Understanding the Benefits of ESG and Sustainability
August 30, 2022
Lourenco Miranda, Managing Director, and Danielle Barrs, Director, of EisnerAmper’s ESG and Sustainability Services are joined by Travis Epp, Audit Partner and Partner-in-Charge of EisnerAmper’s Manufacturing and Distribution Group to define ESG and sustainability and to explain the practical benefits of implementing these strategies for an organization.
DB:It is great to be here. The distinction between ESG and sustainability, in my opinion, is one of the most important things that we could start off with. I come from a corporate sustainability background, both in education and professional experience. So before EisnerAmper, as you mentioned, I worked either for or alongside mostly Fortune 500 public companies. I have led both sustainability and energy strategies, which usually for the most part included things like reducing carbon emissions, developing CSR reports, which is your corporate social responsibility, annual reports. And these reports contained information on how company operations affect the planet and communities. It essentially speaks to doing well by doing good. And that is the idea of being a good corporate citizen while also making it profitable. And that is the foundation of sustainability.
It's the triple bottom line of people, planet and profit. And then on the flip side, ESG, Environmental Social Governance, it also looks at environmental and social issues, but more from the lens of an investor. So it is a tool that is mostly used to evaluate the risks and opportunities that environmental and social issues have on your business. And this is for the most part in order to help investors make more informed decisions about their investments, but that's more, Lourenco's wheelhouse. I focus on maximizing positive impact and making it profitable.
JM:That's really good. So what you're saying is, to summarize, sustainability in effect is people planet, profit and ESG is more directed towards investors. Am I getting that correct?
DB:Yeah. Pretty good recap.
JM:To summarize. Yeah. Okay.
DB:Yeah. Pretty good recap.
JM:So gives us a great segue to you, Lourenco. There are many benefits to ESG. You're a finance expert talking about investing as Danielle did. So tell us about the financial benefits of ESG, which frankly are also often overlooked because people look at the risks, they don't always look at the benefits of ESG. And maybe why some of this reporting though it can be a pain, can also actually be leveraged for good.
Lourenco Miranda:Oh, thank you very much, Joan leveraging in what Danielle just said, ESG is concerned about identifying risks and opportunities that will impact that company to achieve their objectives. And the objectives of our company is to maximize profitability in a sustainable way. It's not only maximizing profitability today, but also be corporate social responsible that this profitability becomes sustainable for future generations. So how do you do that? You do that by applying very basic risk identification and assessment methodologies. So if I put myself in the shoes of a CFO or a CEO of a company, the CEO and the CFO, they have multiple stakeholders that they have to appease and they have to please those stakeholders and manage these stakeholders expectations. So this stakeholders can be external stakeholders or can be internal stakeholders.
So the external stakeholders, as Danielle mentioned, you have the investors, you have regulators, you have your board which I consider that an external, and then also you have the general public, civil society, your suppliers. So you have all the external stakeholders that we have to manage their expectations. And at the same time, you have internal stakeholders that you have to manage expectations too. You have your staff, you have your management team, you have the executive team, you have people that depend on you as a CEO, as a senior manager in the corporation to also manage their expectations and the expectations of the staff. So internal and external stakeholders management.
So you asked about the benefits of ESG, ESG comes and tries to resolve these conflicts or these seemingly conflicting objectives. ESG comes and gives you a methodology, gives the CFO a methodology to identify all the vulnerabilities that the company has towards an environmental risk, could be climate change risk could be something that is related to land utilization, water scarcity that's today is very important in our country. So when the CFO looks at all these challenges and these exposures and these risks that are going to impact the bottom line of the company, the ability to generate cash flows, the ability to go to the market and ask for funding.
So all of these elements, the CFO has as an opportunity there to go to the corporate social responsibility department and ask for help and ask for ideas and opportunities in order to mitigate those risks. So the corporate social responsibility will look at all the list of risks, or that you have an environmental risk linked to climate change. And if the company is too is heavily dependent on carbon, corporate social responsibility team can come in with an opportunity, and tell the CFO, "I can give you solution for that or a mitigant for that exposure, energy efficiency opportunities that could mitigate a dependency on carbon." That's how ESG comes and helps the company to identify risks, assess these risks and find opportunities that will mitigate those. And of course, the CFO is interested to report to shareholders as you mentioned, you have to report to investors as well, that they are managing their risks appropriately and they're identifying them and then doing something about it.
