Chapter 7: ESG/SDG Initiatives and Business Portfolio Management (Part 2)

ESG/SDG risks in conglomerates

• If ESG/SDG initiatives cannot be overlooked as risks, what risks do conglomerates need to look at in particular? The industry as a whole often discusses environmental risks, such as climate change.
• On the other hand, the real problem for conglomerates is thought to be governance risk. Several studies have been conducted on the factors behind the so-called Conglomerate Discount, in which the value of a company is estimated to fall below the sum of its independent businesses. What is often pointed out is that the management teams of these companies do not understand their own businesses, fail to properly allocate resources, and do not make the right investment decisions. It goes without saying that the complexity involved with governance is also a challenge that factors into the management of such business portfolios.
• For example, it is interesting to see how each of the ESG factors are weighted in the score presented by Morgan Stanley Capital International (MCSI) as a part of its ESG Rating. In calculating this score, the weight of each item is decided by evaluating the materiality of each industry. Figure D shows that the weight given to governance in the Industrials industry, which contains many conglomerates when compared to other industries, accounts for 45.7% of the entire score. If we were to try and narrow our focus to Trading Companies and Distributors, which includes Japanese general trading companies, this would rise to 51.5%, which is more than half of the total score.

Source: Prepared by the Deloitte Tohmatsu Group based on details from MCSI's "ESG Industry Materiality Map" (evaluation from May 22, 2022)

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• Japanese conglomerates tend to be less profitable than their overseas counterparts. This is due to their inability to exercise strong governance over how they manage their business portfolios, particularly when it comes to exit decisions. This is where governance risks come into play for ESG/SDG initiatives. Figure E shows that while many conglomerates are currently rated as above average, few Japanese conglomerates find themselves positioned as leaders of their respective industries, as these companies have plenty of room for improvement. In addition, we can also see that governance-related scandals have played a part in lowering these scores.

Source: Prepared by the Deloitte Tohmatsu Group based on details from MCSI’s "ESG Ratings & Climate Search Tool" (evaluation from May 22, 2022)

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• With management teams needing to evaluate not just profitability, but also sustainability, it is difficult for them to properly understand/evaluate the risks from each of their businesses. What makes this even more troublesome is that while the impact from a risk confined to a small single business is limited, reputational risks will end up impacting the entire company no matter how small the business may be. Therefore, the appropriate number of businesses that a business portfolio should contain is limited by the number of companies in which governance can be sufficiently enforced. Businesses that carry unnecessary risks should be avoided, which in this context, means companies may be forced to make a decision based on their “selection and concentration” strategies.

Data-driven management is needed to achieve strong governance

• Conglomerates significantly impacted by governance risks need to not only restructure their business portfolios based on ESG risk assessments, but also strengthen their business data infrastructure that supports such decisions. Digitalization does not only serve to exacerbate the risks associated with ESG/SDGs, but can also be used to enhance governance.
• In the area of business management, business intelligence functions have been enhanced to utilize management dashboards and other tools in place of conventional periodic reporting. Of course, understanding and utilizing information in real time is essential for making business decisions. Did you know there is a robot with a 100%-win rate in rock-paper-scissors? This robot recognizes what move its human opponent has made in an instant, and then produces a winning move with a time lag of less than a millisecond (a speed that humans are unable to even process). Similar technologies can be found in the business world. For example, with AI and RPA-based investment programs becoming mainstream in the stock market, fears surrounding high-speed trading have resulted in tighter regulations being put in place since 2017. A real-world example of this is how professional institutional investors have been able to profit by using programs that can detect when retail investors place their orders, allowing them to preempt these orders and complete their own at high speeds. These investors were able to achieve victory by taking advantage of the “information gap” and “speed at which information was obtained and then acted upon.” Whether this should be dismissed as nothing more than a dirty trick or viewed as an essential part of business is left to individual interpretation. This does, however, make it clear that a single delay in managing the risks from ESG/SDGs could be fatal.
• Deloitte surveys CFOs at Japanese companies on a regular basis. In confirming what kind business data these companies were obtaining (Figure F), it was found that these companies have already obtained large portions of financial data and are putting this data to use. However, this survey also showed that of the data that companies “needed but had still not obtained,” 60% of all respondents ranked data on ESG/SDGs as their most needed data. As companies will now need to manage their businesses using both financial and non-financial information, it is easy to see how ESG/SDGs will play an important role in this.

Source: Prepared by the Deloitte Tohmatsu Group based on details from Deloitte's "CFO Signals Report 2021Q4”

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• Digital technologies are also finding use in internal audits. Digital technologies are already being utilized in several areas, some of which include “collecting and evaluating risk information” (risk sensing) as a part of the risk evaluation process, obtaining and extracting important information and utilizing analytics (AI/CI and OCR) in preparation of audits, understanding what processes and data flows are subject to evaluation (process mining), and automating audit processes (workflow) as well as reporting (internal audit tools and GRC tools). In the future, it is hoped that these technologies will help to make such audits more sophisticated through the use of internal data. This could include detecting for fraud using personnel information.
• It is no exaggeration to state that in conglomerates, which often form holding structures and possess a large number of affiliated companies, the challenge of governance lies in the communication between management and those working at the business’s ground level. In some cases, ESG/SDG initiatives are used as an excuse to explain why a certain business is not producing a profit. Taking into account the fact that society as a whole is still trying to develop a common understanding and framework on these initiatives, companies need to consider early-on how they plan to measure such initiatives, and waste no time in properly understanding what impact the ESG/SDG initiatives from each of their businesses/affiliate companies will have on their profitability/corporate value. Spreading data-driven management is a management issue that conglomerates should give top priority to control for risks such as ESG/SDGs.

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Author

Naoki Okada
Senior Manager, Deloitte Tohmatsu Consulting