There has been a fundamental realignment in the relationship between business and sustainability over the last few years. A clear consensus has emerged among both investors and the wider business community that more disclosure is required. That was clear in ERM’s recent survey of 60 companies which found that 72 percent of chief financial officers and chief sustainability officers believe investors are placing companies under more ESG scrutiny.
The business and investment community seem agreed that measurement matters – not just from an internal perspective (a company’s impact on the environment) but also externally (the impact of the sustainability and ESG agenda on the company itself). This has pushed the debate to a whole new level. Less a question of whether to measure ESG, than what gets valued – and that’s where the conversation gets really stimulating.
For a start there appears to be a lack of common language between investors and companies (or even between a CFO and a sustainability head) as to how the ESG factors affect a company’s revenues, growth prospects, margins, risk profile and brand.
In terms of “what gets valued”, there appears to be, at times, limited reliance placed by investors on ESG-related disclosures made by companies themselves. This then questions whether such disclosures have fed into investment decision-making processes. And while issuing sustainability or ESG reports is becoming standard, it’s not clear whether these disclosures preserve value.
For example, companies that have had the biggest ESG incidents or challenges in recent times have all had fairly extensive disclosures but in many of these cases, the material ESG issues were not covered (let alone measured) in the reports. That’s a crucial failing. The Harvard Business School has looked into sustainability and financial performance and concluded that the focus should be on the material ESG issues – those that are strategically important for their business and do most to improve the bottom line. It is the progress on these material issues – and measuring the progress in a credible way and comparable manner – that will be valued by the investment community.
So what implications does this have for the private equity sector?
There is definitely a sense that the ESG agenda provides a useful lens through which the PE sector can communicate with its stakeholders. It demonstrates their impact from investing in growing responsible, sustainable, well-run and high-performing businesses which create jobs and provide goods and services while minimising adverse impacts and maximising opportunities.
This comes at a time when limited partners are increasingly focusing not just on generating expected returns from their investments but also capturing the benefits to society. LPs are therefore increasingly seeking input from general partners on how ESG aspects are being monitored and managed to both protect and improve performance and enhance the value of underlying investments.
ERM is supporting the UN-backed Principles for Responsible Investment with the development of guidelines for monitoring and reporting of ESG by LPs and GPs, which will be published in 2018. Both LPs and GPs say that ESG reporting builds a stronger relationship between firms, as well as providing a ‘proxy for good management’ and an opportunity to bolster reputation.
GPs say monitoring material ESG risks can shed light on where the opportunities lie within the portfolio. The reporting of ESG data and case studies to investors also helps reinforce a firm’s credentials, especially during fundraising where ESG can be a differentiator. However, there is also recognition that for these efforts to deliver value to stakeholders, they need to focus on the material aspects that LPs use to make investment decisions and recognise that reporting approaches may need to be tailored depending on the needs and characteristics of investors and GPs.
Beyond the immediate LP/GP relationship and the clear business case ‘pull’ for robust ESG disclosure, private equity firms are also feeling the ‘push’ for disclosure from ever-increasing legal and quasi-legal developments (so-called ‘hard’ and ‘soft’ law). Two areas where ERM sees this resulting in commercial consequences for PE are supply chain and climate change-related risk.
Supply chain transparency
Human rights and supply chain issues are applicable to almost all sectors and geographies that PE funds invest in both in terms of risk and opportunity. The difference may lie more in what type of issue affects each portfolio company. For a B2B electronics supplier in the tech or auto supply chain, it may be lack of due diligence on so-called “conflict minerals” – minerals that are extracted in a conflict zone and sold to perpetuate fighting. For apparel firms it may be working conditions in overseas factories. The range of issues and the reach of regulation appears to be growing, increasing the need for disclosure and making this an area of increased interest to private equity firms.
The leading PE funds are using these voluntary and mandatory disclosure expectations as an opportunity to engage with their portfolio companies to enhance their current human rights and supply chain management framework and to be transparent about their approach, status and priorities going forward.
Climate-related financial risk has received more attention from the financial sector since the Paris climate agreement in 2015. This has been driven by recognition that two climate-based dynamics will impact corporate earnings. Firstly there is the potentially disruptive impact of regulatory changes and new technologies as the world transitions to a low carbon economy. Secondly there are the changes in weather patterns and increased frequency of extreme climate events and the implications that these have for operations, the lifespan of assets and supply chains.
