Environmental and Social Governance (ESG) Initiative Adoption as a Payoff Matrix Using the ESG Data Convergence Initiative (EDCI) as a Case Study
Environmental and Social Governance (ESG) initiatives have become more important in assessing a company’s performance in recent years. ESG represents risks that will impact the company’s ability to create long-term value not only for their company but also their shareholders. In fact, according to the Edelman Trust Barometer Special Report, 88% of investors believe companies that prioritize ESG initiatives represent better opportunities for long-term returns than companies that do not. These ESG initiatives are split into three categories, as the name states, environmental, social, and governance.Under environmental you have ideas that mitigate climate change and reduce resource use, some initiatives for this look like becoming net zero, using renewable energy, and an overall assessment of a company’s climate risk. For social measures you have a company’s performance based on diversity, equity, and inclusion, pay equity, and social impact. Finally for governance you are delving into the oversight which is essential to creating that accountability, these metrics include those surrounding board diversity, executive compensation, and ownership.
The reason this has become so important is when looking into future policy and actions that companies are taking. The Securities and Exchange Commission (SEC) on May 25, 2022, proposed amendments to rules and reporting forms with the end goal of having consistent, comparable, and reliable data around ESG performance for investors. These amendments would apply to certain investment advisers, registered investment companies, and business development companies. This means that companies are going to have to begin using ESG considerations as a measure for company performance.
I would like to put this in terms of Game Theory as covered in class to discuss the long-term payoff of adopting ESG monitoring and bettering those initiatives.
Although these numbers are arbitrary, the idea still stands. In the long-term companies who are adopting ESG initiatives are seeing higher performance. This means that Company A and B should be seeing higher numbers for if they were to abide than if they weren’t. Therefore lets say the payoff of abiding by ESG metrics if another company were to also abide by the same metrics is 10. If one company were to abide and the other weren’t you would see a large detriment for the company not abiding because they are being compared and evaluated against one that is transparent and a safer option by investor standards. Therefore the company who is abiding will see a gain compared to if they were both abiding because customers and investors would switch from the unabiding company to the one that is and the unabiding company will feel this loss, which is shown by the -5 on the matrix. If you both don’t abide this means that neither company is being evaluated by ESG standards and they will see a lower long-term profit but still a profit. This is translating currently to initiatives coming out to measure company performance which is having a ripple effect where more and more firms are joining the initiative as a result of it being detrimental not to be part of this.
One initiative as a result of the new emphasis on ESG has been the ESG Data Convergence Initiative (EDCI). This initiative aims to align Private Equity (PE) companies with a set of standardized metrics. This is mainly being spearheaded by a few PE firms that have hired Boston Consulting Group to put together this initiative so that GPs and portfolio companies can benchmark their current position and generate progress toward ESG improvements, while enabling greater transparency and more comparable portfolio information. I won’t go into the specific metrics and progress done by the initiative but more so want to focus on the impact of this work and how it has been consistently growing since its inception. Currently the initiative has 215+
General & Limited Partner Members, $24T+ AUM By Members, and 2,000+ Portfolio Companies Included In Benchmark. In January of 2022, EDCI hit the milestone of 100 initiative participants representing $8T AUM and just in July 2022, EDCI marked a milestone of 200 initiative participants representing $22T of AUM. This immense growth is attributable not only to the profit gains of being part of it but also the losses experienced if they are the only PE firm who is not participating due to the negative comparison and investor shift as a result.
https://www.pwc.com/us/en/services/esg/esg-trends.html
https://www.sec.gov/news/press-release/2022-92
https://www.bcg.com/publications/2021/private-equity-convergence-on-esg-data