The Link Between ESG Performance and Cash Flows

The following post is an answer to a question recently asked in my Quora session: “What role does ESG (Environmental, Social, And Governance) play in the valuation of a company?” To read all of my answers, visit the session here.

Trillions of dollars are flowing into ESG (environmental, social and corporate governance)-oriented assets, so it’s natural that executives and investors wonder how a company’s performance on ESG issues relates to its valuation. ESG can have a significant effect on valuation, but not in the way many think. Some research claims that companies with good ESG rankings get valuation premiums or benefit from lower cost of capital. However, it’s really hard to separate good ESG performance from good financial performance. For example, some industries that are highly valued, such as software and pharmaceuticals, also happen to have high ESG rankings because they don’t leave much of a carbon footprint.

ESG doesn’t change the mechanics of how companies are valued. Collectively and over time, investors are rational and will only pay for a company’s ability to generate cash flow. So the valuation question comes down to how ESG strategies and performance affect a company’s cash flow.

In some cases, the impact is negative. Take the valuation of oil and gas companies with low ESG rankings because of their fossil fuel positions. Investors today are clearly aware of the risk that significant portions of their oil reserves won’t end up being developed because of the growth of alternative energy sources, resulting in stranded assets. The current values of such companies suggest the market has already accounted for those concerns. Note that the concerns are ultimately about future cash flows, not just the ESG score.

On the positive side, companies can increase their value if they systematically look for new and unique ways to increase their cash flows. I see five main ways in which ESG initiatives can do that.

Revenue growth. A strong ESG proposition helps companies tap new markets and expand in existing ones. When governing authorities trust corporate actors, they are more likely to award them the access, approvals, and licenses that afford fresh opportunities for growth. For example, in a recent massive public–private infrastructure project in Long Beach, California, the for-profit companies selected to participate were screened based on their prior performance in sustainability. ESG can also drive consumer preferences. McKinsey research has shown that customers say they are willing to pay to “go green.” When people were asked about purchases in various categories including automotive, building, electronics, and packaging, upward of 70 percent said they would pay an additional 5 percent for a green product if it met the same performance standards as a non-green alternative.

Cost reductions. ESG can reduce costs substantially by helping companies combat rising operating expenses (such as raw-materials costs and the true cost of water or carbon), which McKinsey research found can boost operating profits by as much as 60 percent. Consider 3M’s program to prevent rather than clean up pollution: efforts have included reformulating products, improving manufacturing processes, redesigning equipment, and recycling and reusing waste from production. Since introducing the program in 1975, 3M has saved $2.2 billion.

It’s really hard to separate good ESG performance from good financial performance

Reduced regulatory and legal interventions. Strong performance on ESG can give companies more strategic freedom by easing regulatory pressure. The value at stake may be higher than you think. For pharmaceuticals and health care, the profits at stake are about 25 to 30 percent. In banking—where provisions on capital requirements, “too big to fail” regulations, and consumer protection are so critical—the value at stake is typically 50 to 60 percent. For the automotive, aerospace and defense, and tech sectors, where government subsidies are prevalent, the value at stake can reach 60 percent.

Employee productivity uplift. A commitment to addressing ESG concerns can help companies attract and retain high-quality employees, enhance employee motivation by instilling a sense of purpose, and increase productivity overall. Employees who report feeling not just satisfied but also connected perform better. Walmart, for example, uses a proprietary scorecard to track the work conditions of its suppliers.

Investment and asset optimization. Investment returns can also see a boost when capital is allocated to more promising and sustainable opportunities, such as renewables or waste reduction. An ESG focus can help companies avoid investments that become stranded because of longer-term environmental issues (such as massive write-downs in the value of oil tankers). It’s important to note that taking proper account of investment returns requires starting from the proper baseline. When it comes to ESG, bear in mind that a do-nothing approach is usually an eroding line, not a straight one. Continuing to rely on energy-hungry plants and equipment, for example, can drain cash in the future. While the investments needed to update operations may be substantial, choosing to wait can prove to be much more expensive.

I’m a core leader of McKinsey and Co.’s Strategy and Corporate Finance practice. To learn more about the impact of coronavirus on a company’s value, check out my book Valuation: Measuring and Managing the Value of Companies, 7th Edition, co-authored with Marc Goedhart and David Wessels.

Measuring and Managing the Value of Companies

The seventh edition of Valuation is a handbook that can help managers, investors, and students understand how to foster corporate health and create value for the future—goals that have never been more timely. Available Now.

Learn More