The most common question I get asked in an ESG Investing class is: “How should we integrate ESG thinking into financial analysis of a company?”
The frustration behind this question comes from several sources. Investors complain that ESG reports are often long, voluminous, and often full of fluff. These reports are typically sparse of quantitative data. When it exists it typically shows up in stand-alone tables that lack context and in a PDF document that makes it hard to access and use the data. Worst of all, these data may or may not be relevant to understanding sustainability, both from a financial or a social or an environmental standpoint. For instance, the definition of what is material in the ESG world or not has caused much angst. The SASB has defined materiality narrowly with respect to investors or capital providers. Such a definition is consistent with the securities laws but potentially not fully consistent with what a social activist considers material.
Other market participants lament that financial accounting systems are not integrated with ESG reporting systems. In an ideal world, basic policies, systems, procedures, and controls should exist to both produce high quality data and to permit reliable and enforced external audit for both financial and ESG reports. Some argue that we need a much smaller number of standards, may be just one, as opposed to the multitude from TCFD, SASB, GRI and the like. The recently formed ISSB is perhaps one step towards such an evolution. As of now, the only area where there is some sort of global consistency with somewhat acceptable levels of reliability is in relation to climate. Even that will probably take a long time.
Until the Nirvana state of One standard for reliable ESG data is achieved, I have a few suggestions to begin addressing the integration question.
- Read the risk factors in a firm’s 10-K carefully. Ask whether the hyper-defensive lawyers who dream up every excuse for the firm to get sued refer to ESG factors. If they do not, we have a problem:
- Either the firm is burying its head in the sand with respect to ESG risks.
- Or, we, as investors, have indulged in wishful thinking in that ESG factors are unlikely to pose a material valuation risk in the near to medium term.
- If you do find reference to ESG factors in the risk list, open the sustainability report and look for concrete data points that will help you translate those risk factors, preferably into dollars and a tentative time frame over which the risks will bite.
Let’s test this hypothesis with Coca Cola. Coco Cola is particularly interesting to me given my prior work on negative externalities imposed by the company. The company lists 45 risk factors. I identified 14 ESG related risk factors listed by Coca Cola in its 2020 10-K. Remarkably, there are several red flags related to “P” or the impact of the product on society, a term that Philip Morris International has come up with in their sustainability report.
Here is the list of the 10-K risk factors:
1. Increasing concerns about the environmental impact of plastic bottles and other plastic packaging materials could result in reduced demand for our beverage products and increased production and distribution costs.
2. Water scarcity and poor quality could negatively impact the Coca-Cola system's costs and capacity.
3. Increased demand for food products and decreased agricultural productivity may negatively affect our business (E and P).
4. Climate change and legal or regulatory responses thereto may have a long-term adverse impact on our business and results of operations.
5. Adverse weather conditions could reduce the demand for our products.
6. If we are unable to attract or retain a highly skilled and diverse workforce, our business could be negatively affected
7. If we are unable to renew collective bargaining agreements on satisfactory terms, or we or our bottling partners experience strikes, work stoppages or labor unrest, our business could suffer.
8. Obesity and other health-related concerns may reduce demand for some of our products.
P factors (missing from ESG):
9. If we do not address evolving consumer product and shopping preferences, our business could suffer.
10. Product safety and quality concerns could negatively affect our business.
11. Public debate and concern about perceived negative health consequences of certain ingredients, such as non-nutritive sweeteners and biotechnology-derived substances, and of other substances present in our beverage products or packaging materials, may reduce demand for our beverage products.
12. If negative publicity, whether or not warranted, concerning product safety or quality, workplace and human rights, obesity or other issues damages our brand image, corporate reputation and social license to operate, our business may suffer.
13. Changes in laws and regulations relating to beverage containers and packaging could increase our costs and reduce demand for our products.
14. Significant additional labeling or warning requirements or limitations on the marketing or sale of our products may inhibit sales of affected products.
The next step, of course, is to look for data on quantifying the dollar impact and the likely timing of when these risks might materialize.
As I have mentioned before, companies disclose next to nothing about labor. Hence, assessing the impact of losing talent (# 6) or a collective bargaining dispute (#7) will require significant legwork. A question for the SEC: “Why does a company that lists the potential loss of its skilled workforce disclose so little to enable an investor to quantify the impact of that loss on its cash flows?”
I have attempted to compute the social cost imposed by obesity (#8), emissions and non- recycled plastic bottles (#1) and water issues (#2) in my earlier piece. When and whether regulation or public/media pressure (#4, #11, #12, #13, #14) or changing consumer tastes that move away from sugary drinks (# 9) or investor action (surprisingly not flagged by Coca Cola) will make Coca Cola internalize the cost of the externalities it imposes is, of course, a key question for the investor. Is it a year, a decade, or a generation away?
My earlier analysis had missed the direct impact of climate change on the cost of agricultural inputs that the company relies on (#3) and the lower demand for the company’s products (#5).
What about investors that already incorporate the SASB’s framework and now have a new overwhelming list of 14 factors to consider? My approach is complementary to the SASB approach. Moreover, unexpected macro-economic events listed in some of the 10-K risk factors can change a double-materiality issue in the SASB’s framework (important to the firm’s valuation and its’ social impact) to a single materiality issue (important for the firm alone) and generate negative or positive alphas.
For instance, the pandemic became a point of dynamic materiality as investors’ perception of what is important to valuation and the firm’s workforce changed as the virus progressed. Oil prices have tripled in the last few months and oil stocks have generated positive returns. The demand-supply imbalance of oil might erode the pressure on governments to consider enacting a carbon tax to reduce emissions, which, in turn, will keep oil companies unaffected, on the margin.
An obvious limitation to my approach is that I start with risk factors, which, by definition, are value decreasing from an investor’s standpoint. What about all the positive externalities that a company creates? Sustainability reports might be a place to start thinking about the jobs and taxes that companies contribute or the innovation they come up. How much of these positive externalities are captured in stock price? We know that innovators rarely retain more than a small part of the value their R&D generates for society. Perhaps positive externalities creates social and political capital with regulators and hence help the company postpone or avoid harsh penalties and fines, in case the companies get into compliance trouble. Is this social and political already priced in or likely to be in the nature? That is an open question worthy of more work.
What about risk factors not listed in the 10-K? I suspect climate-change will result in large capex spending of the replacement or maintenance kind. That is, companies have to internalize losses or outlays just to retain product market shares. This consideration is often missing in the 10-K warnings or tangentially alluded to as in #3 above.
In sum, I believe that mapping risk factors to the sustainability report is likely to be far more productive starting point relative to wading through the sustainability report in the hope of picking up signals about ESG risk factors that are material to the firm’s risk and future cash flows.
The biggest question the analysis begs for me is which of the 10-K based risk factors are covered in the sustainability report and which are not. The answer to that question, is itself a great take off point for an investor interested in integrating ESG factors into financial analysis.
This op-ed also appeared on Forbes. Energy Voices is a democratic space presenting the thoughts and opinions of leading Energy & Sustainability writers, their opinions do not necessarily represent those of illuminem.
Shiva Rajgopal is the Kester and Byrnes Professor at Columbia Business School. He works on sustainability and financial reporting questions and is deeply interested in bringing academic work to bear on practical and policy issues.