And because some of these ESG risks, they do not happen in the short term, climate change is something that takes a long time to materialize, can be in five years from now, there are events that we are observing right now, as we speak, we have droughts and water scarcity in the country that are impacting various business in all of the place. We have these that are happening now, of course, that we have to identify and assess immediately. We are already late for that, but there are others that are longer term.
So what the SEC is asking is that you don't only identify these risks now, but also identify the impact of those risks in your financials, in the medium and long term, because the transition and when you're going to materialize and realize and suffer those consequences in your bottom line is going to be in the long term, not necessarily tomorrow. But that's one of the reasons why it's very difficult to get the acceptance from the CFOs now, because they believe that it's a long term risk, but if you don't start now, you are going to be seriously exposed, you won't be able to keep your company sustainable and profitable in the long term. So that's why ESG has a huge benefit for the company.
JM:So just to follow up on that quickly, one of the financial benefits I've also understood is that when you show how you've identified these risks that are mitigating them, that it can give you a higher valuation and therefore maybe give you access to more capital.
Jm:So A, is that true?
LM:It is true. Yeah.
JM:And B, explain a little bit about how that works.
LM:So valuation and how much that company will be worth and how much it will value in the future, is composed by the ability to generate future cash flows and how you discount that to today, to the present value of these future cash flows. That's very basic finance. The risks that will impact the company specifically to the company will impact the ability of this company to generate this future cash flow. Now you have systemic risks, you have risks that are going to impact the whole industry, that's why it's important to understand the different levels of those risks. ESG risks that are specific to company and also general and systemic to an industry and how the market will perceive you and how the market will perceive the company that we are talking about in terms of risks and vulnerabilities, and the ability to weather those risks and to manage those risks through an opportunity, identifying these opportunities in identifying this corporate sustainability opportunities that will help them to manage the market will look at this company and will assess the risk of this company.
And the way that this assess is through the discount factor, or the amount of the cost of capital. Suppose that you're a CFO and you want to get finance from a bank. The bank will look at you and look at all the risks, identify your ability to generate cash flows and how you manage your risks and opportunities. The banks will also look at if you are reporting them, you're disclosing the level of transparency and they will give you a rate for your debt. So how much I'm willing to charge you for that specific loan. And that will be part of your cost of capital. And if you can reduce that, if you can show to the bankers, if you can show to the market that you are managing your risks appropriately, and you are identifying these opportunities, these sustainability opportunities to mitigate those risks, you can reduce your cost of capital.
LM:Increasing valuation, because you reduce the amount of how much you're discounting your cash flows and of course, increasing your evaluation, right?
So there are two pathways to increase your evaluation, the way that you manage the risks that you can generate more sustainable cash flows, that's your numerator, and you can also work in your discount factor, in your cost of capital by convincing the market and showing to the market that you are managing your risks better, and that you are worthy, you deserve a better rate. And that's something that after being a capital provider for a long time, I can attest that can happen, that happens. And it is true that managing your ESG risks can impact in your rate and the ability to have better access to finance and to have better access to capital. And to Investors to Danielle's point in the beginning.
JM:Great, thank you for that clarification. And I think that's really critical for companies to understand, because it's a big, big benefit. Travis I want to bring you in here. And I want to get a little bit granular. As a leader in EisnerAmpers manufacturing, distribution practice, you have many relationships obviously. You talked to mid-market business leaders all the time. What are your observations in regards to the ESG initiatives over the last year?
Travis Epp:Thank you, Joan. I'm glad to be here today. Just to go along with what Lourenco said. I think a key change that's happened over the last year is maybe educating the clients about the importance of ESG and as well, some of the service providers and lenders, I think a year ago, they may have these opportunities, provide benefits to companies, but I still think that they can do a better job of actually communicating those to companies in the manufacturing and distribution industry. So I definitely think that the ESG has gained traction over the last year. I do speak to a number of executives where it's the CFO, COO or board members. And I think a year ago, there was a definitely an awareness at ESG, but it didn't didn't appear that companies were really grabbing the bull by the horn and really starting to develop a strategy. The answer always seemed to be, it was somebody else's responsibility within the organization.
