Week 15: Remarkable findings in the first true materiality ESG analysis

In this issue: ▸ Companies are still spinning on growth ▸ The ESG Unknowns ▸ An ESG analysis of 15 global brands ▸ Discussion with RIMM’s Ravi Chidambaram

ESG on a Sunday

Apr 16, 2023

Dear all,

For all the frameworks, global initiatives, net-zero comedies, esteemed conferences, zillions invested in ESG and “Sustainability”, companies worldwide are still spinning on one thing and one thing only. Growth.

Currently, economic models and financial analyses do not incorporate ESG in any core financial driver for companies. ESG activities conducted by companies as risk management and opportunity aspirations have no bearing on the core financial growth strategy for any company analysed.

In general, ESG analysis focuses on understanding how Company X manages sector-specific risks and opportunities, with risk management taking priority. Sector risks are assigned based on subjective understanding and interpretation of potential ESG risks that may have a significant or limited potential impact on the company’s financial performance and/or valuation.

Financial metrics are not assigned in terms of percentage of revenue affected by a “bad” or non-existent Human Rights policy. Limited information is available on product and/or service levels in terms of potential revenue streams aligned with the EU taxonomy. Exact numbers or appreciation of financial impact, both positive and negative are currently not available, and often estimates are used in many cases as a proxy for investment decisions.

A company is assigned a certain risk and opportunity profile, which is translated into an alphabetic or a numerical rating. Depending on the analytical model used by an asset manager (passive, active, bottom up, thematic, quantitative, etc) ratings and/or underlying ESG data can be trenched, skewed, or extracted and transformed (with a large portion of estimates) into the portfolio management decision-making process.

All investment decisions are forward-looking, based on expectations that Company X will reach or exceed certain targets and, in that process, the investor will gain certain profit relative to the starting point of the investment. In principle, investors using current ESG datasets are making forward-looking investment decisions based on ESG datasets covering past ESG (mostly risk) management performance of the company. Certain ESG data relating to information on products and services are limited, and when available, they are often unconnected to the company’s overall growth strategy for specific client, market or geography segments.

In other words, there is no connection between what, where and how a company plans to grow and how ESG measures deployed by the company will enable, hinder or prevent further growth.

These are so-called “ESG-unknowns” and addressing these questions should lead to further integration of ESG into the core of any company’s business and core of financial analysis. “Sustainable” companies and financial institutions selling ESG funds need to be able to answer questions on:

Financial relevance of ESG in the product and service development
Financial relevance of ESG for market and client segments
Financial relevance of ESG for mergers and acquisitions
Financial relevance of ESG for pricing and sales strategy
Financial relevance of ESG for volume segments of product and or service provided by company
Financial ESG relevance for biggest shareholders of the company
ESG implications for balance sheet of the company
Climate risk accounting in the overall financial accounting not related to own emission but to products and services, core business offerings of the company.

Discussion with RIMM’s Ravi Chidambaram

I have asked Ravi, CEO at RIMM in Singapore, to help me conduct analysis over 15 large and well-known global brands.

ESG analysis of 15 global brands

Ravi, RIMM has recently done a rather unique ESG analysis on some of the biggest companies in the world. As I understand it, the results are rather alarming in so many ways. Can you explain what you have done?

Hi Sasja, yes we ran an interesting thought experiment. We examined the publicly stated 2023 financial targets versus 2023 ESG goals for 15 global large cap companies to see if we could discern any patterns or relationships between these two parameters. We chose companies that are major constituents of the MSCI ACWI and ESG indices.

So, in principle, there is no connection at all between how companies plan to grow and develop their business on the financial side and ESG strategy they present? What have you seen?

Yes, what we found was quite remarkable. We created a simple rubric where we rated the 15 companies on whether their financial targets and ESG targets were either compatible, conflicting, or ambiguous. We discovered that out of the 15 companies in our sample, only one had compatible ESG and financial goals, while 5 had outright conflicting goals, and the remaining 9 had ambiguous goals.

