Understanding a company’s current or potential future success has historically been determined using a combination of financial and non-financial key performance indicators (KPIs). Financial KPIs include things like cash flow, while non-financial KPIs focus on the drivers behind these that cannot be expressed in monetary units, such as customer relationships. These non-financial KPIs commonly provide context to interpret the financial KPIs and highlight risks and opportunities to the business over time.
In recent years, investors and managers are placing more importance on environmental, social, and governance (ESG) indicators. An increasing amount of data shows strong ESG principles can create long-term value. A review of 2000+ studies by McKinsey found that 63% of the studies determined a positive impact of ESG initiatives on equity returns (only 8% recorded a negative impact). A survey by Ernst & Young of 320 institutional investors found that 92% believed ESG issues have a quantifiable impact on company success and 68% said a company’s non-financial performance had played a pivotal role in their investment decisions within the last year.
Why is this important?
As customers, employees, investors, and regulators are growing more aware of ESG issues, companies with robust ESG management practices will be better positioned for long-term success. Having a strong ESG proposition promotes business model resilience and company longevity through revenue growth, cost reduction and risk management, and improved access to capital.
Environmental and social factors will be an increasingly important driver of long-term revenue growth as customers increasingly engage on climate change and civil rights issues. Failure to address ESG practices can even jeopardize revenues. For example, Facebook’s unwillingness to tackle content and moderation issues has resulted in the loss of advertising revenue from some major brands.
This is not limited to consumer brands though. Public institutions are more likely to award contracts to actors they trust can not only execute the mandate but also address issues around disruption of supply chain, human rights violations, etc. Being ahead of the curve on regulatory and legal change allows companies greater freedom to operate and to benefit from public incentives.
Cost Reduction and Risk Management
Non-financial KPIs can also reveal opportunities to help reduce overall costs by streamlining operations, reducing energy and water consumption, and improving resource efficiency.
Being engaged and delivering on ESG promises can also boost employee motivation and help attract quality talent. This leads to increased productivity beyond the increased cost associated with these types of initiatives.
Finally, unsatisfactory ESG policies carry long-term reputational and regulatory risk in the form of fines, penalties, or high legal costs.
Improved Access to Capital
Investors have long been aware that strong governance reduces the risk of material negative events. Environmental and social factors are now emerging as drivers of long-term value as they provide a deeper understanding of asset allocation and investment decisions. It allows companies to avoid investments into assets and technologies that have a high risk of becoming stranded in the future.
A socially and environmentally aware public image can attract additional investors and secure access to future capital. The EY survey found that 96% of respondents have turned down an investment due to a company’s poor governance and 86% due to poor environmental performance. Investor initiatives like the Climate Action 100+ also indicate that this will continue to affect companies’ ability to raise capital.
If ESG performance criteria are so important, why aren’t all companies already doing this?
Well, some hurdles still exist for wider adoption.
ESG implementation can be challenging. Smaller companies might struggle to shoulder the burden to identify, monitor and report on ESG KPIs. Larger corporations require steadfast leaders who can convince their stakeholders to end “business as usual” and align with ESG best practices.
Furthermore, there are limits to ESG reporting. A study by Russell Investments found that less than 25% of sustainability criteria of ESG frameworks were material for many companies in its LargeCap universe. They showed that materiality indeed creates better performance but investments in immaterial ESG issues had no or negative impacts.
Even material ESG factors can give a misleading conclusion, depending on methodology. For example, while Walmart reports a sizeable volume of fossil fuels used, to account for their logistical activities, Amazon does not include it as they outsource their delivery activities to third parties.
Consistent and holistic reporting guidelines, tailored to the stage of the company, will stimulate further adoption, and show the true impact of companies’ activities and their value chains.
This article originally appeared on the SANZARU Group‘s blog on 07-Jul-2020.
- “To Investors, Nonfinancial Performance Reveals True Value of Business.” Sustainable Brands, 5 Apr. 2017, https://sustainablebrands.com/read/stakeholder-trends-and-insights/to-investors-nonfinancial-performance-reveals-true-value-of-business.
- Henisz, Witold, et al. McKinsey & Company, 2019, Five Ways That ESG Creates Value, www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/five-ways-that-esg-creates-value.
- Maretich, Marta. “The Top Three Non-Financial Reasons Why Investors Say No to Deals.” Maximpact Blog, http://maximpactblog.com/the-top-three-non-financial-reasons-why-investors-say-no-to-deals/.
- Ernst & Young. “Tomorrow’s Investment Rules 2.0.” 2015.
- Porter, Michael E., et al. “Where ESG Fails.” Institutional Investor, 20 Nov 2019, www.institutionalinvestor.com/article/b1hm5ghqtxj9s7/Where-ESG-Fails?mc_cid=a3447b9652&mc_eid=97cfe07510&_hsenc=p2ANqtz-9LWVl7zB6WPRhNjILAabar5FeCyspwqZ4Neyla-8bXjS5zKvsVu6NaI21syF_oHI2deq8IY_CSmuN8RyUIq4mTe7M9Eg&_hsmi=78724647.
- Leconte, Pierre. “15 Examples of Non-Financial Performance Measures to Track.” ClearPoint Strategy, 14 Apr 2020, www.clearpointstrategy.com/nonfinancial-performance-measures/.
- Nelson, Mathew. “The Importance of Nonfinancial Performance to Investors.” Harvard Law School Forum on Corporate Governance, Ernst and Young, 25 Apr 2017, https://corpgov.law.harvard.edu/2017/04/25/the-importance-of-nonfinancial-performance-to-investors/.
- Steinbarth, Emily and Bennett, Scott. Russell Investments, “Materiality Matters: Targeting the ESG Issues that Impact Performance.” Harvard Law School Forum on Corporate Governance, 10 May 2018, https://corpgov.law.harvard.edu/2018/05/10/materiality-matters-targeting-the-esg-issues-that-impact-performance/.