Until now, the conversation about ESG has mainly been around metrics and reporting guidelines. While these are critical issues, the need of the hour is to focus on creating long-term and sustained value for all stakeholders. Big gears are cranking across the globe. Away from the ongoing tensions from the Ukraine-Russia conflict, regulators and investors are striving to better define the environmental, social and governance (ESG) phenomenon and implement matrices to ascertain the role of businesses in a society buffeted by existential challenges – climate change, pandemic, war, and social unrest, to name a few. On the other hand, financiers, especially private equity (PE) professionals, are under pressure from limited-partner investors to incorporate ESG goals into their strategies and businesses. A company’s ESG profile, as per some investors, can make or break a deal.
Recently, the US regulator Securities and Exchange Commission (SEC) announced proposals for climate disclosures that mandate public companies to provide information on climate risks along with plans to address them while detailing their carbon footprint. Last year, the Indian market regulator SEBI revised the ESG reporting standards to develop the Business Responsibility and Sustainability Reporting (BRSR) criteria covering hundreds of matrices, making it mandatory for the top 1,000 listed companies to file BRSR from FY22-23.
The additional reporting burden has left many corporates to the point of exasperation. “To what purpose?” many have asked as they scramble to meet new demands. According to the EY 2022 Global Private Equity Survey, firm-level ESG initiatives are one of the top three priorities listed by PE firms, after talent management and product/strategy expansion. As firms expand their ESG footprint, expectations shift from risk management to value creation for potential investees and portfolio companies.
ESG: Disruption or an opportunity to build greener economies?
As per CDP India’s recent report, the financial impact of climate-related risks to Indian companies (responding to CDP) was INR 3,285 billion, with climate-related opportunities cited at INR 3,000 billion. In 2021, 87% of the responding companies, comprising top-listed firms on the stock exchange, identified the potential of climate-related opportunities to make a substantial financial or strategic impact. Interestingly, the financial services sector has identified around INR 650 billion worth of market opportunity – indicating the demand for transition finance, especially in the power generation and material sectors and the shifting supply of capital for green projects.
Beyond these, business media is awash, with two of the biggest conglomerates announcing US$150 billion in clean energy investment by 2030. Upcoming investments worth over US$150 billion in cutting-edge cleantech will help India achieve its ambitious climate commitments announced by PM Narendra Modi at COP26.
A shift toward value creation
CEOs have realized that focusing merely on profits is no longer enough. There’s a pressing need to consider broader stakeholder considerations around customers, financial growth, and society at large. The companies’ KPIs should capture the value created for stakeholders – including traditional measures like revenue and costs as well as brand value, diversity and inclusion, sustainability, community impact, and other measures. This is not a compliance issue alone.
The renewable energy sector dollar volume in the equity capital markets reached a four-year high of US$14.8 billion globally in 2020, while the sector hit a record 74 transactions, according to Dealogic.
From oil and gas companies reassessing alternative energy investments to auto companies embracing electric vehicles, investors and stakeholders are influencing ESG-related transaction decisions.
Simultaneously, a rise in ESG-focused activist funds is impelling a review of corporate portfolios and SG narratives, calling out “greenwashing” when they see it.
Creating long-term, sustainable value
The question is: how can we turn around a risk mitigation and compliance tool into one that creates long-term and sustained value for stakeholders – companies, investors, employees, and the society at large?
In the initial stages, ESG due diligence will help ascertain where the company lies in its journey. The next step would be to chart a pathway that will help companies progress along the ‘Reactive to Progressive to Mature’ continuum.
There will be winners and losers, and those who manage to navigate will reap rich dividends through the Value Creation Framework. Building capacity along with corrective actions and improvement programs will be key to creating the lasting legacy.
While this can be achieved through investor and stakeholder engagement bringing forth access to capital, it will require developing robust methodologies across each point of the investment lifecycle. Coupling these methodologies with ESG risk due diligence will require strategic adjustments to ESG targets based on market shifts. For companies already part of PE portfolios, operators can mitigate ESG risks or capitalize on value-adding opportunities by assessing assets to identify emission-intensive
opportunities and reducing carbon footprints. Other approaches include training deal teams in ESG skills and investing in ESG initiatives in portfolio companies.
PE and portfolio company management teams may also consider asking: What ESG metrics are best suited to measure a company’s success? What should be the reporting requirements? Who will implement and oversee the ESG strategy and policy?
PE can uncover opportunities for value creation as more stakeholders embrace ESG. An ESG strategy must create purpose-driven businesses that can attract a broader base of customers and talent and create value by embedding sustainability.