Lowering Your Cost of Capital Through Effective ESG Disclosure

Welcome to the first of a four-part series of our first blog for 2020. The series explains why achieving best practice ESG disclosure is not only a shareholder imperative but how it can help you more effectively compete for capital in today’s global capital markets. CFO and Board Directors take note, as you will be playing an increasingly important role going forward, particularly because a growing number of investors demand board oversight of ESG performance and accountability.

Part I: Rapid growth of ESG-related investing necessitates best-practice ESG disclosure

Gone are the days when a company could publish an annual sustainability report containing a handful of ESG metrics along with general descriptions of efforts to lessen its environmental impact and be a responsible corporate citizen in the communities where it operates. “Greenwashing” has little influence on today’s investors, among other key stakeholders, all of whom increasingly demand detailed and routine disclosure of robust metrics that accurately measure a company’s ESG performance.

As Larry Fink, Chairman and CEO of BlackRock, the world’s largest institutional investor, with $7 trillion in assets under management, recently wrote in his annual letter to other CEOs around the world, “Given the groundwork we have already laid engaging on disclosure, and the growing investment risks surrounding sustainability, we will be increasingly disposed to vote against management and board directors when companies are not making sufficient progress on sustainability-related disclosures and the business practices and plans underlying them.”

At the end of 2018, portfolios with an ESG mandate were just over $30 trillion globally, or roughly 40% of total assets under management, and are projected to nearly double over the next three years, according to the Global Sustainable Investment Alliance. Much of the capital driving this growth will come from women, millennials and high-net-worth individuals, according to a September 2019 report published by Bank of America Merrill Lynch. They are driving demand for impact and sustainability-themed investing, the two fastest-growing segments of ESG-related investing, while mainstream institutional investors are increasingly incorporating ESG factors into their risk analysis.

Source: Global Sustainable Investment Alliance

Moreover, the corresponding growth in demand for detailed ESG reporting by companies is not limited to institutional investors alone. Other users of this information include equity and credit analysts at investment banks, index providers, credit rating agencies, insurance companies, stock exchanges, as well as a relatively new constituent – firms that rate the ESG performance of individual companies. Further, a growing number of investment banks are establishing dedicated ESG research departments.

While corporate governance standards have, for a relatively long period of time, been considered, to one degree or another, by nearly all institutional investors when selecting which companies to invest in, social and environmental factors have increasingly become a fundamental part of their analysis as well. The newer focus on the ‘E’ and ‘S’ components of ESG began primarily in Europe and has recently accelerated in the US and Japan. In fact, ISS (Institutional Shareholder Services), the powerful shareholder vote advisory firm, has also entered the highly influential ESG ratings market, which we cover in Part III of our series.

Between 2016 and 2018, portfolios employing sustainable investment strategies grew 38% in the US, according to the Global Sustainable Investment Alliance, while in Japan these portfolios quadrupled, rising to 18% of total assets under management. ESG portfolios employing negative/screening methods – the original form of ESG investing that avoids industries considered detrimental to society and/or the environment, such as the alcohol, tobacco, and weapons sectors – totaled nearly $20 trillion at the end of 2018, followed by ESG integration at $17.5 trillion. Both far surpassed corporate/shareholder engagement at approximately $10 trillion.

During the same period, the global issuance of green bonds by sovereigns and corporates tripled to over $100 billion, according to JPMorgan.  Chile issued Latin America’s first sovereign green bond in 2019, a year in which $271 billion in green bonds were issued, based on Bloomberg estimates. Five years ago, Energia Eolica, a Peruvian windfarm operator, was the region’s first corporate issuer of this form of debt.

This clear and strengthening trend in the global capital markets has a direct bearing on any company’s cost of capital, which we cover in the second part of this series. In order to sustain a fair market valuation and raise capital on favorable terms, a company must maintain best practices for ESG reporting. According to an MSCI study published in the July 2019 issue of The Journal of Portfolio Management, “….high ESG ratings [of companies] coincided with higher valuations in terms of both book-to-price and earnings-to-price ratios.[1]

Achieving a global standard for ESG disclosure increasingly falls under the direction of the Chief Financial Officer and the investor relations department, for reasons we will explain in the last part of this series. Further, getting to this level requires a significant effort in terms of time and resources.

 

[1] A higher valuation equates to lower book-to-price and lower earnings-to-price ratios.