ESG: When it comes to acquisition and investment decisions, Environmental, Social, and Governance is an area that investors and stakeholders are increasingly having to consider as part of their analysis and risk management processes.
ESG analysis involves measuring a business against various social and environmental factors, such as pay equality and employee benefits, as well as energy efficiency and waste management, to assess overall performance in these areas.
First introduced in the 1990s, ESG stems from the idea that, for any business to be deemed sustainable, the focus on environmental and social issues needs to be ranked equally with profit; this notion is now increasingly linked to normal business operations.
An increasing focus on ESG due to heightened environmental awareness
This focus on ESG has increased in recent years results from greater environmental awareness amongst consumers, businesses, and governments.
The UK government, for example, has signalled its intention for a green recovery from the COVID-19 pandemic, which comes alongside the goal to reach zero greenhouse emissions by 2050. There are also plans in place to introduce mandatory reporting of climate-related financial information across the economy by 2025.
Alongside changes in legislation, there is rapid growth in consumer awareness and concern about environmental issues and wider social issues, such as working standards.
It is clear that ESG is having a growing impact on all businesses, irrespective of size and sector, including the SME M&A market. Sensible business leaders are increasing their focus on ESG, both to ensure compliance with changing legislation, and to ensure they don’t fall short of consumer, investor and stakeholder expectations – which could have a detrimental impact on value.
Key ESG measures for UK businesses
Broadly, ESG analysis considers how businesses create value for their consumers, employees, and wider society, and how this impacts their current and future performance, in terms of three key measures:
Environmental risk – This measures the extent to which a business’s operations have an environmental focus, and considers various areas, such as:
- Commitment to environmental initiatives
- Energy Efficiency
- Waste Management
- Water Efficiency
Social risk – Social risk considers a business’s policies and practices regarding labour and supply chains, including:
- Working conditions
- Health and safety
- Leave Benefits
- Pay Equality
- Diversity and equal opportunities
Governance risk – Governance analysis looks at how a business’s objectives are set and achieved, how risk is monitored and addressed, and how performance is optimised, regarding:
- Lobbying presence
- Regulatory issues
- Tax corruption
How ESG informs investment decisions – reducing risk, creating value
For investors, ESG analysis is key to understanding a business’s market position, and crucially, its future market performance.
From a position of expected underperformance a few years ago, businesses with a higher ESG performance are now expected to have a better overall future financial performance, as well as long-term value creation for stakeholders – from customers and employees to suppliers and wider society.
It is now anticipated that a business with a high ESG rating will experience declining cost of capital, whereas a business with higher ESG risks rising costs.
ESG analysis does not just affect financial performance expectation, but also considers how intangible and non-financial assets, such as reputation and brand value, impact on the value of a business.
In investment terms, ESG considerations reduce investment risk, whilst creating investment value.
John Farnsworth, Head of Deal Advisory at PKF Smith Cooper, comments:
“ESG analysis is a highly complex area. Unlike other metrics, it doesn’t focus solely on financial performance, but considers other intangible assets such as supply chain ethics, conduct, reputation, and brand value – all of which can be hard to measure”.
“It is clear that investors and acquirers are increasingly focusing on ESG, meaning businesses seeking investment or heading towards a sale need to start working on improving ESG performance. ESG concerns were hitherto mainly limited to listed companies, but its impact is definitely widening – a recent M&A Monitor survey of SME’s reported that 11% are already seeing an impact on value and, of the remainder, 84% expect it to affect valuations in the future”.
“When assessing acquisition and investment targets, there’s no doubt that in future the social purpose and environmental footprint of those companies will be assessed. In essence, ESG has graduated from being a peripheral issue managed alongside normal business operations, to one that is now intrinsically linked to them. Ignoring these ESG trends is clearly inadvisable.”
At PKF Smith Cooper, we understand how critical it is to gain an accurate valuation of your business. Valuation is more than fixing a value – it provides a wealth of insight into your business that is fundamental for growing and developing your organisation. Please do not hesitate to get in touch with our experts, who can help you obtain the right valuation to achieve the best-possible result for you and your business.