So many ramblings on ESG these days, I felt compelled to kick in a few thoughts. Personally, I love the topic of ESG, it is so objectively subjective at the moment, as while it is clearly defined from a qualitative perspective it is wildly subjective from a quantitative perspective. At the moment, no organization has defined the ESG standards to such an extent they are universally accepted and verifiable. While we are on that path via the work being pursued by the World Economic Forum , there is still a ways to go and how will we really define what is good?
In theory, as an investor or operator, we should have been thinking about ESG our entire careers. Afterall, ESG is simply helping us define categories of risks and opportunities that have fallen outside of many traditional business assessment frameworks, e.g. financial, legal, IT, etc. In my mind, ESG is about having the long view, I should emphasize the really long view. Afterall, the value of a business is tied to the cash flows a company generates over its lifetime, thus the longer the lifetime, in theory the more value the company can generate. (Is it old fashioned to think enterprise value = discounted cash flows? — Perhaps another discussion).
The Easy to Understand E — Environment
So let’s think about some practical big picture items and why ESG is now impacting valuations. The simple example industry is petrochemicals; over the course of time, with a particular focus on recent decades, we have as a society understood how finite the life of this industry really is 1) it produces pollution byproducts with the potential to curtail the quality of life on Earth 2) the product is not renewable, in fact it is limited in nature and will eventually run out 3) the act of extracting oil and gas, as well as processing, storing, transporting, etc. are all damaging to our environment in many debatable ways. So while traditional supply and demand economics still drives this industry and it is extremely challenging to replace oil and gas, we know eventually the industry will reach a point that is no longer sustainable. Consequently, as a society we have started to understand and appreciate this; thus we see valuations in the space slipping as the industry time horizon is now more clearly finite.
Societal Impact is Often Muddled
Tougher examples out there include software companies, as dealing in data will likely be a perpetual endeavor. However, we know managing, controlling and disseminating personal information is not without consequence. Social media certainly has a dark side to it, while enabling positive interactions and outcomes, it unfortunately provides a platform that may be abused to spread misinformation. So how sustainable is this? We have started to see companies take proactive steps to “protect” what they have built and to ensure there is some validity to their platforms, otherwise it quite frankly turns into an unreliable platform and people go elsewhere to seek out information. There are deep questions in my mind, if certain technology companies sustainable and if they are a benefit to society.
Governance is Good
A strong governance framework makes an organization tick along like clockwork. There is no need to be concerned the organization is misappropriating resources, is engaging in nepotism, is bending regulations or breaking laws, when governance is prioritized. The breakdown we see in this area is often simply bad actors, think Enron. Getting this right though is not often easy, as it often boils down to trust in management and management having a strong ethical and moral compass. It is not hard necessarily, but it is extremely easy to get it wrong. As the quip goes — “It takes a lifetime to build a good reputation, but you can lose it in a minute.” — the same applies to companies.
Hold on, does ESG matter or not
Hopefully, the takeaway is: Yes, it matters tremendously so. But, there are no bright-line rules. ESG matters to each business but in a different way and clearly business fundamentals, i.e. a profitable business model matters too. The good news, we are now starting to think about this more and more. When I step back, ESG is part of the analysis to understand a business and provides some useful perspectives to look at what had until recently been an untraditional vantage. Ultimately, the way I am thinking about the businesses I work with — are they going to be around in perpetuity and how do we make them future proof to withstand the forces of science, society and stewardship.