How to integrate ESG criteria into financial analysis? The Coca-Cola Affair
Does the company report ESG risk factors in its 10-K? If so, look for ways to quantify in the sustainability report. If you don’t see the 10-K ESG risk factors listed in the sustainability report, either the company is out of touch or they think ESG risks are unlikely to be assessed in the near term.
The most common question I get asked in an ESG investing course is, “How should we incorporate ESG thinking into a company’s financial analysis?”
The frustration behind this question comes from several sources. Investors complain that ESG reports are often long, voluminous and often full of fluff. These reports generally contain little quantitative data. When it exists, it usually appears in stand-alone tables that lack context and in a PDF document that makes it difficult to access and use the data. Worse still, this data may or may not be relevant to understanding sustainability, whether from a financial, social or environmental perspective. For example, the definition of what is important or not in the ESG world has caused a lot of angst. SASB has defined materiality narrowly with respect to investors or providers of capital. Such a definition is consistent with securities laws, but potentially not entirely consistent with what a social activist considers important.
Other market participants complain that financial accounting systems are not integrated with ESG reporting systems. In an ideal world, core policies, systems, procedures, and controls should exist to both produce high-quality data and enable reliable and diligent external auditing for financial and ESG reporting. Some argue that we need a much smaller number of standards, perhaps just one, as opposed to the multitude of TCFD, SASB, GRI and others. The recently formed ISSB is perhaps a step towards such an evolution. Right now the only area where there is any kind of overall consistency with somewhat acceptable levels of reliability is in climate. Even that will probably take a long time.
Until the Nirvana state of the One standard for reliable ESG data is achieved, I have a few suggestions for starting to address the issue of integration.
· Carefully read the risk factors in a company’s 10-K. Ask yourself if the hyper-defensive lawyers who make up all the excuses for the firm to be sued are referring to ESG factors. If they don’t, we have a problem.
o Or the company hides in the face of ESG risks.
o Or, as investors, we have indulged in wishful thinking as ESG factors are unlikely to pose significant valuation risk in the short to medium term.
If you find a reference to ESG factors in the list of risks, open the sustainability report and look for concrete data points that will help you translate those risk factors, preferably into dollars and a tentative time frame in which the risks will arise.
Let’s test this hypothesis with Coca Cola. Coco Cola is of particular interest to me given my previous work on firm-imposed negative externalities. The company lists 45 risk factors. I have identified 14 ESG-related risk factors listed by Coca Cola in its 2020 10-K. Remarkably, there are several red flags related to the “P” or product impact on society, a term that Philip Morris International proposed in its sustainability report.
Here is the list of 10-K risk factors:
1. Growing concerns about the environmental impact of plastic bottles and other plastic packaging materials could lead to reduced demand for our beverages and increased production and distribution costs.
2. Water scarcity and poor quality could negatively impact Coca-Cola system costs and capacity.
3. Increased demand for food products and reduced agricultural productivity may adversely affect our activities (E&P).
4. Climate change and legal or regulatory responses to it may have a long-term negative impact on our business and results of operations.
5. Adverse weather conditions could reduce demand for our products.
6. If we are unable to attract or retain a highly skilled and diverse workforce, our business could be adversely affected
7. If we are unable to renew collective agreements on satisfactory terms, or if we or our bottling partners suffer strikes, work stoppages or industrial unrest, our business could suffer.
8. Obesity and other health issues may reduce demand for some of our products.
P factors (absent from the ESG):
9. If we don’t address changing consumer products and purchasing preferences, our business could suffer.
10. Product safety and quality issues could negatively impact our business.
11. Public debate and concerns regarding the perceived negative health consequences of certain ingredients, such as non-nutritive sweeteners and substances derived from biotechnology, and other substances found in our beverage products or packaging materials , may reduce demand for our beverage products.
12. If negative publicity, justified or not, relating to product safety or quality, the workplace and human rights, obesity or other issues harms our brand image, reputation corporate governance and our social license to operate, our business may suffer.
13. Changes in laws and regulations relating to beverage containers and packaging could increase our costs and reduce demand for our products.
14. Significant additional labeling or warning requirements or limitations on the marketing or sale of our products may impede sales of affected products.
The next step, of course, is to look for data on quantifying the dollar’s impact and when those risks are likely to materialize.
As I mentioned before, the companies hardly disclose anything about the job. Therefore, assessing the impact of lost talent (#6) or a collective bargaining dispute (#7) will require significant groundwork. A question for the SEC: “Why would a company that lists the potential loss of its skilled labor disclose so little to allow an investor to quantify the impact of that loss on its cash flow?”
I attempted to calculate the social cost imposed by obesity (#8), emissions and unrecycled plastic bottles (#1) and water problems (#2) in my previous article. When and if regulation or public/media pressure (#4, #11, #12, #13, #14) or changing consumer tastes away from sugary drinks (#9) or action of investors (surprisingly not reported by Coca Cola) will make Coca Cola internalize the cost of the externalities it imposes is of course a key question for the investor. Is it in a year, a decade or a generation?
My previous analysis had omitted the direct impact of climate change on the cost of agricultural inputs the business relies on (#3) and reduced demand for the company’s products (#5).
What about investors who already enter the SASB framework and now have a crushing new list of 14 factors to consider? My approach is complementary to the SASB approach. In addition, unexpected macroeconomic events listed in some of the 10-K risk factors can turn a dual materiality issue under SASB (important for the company’s valuation and its social impact) into a materiality issue. unique (important for the business alone) and generate negative or positive alphas.
For example, the pandemic has become a dynamic point of materiality as investors’ perception of what is important to the company’s valuation and workforce has shifted as the virus has progressed. Oil prices have tripled in recent months and oil stocks have generated positive returns. The imbalance between oil supply and demand could erode pressure on governments to consider adopting a carbon tax to reduce emissions, which in turn will keep oil companies away, on the sidelines.
An obvious limitation to my approach is that I start with risk factors, which by definition are decreasing value from an investor’s perspective. What about all the positive externalities that a company creates? Sustainability reports can be a starting point for thinking about the jobs and taxes companies contribute or the innovation they deliver. How much of these positive externalities is captured in stock prices? We know that innovators rarely retain more than a small portion of the value their R&D generates for society. Perhaps the positive externalities create social and political capital with regulators and thus help the company defer or avoid severe penalties and fines, in case companies have compliance issues. Is this social and political already taken into account or likely to be in nature? This is an open question that deserves more work.
What about risk factors not listed in the 10-K? I suspect that climate change will lead to large capital expenditures such as replacement or maintenance. That is, firms must internalize losses or expenses just to maintain product market share. This consideration is often absent from 10-K warnings or is tangentially mentioned as in point 3 above.
In summary, I think that mapping the risk factors in the sustainability report is likely to be a much more productive starting point than skimming through the sustainability report hoping to pick up signals on ESG risk that are material to business risk and future cash flow. flows.
The biggest question the analysis leaves me with is which 10-K based risk factors are covered in the sustainability report and which are not. The answer to this question is in itself an excellent starting point for an investor interested in integrating ESG factors into financial analysis.