Here’s a brief overview of our taxonomy:

Compatible - financial targets clearly match ESG goals.
Example: A fossil fuel company stated that 30% of their net income in 2023 should come from their renewables division, while their ESG goal was to reduce emissions intensity by 15% in 2023 as more renewable capacity comes on-stream.

Conflicting - financial targets clearly clash with stated ESG goals.
Example: A global food company that uses large quantities of palm oil in several key product lines has a stated aim of buying only certified palm oil by 2024, yet is targeting significant product volume increases to meet their revenue growth targets. It seems unlikely that certified palm oil could meet that product volume increase when even their current volumes are not even close to using 100% certified palm.
Ambiguous - there is no clear connection or disconnection between stated financial targets and ESG goals. This was the most common outcome we encountered.

What does this mean? Some examples:

ESG goals were more “charity driven” with actions such as giving away money, planting trees, and subsidising poor people, so no way to see if their financial targets are compatible with managing key ESG-related externalities that could affect financial goals.

A classic Friedman move: the social responsibility of business is to make money, giving some of it away in charitable contributions, if you are so inclined, as the best ESG you can practice.

ESG goals are “tangential” to their financial goals, such as targets related to increasing female or minority hires, or buying more from minority suppliers, which may be viewed as worthy goals unto themselves, but are not clear on if they would have any direct link to achieving financial targets.

ESG goals that are seen as a “red herring” meant to distract from business as usual, such as companies stating emissions reduction targets despite the company’s business model not really depending much on efficient energy use for profits, nor are they major emitters in the first place.

In other words, does this mean that ESG still is just a side-kick to real business? This is rather depressing news given all commitments and all ESG reports?

Yes, at first glance, it seems very much so. It appears as if most companies are not setting financial targets with ESG in mind. ESG still seems like an “add-on’” CSR exercise that is then appended to a report. The fatal flaw in this approach is that most companies are not placing a price on ESG-related externalities. Carbon taxes, changes in consumer preferences, supply chain disruptions and workforce participation all have ESG-related issues at their core and all can deeply disrupt a company’s “business as usual” approach. Therefore, in our view, there is a pressing need to integrate ESG and financial planning at companies and communicate that clearly to all stakeholders - from investors to regulators.

Now that we have seen that the connection between financial and ESG goals are non-existent, what can we do to change this? How do we bring in true materiality and explain it?

At RIMM we believe in what we call “true materiality,” which refers to the need to see what ESG factors can disrupt a company’s business model and how the company is managing these ESG externalities. This assessment will vary by industry and country. The starting point of this analysis is to examine the key cost drivers in the business, including both the cost of the goods sold and operating expenses. Once these cost drivers are identified, each one needs to be tagged to a set of ESG KPIs that would impact that cost. After isolating the ESG KPIs by cost category, (what we call true materiality), we need to rate the company’s performance for each ESG KPI to determine both an absolute rating and a rating within each cost category. The rating can be developed through a combination of absolute scoring, relative scoring based on industry benchmarking or “alternative” data that provides a third-party view on the company’s ESG performance for a certain KPI.

For example, in the case of beverage company, we determined that the key cost drivers in production are ingredients, packaging and water. We tagged a total of 20 ESG KPIs that could affect these costs and split them into the three cost buckets. For packaging, relevant ESG KPIs could include sustainable packaging initiatives, recycling of materials, and sustainable supplier sourcing. For ingredients, some relevant KPIs could be organic product initiatives or consumer health-related incidents. Rating each of these key cost categories allows managers at a company or investors in the company to see how “true materiality” factors, if not properly addressed, could fundamentally impact their “business as usual” approach.

We have to stress that true materiality is not an endgame. It is an analytical framework that allows companies and investors - and indeed all stakeholders - to engage and dig deeper between the ESG and financial connections that are so crucial to all companies. The reality is that public disclosure, even with the big push towards ESG reporting, does not give us enough to really get to the bottom of “true materiality”. It is only a point of departure to more honest discussions within companies and with their stakeholders.

Have a great nothing is as it seems week!

Best regards,

Sasja