So if we fast forward a year, I would say that some companies have created policies and procedures, but for the most part, I would say the biggest step forward is that more companies are now including ESG and corporate sustainability in their mission statements. And as Danielle and Lourenco alluded to, investors and lenders are including ESG and corporate sustainability as part of their analysis when they review companies.
JM:That's interesting. Just to follow up on that briefly, are any of your clients talking about the SEC climate disclosure rules requirements, has that raised this in their minds? And are they asking questions about it? And if so, what are those questions?
TE:Right now we're at the preliminary stage. Public companies are obviously very concerned about meeting the requirements with the SEC, but I think they're still formulating what their responses will be and what they have to do.
Yeah. They're probably waiting for the actual rules to come out. I understand there were 14,000 comments sent to the SEC. Danielle, I want to stay a little granular, because you've been hands on with companies to reduce their carbon footprint. Can you give us an example of how companies are doing this and then how that would show up in their ESG reporting for example?
DB:Absolutely. And you hit on one of my favorite topics of all time, which is emissions in carbon footprint. One of my favorite projects that I've led was a development project for onsite, renewable energy.
Essentially the task was to achieve carbon neutrality for a particular site that we had and because of space limitations in this case, rooftop solar alone, was not enough to cover the eight megawatts of energy, it would've taken to achieve this. And just to go back for a minute, carbon neutrality essentially means that your energy consumption is balanced out. So whatever amount of electricity you're using, if you want to achieve carbon neutrality, you have to balance that out with, let's say, renewable energy. And the idea is to reduce fossil fuel consumption, which reduces emissions. Eight megawatts is a lot for one facility. So for reference a one megawatt solar array usually takes up between six to eight acres of space.
So this is really hard to do on one site, whether it's a manufacturing facility or an office space. So not many facilities have the space to accommodate that. In this particular situation, we had looked at solar carports initially, which have an additional benefit of covered parking. And there are solar arrays on top of this covered parking, which was nice in this case because the site happened to be in Southern Florida. So you get covered parking for employees as well, even then it couldn't cover the electricity consumption for all of the buildings on that site. So long story short is that we ended up partnering with the county to repurpose a 35 acre brownfield, which essentially means that land was deemed unfit for the majority of residential and commercial construction due to contamination or potential contamination of soil groundwater, et cetera.
Because those 35 acres were in addition to maximizing the onsite space, which we ended up doing with both rooftop solar and carports, a combination, with these 35 acres, the company actually had not only enough electricity to cover their consumption, but excess electricity generation, which was then pushed to the grid and sold to neighboring businesses. This was one of my favorite projects because it shows how much you can achieve with a little bit of creativity and strategic partnerships.
JM:Oh, I love that story. It's brilliant. Just to follow up on that really quickly, how did they see that opportunity for that unusable land that can then be repurposed so perfectly and did they have to persuade the county to let them do this? How did that negotiation work out?
DB:It's interesting. Florida happens to be a regulated state, which means that utilities have full control over the grid. So we had to engage with the state anyways, which obviously has a lot of conversations with the county. So we were looking and speaking with those people anyways, about the project, we had to because it's so regulated there. So we happened to be speaking with the county anyways and after many conversations they had just mentioned, "Look, we have a field. Is this something that you could do?" They had tried to put a community facility on that land and they were not allowed, it got shut down because of the state of the land. And so a solar array essentially, you can put that on a brownfield. No problem. There's not going to be people there. It's not going to be children there.
So that is a great way to repurpose the land. We jumped on it right away and the land happened to be, and this is an important point, close enough to the site that we could build a transmission line from the site to this particular field. If we couldn't, that would've been a different story because then you have to push the electricity to the grid, essentially sell it to the grid and then buy it back. And usually, when you buy it back, it's more expensive than when you sell it. So you're not actually turning a profit off of that at all. The site happened to be within a stone's throw of the building. So we were able to build transmission lines that went right from the site to the brownfield.
JM:Brilliant. I love it. One of the lessons in that is keep asking for options, right?
