Today's post is by Nene Glenn Gianfala, CPA/ABV/CEIV/ASA-BV/IA, a Vice President of the Valuation Advisory group at Chaffe & Associates, Inc. She has over 15 years of experience in business and intangible asset valuations. Nene provides valuation services to public and private companies for estate, gift and income tax planning, financial reporting, corporate planning, employee stock ownership plans and litigation.
Environmental, social, and governance (ESG) factors are becoming more important to corporations, their owners and other stakeholders. ESG factors are non-financial metrics that investors use to analyse a company’s sustainability.
But what exactly is ESG?
Environmental: climate change, resource depletion, pollution, energy efficiency, deforestation, waste management, and water scarcity
Social: customer satisfaction, data protection, privacy, diversity, community relations, human rights, and labor standards
Governance: board composition, executive compensation, lobbying, political contributions, whistleblower schemes, and donations
Background of ESG
“Supporters argue that prioritising ESG leads to sustainability. Sustainability is “meeting the needs of the present without compromising the ability of future generations to meet their own needs.”(1) As a call for action for sustainability, the UN published the 17 Sustainable Development Goals to promote prosperity while protecting the planet. Corporate sustainability reports often cite the 17 goals outlined below..”
1. Source: https://www.urbanistes.info/sdgs-17-goals-to-transform-our-world/
ESG standards are being promoted by numerous stakeholders, including:
- Investors who want transparency
- Regulators that are pursuing transparent, comparable disclosures
- Corporations that want accountability from peers
- Consultants that are seeking to expand the scope of services they provide to clients
The UK has been a leader in ESG beginning in 2019 with a law targeting net zero greenhouse gas (GHG) emissions by 2050. This target led to an expansion of reporting requirements by the Financial Conduct Authority (FCA), including sustainability metrics. For UK companies, the Sustainability Disclosure Requirements (SDR) will provide a framework including metrics/targets; mandatory disclosure is expected by 2025.
In the European Union (EU), ESG reporting is mandatory for large companies. Like the UK, the EU has targeted 2050 for carbon neutrality. Last year, the European Council approved the Corporate Sustainability Reporting Directive (CSRD), which broadens the scope of ESG factors that must be disclosed. Like the new requirements in the UK, these new strict standards are being enforced to help avoid greenwashing, the exaggeration of a company’s environmental impact.
The International Sustainability Standards Board (ISSB), which is responsible for developing the International Financial Reporting Standards (IFRS) sustainability disclosure standards, went further with disclosures, requiring additional information on capital deployment toward climate -related risks, internal carbon pricing, and remuneration for executive management based on climate-related considerations.
Increased pressure from stakeholders led the United States Securities and Exchange Commission (SEC) to also propose climate disclosure rules in 2022. The proposed rules were more than 500 pages. The SEC received thousands of comments on the proposed rules, and the final rules are scheduled to be released by the SEC in the 2nd quarter of 2023. The proposed rules are divided into three levels:
- The direct impact on climate change
- The indirect impact of operations on the environment
- The indirect impact from customers and supplier activities in the company’s value chain on the environment.
The last level (Scope 3) is only required for the largest companies, and due to the complexity of the calculations, Scope 3 emission reporting has a safe harbour provision. As ESG develops, more SEC disclosure rules are anticipated to cover other ESG factors, such as human capital development and cybersecurity risks.
ESG and Business Valuation
“The qualitative benefits of sustainable investing and ESG practices are understandable, but the problem arises in quantifying the factors and making them comparable across all companies and industries. Due to increased stakeholder demand, some companies have begun to voluntarily disclose ESG information. However, the challenge with existing ESG disclosures is the lack of consistency.”
Private and public companies are already feeling pressure related to ESG practices. Credit markets are correlating low ESG scores with poor creditworthiness. Some global lending authorities, such as the European Banking Authority and the Securities and Exchange Board of India, have issued guidelines that require lenders to assess a borrower’s ESG risks. Companies considered to have a poor ESG score need to be aware that it might impact debt terms, such as a higher interest rate or renewal of their lines of credit
because the lending institution is trying to limit exposure to companies with high ESG risk. A recent white paper by Randy Priem and Andrea Gabellone (2) further analysed the impact of ESG scores on a company’s cost of capital and found that ESG scores impact a company’s cost of debt.
While a poor ESG score could potentially impact debt terms, a high ESG score is expected to increase the value of a business.
According to a report published by McKinsey (3) in November 2019, ESG creates value for companies in five key areas:
- revenue growth
- lower costs
- regulatory and legal intervention
- increased productivity
- optimisation of assets
Another study published by Deloitte (4) in 2022 found that a higher ESG score was associated with a higher EV/EBITDA multiple. However, Deloitte notes the limitations of the study including the fact it was limited to four industries.
Business appraisers must be aware of these issues and incorporate ESG-related risk questions into due diligence procedures. There are several alternatives to factor ESG risks into valuation models, such as: adjusting the cash flows, discount rates, or pricing multiples. Some examples for adjusting cash flows would be to factor in the loss of revenue from poor ESG practices, additional capital expenditures for green upgrades or fines paid for an environmental disaster.
To adjust discount rates, ESG scores may be used to assess risk. However, as mentioned earlier in this report, current ESG disclosures are inconsistent and not comparable across companies or industries, so it is essential for the valuer to understand what is included in the rating. It is also important for the valuator to be careful not to double dip since some industry betas might already factor in some ESG risk. The International Valuations Standards Council (IVSC) and its ESG Working Group are working on a framework for incorporating ESG factors into financial analysis, which is anticipated to be released this year.
In summary, it is important for valuators to stay aware of these new rules and proposed standards as they are released over the next year. Assessing potential new risks related to ESG factors need s to be explicitly incorporated in the due diligence process. ESG factors may impact a company’s cost of capital, whether from greater lending risks or higher required rates of return on equity due to a Company’s sustainability practices.
2. Priem, Randy and Gabellone, Andrea (2022). The impact of a firm’s ESG score on its cost of capital: can a high ESG score serve as a substitute for a weaker legal environment? [White Paper] United Business Institute. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4286057
3. Henisz, Witold; Koller, Tim; and Nuttall, Robin. (2019, November) Five ways that ESG creates value. McKinsey Quarterly, 55(4). https://www.mckinsey.com/~/media/McKinsey/Business%20Functions/Strategy%20and%20Corporate%20Finance /Our%20Insights/Five%20ways%20that%20ESG%20creates%20value/Five-ways-that-ESG-creates-value.ashx
4 Deloitte. (2022). Does a company’s ESG score have a measurable impact on its market value? https://www2.deloitte.com/ch/en/pages/financial-advisory/articles/does-a-company-ESG-score-have-a- measurable-impact-on-its-market-value.html