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November 9, 2021

ESG becoming core to investor appeal

huge 3d magnet and flying dollars
huge 3d magnet and flying dollars

As performance against ESG criteria increasingly has an impact on stock market value and ability to attract investors, companies — and their bankers — are grappling with the strategic consequences

The idea of a business having responsibility for its impact on broader society is certainly not new. And while many companies have long taken corporate social responsibility seriously, it was unlikely to be considered a central aspect of their activity or strategy — until recently.

As sustainability has risen up the agenda, and the discourse around the role of environmental, social and governance factors in a well-functioning economy has become more sophisticated, these issues are increasingly being thrust into the front-and-centre of business decisions. The pressure for business action in relation to climate change and decarbonisation is becoming a particularly strong factor.

Whether it is consumer pressure for change, a more stringent regulatory environment or increasing investor appetite for assets with sound ESG credentials, it is becoming increasingly difficult for companies to sideline their environmental and social impact.

“Conscientious capitalism is getting its day in the sun, and I think there is a growing awareness and acceptance that that’s the right path for the markets and for society,” observes Robert Santangelo, chair of Credit Suisse’s investment banking ESG advisory group. “To me, it’s something that’s probably overdue and it also has a lot of runway. I think there is a growing belief that this is not just a ‘flash in the pan’.”

Keith Tuffley, global co-head of sustainability and corporate transitions at Citi, agrees. “These are issues that are becoming core to company strategy and are being dealt with at boardroom level,” he says. “That means firms asking themselves probing questions about the future and, increasingly, looking at these issues not only through a risk lens, but also through an opportunity lens. As we see multiple different sectors transform, it’s a question of how they are investing their capital to thrive in this new economy which is being created.”

A broad market trend

Within a capital markets and investment banking context, one of the most significant developments has been how ESG has become a part of the backdrop for a far wider range of transactions than labelled bonds and loans.

The practice of including ESG in decision-making has become increasingly commonplace across institutional investors, such as asset managers and other major players like private equity. “This is not just about dedicated ESG funds — a growing number of funds now have an ESG overlay,” says Emily Rose Laochua, a managing director in Credit Suisse’s ESG financing group. “It’s an investor base that is continuing to grow in terms of capital and engagement. So, for issuers, ESG considerations are increasingly harder to ignore.”

Refinitiv data shows that in the first nine months of 2021, there were $28.5bn worth of primary equity capital markets transactions related to sustainable companies (according to Refinitiv’s business classification system) — a 48% increase compared to the first nine months of 2020. But it is not only companies with pure play green or sustainable business models (such as a renewable energy company or a plant-based food company) where this trend is starting to have an impact.

ESG and IPOs

When thinking about initial public offerings (IPOs) in particular, several bankers confirm that ESG now plays a role in every transaction.

“Nowadays, every company looking to IPO will have to consider its position against ESG criteria, and if that will make an impact on its ability to attract investors and/or the pricing,” notes Luis Vaz-Pinto, global head of equity capital markets at Société Générale.

“Clearly not every IPO is the same, but there are some where sustainability is core to a company’s whole future strategy,” says Citi’s Tuffley, adding that is not just “companies that have started with a mission-driven focus around sustainability — that’s also companies in sectors that are facing major challenges from an ESG standpoint.”

In the context of an IPO, Tuffley says this means such firms will need to “draw out the future of what the business looks like and whether it is leveraged to the sustainability revolution”. For companies with perceived ESG challenges, “they have to address how they are going to structure their business and develop a strategy for thriving in a world that is increasingly focused on those challenges,” he adds.

In effect, there are some companies where emphasising ESG credentials can increase investor appeal, and also some where perceived ESG risks must be managed as part of the equity story. Remy Briand, global head of ESG and climate at indices and financial market data provider MSCI, notes a shift where it now provides pre-IPO ESG ratings for companies planning to list, due to investor demand for this data.

Laochua says for firms looking to distinguish themselves during the IPO process and attract potential ESG investors, “things that are important will be disclosure around material ESG risks and opportunities, and broader communication about the business’s approach to ESG considerations (if they have that information already available). For firms that are not going to check all the boxes on day one, that could include a strategy for how they’re going to address their ESG challenges and opportunities in the future, which key metrics they will disclose going forward, and a commitment to publish a regular impact or sustainability report.”

But bankers also stress that a strong ESG story would not be enough on its own to attract investment. As Vaz-Pinto observes: “With an IPO, clearly a company has to convince investors about their broader equity story, so it’s not just about being ‘green’ or other aspects of ESG. There’s a whole range of things, such as the company’s growth, the management team, it’s strategic positioning within its sector, etc … having a good ESG story is more and more necessary for an IPO, but that alone is not sufficient.”

Shrinking access to capital

There is also debate among bankers about the extent to which certain carbon-heavy sectors — such as coal extraction — would struggle to obtain financing. Others believe it may still be possible, although accept it would require a hefty premium. All agree this is an area that is moving fast.

“There are definitely some pockets of the market where this has already crystallised, in terms of limited investor interest in assets that are seen to be compromised by negative ESG factors,” says Rama Variankaval, global head of the Center for Carbon Transition at JPMorgan. “And there are other areas where current trends would suggest it will crystallise at some future point in time. So, there is a clear incentive for companies to act now to get ahead of the markets.”