JM:Be creative. Yeah. Keep looking for solutions. So Lourenco, as I mentioned a minute ago, the SEC is planning to require companies to report on two types of financial risks. There's the risks and you alluded to them in your comments a minute ago of climate change, and then there's the transition to net zero. So we're going to dive more deeply into this in a later episode, but tell us today, how can companies reflect the climate related risk to their operations in their financials? Because it may sound obvious, you can look at the rate of hurricanes that are building up in your area, look at the Noah reports perhaps, but share with us how companies can literally find climate related risks into their operations and then put that in their financials. Because I would imagine that some of that is really estimating.
LM:That's a very good question, Joan. So again, I'm going to put myself in the CFO shoes and I feel the pain and your question is the question from many CFOs out there, so how I'm going to do that? So the first thing that you have to understand is what is a climate related risk for your business. Then after that, as a CFO, you understand your business and where the strategy of your company is going to go in the short term and the long term. So you understand that, your board decided on that. So there's a tone from the top saying that it's important that you understand your strategy and understand your risks and opportunities. You already do that for your 10K, in your 10K the second line there, the second section is risks.
So you already have a CFO or you have in the day to day activities to identify risks that will impact their strategy. The question is how you add climate related risks to this mix. And to this same process that you already have to identify risks, there's going to be another element of climate related risks. So now you ask what is climate related risk that will impact your business? So we have to think about what's behind the climate related risk? What's taxonomy? What are the causes and what risk factors of a climate related risks? There are basically two, the first one is physical risks. And physical risks, as you mentioned, the hurricanes and the droughts and wildfires, they can happen in a acute way. Hurricanes is acute. So something that happens like a disease, you have something that happens and you cure and it happens and you cure and it happens and you cure.
So that's something that happens in instances and then goes away. And there are things that are perennial, things that are going to persist for a long time. These are the chronic things that you have a chronic disease that's going to persist for a long time. Climate related risks, physical risk is the same thing. So you have these risks that will happen and will destroy your building or is it be a flood that we're going to destroy your physical assets, going to be a drought that will not enable your plant to generate the output because you depend on water so that sometimes you are heavily dependent on water and you have water scarcity, that's something that will impact your cash flow. You're going to impact your output from your specific plant, that depends on that. If your plant is located in a place that is highly ... There's a drought or there wildfires again is an example of a physical risk that will impact ability to generate cash flows.
Again, you have to start linking those risks to the bottom line. How do you do that? You first have to understand your business. If you have plants in those regions, you have to understand that you're exposed to these risks. Again, if you are in a coastal areas of the country, you're going to be exposed to other types of physical risks, things that can happen in a longer term, like sea level rising that can take a longer period of time to manifest. And if you have, for instance, in the business of real estate, in the coastal areas of the United States, you're going to be exposed to this type of risk in the medium and long term. We have to start paying attention to that, identifying those risks. And again, talking to the sustainability people and asking for opportunities to mitigate those risks, they are clear opportunities there.
If you have exposures to physical risk, you can apply sustainability opportunities to mitigate that. The second type of climate related risk is transition, people call transition risks. So transition risks are the ones that are dependent on how much you are vulnerable to a specific type of energy as Danielle will speak here with waving hands, but it's how much your company is dependent on fossil fuels.
LM:On hydrocarbons. And if you are, for instance, in manufacturing industry, and you're highly dependent on that specific type of fossil fuel, or if it's coal or if it's oil, if it's gas, however it is, if you are too much dependent on that, any change in a legislation, any change in carbon prices, any changes in attacks or any changes in legislation or technology, public opinion towards a specific utilization of fossil fuel, people probably don't want to drive cars that are no longer electric. So they're not electric, they are using a combustion engines.
JM:The ability to sell your product is reduced.
LM:Exactly. That's called transition risk, they are depending on technology advancements, changes in legislation so you have to understand how vulnerable your business is to carbon. If it's too carbon dependent, if it is, you have to start thinking about how a change in legislation, how a change in carbon tax, or a change in the technology will impact your ability to generate cash flows. That's the second type of risk identification. That's a physical risk and the transition risk, transition risk will be more difficult to measure because changes in legislation are not too predictable.
