The pandemic, devastating weather events, and the invasion of Ukraine are examples of macro-environmental shocks impacting companies worldwide. In a connected world, events that occur on one side of the globe ripple through to the other. When considering the purpose of ESG, the question remains, does ESG analysis alone adequately protect portfolios against large environmental disruptions? Here, we discuss the importance of taking a holistic approach to sustainability that considers firm competitiveness and its ability to dynamically adapt and react to black swan events — to be resilient.

In a world of increasing upheaval, investors are increasingly assessing business sustainability. Identifying companies with strong ESG credentials is, however, only part of the picture. Understanding macro-environmental factors that may emerge, combined with identifying a company’s ability to manage, adapt, and react in these uncertain times, is paramount.

The pandemic was a global, black swan event that sensitised businesses to their operational vulnerability. This year’s invasion of Ukraine has further disrupted global supply chains, driving a greater focus on the vulnerability of business operations against unquantifiable and unanticipated risks.

Today, there is a greater emphasis on the sustainability of operations than merely focusing on economic (financial) growth. In an increasingly volatile world, which makes predictions of future performance difficult, investors turn to ESG to summon sustainable returns.

ESG has evolved from ethical and impact based investing into a risk-based realm where investors seek to protect their portfolios from tail risks by ensuring underlying investments are robust when struck by a risk event.

For long-term investors, a firm’s ESG credentials are only one piece of the sustainability puzzle, as typical ESG analysis does not account for tomorrow’s opportunities or challenges.

To better fulfil the purpose of ESG, understanding the business outlook requires one to establish whether the business operates in an industry with a low risk of macro-environmental factors affecting the predictability of earnings — a kind of scenario analysis.

However, ESG and the forward-looking assessment (that we call PESTLE, discussed below) are two components of holistic sustainability analysis. Investors must identify whether a firm is resilient and can recover and grow through challenging times — do they hold a Dynamic Capability?

The Purpose of ESG

For companies, there has been a growing trend to adopt Environmental, Social and Governance (ESG) initiatives. This has been driven by several factors, including share price performance, reducing capital costs, insurance costs, or other benefits such as pursuing operational excellence and driving brand stewardship.

These have stemmed from the complexity of modern business operations (often spanning multiple jurisdictions), increasing digitalisation, and the consideration of additional stakeholders. As business environments grow, they become more complex and fragile simultaneously as companies are exposed to the impacts of environmental disruption and societal turbulence.

For investors, the purpose of ESG is to incorporate non-financial measures into the decision-making process and reduce or remove long-dated investment risks. By understanding a company’s ESG activities, investors can better account for these non-financial aspects of performance.

When investing, the assessment of ESG considerations creates value in a number of ways, including top-line growth, cost reductions, reduced regulatory and legal intervention, employee productivity uplift, asset or investment optimisation, or brand leadership.

Typically, ESG analysis explores-

• Environment (E)  —  how the business interacts with the natural environment, the impacts of its operations, and the actions the company takes to mitigate negative effects.
• Social (S)  —  how an organisation’s activities affect people — from its own workforce to customers, local communities and those who work in its extended supply chain.
• Governance (G)  —  the decision-making process and the distribution of rights and responsibilities. Here investors review the policies, structures and procedures by which an organisation is run.

Dynamic Environments

Business environments are characterised by more volatility, complexity, uncertainty and ambiguity than ever before. Rapid technological advancements, the pandemic, and the recent Ukraine-Russian conflict are examples of accelerating macro-environmental changes.

ESG approaches, while valuable, do present some gaps in investment analysis. An analysis of carbon footprints and waste management may fail to account for exposure to climate change disasters or supply chain breakdowns in the face of environmental disasters.

Additionally, when assessing social factors such as workplace relations or cultural satisfaction, one may fail to account for broader workforce vulnerability in crises like the pandemic or social movements such as the rise of electrified vehicles.

Adopting a framework similar to our PESTLE (Political, Environmental, Social, Technological, Legal and Economic) analysis is one of three components investors should use in sustainability analysis. Here, the assessment is focused on external forces that may impact future growth.

