In a series of articles I am deep-diving into the world of ESG reporting to explore how ESG data is used by analysts and fund managers, what is driving companies to report on ESG and how they do that, and how the evolution to one global reporting standard is progressing.
Where better to start my diving expedition than with actual companies, the source of reported ESG data? They are at the heart of the global climate debate, often as part of the problem but many times as part of the solution as well.
On the one hand the ‘old’ fossil-burning industry contributed heavily to climate change (this report from 2017 identified that 100 energy companies have been responsible for 52% of all industrial emissions since human-driven climate change was officially recognized). On the other hand, many of those same companies are now switching to forms of green energy and a lot of newly incorporated companies are focussing on green solutions as their core business model.
Today, ESG reporting is mandatory depending on geography. Large companies (+500 employees) in the EU for example have to abide by Directive 2014/95/EU on reporting of non-financial information including ESG. By contrast, reporting on ESG matters is on a voluntary basis for US companies.
Notwithstanding an obligation to report on ESG matters, companies realise that there is shareholder value to be increased and sustainable development for society to be contributed to. Many provide high-quality ESG data in their annual reporting, often in combination with financial data, which is called ‘integrated’ reporting.
The group of companies that publish high-quality ESG data includes Royal FrieslandCampina, one of the worlds largest dairy companies, with € 11.3 billion in revenues and € 0.4 billion of operating profit in 2019. It published its first Integrated Report over FY2018 and included certain dilemma’s it is facing, its goals and its challenges.
The company believes that such transparency will help to achieve its sustainability ambitions and that of third parties.
FrieslandCampina won a World Finance Sustainability Award in 2019 for having “shown an admirable commitment to environmentalism and sustainability, and are making the business world a much greener place“.
How companies can benefit from reporting ESG
The phrase “ESG” may have been first mentioned in a report called “Who cares wins” by a joint initiative of financial institutions that were invited by United Nations Secretary-General Kofi Annan in 2003. These institutions were asked to develop guidelines and recommendations on how to better integrate environmental, social and corporate governance issues in asset management, securities brokerage services and associated research functions.
This quote from “Who cares wins” describes well the expected benefits of ESG reporting for companies.
“Companies that perform better with regard to these (environmental, social and corporate governance) issues can increase shareholder value by, for example, properly managing risks, anticipating regulatory action or accessing new markets, while at the same time contributing to the sustainable development of the societies in which they operate.
Moreover, these issues can have a strong impact on reputation and brands, an increasingly important part of company value.”
“Who Cares Wins – Connecting Financial Markets to a Changing World”
From this initial expectation of how ESG reporting benefits companies, 5 distinct value-drivers can be derived (McKinsey Quarterly, Nov 2019):
1 – Stimulation of top-line growth
Having a solid ESG approach and reputation can benefit a company’s top-line in a number of ways. Governmental bodies usually look favourably at issuing permissions or licenses to companies that embrace ESG, allowing a company to easier access new markets or expand existing ones. Also, transparent ESG communication will increase sales as customers (B2B or B2C) tend to favor sustainable products over non-sustainable alternatives and are willing to pay for that.
McKinsey research demonstrates that customers in a variety of industries were willing to pay up to 5% higher prices if a green product meets the same performance standards as non-green alternatives.
FrieslandCampina validates the statement that sustainability factors generate a price differential. Its ‘value-creating model’ (Annual Report 2019) states that “The premium price we receive for more sustainable dairy products directly benefits the dairy farms that devote effort to animal, nature and the environment“
2 – Reduction of cost
Obviously, being mindful of energy usage, reducing spillage and using green raw materials will not only reduce a companies’ carbon footprint but also leads to lower operating expense. Companies that transfer to green production can seize that opportunity to make their production processes more efficient, also lowering future cost.
In a blog by Michael D’heur, he describes how in various companies a switch to sustainable production in the entire chain leads to cost efficiencies that soon exceed the initial investment.
At FrieslandCampina, sustainable production KPI’s are tracked and published in its integrated report (see table to the right).
Friesland Campina voices its ambition to make the entire dairy chain – from grass to glass – sustainable by optimizing the supply chain performance through the ‘Unlock Supply Chain’ program, reducing costs and increasing versatility.
3 – Minimization of regulatory- and legal interventions
All industries are impacted by regulations of sorts. This can vary from relative light regulation in the consumer goods industry (for example: food safety) to the highly regulated world of banks and other financial institutions.
By transparently sharing ESG elements – especially on governance – companies can expect to see decreasing regulatory pressure which subsequently will lead to greater strategic freedom.
A hefty public debate in the Netherlands around the emission of nitrogen puts dairy farmers and FrieslandCampina in a difficult spot. In an effort to reduce this emission at national level, the Dutch Government has imposed restrictions to the sector that would lead to a decrease of cattle by 50%. Emotions reached high levels towards the end of 2019 when farmers demonstrated in the countries’ capital of The Hague.