LM:Technology takes time to mature. And that's why people talk about pathways to transition. Don't think that the companies have to start thinking about, and that's totally in Danielle's know how, is how to come up with these pathways. So you sit down with the CFO, that's concerned about the cash flows and then cost of capital and all these things. And together with the corporate social responsibility, we come with solutions and coming up with these strategies, these pathways towards what you called net zero, sometimes net series is going to be very hard to achieve, but pathways to reduce your dependency, dependency of your company through fossil fuels. That's the transition risk is about and how you mitigate that is through very clear sustainability pathways towards this to become less dependent in carbon. And that's dependent in the fossil fuels.
JM:So you're reducing that risk.
LM:You're reducing that risk.
JM:So do you have to report, let's say your general motors as an example, and they're transitioning their entire fleet from ICEs, Internal Combustion Engine vehicles to electric vehicles, does the transition risk, the risk to their cash flow from maybe losing the income from the internal combustion engine sales and from changing over their plants, how does the transition risk get reflected in the financials from the actual transition of their business?
LM:That's a very good question. So probably two or three factors that the CFO has to start thinking about the transition, the first one cannot be disorderly. It cannot be a abrupt transition or disorderly transition has to be an ordered transition, an orderly transition that the pathways towards de-carbonization cannot happen all at once, why? Because again there is an economic dependency on fossil fuels. Today we haven't reached the peak of our utilization of carbon or fossil fuels. We're not there yet. So there is a transition, that's why it's called transition risk. It's not something that happens overnight, it happens from today for 10 years from now, 20 years from now. So the companies, we have to start thinking about how to be aware of all the impacts of new technologies. So you're mentioning, moving from internal combustion to electric vehicles, the first question that comes to mind, what do you do with the batteries?
LM:So to build a battery, you are highly dependent on wear metals, wear metals like nickel, cobalt, cadmium all these they have to be mined. You don't find them on the surface, you have to mine them. And whenever you mine nickel, and whenever you mine cobalt and all these rare metals, there is a huge environmental impact, environmental impact in terms of the communities, that's also a social impact of mining. In the value chain of electric vehicles, you have to start thinking about this. And that because you have a huge dependence on nickel and all these harrier metals, the prices of these rare metals are extremely volatile. In today's market they are even more volatile after the war in Ukraine. There's a huge impact in the rare metals pricing.
JM:So they'd have to factor that pricing into their financial as well.
LM:A hundred percent. That's a transition risk that they have to think about. Transition risk has to do with technology, in case of the electric vehicles, it's the battery and battery efficiency utilization, and disposal. And the second one is how they fund themselves based on all these future cash flows and price dependency. And that's transition risk, new technologies, new regulations. So we have a lot of policies that are coming, tax benefits that will help with the transition because you have a tax benefit, people will buy more electrics. And then for the CFO and CFO minds, is more cash flows that they're generating. They have to balance all these, and you have to understand all the risk factors and the causes of those risks that comes from the transition risks.
JM:Yeah, it's a lot of elements that go into this.
LM:Yeah. It's a lot when moving parts.
JM:So Travis, I want to bring you in on this and take us as an example I gave, of course as manufacturing in General Motors, but what are some of the challenges since you've worked with manufacturing, distribution companies, what are some of the challenges you've seen in real life? Lourenco was talking about what you have to address and be in the seat of the CFO. You've actually been working with CFOs in manufacturing distribution companies. So what are some of the challenges that you've seen specifically? And if you could just build on that.
TE:Thank you, Joan, in regards to ESG, obviously there's different aspects. One aspect I'll mention briefly is the importance of ESG on employee retention and attracting employees because in today's workforce, having solid ESG program is very beneficial to the employees of companies. But I think when we consider manufacturing and distribution companies, a lot of what we focus on first is the environmental aspect relating to manufacturing. And just to carry that on a little bit further, talking about manufacturing in America. Right now, because of what's happened over a number of decades, what we've done is we've outsourced the manufacturing floor to foreign countries. So right now, when we're asking our American companies to be compliant with ESG policies, there is a feeling that they're not on a level playing field, and there's a bit of a competitive disadvantage because again, these foreign entities aren't committed to ESG.
This is an inconsistency that I think some US companies are really trying to wrap their heads around. And also, I'd like to add onto a comment that Danielle made a little bit earlier. I had the opportunity of touring a large manufacturing campus of a company, and they happen to be located in another state where there's a lot of agricultural land, right near them. And on one of the fields near their location, the entire agricultural producing field was converted into a solar field. And the owners of the solar field approached the company and said, "Would you like to buy all of our solar production?" And the company was very interested, but the challenge was that entire field could only provide 1% of their energy needs. So that was obviously a challenge for that company.
