This first part of the Champion Paper of the latest Corporate Governance Paper Competition held by The Hong Kong Institute of Chartered Secretaries (the Institute) provides a cost-benefit analysis of environmental, social and governance (ESG) reporting.
Gone are the days when financial results are the only indicator of a company’s value. Advocates believe that ESG reporting benefits the company, stockholders, stakeholders and the community as a whole, as it promotes open communication, facilitates social trust and increases social capital. Moreover, globally and in Hong Kong, ESG disclosure requirements are becoming increasingly stringent. While it is generally accepted that connecting ESG metrics with financial performance produces a more holistic view of a company’s productivity and performance, compiling such a report does not come without a cost. This paper sets out to conduct a cost-benefit analysis of ESG reporting and to shed light on how reporting creates value in the long run.
Does ESG reporting enhance value?
A well-established ESG reporting framework encourages companies to embrace sustainable business practices, which is a key to growth. According to research conducted by Accenture, 80% of surveyed CEOs treat ESG reporting as a means to gain competitive advantage. Moreover, a study conducted by McKinsey in 2019 revealed that 70% of customers are willing to pay an additional 5% for a green product if it performs as well as a non-green alternative. Given that ESG could drive customer preference, it is possible for firms to ‘do well while doing good’. ESG is thus a significant driver for strategic product and business model innovation. ESG initiatives represent opportunities for value creation and profit maximisation, and mandatory reporting incentivises companies to incorporate sustainability into their business strategy.
Additionally, ESG reports provide investors with useful insights. ESG reports outline how the company’s business model is affected by ESG-related issues and how the company is responding to those challenges. Companies with superior ESG reporting are valued positively by the financial market in the following ways. First, eco-efficient firms have been shown to have higher stock market valuations. Second, from a social perspective, employee satisfaction contributes to better stock market performance.
Furthermore, thanks to the growing importance of ESG issues, ESG reports are frequently used by various stakeholders to assess companies’ strengths. Different stakeholders, especially government authorities, prefer to cooperate with companies that demonstrate superior sustainability performance. For instance, the Californian government selected for-profit companies to participate in a massive public-private infrastructure project in Long Beach on the basis of their prior performance in sustainability, believing that companies with better ESG performance also possess greater product and process innovation. By improving the relationship with the government and gaining public confidence, companies with strong ESG performance are more likely to be granted access, approval and licences, which translates to new opportunities for growth.
ESG reporting is also a path to lower costs. The collection and disclosure of data in areas such as emissions and the use of resources are essential for enabling companies to review their efficiency and for developing reduction initiatives accordingly. A study conducted by McKinsey suggests that companies can increase their operating profits by as much as 60% as a result of reducing expenses after integrating ESG initiatives into their businesses. As the reporting process involves careful calculation and data extraction, it helps the reporting company to identify gaps and formulate future strategies to allocate capital more efficiently.
Legal risk mitigation and ESG objectives often go hand in hand. To date, over 35 stock exchanges around the world have issued or committed to issuing ESG reporting guidance for their listed companies. In some jurisdictions, such as Hong Kong, the UK, the European Union, the US and the Mainland, certain companies (usually state-owned or listed corporations) are mandated to provide reports disclosing some ESG matters. As more governments are making ESG disclosure compulsory, non-compliance would effectively bring dire legal, reputational and financial consequences.
Companies can greatly enhance their risk management and control by fulfilling the reporting requirements. The process of reporting acts as a catalyst that prompts companies to access and elevate environmental and social risks that may impact their businesses. By complying with the disclosure rules, companies are better prepared to manage those risks. Recent research also suggests that firms which undertake ESG reporting fare better in terms of mitigating ESG risks and maintaining a positive public perception. It is well recognised that if non-financial risk is not properly managed, it can deteriorate into financial risk. There is an abundance of examples demonstrating how environmental and social risks may affect a company’s financial performance, namely share price and cost of capital.
Share price. To begin with, a lack of sound ESG management may lead to substantial damages and a slump in share price. For instance, British Petroleum (BP) was charged with criminal manslaughter and environmental crimes, and was ordered to pay US$20.8 billion as a result of the 2010 Deepwater Horizon oil spill in the Gulf of Mexico. On top of the hefty fine, the clean-up and compensation cost an additional US$65 billion. BP’s share price fell by 51% on the New York Stock Exchange between 20 April 2010 and 29 June 2010 as the catastrophe unfolded and its long-term share price remained lower than other oil majors in 2010–2015. As stock price represents the investors’ vote of confidence, it is not hard to understand why ESG-related scandals (especially those which warrant scrutiny from legal enforcement) have an adverse effect on stock prices.
Cost of capital. A company’s failure to mitigate ESG risks may also result in a declining cost of capital (CoC). CoC is the cost of the company’s funds and such a metric is used internally to evaluate whether a capital project is worth the expenditure. Depending on the mode of financing used, CoC can include either one or both of (i) cost of debt (CoD) and (ii) cost of equity (CoE). MSCI research suggests that companies with high ESG scores experience lower levels of CoC compared with those scoring poor ESG ratings, in both developed and emerging markets. A joint study conducted by Arabesque Partners and Oxford University reported that 90% (26 out of 29) of empirical studies from 1974 to 2012 show that sound ESG standards lower the CoC.
