) and users of capital (firms). While the primary rounds of ESG investments received largely uncritical praise from shareholders and stakeholders, most organizations fail to obviously articulate the worth proposition of ESG investments and assess whether and the way such investments have created value.
These deficiencies are exacerbated by the prevailing view that ESG considerations will not be financial in nature and that such a goal cannot subsequently be achieved or mustn’t even be attempted.
However, this view ignores the proven fact that ESG shouldn’t be non-financial information, but pre-financial information.
ESG stands for aspects that assess an organization’s long-term financial resilience. Given the character of ESG investing, the evaluation must temporarily disregard typical return metrics resembling EBITDA, earnings and money flows and as a substitute focus first on how ESG impacts value creation. This is essential to creating the critical connection between investing in ESG and returns.
In the short term, an emphasis on value creation would bring much-needed financial discipline to ESG investing and increase the informational value of sustainability reporting and disclosures. In the long run, such a spotlight may also help speed up the transition of ESG from a market-driven phenomenon to a standardized, principles-based framework.
The connection between ESG and intangible value creation
As the worldwide economy evolves into an economy driven by intangible assets, it’s becoming clear that “profits” will not be enough to capture value creation through investment. Authors Baruch Lev and Feng Gu examine the predictive power of reported earnings and book value for market value between 1950 and 2013. They find that the R2 fell from about 90% to 50% during this time. Recent evidence suggests that the worldwide pandemic has accelerated this trend.
Since ESG represents an try and close this value creation gap in financial reporting, it is not any surprise that as value creation increasingly shifts towards intangible assets, the rise and acceptance of ESG also continues.
To assess ESG value creation, we must first accept that there is no such thing as a one-size-fits-all approach to ESG. The value creation opportunities for ESG investing depend largely on the industry wherein an organization operates. To generate economic value from ESG investments or every other investment, an organization must generate returns in excess of those required for the physical assets and financial capital employed. ESG value creation opportunities are higher for firms with a differentiated, value-creating and high-margin business model than for firms with a standardized, physical assets-intensive and low-margin business model.
Against this backdrop, it is obvious that ESG value creation manifests itself within the creation and preservation of intangible assets. But which of the E, S and G values generate which intangible assets? Answering this query is essential for firms to formulate the worth contribution of ESG investments. The following figure provides a framework for answering this query by examining specific groups of intangible assets, including brands, human capital, customer franchises and technology. It examines the life cycle of value creation in three separate phases:
- Direct assets: The intangible assets directly affected by the E, S or G investment.
- Indirect assets: Those intangible assets that profit from the rise in value of the direct intangible assets targeted by the E, S or G investment.
- Scalable value creation: The final stage of the lifecycle is the popularity that the worth creation of intangible assets through ESG investments is scalable resulting from the linkage with other intangible assets. Such characteristics are the explanation why the worth created by ESG investments could have little correlation with the investment amount.
Because the worth drivers of intangible assets are well documented and understood, and we now have a greater understanding of how E, S and G investments result in intangible value creation, we will discover certain characteristics to evaluate the expected relative value creation of ESG investments across firms. Here are six such characteristics with transient descriptions:
- Trust within the brand/brand strength: The more an organization trusts its brand and repute, the upper the expected return from ESG investments.
- Dependence on human capital: The more an organization relies on human capital, the upper the expected return on ESG investments.
- Value-creating business model: The higher the corporate valuation premium over tangible assets and capital or the flexibility to generate an organization valuation premium, the upper the expected return from ESG investments.
- Type of customer relationships: The stronger the connection to the top customer or the presence with the top customer, the upper the expected return on ESG investments.
- Tangible asset intensity: The more a business model relies on physical assets, the less potential value may be created through ESG investments.
- Market-dominant technology: Proprietary technologies can generate consumer demand that’s less elastic to the worth of other intangible assets. Therefore, the more a business model relies on proprietary technologies, the less potential value that may be created through ESG investing.
The following graphic analyzes these six criteria for five firms from different industries. The larger the realm covered, the greater the expected value creation from ESG investments.
While the above criteria are undoubtedly six key criteria for ESG value creation, such a framework is neither limited to only six criteria nor does it require the appliance of those specific criteria.
What’s next for ESG?
In the short term, specializing in creating intangible value can result in greater financial discipline in ESG investing and shape sustainability reporting to transcend limitless lists of statistics and overtly qualitative presentations.
In the long term, a concentrate on intangible value creation can facilitate the transition to a financial reporting system that captures intangible value creation. The important goal of developing a standardized, principles-based framework is to make sure the usefulness and relevance of monetary reports. However, the present accounting framework not only fails to offer relevant information on value creation, it also actively hinders efforts to completely implement value-creating ESG priorities.
A recent article states: “Constrained by accounting: Exploring how current accounting practices constrain the transition to net zero” the authors analyze BP’s commitment to change into carbon neutral by 2050 within the context of ESG and the present accounting model for intangible assets and liabilities. They argue that the present accounting model unduly penalizes and demotivates firms that try and make such investments. Nowhere is that this need expressed more succinctly than within the authors’ evaluation of each technology and brand intangibles, the latter of that are discussed below:
“We assume that while an organization does not control the environment, its employees, or other stakeholders, it controls its relationship with these entities, which is linked to its reputation, by aligning its decisions with social norms. It follows that the definition of an asset should be applied to an entity’s reputation or its social license to operate, resulting in a capitalization and fair valuation of these assets. This treatment balances the requirement to recognize social obligations as liabilities and reduces the punitive treatment of costs associated with compliance with social norms. Such costs could be viewed as an investment in reputation, and the potential benefit to the organization from such an investment would be capitalized.”
These constraints will not be limited to brands and technologies, but additionally apply to human capital. In “Two Sigma Impact: Finding Unused Value in the Workforce” the authors find that current accounting practices result in behavior that limits opportunities for human capital value creation. The authors state:
“Private equity tends to view labor as something to be cut rather than something to invest in. This creates a major blind spot for the industry. What if there was another, more productive way to look at workforce issues?”
These examples underscore the inextricable link between ESG and the efforts of accounting standard-setters to explore ways to systematically address the creation of intangible assets. The limitation of accounting frameworks to systematically address intangible assets shouldn’t be resulting from a failure to acknowledge their importance, but quite resulting from the dearth of a viable framework that’s practical, objective and universally applicable.
By specializing in value creation, the most effective ideas, concepts and frameworks emerging from ESG can feed into the continuing debate on how one can higher communicate value creation through accounting and financial reporting processes. Building on the ESG initiative, investors can pave the method to an answer.
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