Key Operational Considerations In The Sustainable Economy - ESG And The Sustainable Economy

ESG FROM THE OPERATOR'S PERSPECTIVE

In recent years, businesses that demonstrate certain environmental, social, and governance (ESG) criteria have seen a pronounced uptick in interest from many investors, particularly from institutional investors who were in the vanguard of the ESG movement. This interest has manifested not only in higher stock prices on public markets, increased interest in private fundraising rounds, and competitive pricing in project finance, but also in ripple effects through supply chains, hiring, and other aspects of operations. So too do ESG criteria— and public announcements regarding investment decisions made by investors utilizing ESG criteria—increasingly impact a business's brand and consumer relations. In parallel with this trend, businesses around the world have independently created and implemented ESG-related policies in a variety of areas.

But what is ESG in the context of an operating business? Typically, discussions around ESG in this area target various practices that contribute to a business's ESG profile vis-à-vis investors. Consequently, ESG policies and practices are largely about accounting for and mitigating the risk that externalities will negatively impact an investment or business line. Thus, environmental criteria frequently focus on objectively accounting for observed changes in the natural world, regardless of their cause. Social criteria center on objectively accounting for the wider societal and economic impact that working conditions and practices can have. Finally, governance criteria account for the risks inherent in the failure to comply with applicable law, as well as the failure to prevent employee turnover and discontent, or to holistically take into account the views of a range of people—any of whom may be customers, investors, or business partners.

Often, ESG practices are oriented toward the long term and actions beyond only those that are required by law. However, there is wide variation among businesses in how they may approach ESGrelated matters. For example, ESG considerations at the operating company level can include:

• Diversifying a business's workforce, executive team, and board, whether by reference to race, gender, sexual orientation, country of origin, or socioeconomic status, as a way to respond to customer requirements or market changes.
• Taking into account identified externalities that a business creates and taking steps to mitigate them. For example, a dairy farm could identify the costs of methane emissions to local residents and the climate, then mitigate them by installing a digester that captures the methane and converts it to renewable fuel.
• Expanding a business's focus on shareholder value to a focus on stakeholder value. The Business Roundtable has stated that stakeholders include "employees, customers, suppliers, and communities." The 2020 Davos Manifesto expands that slightly to include society at large and states that "the purpose of a company is to engage all its stakeholders in shared and sustained value creation[...]. The best way to understand and harmonize the divergent interests of all stakeholders is through a shared commitment to policies and decisions that strengthen the long-term prosperity of a company."1 Thus, a company that focuses on stakeholder value could consider issues as diverse as compensation of employees relative to executives, scope 3 greenhouse gas emissions, longevity of products sold to customers, and hiring from marginalized communities. Moreover, local law that governs business organizations can affect the extent to which a business considers matters that do not directly impact shareholder value.
• Anticipating and mitigating future and large-scale risks. This is the point at which ESG begins to merge with impact and justice missions. For example, many large companies currently purchase renewable energy credits (RECs). More recently, some have begun purchasing carbon credits, and a few have entered into voluntary carbon removals contracts. While this type of activity is, of course, about using corporate resources to impact climate change, there is wide variation in the reasons for any given company's entrance into this market. For example, some companies may acquire RECs solely in response to customer or investor pressure concerning corporate citizenship or otherwise. Others may be thinking farther into the future about the disruptions that are expected to result from climate change and how that may impact the business's customer or employee base, supply chain, or access to capital. Others still may venture into this market out of a desire to create positive and long-term impacts on the climate, environmental or energy justice communities. Similarly dramatic variations can be seen in the reasons that a company will engage with any ESG-related segment, including: forced labor in supply chains; justice, diversity, equity, inclusion, and accessibility; environmental impacts of supply chain sources and operations; and many others.