On the one hand the dairy industry faces reputational damage by these protests and the implied image of environmental polluters. On the other hand the governmental measures pose a direct threat to the businesses of farmers and, ultimately, FrieslandCampina. Either way, it illustrates the impact that legislation and regulation can have on an entire industry.
4 – Increase of employee productivity
Companies that give high priority to matters of ESG are in a better position to attract and maintain talent. The World’s Most Attractive Employers, according to a survey under students by Universum in 2019, score 25 percent higher on ESG than the global average. And the other way around: companies that employ highly motivated staff tend to score better on ESG. Fortune’s 2019 Best Companies to Work For have ESG scores 14 percent higher than the global average.
Further, giving priority to ESG boosts motivation of employees by adding a sense of purpose, and increases the productivity of its staff in general. On the flip side, by ignoring ESG companies will run a risk of slowing down production due to strikes or other labour-union driven protests and an overall decrease in staff productivity.
When improving employee satisfaction and working conditions in general it is important that companies look at the entire supply chain that they are part of and include also suppliers and contractors.
FrieslandCampina identifies a relative high risk of human rights violations in the agricultural sector and contributes to banning child- and forced labour. It also expects that same stand from its business partners.
The company has not yet set up any human rights-related KPI’s however will further embed a Human Rights Policy in the organization and start conducting human rights due diligence.
5 – Optimization of investment- and capital expenditures
For starters, investing in sustainable assets will lead to a better return on investment since such investments usually improve the production process (reduction of waste, increased energy efficiency). Also it avoids risk of ‘stranded’ assets, i.e. assets that lead to environmental issues such as pollution or excessive co2 emissions. Stranded assets need to be taken out of production, leading to an often significant write-off.
Second, research demonstrates that companies that do well on ESG benefit from lower cost of capital, cost of equity and cost of debt. A study by MCSI over the period from December 2015 to November 2019 on companies in its MSCI World Index shows that the average cost of capital of the highest-ESG-scored quintile was 6.16%, compared to 6.55% for the lowest-ESG-scored quintile.
The reasoning behind this phenomenon is that companies with high ESG standards are less exposed to systematic risk (risk that impacts the broad market). Also such companies would be less likely to default, which has a direct impact on the cost of debt.
In September 2020, FrieslandCampina issued a € 300 million perpetual subordinated hybrid securities. Rating agency Fitch rated this securities BBB- and indicated that the ESG score for the company stands at 3 for the moment, on a scale from 1 (no impact) to 5 (high impact). This means that the neutral rating on ESG had no bearing on the overall rating of the debt instrument. Arguably, a higher ESG score would lead to a better credit rating and, ultimately, lower cost for the company.
In conclusion
When I started out thinking about ESG reporting, I expected that is should be used as a ‘tool’ for us investors to make companies turn up their efforts to battle climate change a few notches (see this earlier blog). Having looked closer at what companies stand to benefit from a strong ESG profile and related reporting, I now see that there should really be no need for any outside pushing at all.
Companies that have a focus on Environmental-, Social- and Governance matters, create value in many different ways and executives that ignore those opportunities simply destroy value for their share- and other stakeholders.
If only there was a way to easily select those ESG winners from the pack……. Let’s talk about that in a next blog!
The ‘how’ and ‘why’ at Royal FrieslandCampina
Throughout this blog, reference is made to the integrated report published by FrieslandCampina. I selected this company because of its relevance to the topic of environment and climate change, as well as for its very transparent public reporting.
Responses to questions asked to FrieslandCampina, and their integrated annual report 2019 provided useful insights as to why the company decided to be transparent on ESG and also on how they practically go about preparing that report.
Starting with the ‘why’ of things, it soon becomes apparent that sustainability is in the core coding of FrieslandCampina. Indeed, its ‘company purpose’ statement reads as follows:
Nourishing by nature: better nutrition for the world, a good living for our farmers, now and for generations to come
Annual Report Royal FrieslandCampina N.V. 2019
Investments in sustainable long-term growth, growing in a climate neutral way and reduction of the use of scarce natural resources are the main drivers to achieve the “future” target.
With that purpose statement as a starting point, FrieslandCampina explains how it creates value in the chain in an informative page of its integrated report over 2019, and makes the connection to the UN’s Sustainable Development Goals that the company has adopted.
For it’s sustainability reporting, FrieslandCampina applies a global reporting framework issued by the Global Reporting Initiative (GRI). The full GRI table is disclosed as an annex to the Annual Report. More on sustainability reporting standards in a next blog.
Having a global presence with branches in 36 countries, the data-collecting process to compile sustainability KPI’s is complex, and FrieslandCampina uses various systems and the help of external consultants to collect-, aggregate and report the data from its subsidiaries.
PwC auditors provide assurance over the process and outcome.
The sustainability targets that RFC deems relevant are:
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