Why you need to price ESG into valuations now and how to get started

September 2021

By Pragya Jain, Ralph Dodd, Robert Behan and Stuart Booth

In order to successfully invest for the future, companies need to fully understand the impact of ESG on the value of their business. Empowered with quantitative information, decision makers can accelerate change and prioritise investment with the confidence they are both leading in their market place and creating sustainable value. While traditional valuation approaches are still valid, they need to be robustly applied to capture how a company is perceived by its employees, regulators, customers and investors and the potential consequences on cash flow.

Increasing focus on ESG and the information gap

From changing consumer attitudes to the transition to net zero, there are a number of significant factors driving the increased focus on ESG and putting it firmly at the centre of the strategic agenda. But our clients tell us that while the importance of taking action on ESG is clear, they lack the information they need to make informed decisions on how. An infrastructure fund recently mentioned to us that they performed a climate risk assessment of their portfolio which was more qualitative than quantitative due to lack of information. While it was a useful exercise for them, it wasn’t robust enough to give them the clarity they needed to invest in the future of the assets now.

This is not just an issue faced in the infrastructure sector. The market focus on ESG may have increased dramatically over the past few months, but the quality of information available to measure both a company’s ESG performance and the impact of its actions has not kept pace and varies considerably across different sectors:

There are no universally accepted ESG ratings against which companies can be benchmarked, with information often volunteered by companies as opposed to audited.
Clearly, the ability to measure environmental factors – the ‘E’ in ESG – is the most developed, which is primarily down to availability of numerical data. For example, it is more difficult to integrate changing workforce requirements (an ‘S’ factor) into cash flow models than future carbon prices, but this doesn’t mean that the value impact is less significant.
Within ‘E’, the best quality information is typically available on carbon emissions. It follows that we are seeing the clearest correlation between ESG performance and share price in carbon intensive industries at the moment, like in the energy sector, where market analysts are increasingly making explicit adjustments to valuation for ESG. There is, however, no consensus on how this adjustment should be made or benchmarked.

Taking a stakeholder perspective to measure value

As a result, when we’ve been discussing the value impact of ESG with clients, we’ve found that to date their approach to its valuation typically falls into three buckets:

a) Market based approach: relying on a quoted company share price to illustrate the impact of ESG actions on value. ESG rating systems are still early stage and share prices are typically too volatile and all-encompassing to draw out the impact of individual ESG issues, making this approach tricky to use in practice;

b) Subjective adjustments: tweaking the discount rate or terminal value assumptions in a discounted cash flow analysis. Better than simply relying on the market evidence in option A, but too subjective for decision makers to rely on - how much do you tweak a discount rate or terminal value by, when there is insufficient market data to tie it to?; or

c) Direct cash-flow adjustments: identify those ESG elements most critical to the company's success and value and financially model these. This approach is the most meaningful, but can be time intensive, particularly with so many potential ESG issues to factor in.

We recommend a more targeted version of option C; exploring what the most material ESG demands of key stakeholders are, then assessing the costs to meet or exceed them and the financial implications of doing so:

Customers
Employees
Regulators and supply chain
Investors

Customers

Cash flow scenarios: find out what ESG issues are most material to your customers (e.g. it may be waste rather than CO2 emissions) and benchmark your performance in these areas against competitors. Then consider price elasticity of different customers to estimate whether this will enhance or destroy brand value through changes in demand or discounted/premium pricing.
Terminal value: what are the long term prospects for customers in your sector - consider whether they will move to greener substitute products or services that emerge, as this will need to be reflected in estimates of market share and size and therefore terminal value beyond the explicit forecast period.

Employees

Cash flow scenarios: find out what ESG issues are most material to your employees, and benchmark performance against competitors. Consider the extent to which this has a meaningful impact on employee retention and talent recruitment, as this will drive cash flow. For example, employee retention may be more relevant for sectors where there are long standing relationships such as in consulting and business services, whereas employee ingenuity and innovation may be more relevant to a technology business.

Regulators and supply chain

Cash flow scenarios: compare forecast emissions against forecast energy prices, capturing expected changes in carbon taxes for example. Whilst scope 3 emissions may not be directly felt by the company, increases in taxes may well flow up through the supply chain to impact cash flow.

Investors

Debt holders (cost of debt): Given the significant demand from investors and lenders for ESG investment opportunities, there may also be a ‘greenium’ to access capital if your company is perceived as working to a more sustainable objective. We’re seeing ESG performance metrics increasingly being linked to the cost of debt through the inclusion of ESG linked debt margin ratchets. Depending on the instrument (i.e. a loan or a bond) the cost of debt may increase or decrease in line with the borrower's performance on pre-agreed ESG targets. Despite these advancements, we rarely see this factored into valuations, so assessing which ESG KPIs lenders are focusing on within your sector and understanding your own performance in these areas could have a significant impact on cost of debt and therefore value.
Equity (cost of equity): Will you attract investors from increasing numbers of green funds or go to the back of the IPO queue behind “greener” listings? Though evidence of this impact is still nascent, we expect this to grow stronger as ESG headwinds build up and more evidence is gathered.

For each of the above, the costs (e.g. investment capex from designing a new product or closing down a factory, cannibalisation of the “old school” product) of meeting or outperforming ESG metrics will need to be factored in to estimate the net impact.

Conclusion

We can’t afford to wait for the ESG information gap to close. Unless we meaningfully and proactively identify the value impact of ESG, we risk depriving decision makers of the very information they need to prioritise investment, accelerate change and deliver truly sustainable value.

For more information or to discuss the points raised in this article please reach out to a member of the team below.