ESG: where value and leadership converge

Funds are flooding into capital markets in a quest for ESG-friendly investments, driven by increased social awareness, government pressure, rising volatility in the price of energy and raw materials due to geopolitics, and a search for profitable business opportunities.

While you might be forgiven for instinctively assuming that this means that capital markets reward actual ESG leadership, we decided to take a hard, cold look at the numbers. And to the question of whether capital markets do in fact reward ESG leadership, our research has come up with a less-than-categorical answer: “sometimes.”

In many sectors, among them automotive components, we observe a positive correlation between reductions in scope 1 and 2 greenhouse gas (GHG) emissions intensity (defined as tons of CO₂ emitted per unit of revenue) and EV/EBITDA multiples. Indeed, ESG-leading tier 1 automotive components manufacturers—defined in this context as those companies that achieved the greatest reduction in scope 1 and 2 GHG emissions intensity between 2017 and 2019—are reaping valuation premiums of 61 percent compared to ESG followers. And these premiums are likely to increase as automotive original equipment manufacturers (OEMs) demand that their suppliers step up to the plate to help them reduce their own upstream scope 3 emissions.

Interestingly, automotive components manufacturers are among the least transparent in the business world in terms of GHG emissions disclosure: only 54 percent of the companies we examined published climate-related disclosures for 2019, as reported in 2020. Companies might do well to reconsider their policies in this regard, given the significant valuation premiums associated with ESG leadership in the sector and the clearly stated intention of OEMs to decarbonize their supply chains and operations.

Reducing all of the above to dollars and cents, and assuming that there is more than a coincidental relationship between ESG performance and valuations in the automotive components sector, our analysis shows that $17 billion of economic value is waiting to be captured across the industry if ESG followers catch up to ESG leaders, assuming EV/EBITDA multiples remain at 2020 levels. And if progress on GHG emissions intensity and, soon enough, absolute emissions reductions, can be achieved by improving supply chain and operational efficiency, which present strong business cases on their own merits, what exactly are tier 1 automotive components manufacturers waiting for?

Time is of the essence. Now is the time for automotive components manufacturers to stand up to the challenge and begin to shape what ESG leadership means in capital markets. There are deep multibillion-dollar ESG-focused capital markets, and they are getting deeper every day.

Do capital markets reward ESG leadership? Sometimes

With daily evidence of extreme weather due to climate change, we all may be relieved to learn that capital is flooding into ESG funds. Indeed, according to Refinitiv, the second quarter of 2021 also marked an all-time record of issues since records began in 2015. This second half built on the momentum of the first half of 2021, during which the volume of what they refer to as “sustainable” and “social” bonds issued totaled $552 billion. In fact, these issues nearly doubled their share of first-half activity, from 5.4 percent in 2020 to 10.4 percent in 2021, as a percentage of total issuances.

This growth in the availability of ESG-friendly debt is largely attributable to the private sector. Corporate issuers including Enel, Interbrew, Google, Equinor, HP, and Intel accounted for 56 percent of issuances, up from 43 percent during the first half of 2020, and replaced sovereign issuers in the lead.

For its part, Morningstar reported that in H1 2021, assets under management of sustainable funds globally reached $2.2 trillion, of which $1.8 trillion were in Europe. Estimates of global “excess savings” of $2 trillion due to COVID-19 restrictions point to increasing rather than decreasing capital flows.

At the same time, regulators are stating plainly that they will more closely scrutinize environmental disclosure statements to root out “greenwashing.” The US Securities and Exchange Commission (SEC) has established the Climate and ESG Task Force in the Division of Enforcement; the initial focus will be to identify any material gaps or misstatements in issuers’ disclosure of climate risks under existing rules.

And in Europe, the European Commission mandated the Platform on Sustainable Finance, an independent expert group, to make recommendations on the technical screening criteria for activities that can make a substantial contribution to the four environmental objectives of the EU taxonomy, the first being climate mitigation and climate adaptation. The Platform published its draft recommendations on August 3, 2021, with stakeholder feedback welcomed through the end of September. The Platform is currently finalizing these recommendations before handing them over to the Commission, which will then start its work on the Environmental Delegated Act.

In addition, and in line with the breadth of ESG, the Platform on Sustainable Finance is working on a concept of a social taxonomy. The report on this is still pending at the time of this report’s publication and, once received by the Commission, will be studied pursuant to the sustainable finance delegated acts for environmental reporting.

And the Glasgow Financial Alliance for Net Zero (GFANZ), representing all parts of the financial system and with assets of greater than $130 trillion, has committed that its members’ lending, investing, and insuring will be in line with net zero by 2050. To do this, it has established a number of workstreams, including one focused on accelerating decarbonization in the real economy by articulating financial sector expectations of transition plans from the companies GFANZ members invest in, insure, and finance. If GFANZ achieves it stated goals, then we would appear to be at the very beginning of the transformation of capital pools.

So, what does this mean for the increasingly few companies that are still not taking ESG issues, and particularly climate-related disclosure, seriously?

To frame the opportunities presented by these large and growing capital flows, particularly in the context of rapid regulatory changes, Kearney has characterized the relationship between companies’ valuation multiples—defined as enterprise value divided by EBITDA—and their preparedness for the transition to a zero-carbon economy as the first focus for ESG.

For many sectors, we referred to the Transition Pathway Initiative (TPI) for sector cohorts of firms, as well as to rank companies on how well they manage and reduce their GHG emissions as they navigate the path of making a substantial contribution to the zero-carbon transition. (For a detailed description of the TPI, please see the sidebar in Kearney’s cross-sector ESG Value and Leadership Index.) For industries that the TPI does not assess at this time—including the auto components sector—we used an alternative method to assess their environmental sustainability.

Greenhouse gas emissions intensity (tons of carbon dioxide emitted per unit of revenue) is the emerging investor standard, but we ran into two problems when we attempted to apply it to tier 1 suppliers in the auto components sector. The first is the paucity of published data compared to other industries (see figure 1). The second is heterogeneity: the manufacture of some types of components is inherently more emissions-intensive than that of others, so looking at GHG emissions intensity across a sector with such different companies would not be an apples-to-apples comparison. To get around these obstacles, we chose to examine the extent to which each company was able to reduce its GHG emissions intensity over the three-year period from 2017 to 2019.