The growing interest in climate-related financial risk led the Financial Stability Board chaired by Bank of England Governor Mark Carney to establish the Task Force on Climate Related Disclosures (TCFD). The TCFD published its recommendations in 2017, calling for listed companies to use scenario analysis to assess the implications that climate change has for their business and to integrate this into their commercial strategy. The panel calls on companies to disclose the financial consequences in their annual filings.
ERM has authored a ‘how to’ TCFD guide called The Technical Supplement on Scenario Analysis which explains how the type of scenario analysis advocated by the taskforce can be used to enable companies to address uncertainties and the likely impact on strategy and financial performance.
More recently, we have seen interest from financial regulators, such as the UK’s Prudential Regulation Authority, starting to probe some segments of the financial sector to understand how climate-related financial risk is being governed and integrated into business processes.
From disclosures to actions
Asset owners and listed equity asset managers in particular have become more demanding. Research by Share Action indicated that major asset management firms are becoming more comfortable with expressing, on behalf of clients, their discontent with corporate management about weak disclosures on climate-related risks. A number of institutions including Northern Trust, Morgan Stanley, Deutsche Asset Management, Fidelity, Legal & General Investment Management, Norges, UBS, TIAA, Blackrock, Vanguard, Fidelity Management & Research Co (Fidelity) and Goldman Sachs Asset Management voted for climate-focused shareholder resolutions in 2017, several for the first time.
The trickle down to PE and infrastructure is only just beginning, with the asset owners that originally put pressure on listed equity managers now beginning to ask the same questions of private equity firms, particularly those GPs with an investment focus on sectors and value chains considered to be most vulnerable.
For many PE and infrastructure investors, this is not a new issue. Climate-related financial risk has been considered at the interface between commercial, financial and environmental due diligence for some time. However, vulnerabilities do exist in some portfolios. These are often in businesses which appear to be unaffected by climate change, but which sit in a value chain that is dependent upon carbon emissions or vulnerable to climate change and at risk of disruption, due to a policy or technology change or global warming.
As with other sectors, there will also likely be a call for more disclosure on governance procedures and the underlying risks and opportunities in a portfolio. TCFD considerations have been incorporated in the PRI’s recently published voluntary climate-related indicators within its reporting framework for signatories. PE and infrastructure investors are likely to face increasing questions from asset owners on how they are managing climate-related financial risk and the nature of any exposure they have in their portfolio and the actions they are taking to mitigate them.
However beyond disclosure, the primary focus for PE and infrastructure investors should be to ensure that climate-related financial risk does not present downside impact to their investment returns and, where possible, any upside opportunities are identified and actioned. As listed entities divest themselves of divisions or assets considered vulnerable to climate risk, short-term buying opportunities may emerge, with meaningful value creation opportunities. Likewise, there will in some cases be medium term (or even short term) risks, best understood at the point of investment if exit objectives are to be realised.
Measurement to value
Responsible operation of portfolio companies is fundamental to performance but the impact of the ESG agenda on a portfolio company also has the potential to erode and/or create value.
The key for PE firms is to understand which aspects of the ESG ‘universe’ are salient and material to their returns on investment. Measurement in itself is not a panacea. These issues need to be managed via investment due diligence and active portfolio company engagement so that they become key levers of value protection and value creation at exit. These outcomes can also be captured in a compelling message that meets LPs’ increasing disclosure expectations. Investors need to play their part by focusing their engagement on issues that are material and relevant, asking for the appropriate information and providing feedback where relevant.
Given the ‘private’ nature of the PE industry, being pushed and pulled into making public ESG disclosures may seem countercultural. If companies focus their efforts on improving the management of those material ESG issues that are strategically important to their business, the measurement of such performance improvements will be the outcome of good ESG management rather than a process where the tail is wagging the dog. This in turn can raise the profile of such issues with both internal and external stakeholders, and enable the buy-in from boards to support performance improvement programmes that address ESG issues and deliver monetary and reputational gain for the company and its stakeholders.
This article was sponsored by ERM. It appeared in the Responsible Investment supplement published with the February issue of Private Equity International.