Ed. note: This is adapted from my book Killing Sustainability – available for free as part of your PracticalESG.com membership. This topic continues to be a critical matter companies struggle with on a daily basis, and that sets expectations for boards, managers, staff and investors.
It frustrates me in discussions about ESG and finance that the focus tends to be on share price. The underlying drivers of revenue, cash flow and operating environments are usually ignored. I don’t know why that is. Without revenue, there is no sustained return on investment – and no company. While a company can operate at a share price of zero or with no public shares at all, its options for operating at zero revenue are limited.
The real financial opportunity in ESG is in finding new revenue/cash flow, which is not as difficult as you may think.
Share Prices are Unpredictable
Theoretically, capital markets value shares based on an assessment of future revenue/profits and current asset value (e.g., plants, property, equipment and intangibles), but stock prices fluctuate wildly for other (sometimes irrational) reasons. Nobel laureate Robert Shiller once said “Fundamentally, stock markets are driven by popular narratives, which don’t need basis in solid facts”. For instance, stationary exercise bicycle maker Peloton saw their stock drop 16% over two days when their product was visually associated with the death of a fictional character on the 2021 reboot of the TV show “Sex and the City”. Peloton felt compelled to respond and attempt to reclaim the loss in value by making a commercial with the real-life actor saying he was fine.
In the first part of 2021, there was a feeding frenzy by investors for new electric vehicle manufacturers in the U.S. going public through special purpose acquisition companies (SPACs). These automakers had no manufacturing or automotive experience or proven revenues. As the year wound down, the lack of revenue reality set in for those that didn’t appreciate fundamentals initially, and shares in the companies plunged.
Funds Are Suffering Too
California is ending the ESG option in its auto enrollment workplace pension plan CalSavers.
California’s pioneering auto-enrollment workplace pension scheme, CalSavers, has been forced … to put out a request for proposals (RfP) to manage its ESG option. This comes after attempts to renew with current provider Newton Investment Management faltered, following low uptake among members… the ESG option had attracted just 0.4% of CalSavers accounts.
MSCI Global Climate Select ETF launched in November 2021 coinciding with the exuberance of COP26. According to the Financial Times:
The fund has amassed less than $2mn and is likely to be wound down as soon as the end of March without further investment, said Ethan Powell, founder of Dallas-based Impact Shares, the fund manager. He said Impact Shares has been spending about $25,000 a month to manage the ETF.
Seed funding targets for the ETF were not met, which prevented key requirements from major banks from being met – therefore preventing them from fulfilling their funding commitments. This created a snowball effect as some banks conditioned their pledges on the participation of the banks that did not go through with their pledges.
Share price is frequently influenced by fantasy, hopes, internet memes, Reddit groups or worse – generating returns for high-frequency and stock manipulation traders. But it is antithetical to long term ESG benefit and can be illegal. As Ulrich Atz of NYU Stern School of Business stated in his study of ESG studies, “mechanically linking ESG to alpha can lead to specious results for a range of reasons.”
Cash is King – Let it Reign
Understanding, harnessing and predicting product demand is in many ways easier and more stable than predicting capital markets. For instance, B2B purchasing contracts with ESG/sustainability mandates are definitive. Revenue gains/losses are linked to these contracts/purchase orders. More or expanded contracts generally means more or expanded revenues/profits.
During a December 2021 webinar sponsored by Responsible Investor, Anne Simpson (who was then CalPERS Managing Investment Director, Board Governance & Sustainability) mentioned specifically that CalPERS seeks out revenue growth opportunities with their ESG criteria – pointing out that they buy stock based on the expectation of future revenue. That view of “revenue first, then market value” seems uncommon with respect to ESG and finance. It is almost silly to have to mention that operating revenue/profits and cash flow are separate from stock price.
McKinsey contends that one of six features of the Net-Zero transition through 2050 is that it will be “rich in opportunity.” They highlight prospects for new revenue and reducing direct operating costs, which then improve profitability/margin. Meaningful cost savings will be harvested over the long term from decarbonizing processes and products. In the near- to mid-term, new customers (i.e., revenue sources) will increase with demand for decarbonized products and suppliers from multiple directions:
- Decarbonizing process and products;
- Replacing high emissions products and processes with low emissions ones; and
- New service offerings to aid decarbonization, such as supply chain inputs like transportation.
Not to keep beating McKinsey’s drum but just last week they published a piece on the “rise of the inclusive, sustainable consumers” and how ESG issues have become what I call “key buying criteria”:
…consumers are shopping around. There’s been a huge loyalty disruption, and it continues. Consumers are choosing brands and retailers for different reasons, and they’re also very likely to stick with the new brands and retailers that they’re trying… more than ever, values are actually shaping how consumers are deciding to spend that next dollar… when we ask people what is important in their purchasing decisions, values come up, environmental comes up. Social responsibility comes up. DEI [diversity, equity, and inclusion] comes up.
Keeping up with consumer/customer key buying criteria means (hopefully increased) revenue and cash flow linked directly to ESG initiatives which then should benefit stock prices due to improved fundamentals.
Even so, capital markets still sometimes disrespect fundamentals of cash flow. The attempt by investment fund Third Point in late 2021 to break up Royal Dutch Shell is an example. One observer said that Third Point
“might have done Shell a favor by highlighting how cheap the stock is. By [Third Point’s] own calculations, the market is assigning zero value to the upstream, refining and chemical businesses, which still generate the bulk of operating cash flow. So, while a separation might not occur, share price appreciation could just be based on traditional business fundamentals.”
What This Means
I sum it up by ripping off the old “parts is parts” Wendy’s commercial from the 1980s – fundamentals is fundamentals. Companies should look at operational aspects of ESG as the primary driver of value rather than attempting to immediately/directly link ESG and share price. ESG can – and does – build on revenue growth and cost reductions. If those are well managed, share price is likely to follow and be based more on reality than fantasy.
Here are some things to consider when determining how ESG can improve operating revenue/cost:
- What does the company make or offer? What need does it fill? Why does that need exist in the first place?
- What costs are built into product pricing?
- Why do customers buy from the company? What are customers’ key buying criteria? How are those changing, especially in relation to ESG matters?
- What are the manufacturing processes involved? What is the status of manufacturing capacity, efficiency, or limitations? Where are their opportunities to improve efficiencies/reduce costs within an ESG initiative?
- What are the most critical aspects of revenue generation and profitability?
- What are the direct and indirect cost drivers with the biggest impact?
- Are ESG risks adequately identified and placed into operational contexts, not just investor contexts?
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