ESG decoded: the Value Ecosystem

Photo credit: Sandy Millar on Unsplash

There has been much debate recently about the topic of ESG, environmental, social, and governance impacts on the corporate world.

The trouble is, measures of ESG often contradict, and according to a recent article by Professor Aswath Damodaran, a well-known valuation academic, don't predict things about value very well. In other words, it's difficult to value ESG.

So, the question emerges, how to resolve the ESG question better? The answer lies in what I call the Value Ecosystem.

What is the Value Ecosystem?

Well, this picture will explain.

The Value Ecosystem reflects that value arises from the dynamic interaction between stakeholders. You might recognize from the concept of Porter's Five Forces that these stakeholders are the forces that interact on corporate value.

The historical view on these five forces is that you optimised shareholder value at the expense of each of the other stakeholders, that is; shareholders negotiated competitively with other stakeholders.

Which, as we see now, has led to some short-term outcomes which have been exposed by the ESG movement.

To allow for this thinking sea change, Porter evolved his model to what is called shared value (excuse paywall) which maximises value for all of the involved stakeholders.

Some users have found Porter's concepts difficult to action as they believe it to be impossible to optimise all of the outcomes. However, it easier to conceptualise as a view that shareholder value can be optimised by negotiating such that all other stakeholders receive at a minimum fair outcomes, and that room exists to negotiate collaboratively such that additional value can be shared between shareholders and other stakeholders.

The chart explains the relationships and how value is measured between each of the four aspects of the value ecosystem. Of course, traditional measures of shareholder value only measure value from the point of view of shareholders.

However, companies, in order to deliver shareholder value, need to provide value to the customers, the environment, and society within which they operate, and their suppliers in order to continue to operate and deliver surplus returns to shareholders.

Thinking about value evolving from your ecosystem can deliver long-term sustainable returns. It also allows the dynamic reality to be modeled and embedded in the way you think about value for a company.

It also allows you to put ESG measures in context. For example, if a company produces very small tier-one carbon contributions, it's very unlikely that mitigation actions will have a material impact on value as it is unlikely to upset the negotiations between stakeholders.

In this way, it is possible to see the ESG concepts as analogous to the human resources concept of hygiene factors and motivators.  That is, for many companies, good ESG is likely to only enable the company to get to the starting gate in terms of delivering corporate value (that is, people will deal with them), it's unlikely to deliver substantial long-term excess returns. In the language of that HR construct, it's a hygiene factor and not a driver of investor or other stakeholder motivation.

For other businesses, ESG will fundamentally reshape their value proposition to stakeholders, and may motivate a new series of investors to (or away from) the table. An ecosystem view of the world allows you to understand these important nuances for different companies.

How do you use the value ecosystem?

The first necessity is to understand the value that the business has for each of its stakeholders.

It's then important to model how that value is captured by the financials, or not, in some cases. For example, cultural measures might loom large in the employees mind, but seldom make it into the financials, at least in short term financials.

Then, in order to manage value more productively in future, you can negotiate collaboratively with those stakeholders to optimise your value. It's very important to act fairly such that the relationships are both sustainable, and do not have the prospect of reprisals built into them.

This is a very different model from the 1980s view of shareholder value, which was a fairly rapacious and short-term one.

Takeaways

In conclusion, the value ecosystem provides an important lens through which to understand the nuances associated with the discussions of ESG. It's not just enough to consider that ESG is going to create value because in some cases, it will merely preserve value that may be lost if those ESG protocols are not put in place.

Accordingly, it's important to understand the web of interrelationships that your business enjoys with its stakeholders in order to manage that value better for the future. In order to do that, you need to understand how value is thought about by each of the stakeholders, whether your existing financials and other measurement systems identify that value, and then negotiate much more collaboratively than in the past.

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Richard Stewart OAM is a Corporate Value Advisory partner with PwC. He has been with them for 36 years in Australia, Europe and the USA, doing his first valuation in 1992. He has helped his clients achieve great outcomes using his value skills in the context of major decisions, M&A, disputes and regulatory matters. His clients span both the globe and the industry spectrum. He holds a BEc, MBA, FCA, FCPA, SFFin, FAICD and is an accredited Business Valuation Specialist with CAANZ. He has written two books, Strategic Value, and Hitting Pay Dirt, and is an Adjunct Professor at UTS. The opinions in this article are his own and not necessarily PwC's.