Chapter 6: ESG/SDG Initiatives and Business Portfolio Management (Part 1)

Business portfolio management based on sustainability

Conglomerate companies are by no means exempt from the fact that each of their businesses must be sustainable in addition to being profitable in terms of how they are managed. By looking at ESG/SDG perspectives when evaluating each of their businesses, companies may find more opportunities to make managerial decisions on risks stemming from unsustainable businesses. A possible decision could include withdrawing from the business of coal-fired power generation. In contrast, ESG/SDG initiatives will drive up costs, making it difficult for companies to decide whether they should focus on ESG/SDGs even at the expense of profitability. Where we would start is by evaluating whether these ESG/SDG initiatives had at least some sort of positive impact in enhancing the company’s value. The following two paths could be taken to enhance the company’s value (Figure A).

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(1) Even if ESG/SDG initiatives do not contribute to profitability, do they directly enhance the value of a company?

• If companies were truly being required by their investors to implement ESG/SDG initiatives, then logically their ESG scores should be driving down their capital costs. However, even if we were to analyze the correlation between a company’s ESG scores (metrics used to quantify these ESG initiatives) and its corporate value, we would find that the company’s current value on the stock market would not necessarily indicate that ESG scores have an impact in lowering their capital costs.
• An increasing number of institutional investors and funds are adopting ESG/SDGs as their investment criteria. However, at this moment they are mostly using this criterion as a way to apply negative screening (a method of screening potential investment candidates). More recently, investors have begun to proactively encourage companies to take action regarding these topics. This is evidenced by the decarbonization proposal institutional investors in Europe submitted to J-Power in May 2022. As this will have an impact on a company’s value, it will become necessary to define and put in place regulations/standards that place a direct burden on companies, such as a tax for CO2 emissions.

(2) Will ESG/SDG initiatives both increase a company’s value and improve its profitability?

• Similar to what we saw in (1), analyzing the correlation between profitability and ESG scores shows that ROE, which indicates short-term profitability, does not correlate with ESG scores, which indicates long-term profitability.
• In many cases, companies achieving both high ROE and ESG scores have created a positive feedback loop in which ROE enables them to invest in the future, leading to them enhancing their ESG initiatives.
• Investing more in ESG may lower ROE in the short term, and investors will not be satisfied unless there are scenarios which show economic value improving over the long term.

Although analysis suggests that enhancing a company’s sustainability may profit them in the long term, its impact on profitability will be limited in the short time. For conglomerates in particular, the sustainability of a particular business will not necessarily have a direct impact on the company’s survival. This is why these companies need to understand that strengthening their ESG/SDG initiatives is just one of many choices, and that the wiser option would be to find a way to balance these initiatives against profitability and to ascertain when their businesses will peak, deciding then whether to maintain the status quo, strengthen their initiatives, or withdraw from said business.

Growing risks from ESG/SDGs brought on by a wave of digitalization

• ESG investments will have a limited impact in the short term in terms of profitability (returns). However, the world has continued to make more ESG investments. As shown in Figure B, the Global Sustainable Investment Alliance (GSIA) announced in July 2021 that global ESG (environment, social and corporate governance) investments during 2020 amounted to USD 35.3 trillion (about JPY 3,900 trillion) (up 15% from 2018).  Japan saw an increase of 32%, which translates to USD 2.9 trillion (about JPY 310 trillion).

Source: Prepared by Deloitte Tohmatsu Group based on details from GSIA’s "Global Sustainable Investment Review 2020”

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• Why do ESG investments continue to see this much growth despite not outperforming other investments? One theory is that the risks from not proactively engaging in ESG/SDGs has grown. In recent years, a wide range of corporate scandals that include not only environmental issues, but also issues such as child labor and personal information leaks, have continued at an incessant rate. These scandals have not only resulted in simple penalties/compensation, but have also damaged the brand image of these companies, which has had an immeasurable impact on their profits. If there is a greater risk associated with investing in companies that do not conform to ESG standards, more ESG investments are likely to be made based on a risk-versus-return perspective, even if these investments have no impact on returns. 
• For example, looking at which risks companies are focusing on (Figure C) reveals that, with the exception of COVID-19, risks stemming from climate change and workforce availability have significantly risen. Risks associated with climate change include not only physical, but also financial and reputational risks. As for risks associated with workforce availability, companies are facing growing risks not only from inhumane labor conditions (which is best exemplified by child labor), but also from the fact that workers are increasingly taking into account a company’s purpose (raison d’etre) and environmental/social contributions in selecting their workplace.

Source: Prepared by Deloitte Tohmatsu Group based on five years' worth of surveys (2018 to 2022) from Allianz Global Corporate & Specialty’s “Allianz Risk Barometer”

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• The number of ESG-related lawsuits has seen an increase in recent years, and the market for D&O insurance, which insures corporate directors and officers against damages, is on the rise. So-called “litigation funds” that provide funds for large-scale class action lawsuits against companies have emerged overseas, and the flow of funds to ESG lawsuits cannot be ignored. Tokio Marine & Nichido Fire Insurance revealed in November 2021 that it will consider utilizing ESG scores to determine D&O insurance premiums.
• In fact, the recent wave of digitalization has played a large role in exacerbating these risks from an ESG perspective. As written above, addressing social issues with a public goods aspect will contribute little in terms of returns. This leads to a dynamic in which the logical strategy is to leave the resolution of such issues to others, presenting a sort of “prisoner’s dilemma” from an economic sense. The main method to resolve such a “prisoner’s dilemma” and encourage cooperation would be to expose betrayal and to enforce stronger penalties. The former is especially effective because we live in a world where digitalization has allowed us to expose and document any corporate activity that works against ESG, as well as facilitate the quick spread of information. This will also leave a digital tattoo on companies that will not be forgotten for some time. An example of this could include a case in which a photo taken from a satellite reveals environmental damage, which in turn damages the value of the company. Our world is growing less tolerant of such betrayals due to greater public scrutiny brought about by digitalization, in addition to a growing demand to disclose more information from ESG-related initiatives.

Author

Naoki Okada
Senior Manager, Deloitte Tohmatsu Consulting