The Business Case for ESG

Brandon B. Boze is partner at ValueAct Capital; David F. Larcker is James Irvin Miller Professor of Accounting at Stanford Graduate School of Business; and Eva T. Zlotnicka is Vice President at ValueAct Capital. This post is based on a recent paper by Mr. Boze, Professor Larcker, Ms. Zlotnicka, Margarita Krivitski, and Brian Tayan. Related research from the Program on Corporate Governance includes Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here).

We recently published a paper on SSRN, The Business Case for ESG, that examines the potential for corporate managers, boards of directors, and institutional investors around how best to incorporate ESG (environmental, social, governance) factors into strategic and investment decision-making processes. Central to the topic is the premise that both companies and investors have become too short-term oriented in their investment horizon, leading to decisions that increase near-term reported profits at the expense of the long-term sustainability of those profits. The costs of those decisions are assumed to manifest themselves as externalities, borne by members of the workforce or society at large.

Prominent investors such as Larry Fink at BlackRock adopt this viewpoint:

To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate. Without a sense of purpose, no company, either public or private, can achieve its full potential. It will ultimately lose the license to operate from key stakeholders. It will succumb to short-term pressures to distribute earnings, and, in the process, sacrifice investments in employee development, innovation, and capital expenditures that are necessary for long-term growth.

Similarly, Martin Lipton of law firm Wachtell, Lipton, Rosen & Katz has urged corporate clients to adopt what he calls “The New Paradigm,” a more stakeholder-centric orientation that emphasizes a long-term investment horizon:

In essence, the New Paradigm recalibrates the relationship between public corporations and their major institutional investors and conceives of corporate governance as a collaboration among corporations, shareholders and other stakeholders working together to achieve long-term value and resist short-termism.

Evaluating claims such as these on a national or macro-level would require an accurate measurement of the time horizons of business managers today and the degree to which, if any, they ignore or underestimate long-term environmental or social costs in the pursuit of near-term profits.

Boards can improve their analysis of ESG risks and opportunities at a practical level by considering how long-term investors integrate ESG factors into their decision-making process. To do so, we examine a framework informed by the experience of ValueAct Capital. ValueAct is a long-term investor which aims to work constructively with portfolio company management teams and boards in a variety of ways, including at times having a ValueAct representative serve on the board.

Broad Integration of ESG Factors

In many ways, a focus on the durability of earnings and downside risk inherently incorporates many concepts commonly associated with ESG. To that end, ValueAct has also adopted an approach to evaluate ESG-related factors as part of its decision-making process and has deepened engagement with its portfolio companies around these issues. It does so because analysis of ESG factors can:

  • Provide an effective risk management framework
  • Provide a new lens for strategy development and growth opportunities
  • Address the demands of stakeholders such as customers, employees, and investors

As such, ValueAct generally incorporates ESG factors into its process by identifying relevant stakeholders and factors, isolating and evaluating potential risks, and supporting companies as they invest in their businesses to increase returns.

Identifying Relevant Factors. The first step is to map the ecosystem of stakeholders associated with the company and analyze their interests (i.e., their incentives, values, viewpoints, etc.). These stakeholders typically include customers, suppliers, employees, regulators, the general public (including environmental impact), shareholders, and competitors. Once this ecosystem is mapped, it is easier to understand which ESG factors are most relevant to a particular company. Certain factors such as governance and human capital might be applicable broadly, while others such as environmental footprint might be more limited.

As an example of this process, ValueAct created an ecosystem map as part of its diligence of the private student loan industry, including the leading provider Sallie Mae. The map identifies students and their parents, colleges and their financial aid officers, government regulators, U.S. taxpayers, and shareholders as key stakeholders and summarizes the goals of each.

Isolating and Evaluating Potential Risks. Once the relevant factors have been identified, one can evaluate and quantify (to the extent possible) the company’s position and associated risk in each area. The active engagement of an investor with a significant stake and long-term perspective can elevate a company’s discussion of risk at the C-suite and board level, encourage corporate investment to mitigate risk if needed (even at the expense of near-term profit), and provide support for the management team as it justifies its decisions to the broader investment community.

In the example of the student loan industry above, the federal government is an important focal point given its dual role as lender and policy maker.  This suggests several questions:

  • Can private student loans provide better value to students than federal programs?
  • How might policy changes impact the competitive dynamic between private and federal programs?
  • What impact do various sources of student loans have on both school and student outcomes?

In attempting to answer these questions from an investor’s perspective, ValueAct was better able to evaluate how private student loan providers could play a positive role in any higher education policy focused on access, quality and affordability, and therefore serve as an important part of the long-term solution to fund higher education.

Investing to Increase Returns. Beyond risk reduction, ESG factor analysis can lead to the identification of investments or activities by the company that increase long-term returns. For example, a company’s investment in a more sustainable supply chain can deepen relationships with customers (thereby promoting volume growth and premium pricing), attract talent to the organization, and perhaps reduce costs. In the private student loan ecosystem, investments behind improving student outcomes can significantly reduce default risk while also improving the brand in the eyes of customers, employees and regulators. These positive effects can build on one another and create a powerful flywheel effect.  To identify and capitalize on opportunities such as these, senior business leadership must consider material ESG factors as core inputs into their strategy development.

Beyond ESG: Investing Behind Business Models and Transitions Integral to Solving Global Problems

Integration of ESG-related factors is broadly applicable across all companies. In ValueAct’s experience, there is also an opportunity for institutional investors to identify and invest behind companies where sustainability is at the center of the investment thesis, or whose business models are core to the ultimate solution for specific environmental and social problems (increasingly referred to as “impact investing”). These global problems can include carbon emissions, waste recovery, access to education, affordability of healthcare, and biodiversity loss, to name a few.