PESTLE helps with understanding ESG trends related to material issues identified. For example, changing regulatory frameworks regarding emissions may fundamentally impact a business; or political regimes in supplier regions may impact supply volatility or a company’s reputation.

Since investment analysis is static at a point in time, investors must consider the dynamic nature of business environments. By only considering PESTLE, one is limited to conceptual scenarios that may impact a firm’s operations, whereas incorporating ESG analysis will provide the lens to consider the exposure of these risks.

Within rapidly changing environments, a firm’s ability to maintain its competitive advantage is constantly threatened by factors influencing its resource-based strategy. For investors, understanding how ESG and these dynamic environments interact requires identifying companies that can manage both parts of the equation.

Dynamic Capabilities

This leads us to our third component, Dynamic Capabilities (DC). When a firm has achieved a Sustainable Competitive Advantage (SCA), its strategic approach has found a recipe that creates value that only belongs to the firm, where imitation is impossible.

A competitive advantage is not sustainable forever as the resources driving their competitive advantage may change due to externalities. At ECP, we employ the DC framework to gauge and assess a firm’s ability to manage, react and grow in times of uncertainty.

DC’s are processes embedded in firms — they emerge from history and experience and can be identified by exploring the following activities:

• Sensing  —  an organisation’s knowledge and learning capabilities. Here, a firm’s knowledge management (organisational learning and skills acquisition) can be uncovered by identifying a track record of learning that drives continuous product improvement, human capital retention, or through IP protections.
• Seizing  —  an organisation’s innovation and execution capabilities. Here, a firm’s ability to innovate or seize business opportunities can be identified by a proven track record in overseas markets, how the company approaches innovation (complimentary, disruption, or partnerships), or rewarding employees for innovative ideas.
• Transforming  —  organisational culture and change. Here, a firm’s organisational culture thrives through change — they hold an ability to transform or renew business activities. These are often entrepreneurial cultures with a proven track record in pivoting or refocusing business activities to deliver sales growth.

DC’s are essentially change-oriented capabilities that help firms redeploy and reconfigure their resource base to meet evolving customer demands and competitor strategies. Not all firms have this ability, and the best businesses are those that have this dynamic capability.

Assuming that a competitive advantage simply ‘exists’ without considering the factors surrounding a firm’s resources is a shortcoming in many approaches to sustainability analysis. Examining how resources are developed, how they are integrated within the firm and how they are released needs to be understood.

DC’s bridge these gaps by adopting a process approach that acts as a buffer between firm resources and the changing business environment. DC’s help a firm adjust its resource mix to maintain the sustainability of the firm’s competitive advantage, which otherwise might be quickly eroded.

A company that holds a dynamic capability means their behavioural orientation constantly integrates, reconfigures, renews, and recreates its resources to remain competitive through time — these continually upgrade and reconstruct its core capabilities.

Resilience

At ECP, we believe sustainable business is good business. Sustainability is more than simply reporting non-financial measures. Sustainability is what is required in the face of uncertainty, it is the new digitalisation but with a much larger effect on a firm’s long-term competitiveness.

There are many examples of firms that fail due to macro-environmental changes (i.e. pandemics, technological advances, social challenges). When major stress events occur, companies that appropriately respond are provided with the opportunity to emerge stronger than before.

On the contrary, those that fail to adapt lose their competitive advantage and may face extinction. Black swan events that drive increasing uncertainties in business environments not only trigger innovation but also result in other reactive strategies such as changing business models or restructuring to ensure survival.

Companies that can adapt to disruption in times of stress, emphasising resource development and renewal, will sustain value creation. This operating resilience will not only aid in their survival over the long term but provides the necessary ingredients for long-term competitive excellence.

The article has been prepared by ECP Asset Management Pty Ltd (ECP). ECP is a funds management firm based in Sydney, Australia. For further information, visit www.ecpam.com. This material has been prepared for informational purposes only and is not intended to provide and should not be relied on for financial advice. ABN 26 158 827 582, AFSL 421704, CAR 44198.