And a third comment I would like to make from the perspective of some of the manufacturing and distribution companies, and they may be more mid-market than the extremely large companies is, have they really seen the benefit of ESG in terms of cost competitiveness? I know I've spoken to some lenders and asked if our clients can receive a benefit or reduced interest rate by ESG policies. And I can definitely say there wasn't a direct guess to those questions. So I think if some of the lenders and other, again, people who provide capital can give a better answer there and make it more obvious to M&D companies, that there is a benefit, I think that will help to further along the adoption of ESG.
JM:That's interesting. Let me just pull on that thread for a second. So are you saying in effect that if companies can get the raw materials or reduce their costs of good sold at large, that they should be able to get better financing for that or better cost of capital and better ESG ratings, for lack of a better word, if they can get their raw materials or reduce their cost of good sold in a sustainable way in an environmentally friendly way.
TE:I think what needs to be done is, the lenders need to be a little bit clearer to some of maybe the mid-market companies and say, "If you are able to demonstrate that you have developed enacted and are monitoring an ESG policy, then we will be able to give you a better interest rate than if you have not adopted those policies."
Great. And that can include using recycled materials in your raw materials, as opposed to brand new, natural resources, et cetera, I imagine. That's really great. That's really helpful. So just before we close out, I want to give Danielle a second to comment since that is so tied into what you've been working on. So go for it.
DB:Yeah. Thanks Joan. I want to clarify something important. So I appreciate that segue. ESG in itself does not improve operations. So to go back to the sustainability versus ESG concepts, the concept of ESG refers to a series of risk management tools. ESG is retrospective, it is a snapshot. So you're looking at policies or data that already exists. Where sustainability is very strategy focused and so Lourenco mentioned roadmaps and pathways to de-carbonization this economic transition. So sustainability is very forward looking, it's proactive. And that's important when we look at the division of solutions for our clients, especially in manufacturing.
So sustainability strategy is meant to address things like operational improvement that we've talked about and integrating ESG in their operations or performance improvement, that's where you get into strategic planning. So from an environmental management perspective, that could be through energy efficiency, looking at HVAC systems, looking at LED lighting, retrofits or smart lighting, looking at resource and supply chain optimization materials as you mentioned. Circular economy is a big one, especially in building materials, building automation, IOT, the sky really is the limit here, which is why I love strategy because that's the creative part of it.
On the ESG side of things, I'm usually talking to clients about how to measure, manage, address climate related risks. Many of which Lourenco talked about, for example, the effect of this very notable increase of extreme weather events. We've mentioned droughts, we've mentioned sea level rise, and especially for a large property portfolio, you really need to look at those physical risks and every industry's going to be different, but for manufacturing, especially in any business with a large building portfolio, these really are the things that you need to address and that's on the risk side, that's ESG, but the sustainability strategy portion is looking at how all of this resilience, tenant safety insurance rates, what we can do about it proactively to make sure that our impact doesn't keep exacerbating these problems. And there are so many things to think about. So it really is important that we work closely with our clients to really understand where their vulnerabilities lie and how to mitigate any risks associated with those specific vulnerabilities.
JM:And be industry specific.
DB:And be industry specific. Absolutely.
JM:Okay. We could talk for about seven hours about all of this. So in the interest of time, we will do that in future episodes, Danielle Barrs, Lourenco Miranda, and Travis Epp thank you all for your incredible insights today. I know I've learned a few things and I'm sure anybody else listening has as well. Stay tuned for our upcoming episodes, including about all of the things we've talked about today, risks and execution on these and ESG ratings, and frankly, why you'll be surprised which companies have a good ESG rating, which ones don't.
If you have any questions about ESG or are interested in exploring support for your own ESG reporting and sustainability work, please reach out to Lourenco, Danielle or Travis at EisnerAmper through the firm's website and EisnerAmper.com. Thank you for joining us today for this episode of EisnerAmpers ESG in Focus podcast, I'm Joan Michelson. See you next time.
Transcribed by Rev.com