It can be difficult to translate these broad concepts into actionable items, particularly in the context of an active business with a traditional focus on near-term financial performance. But an ESG focus can be and is achieved every day around the world; largely by reconciling the values and goals of a business beyond mere profitability with the values and goals of the people with whom the business interacts or seeks alignment. This can be an enormous task requiring a large degree of coordination. It can also seem as though there is no good starting point. So, how are businesses implementing their ESG goals?

One popular option is for a business to create a chief sustainability officer or ESG officer role to implement policies to guide how the business accounts for ESG criteria in certain aspects of its operations or across its entire platform. Consultants are frequently essential to this effort, for example by creating baseline studies, identifying areas where operations are already exemplary or could be with reasonable adjustments, helping the business determine the best steps to advance its goals, identifying opportunities to do so, and designing campaigns to communicate those goals and the business's efforts to meet them.

From there, there are numerous approaches to the integration of ESG criteria into a business, but a few general trends emerge:

• Personnel matters. ESG can factor into a number of decisions related to personnel, from choices about transportation subsidies to fair wages; diversity and inclusion in hiring, responsibilities, and promotions; employee perks at the office; and work-fromhome policies. Each of these categories and many more have the potential to impact environmental sensitivity and justice, labor standards, and governance practices.
• Supplier policies and evaluations, including selection of preferred providers based on the outcome of those evaluations. Businesses without existing policies and procedures can create simple policies that incorporate ESG-related criteria. Businesses with existing policies and procedures can further integrate ESG criteria by including methods designed to evaluate a supplier's compliance with specific types of law and regulations, as well as how the supplier goes above and beyond those requirements by reference to stated criteria or voluntary standards such as those created by the Sustainability Accounting Standards Board (SASB), the Global Reporting Initiative (GRI), and the World Resources Institute. For example, a procedure may evaluate how the supplier works to mitigate pollution from its operations, whether it uses forced or low-wage labor, whether women or ethnic minorities are treated fairly or given substantial roles, and whether the business takes into account similar criteria when working with its own supply chain.
• Service provider policies and evaluations. It is a growing trend to formally incorporate ESG-related criteria into service provider bidding processes, as well as periodic evaluations. The criteria included in these processes often include factors designed to probe how service providers foster a diverse and inclusive workforce, address their own environmental footprint, and participate in their community or the communities where their customers are located.
• Investments. Many operating businesses invest in other businesses and funds for a variety of reasons; e.g., to foster growth of innovative technologies, grow business partnerships, or simply manage risk and grow value. Needless to say, businesses that make these investments can, and increasingly do, act like an institutional investor in evaluating targets using ESG criteria.
• Mergers and acquisitions. Business mergers and acquisitions can help both the acquirer and the target to grow through greater efficiencies, and access to customers, financing, new markets, and complementary talent and resources. Businesses that are focused on ESG as a guiding business principle should consider how ESG criteria are accounted for throughout this process:
  • In the initial evaluation of a potential business combination, both the acquirer and the target should consider each other's ESG metrics and how well their existing practices may fit together, as well as areas where there is room for improvement.
  • During due diligence, the acquirer's legal teams and consultants should be instructed to weigh ESG factors in addition to mere legal compliance and overt risk.
  • When determining the appropriate price for the target, both parties should consider whether and how much value should be attributed to the target's ESG-related practices.
  • When determining whether equity or cash consideration should be used in the transaction, the target's shareholders should consider whether the value of the acquirer's stock is impacted by the acquirer's ESG score and potential future changes in its stock price depending on how its ESG practices may change in the future, including by reason of integrating the target into the acquirer's business after the transaction closes.
  • When evaluating how the acquisition will be financed, the acquirer should consider whether its or its target's ESG score warrants preferred lending terms or whether the acquirer could efficiently raise financing using a green, social, or sustainability bond.
  • Finally, when integrating the target after the transaction, the acquirer should analyze how and to what extent its own and its new subsidiary's ESG-related practices should be melded. Does the subsidiary already have excellent practices? Should any of them be integrated into the parent company's broader operation? Or, how should the parent company's practices be translated for the new subsidiary?

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