Below we explore two of those problems—carbon emissions and access to education—and provide an example of companies that are transitioning their business models to address these problems.

Carbon Emissions

Electricity production accounts for over a quarter (27.5 percent) of greenhouse gas emissions in the U.S. Approximately 64 percent of electricity production comes from fossil fuels such as coal and natural gas, 19 percent from nuclear and 17 percent from renewables such as wind and solar. Renewables have steadily gained share as they have become more cost competitive with fossil fuels in certain geographies. Increased investment can accelerate this transition and pull forward the benefits from a climate change perspective.

Global power company AES has a 38-year history of owning and operating contracted generating capacity to utilities around the world. By early 2018, AES was addressing the environmental cost of its reliance on coal as an energy source and was in the process of repositioning its portfolio to renewable sources. The company subsequently made a series of changes to accelerate the transition of its business model. In early 2018, AES announced a broad reorganization, including asset divestitures primarily related to coal plants. The company also committed to a target of decreasing reliance on coal from 41 percent of supply in 2015 to 29 percent by 2020. It publicly set a carbon intensity reduction target of 70 percent by 2030. Through joint ventures with Siemens and others, it built capacity for energy storage and development of renewables. In November 2018, the company voluntarily released a Climate Scenario Report, claiming to be the first U.S. publicly listed energy-related business to do so in accordance with guidelines set by the Task Force for Climate-related Financial Disclosures (TCFD). The company also modified its mission statement to emphasize its commitment to transformation to: “Improve lives by accelerating a safer and greener energy future.”

These actions appear to have had a number of ripple effects. According to AES, the updated mission statement galvanized the company’s culture, helping it to attract talent, increase workforce productivity, and further innovation. The company also received recognition from external parties for its reporting efforts. Shareholders who had pressured the company to conduct a climate-change risk assessment voluntarily withdrew their proxy resolution, and according to AES, some foreign and domestic investors, who previously would not invest in AES because of its exposure to coal, made new investments. During this time of investment in a less carbon intensive business, the company’s price-to-earnings (P/E) multiple expanded from approximately 9x in January 2018 to 14x by March 2019 and its stock price outpaced industry indexes (see Exhibit 2).

Access to Education

Higher education is a critical determinant of future wages, with college graduates earnings approximately 80 percent more per year than those with only a high school degree. The cost of college education, however, has been rising significantly for many years, and student loans become the fastest growing category of consumer debt, rising to $1.6 trillion by the end of 2018. Addressing the problems of access and affordability while maintaining quality offers substantial potential benefits for U.S. citizens and the economy.

The for-profit education industry has long had the potential to provide this solution by offering a less expensive educational experience focused on occupational training. By and large, however, the industry had not achieved this objective. By the early 2010s, poor student outcomes and high student loan default rates led to regulatory scrutiny. The federal government began to enforce punitive performance requirements and cut off funding to those institutions whose graduates could not find well-paying jobs. These actions led to the collapse of several companies in the industry, such as ITT Educational and Corinthian Colleges. Meanwhile, the survivors experienced precipitous declines in revenue and profits. In the case of Strategic Education (formerly Strayer Education), one of the largest for-profit education companies in the United States whose history dates back to 1892, operating margins, which exceeded 35 percent prior to the change, fell into the teens. The company’s stock price declined from a high of $254.50 In April 2010 to a low of $34 per share in December 2013 (see Exhibit 3).

Since mid-2015, Strategic Education made a series of changes to reposition itself for durable growth, based on a business model that contributes to positive societal change. The company reduced tuition rates to increase affordability. It made investment in machine learning and artificial intelligence to lower its costs and improve student outcomes, passing on the savings as lower tuition. It also increased its efforts to measure student outcomes and take the learnings to foster continuous innovation in the education experience. Recently, it merged with Capella University—an online graduate school education company—to build scale and further its competency-based learning. Strategic Education has also expanded non-degree educational offerings for employed workforce members, with corporate partnerships representing approximately a quarter of enrollment and growing.

Subsequently, student experience and retention improved, leading to higher unit economics. Operating margins and profits increased. In 2018 alone, enrollment at Strayer University increased by 8 percent to nearly 48,000 students while the continuation rate and number of students completing the requirements for graduation also rose. Importantly, the company has positioned itself as a contributor to positive social outcomes by improving education and training for students and adults at lower cost.

Concluding Remarks

The examples of AES and Strategic Education illustrate how some companies can benefit from a foundational shift in their business model to explicitly address stakeholder concerns, leading to more sustainable long-term economics. In some cases, it requires that management and the board be amenable to collaborating with stakeholders to determine how to achieve those changes or with a significant shareholder to champion this decision among the broader shareholder base. Ultimately, certain incumbents whose industry faces significant environmental or social challenges can create value and generate returns by more centrally focusing on addressing those challenges.

Why This Matters

  1. The examples included in this Closer Look involve companies that appear to have a long-term investment horizon and are willing to bear the cost of an up-front investment in order to increase long-term value. How prevalent are companies with a long-term perspective? How many companies miss long-term opportunities because they are excessively focused on short-term profits? What does this say about the quality of corporate governance and board oversight in companies today?
  2. This paper offers two case studies of companies transitioning “beyond ESG” to solve global problems. Both are traditional businesses whose executives and board members recast their business models to try to solve environmental and/or social problems and improve long-term profit opportunities. Just how widespread are such opportunities? Can every company achieve such a transition and do so profitably?
  3. The approach described in this Closer Look suggests that opportunities exist for investors to earn competitive risk-adjusted returns with a favorable ESG focus. How large is this opportunity? How does this compare to the total universe of publicly traded companies?

The complete paper is available here.

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