Episode 2: Sustainability, the foundation for value creation

Full transcript

Ivy Kuo:Hello, I'm Ivy Kuo, PwC Asia Pacific Sustainability Leader, and you're listening to PwC's ESG podcast, Defining Asia Pacific's Future. The podcast for bite size updates on the latest sustainability trends, from climate change to social and labour rights due diligence. We bring together ESG practitioners to discuss and solve today and tomorrow's sustainability challenges. Reflecting PwC's strategy of building trust and delivering sustained outcomes. Following the success of earlier episodes, I'm pleased to announce that we will feature various PwC sustainability specialists in this podcast series.

Welcome to this podcast where we will explore value creation in investments through sustainability. The early environmental movement and the practice of ESG in financial services was primarily focused on risk management. The main idea was to minimise the negative impact of economic activities, with the belief that this alone was sufficient to meet the criteria and the definition of sustainable development. By 2015, it became evident that although the efforts were made to reduce negative environmental and social impacts, there were still significant adverse effects. So what brought about this change?

I'm joined here today by Dean Alborough, a Director in PwC's Asia Pacific Sustainability team, who will help to address this question. Hi Dean, thank you for joining us today. First, can you briefly explain what value creation is and why is this not a new investment approach?

Dean Alborough:Thanks Ivy, great to be here. I mean, value creation is made up of two main components. It's the financial value creation in a business, and also the positive environmental and social impacts that the business has on the world around. And this is really the concept of double materiality. At the heart of private equity is the ability of a direct investor to generate additional value. We call it alpha (a term used in investing to describe an investment’s ability to beat the expected market or benchmark return. Alpha is also often referred to as “excess return” or the “abnormal rate of return” in relation to a benchmark, when adjusted for risk), in an investment through direct action and their influence. And therefore value creation with environmental and social outcomes, it's not really a new approach. It's been part of the private investor mindset for a long time, and many private equity investors already possess these skill sets.

Businesses and organisations pre 2015 really focused on pure risk management when it came to sustainability issues. There wasn't really a concept of positive impact as we now know it. But leading up to 2015, there was a realisation that the planet was still on a path of incremental decline. So although we were managing many risks, there was still negative impact happening. And the overall trend was a negative one. And the United Nations really helped to shift this into a positive outcome space through the United Nations Sustainable Development Goals (UN SDGs).

Pre 2015 and pre the UN SDGs, listed businesses, really through risk management, just focused on integrated reporting frameworks such as the Global Reporting Initiative. And these had a heavy focus of impact disclosure and specifically negative impact disclosure. And this is probably a key reason why the private sector never really picked up these frameworks and used them. But with the advent of the United Nations Sustainable Development Goals, although they were never really designed for it, the private sector suddenly had a reporting framework where it could talk about and focus on the positive work that they were doing and no negative impact disclosure required.

Around about this time, we saw many sustainability reports coming out just focused on positive impact. And this really started the movement going and gaining traction. And the private sector really took a lead at this point, moving from pure risk management in ESG and sustainability, to positive impact. And what we've seen in the markets is that now it's the listed space that is actually playing a little bit of catch up in terms of positive impact methodologies and approaches.

Ivy Kuo:And how has this value creation become a powerful construct for investors since 2015?

Dean Alborough:Firstly, the market expectations are shifting quite rapidly, and there's a growing number of asset owners asking not just for financial returns from their capital, but also what positive impact is coming out of the capital that's been managed. So that's a huge ongoing shift in the markets. Then secondly, many investors already have fantastic platforms and opportunities for positive impact and further financial value creation that they may not really be taking advantage of. And by building in a fit for purpose, positive impact capability in the investment firm, which can be quite lean, it doesn't have to be administratively burdensome, these positive impact aspects of the investing can be realised and demonstrated to their clients, the actual asset owners.

Ivy Kuo:Oh, that's great. So the market is changing and some of the investors already have the capability or are on the path of doing so in terms of changing and then turning this value creation into something real. So how has this been applied, if you can share, and where are we today?

Dean Alborough:Yeah. So from a positive environmental and social impact perspective, it's been around a little while. A few decades ago, sustainable development research began to be undertaken on large capital projects and infrastructure projects. And when the impact investing movement began to pick up momentum post 2015, many of these previous methodologies and approaches began to be drawn on. And then over the last eight years, there's been a significant refinement and move towards making these approaches more relevant and to standardise the positive impact approaches as they can be applied to the investment space.