Tuffley points to the impact of the Glasgow Financial Alliance for Net Zero initiative, which many financial firms have signed up to, that commits firms to not only having targets for net-zero carbon emissions by 2050, but also setting targets for meaningful reductions by 2030 within 18–36 months of joining the alliance.

This will, he says, mean “that a lot of banks, investors and insurers will now be focusing on what they can do to decarbonise their portfolios. And that will result in big shifts in capital away from high carbon businesses to low carbon businesses.

“All things being equal, if you are in a carbon-intensive business, and you do not have plans in place for decarbonisation, I think you can expect to soon start seeing a higher cost of capital or even a complete absence of access to capital,” he adds.

The right assets

Companies are also becoming increasingly cognisant of the long-term impact of owning ESG-compromised assets, as well as the potential benefits from acquiring ESG-positive assets.

“We are spending time with companies across all sectors to figure out what their ESG liabilities are and the right strategy to eliminate or reduce them, and to introduce more ESG-positive assets. This is driving a lot of mergers and acquisitions activity,” says Variankaval.

Laurent Bouvier, global head of ESG advisory at UBS, stresses the importance for companies of considering long-term aims before deciding to sell assets due to ESG concerns. “Issuers need to take a long-term perspective, and not only think about the current context, but also what the world is going to look like in three, four, five, even 10 years from now,” he says. In that context, he suggests, spinning off assets with a negative ESG profile without considering wider strategy would “not adequately address the dynamic nature of these issues”.

On the face of it, the idea that heavy carbon-emitting assets will increasingly struggle to access capital or be spun off into obscurity could seem good news. But if this process is not managed thoughtfully, it has the potential to cause serious disruption and hardship for populations across the globe. One needs only to look at the impact of the current energy shocks being experienced in various economies to get a flavour of this.

Some in the industry believe that given the urgency of addressing climate change and the extent of public pressure around it, there are limited alternatives. Had the global community acted on climate change concerns sooner, it may have been possible to have a much smoother transition, but there is now limited room for manoeuvre.

But there are others who advocate for a more considered approach. Bouvier says: “I think we are getting to a point where in certain sectors you might struggle to obtain finance, and that, I think, is problematic. These are companies with employees, technologies and expertise, and that often are still fulfilling an important purpose in the current economy. I believe there is a social responsibility for the approach to these ‘stranded assets’ to be actively managed and where possible, strategically repositioned.”

Creating long-term value

However, for those assets where it is possible to engage in a transition process, there are widely seen to be considerable value-creation opportunities.

For instance, Megan Starr, global head of impact at the multinational private equity firm The Carlyle Group, says: “We’ve taken a distinctive approach, in that we don’t invest on the basis that either you’re an impact company or you’re not. We meet companies where they are, and one of our levers for driving value is helping them to improve their ESG performance. We believe that leads to better financial outcomes in the long term.

“We’re not just focused on companies that have every ESG competency perfectly handled. We’re assessing the material ESG risks, understanding where a company might have gaps and also looking at our ability to improve those dimensions in our hold period,” she adds.

In the past, an often-raised concern in relation to sustainability was that although there may be strong moral and ethical reasons for prioritising these issues, there remained a lack of clear-cut evidence that it would have a positive financial impact for a company. This is demonstrably no longer the case. “There are very clear financial drivers behind this,” Ms Starr notes. “In the public markets, we’re seeing increased valuations for companies with ESG-linked business models, a lower cost of capital for companies making linkages to ESG performance and we’re also seeing changing consumer preferences.”

Jeff McDermott, global co-head of investment banking at Nomura and founder at Nomura Greentech — a boutique investment bank focused on sustainability, since acquired by Nomura — says many companies “have woken up to the strong value-creation opportunity and are playing offensively”.

These companies, McDermott continues, “see the increased demand for more sustainable products and services — as well as the fact that multiple sectors are transitioning to being lower carbon-emitting, more resource efficient and more digitally networked — and they are looking for the best places in the value chain to participate. That includes identifying acquisitions that can support them in that goal. Similarly, there are a lot of smaller, innovative companies that know they would be able to have a much bigger impact within a larger organisation.”

ESG activism

In contrast, firms that are seen to be laggards on these issues are increasingly at risk of being targeted by activists with an ESG agenda. Perhaps the most high-profile example of this is the proxy campaign hedge fund Engine No. 1 pursued against oil giant ExxonMobil during the first six months of 2021. The hedge fund argued that a continued focus on fossil fuels posed an “existential risk” to Exxon, and criticised it for inadequate progress on transition to a more sustainable business model. Ultimately, it was able to secure board seats for three chosen candidates after it persuaded several large shareholders to vote alongside it at Exxon’s annual general meeting in May.

Santangelo expects that ESG-related activism will increase, particularly as “companies that are more sensitive and forward-leaning on some of these ESG topics are being rewarded by the market on stock performance”.

“We expect boards to listen and engage just like they would with any other activist, and really weigh up whether the suggestions being made are good for the company,” Santangelo adds. “I think that ESG-linked activism will ultimately become another dimension of that broader engagement between companies and activists around what creates value.”

McDermott echoes this view, suggesting that “constructive engagement’ between companies and activists on these “difficult issues” will be the right approach in most cases, and “yield the best results for everyone”.

This article first appeared in The Banker’s November 2021 edition.

A service from the Financial Times