If a company finances through debt, its credit rating would determine the effective interest rate of any loans borrowed from financial institutions (that is, the CoD). Similarly, an issuer’s creditworthiness plays a key role for investors to assess how much they would demand in exchange for owning a share (that is, the CoE). The credit ratings of a firm can be influenced by a number of macro factors (such as policies, technological advancement, geopolitical disputes) and micro factors (such as corporate governance, compliance, balance sheet figures and reputation).
Mandatory ESG reporting increases the transparency of corporate governance and provides some basis for investors and banks to assess a company’s ESG performance and initiatives. Better ESG disclosure contributes to a reduction in CoE, as it provides a more precise and accurate valuation of the company. In accordance with disclosure theory, a better ESG disclosure practice can significantly reduce the estimation risk in the market and lower the information asymmetries between managers and investors. Research also suggests that the negative relationship between the quality of ESG disclosure and CoC is particularly pronounced for companies in environmentally sensitive industries. As such, firms with decent sustainability standards enjoy significantly lower CoC.
Thanks to the rising awareness of environmental and social issues, ESG reporting contributes significantly to an improvement in a company’s reputation, which may, in turn, lead to greater profitability. In light of a survey published by Ernst & Young and Boston College Centre for Corporate Citizenship in 2013, most of the companies that published ESG reports recognised that those reports helped improve their reputation.
Customer perception. ESG reporting has a significant impact on customer perceptions. A company’s failure to manage ESG risks, for example, may lead to a customer backlash. For instance, customers initiated a boycott campaign and staged several protests against L’Oreal S.A., as the company was considered to be unethical for conducting cosmetic tests using animals.
Partnerships with suppliers and distributors. ESG reporting is also crucial for effective supply chain management, and this in turn has great implications for suppliers. For example, Boohoo, the UK fast-fashion giant, was slammed for paying £3.50 an hour (£5.20 below the minimum wage) and failing to take protective measures against the coronavirus in its Leicester factory in the UK. In response to that, some of the biggest e-commerce retailers, including Amazon, ASOS and Zalando, announced they were dropping the brand. Disassociation with unethical producers and penalising wrongdoers on behalf of the public are good indicators that these online retailers are managing ESG risk and that they hope to introduce transparency into their production systems.
Talent acquisition and retention. Talent acquisition is another significant benefit of ESG reporting. A company’s ESG reputation is an important factor in an employee’s choice of employer. A recent study has shown that a sustainable business model which engages proactively with environmental and societal dimensions taps into the higher sense of purpose that many employees yearn for. As human capital is one of the most important company assets, a good standing would help companies to acquire talent, which in turn translates to better product and service delivery.
Volunteer Canada conducted one of the largest studies to date, in terms of sample size (66,000 employees from over 300 companies), on employee perspectives and company community investment. About half the respondents stated that they would feel proud and valued if their employing company made significant contributions to the community. It can therefore be concluded that reporting on environmental and social aspects fosters a sense of belonging among employees, thereby helping to retain employees.
In another study on the relationship between employee satisfaction and corporate financial performance, Alex Edmans, Professor of Finance, London Business School, observed that companies listed on Fortune’s 100 Best Companies to Work For generated between 2.3% and 3.8% higher stock returns per year than their peers over a 25-year study period. This indicates that workplace satisfaction can create value beyond talent attraction; it can also contribute to higher financial performance. An inferior ESG reputation can compromise productivity with labour actions such as strikes, complaints and disunity between different departments.
In response to the new ESG reporting requirements in Hong Kong (summarised in part two of this paper), issuers should familiarise themselves with all relevant amendments, and start their preparation as early as possible to allow fine-tuning and adjustments. Moreover, to facilitate the integration of ESG issues into key governance processes, the board could establish a new ESG committee or expand the roles of an existing committee. An executive-level ESG working group with authority and expertise would help the company to better assess and manage ESG issues. The board should conduct the materiality assessment systematically and adjust the list of material ESG issues accordingly.
In response to the trend towards greater reporting standardisation, issuers should look for new ways to differentiate their ESG reports. For instance, issuers can devote resources to internally validating the data collected to ensure that data obtained is of high quality. Another major way that an issuer can signal its credibility is through assurance. Third-party assurance increases stakeholders’ perception of the reliability of ESG reporting and is particularly valuable where investors rely on ESG ratings in their decision-making.
Mandatory ESG disclosure represents a pivotal change in the sustainability reporting landscape, with authorities and standard-setters beginning to realise the complex nature of today’s business model and the potential value of non-financial metrics. Introducing stringent reporting requirements has helped Hong Kong Exchanges and Clearing Ltd attract eco-friendly investors and enhance Hong Kong’s competitiveness as a market and as a stock exchange. Issuers should view this as an opportunity to develop innovative approaches to boost performance, expand access to capital, and identify risk and potential ways to reduce costs.
Ngan Sum Long, Bachelor of Business Administration (Law); and Kwong Lok Lam, Bachelor of Laws
The University of Hong Kong
This article is a summary of the 2020 Champion Paper – Does Investment in ESG Values Generate Investment Value? A Cost-Benefit Analysis of ESG Reporting in Hong Kong. More information on the annual Corporate Governance Paper Competition is available on the Studentship section of the Institute’s website: www.hkics.org.hk. Part two of this article will be published in next month’s CSj.