And then today we are sitting with a really fast-growing impact investing sector, the global impact investing network, known as the GIIN (Global Impact Investing Network), estimates that about 3,340 odd organisations currently manage over US$1.16 trillion dollars of assets under management. And of this, the majority of the impact capital has really been applied to two areas, and that's climate change and social issues such as healthcare, housing, and financial inclusion. What's really been missing and very little has been invested in it is biodiversity. And there's a growing realisation that there's a critical link between climate change and biodiversity. So many players in the space are looking to unlock the investment model into the biodiversity space.

So from a financial value creation perspective, clients are looking to better understand the sustainability levers within their own business and how these levers influence the financial bottom line, both positively and negatively. They're looking to minimise the erosion of value through sustainability risks. They're looking to preserve value through management of current operations and identifying the value linked sustainability aspects in their business and how they can build resilience around these.

And then finally, through robust valuation approaches, they're looking to optimise these levers in their business to add financial value to the bottom line. And examples of this that we see in the market include operational efficiencies such as a rationalised energy management solution in the business, or even a realignment of their activities to take advantage of a new regulatory regime such as carbon tax, or to take advantage of cross-border trade regimes. And then going all the way up to the refinement of strategy and even looking at opening up brand new markets in their business to unlock additional value.

Ivy Kuo:Thank you. I think protection of value as well as creation of value is on the top line, not just in private investors, but across our real economy clients. So what skillsets are required to understand and apply this value creation concept to sustainability.

Dean Alborough:To really undertake a sustainability value creation implementation across a business, one's really looking at a multidisciplinary skillset that needs to be applied. So in the skillset we can include environmental and social technical skills, a deep understanding of governance, a legal capability to understand the current and future compliance regime of the business, deep industry technical knowledge, commercial knowledge of how the business operates, and understanding of the value chain, the local and global economy that the business finds itself in, and understanding of the market's sustainability expectations of that particular market segment. And then finally, financial modeling and valuation skills.

So I think it's critical to emphasise that with all these skill sets, it's not enough to just technically identify risks and opportunities to value creation, but it's even more important to be able to calibrate the materiality of these risks and opportunities.

Ivy Kuo:So last question for you. Where do you see this value creation going?

Dean Alborough:Well, the landscape is moving very quickly, that's for sure. And I think everyone in the sustainability space finds themselves just trying to keep up with it. But globally, there's a movement towards generating positive environmental and social outcomes with capital deployed. This is from increased pressure from limited partners and asset owners. They don't just want to see returns. They certainly want to see environmental and social positive outcomes. And we see more and more fund managers move toward a space of generating these positive environmental social outcomes, if not in fact, becoming pure impact investors entirely. And over time, I think this trend will continue as fund managers move more along the sustainability spectrum into the positive impact space, or at least get very close to it.

On the financial value creation side of things, I think we've seen more and more investors looking at business sustainability proposition and how this can be leveraged to drive further financial value. We're still at the nascent stages of this, but over time, the methods and skillsets of identifying the sustainability levers and what's driving financial value creation of business will become more and more sophisticated, and already over the last few months there have been huge strides made in this space. And PwC is at the forefront of this and continually applying our commercial and financial skills to understand the play between sustainability and the success of the businesses of our clients.

Ivy Kuo:Dean, thank you so much for sharing your insights. The discussion has shown that there's a growing recognition and emphasis on sustainability in the world, the marketplace, and among us, the business leaders. It is becoming increasingly evident that sustainability is being valued both implicitly and explicitly. We now realise that there are great opportunities to explore how sustainability practices not only contribute to positive environmental and social outcomes, but also generate financial values through business activities.

The integration of environmental and social factors, governance and accountability directly relates to the world we live in. From the impacts of climate change, to the opportunities for inclusion and just transition. We can't hold back. We have to accelerate focusing on having the right conversations, collaborations, and commitment to truly deliver sustained outcomes.

PwC refers to the PwC network and or one or more of its member firms. Each of which is a separate legal entity. This content is for general information purposes only and should not be used as a substitute for consultation with professional advisors. All opinions are our own and not reflective of any organisations with which we may otherwise be associated.

© 2023 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.