Five ways that ESG creates value

Organisations globally have been allocating an increased amount of resources towards improving Environmental, Social, and Governance (ESG)*, making the case for a strong ESG proposition evermore compelling. However, McKinsey & Company believe that the understanding of why these criteria link to value creation remains less understood. McKinsey’s five points below will help you systematically understand how a strong ESG proposition could make financial sense, should the specific instances arise.

Five ways that ESG creates value

THIS ARTICLE’S KEY TAKEAWAYS:

  • A strong ESG proposition helps companies tap new markets and expand into existing ones.
  • Positive social impact correlates with higher job satisfaction—when companies “give back,” employees react with enthusiasm.
  • Being thoughtful and transparent about ESG risk enhances long-term value—even if doing so can feel uncomfortable and engender some short-term pain.

 

The five ways that ESG can create value for your firm

The linkage from ESG to value creation is solid indeed. Five levers in particular, across the bottom and top lines, can be difference makers. In a world where environmental, social, and governmental concerns are becoming more urgent than ever, leaders should keep those connections in mind.

McKinsey identifies the five key linkages as those listed below, to which we’ve identified the key points of each:

 

1. Top-line growth

A strong ESG proposition helps companies tap new markets and expand into existing ones. When governing authorities trust corporate actors, they are more likely to award them the access, approvals, and licenses that afford fresh opportunities for growth. For example, enhanced ESG implementation has evidently paid off in this manner for firms from all industries. For example, infrastructure and mining firms who had stronger prior performance in sustainability experienced either preference in bidding/selection processes or less extensive planning and operational delays in extracting resources.

ESG can also drive consumer preference. McKinsey research has shown that customers say they are willing to pay to “go green.”… upward of 70 percent of consumers surveyed on purchases in multiple industries, including the automotive, building, electronics, and packaging categories, said they would pay an additional 5 percent for a green product if it met the same performance standards as a nongreen alternative.

 

2. Cost reductions

ESG can also reduce costs substantially. Among other advantages, executing ESG effectively can help combat rising operating expenses (such as raw-material costs and the true cost of water or carbon), which McKinsey research has found can affect operating profits by as much as 60 percent.

As with each of the five links to ESG value creation, the first step to realising value begins with recognising the opportunity. Consider 3M, which has long understood that being proactive about environmental risk can be a source of competitive advantage. The company has saved $2.2 billion since introducing its “pollution prevention pays” (3Ps) program, in 1975, preventing pollution up front by reformulating products, improving manufacturing processes, redesigning equipment, and recycling and reusing waste from production.

FedEx, for its part, decided to convert 20% of its vehicles to electric or hybrid engines, thus becoming more sustainable and saving fuel costs. As of 2020, Fedex has met this 20% goal, which has reduced fuel consumption by more than 50 million gallons.

 

3. Reduced regulatory and legal interventions

A stronger external-value proposition can enable companies to achieve greater strategic freedom, easing regulatory pressure. There have been multiple instances across the world where strength in ESG helps reduce companies’ risk of adverse government action, even at times engendering government support. The value at stake may be higher than you think. McKinsey estimate that approximately one-third of corporate profits are at risk from state intervention.

 

4. Employee productivity uplift

A strong ESG proposition can help companies attract and retain quality employees, enhance employee motivation by instilling a sense of purpose, and increase productivity overall. According to a 2011 study in the Journal of Financial Economics, employee satisfaction is positively correlated with shareholder returns.

Moreover, it’s long been observed that employees with a sense not just of satisfaction but also of connection perform better. The stronger an employee’s perception of impact on the beneficiaries of their work, the greater the employee’s motivation to act in a “prosocial” way.

Just as a sense of higher purpose can inspire employees to perform better, a weaker ESG proposition can drag productivity down.

 

5. Investment and asset optimisation

A strong ESG proposition can enhance investment returns by allocating capital to more promising and more sustainable opportunities (for example, renewables, waste reduction, and scrubbers). It can also help companies avoid stranded investments that may not pay off because of longer-term environmental issues (such as massive write-downs in the value of oil tankers).

While the investments required to update your operations may be substantial, choosing to wait it out can be the most expensive option of all. And bans or limitations on such things as single-use plastics or diesel-fuelled cars in city centres (London, as an example) will introduce new constraints on multiple businesses, many of which could find themselves having to catch up. One way to get ahead of the future curve is to consider repurposing assets right now—for instance, converting failing parking garages into uses with higher demand, such as residences or day-care facilities, a trend we’re beginning to see in reviving cities.

 

To further the points above, the following table contrasts what McKinsey consider to be strong and weak company ESG propositions;

 

Five ways that ESG creates value

 

* ESG Definition

ESG stands for Environmental, Social, and Governance (ESG) and takes a holistic view to sustainability beyond purely just environmental issues. An effective ESG approach links to higher value creation and organisation performance. Understanding how requires an understanding of the individual elements of ESG, which are:

  • “The E in ESG, environmental criteria, includes the energy your company takes in and the waste it discharges, the resources it needs, and the consequences for living beings as a result. Not least, E encompasses carbon emissions and climate change. Every company uses energy and resources; every company affects, and is affected by, the environment.
  • S, social criteria, addresses the relationships your company has and the reputation it fosters with people and institutions in the communities where you do business. S includes labor relations and diversity and inclusion. Every company operates within a broader, diverse society.
  • G, governance, is the internal system of practices, controls, and procedures your company adopts in order to govern itself, make effective decisions, comply with the law, and meet the needs of external stakeholders. Every company, which is itself a legal creation, requires governance.” McKinsey & Company

 

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