ES and CG: Two sides of the same value-creation coin

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By Darrin R. Hartzler – Manager of the Corporate Governance Group, ESG Sustainability Advice and Solutions, at IFC

 

 

 

In my role as manager of IFC’s Corporate Governance Group, I spend a great deal of time talking with business leaders in emerging markets about how to make companies sustainable, including the value of good corporate governance practices for companies.

There is growing global acceptance of the connection between strong corporate governance and solid business performance. But even as more companies see the value, it is becoming increasing clear that corporate governance alone – with its internal focus on the structures by which companies are directed and controlled – is not sufficient to mitigate the full breadth of risks that companies face today.

Environmental practices, labour relations, land acquisition, impacts on biodiversity – such issues, if handled poorly or overlooked entirely, can pose major problems for companies. They can lead to community unrest, labour disputes, disrupted operations, negative media coverage and burdensome reactive regulation. Ultimately, this can impact company profitability, valuation, share price and cost of capital.

By contrast, heightened focus on environmental and social practices and issues represents a strong business opportunity. Support for the global Sustainable Development Goals agreed by the United Nations agenda can yield significant brand enhancements, for example. Demonstrated commitment to them can translate to competitive advantage – particularly as renewed international commitments on climate change and international development have triggered trillions of dollars in public finance toward projects in emerging markets to promote development and environmental stewardship.

This is of particular importance for family owned firms, which dominate the markets where IFC invests. Improving corporate governance and reducing environmental and social risks will safeguard the family’s good name as sustainable leaders in the marketplace.

Taking the longer view

Conventional business wisdom suggests that addressing environmental and social issues is a cost, pure and simple. For instance, a company that is constructing a new facility may not see the value in funding the relocation of a squatter community or preserving a culturally significant site near the property. Instead, what they see is a rising project price tag in additional  transaction costs, project delays and budget overruns.

“Whereas governance strengthens the internal functioning of a company, environmental and social stewardship also strengthens its outward-facing relationships”

In fact, the opposite is true. Companies that fail to attend to the potential environmental and social issues that could impact on business operations could incur even greater transaction costs, longer project delays and larger budget overruns, resulting from lack of community acceptance and disapproval.

Climate change falls into this category, too. Even more than political and regulatory risks, the physical risks associated with climate change pose real challenges for businesses. Issues such as water scarcity, weather volatilities, rising sea levels, powerful storm surges, all impact everything from business continuity to supply chain disruptions, from changing consumer preferences to facilities and infrastructure damage. In 2011 alone, extreme weather events – the rising frequency of which are related to incremental changes in environmental conditions – resulted in overall losses of more than $148billion and insured losses of more than $55billion, according to a report from Ceres. A lack of focus here could cost companies well beyond what they might have spent to mitigate potential impacts upfront.

Integrated approach to complementary issues

There is real value in pushing for more integration on corporate governance and environmental and social sustainability because they are highly complementary issues. Whereas governance strengthens the internal functioning of a company, environmental and social stewardship also strengthens its outward-facing relationships.

At IFC, we are a work in progress on this integration. We are updating our corporate governance methodology – used to assess companies’ internal governance practices, uncover gaps and recommend changes – to include sustainability in the governance of companies. A new section addresses stakeholder engagement. In addition to governance, our performance standards address the range of social and environmental considerations. The reason is simple: the more experience we gain in emerging markets, the more we understand that the business case for each is incomplete without the other.

This holistic approach allows a more complete picture of the full slate of risks companies face – as well as the potential opportunity to create value and longer term company sustainability.

All roads lead back to the board

Strong environmental and social performance requires board-level commitment. The tone for stewardship is set at the top, with a healthy, well-functioning and diverse board that will make the right decisions regarding the company’s environmental and social exposure. For family firms, it is often the second or third generation of leaders that brings this focus to the board.

This leadership is particularly important in emerging markets, which may lack regulatory frameworks to require a minimum baseline of compliance. A 2016 study from Cambridge Associates quantifies this, revealing a stronger correlation between company performance and the presence of an integrated environmental, social and governance (ESG) strategy in emerging markets than in developed markets.

Our own experience in Myanmar demonstrates the importance of strengthening the board in building an effective environmental and social strategy. The integrated effort helped Yoma Bank access the capital it needed to grow in a fragile market only just opening up. Our multi-pronged advisory assistance programme started with establishing a formal board and setting clear board policies and procedures, along with other governance upgrades. In parallel, we worked with this new board and bank leadership to develop environmental and social guidelines to support the bank’s lending due diligence processes. In combination with m,additional guidance and support, these efforts paved the way for new financing in the form of a $5million convertible IFC loan.

Investors are taking notice

As a development finance institution, IFC is inherently focussed on environmental and social stewardship. It is embedded in our mission to promote private sector growth as a means to end extreme poverty and boost shared prosperity. To access IFC financing, Yoma Bank needed to make a series of changes to meet our ESG standards.

We’re not alone. A growing number of institutional investors are adopting models to analyse and price increasingly complex and acute social and environmental issues. In the United States, for instance, assets under management using ESG strategies are estimated at more than $8trillion, a 33 per cent increase since 2014. Regulators, too, are exploring the addition of environmental and social standards into their compacts, meaning that companies will be forced to address the issues.

Balancing the cost story with the value-creation story

Still, there is indeed a cost. To ensure the appropriate cost-benefit balance, companies will need to develop their environmental, social and governance value-creation story. Creating this value stems from three inter-related components: a sustainability strategy, a clear business case and a business model that realises the benefits – the proverbial triple bottom line of people, planet and profit.

 

About the Author:

Darrin R. Hartzler is the Manager of the Corporate Governance Group in the Environment, Social and Governance Department at IFC. His global team is responsible for addressing corporate governance issues in new IFC investments and providing support to corporate governance advisory services. His team is also in charge of IFC’s policies on nominating directors to the boards of our investee companies.

Darrin joined IFC in 1998 in Ukraine to design and run a corporate governance advisory services project assisting the country in its transition to a market economy. In 2002 he moved to headquarters where he helped develop and roll out an IFC Corporate Governance Methodology for assessing corporate governance practices in emerging markets companies. Corporate governance analysis is now required as part of every IFC investment, and his team is working with other development finance institutions to take a common approach to corporate governance due diligence.