ESG Business Models – Downside Risk and Upside Opportunity
What are the best ESG business models for a greener economy?
We speak to many investors and managers in the course of our work, and many find that rigid ESG reporting and disclosure requirements do not necessarily give them the insights into investee risk or impact they had hoped for. Different companies within the same sector may be exposed to different ESG risks and opportunities from their relationships with other entities, their presence in particular regions, or their reliance on certain raw inputs. Increasingly, in order to identify which risks and opportunities are material – and evaluate the ones that are – investors need to look behind the scenes and take an active interest in investees’ business models.
How can we analyse ESG business models?
The term ‘business model’ is often used day-to-day to broadly mean a similar idea to business strategy. More strictly, it has been defined as “how the firm creates, delivers and captures value for the organisation and its stakeholders” as well as depicting “the content, structure, and governance of transactions designed so as to create value through the exploitation of business opportunities”.
For our purposes, a business model is, at minimum, a description of how an organisation engages with other entities and objects (customers, suppliers, raw materials etc), and works within itself to create value. For profit-making businesses, this value generally needs to be monetisable – in other words, there needs to be a way of extracting payment in exchange for the value creation.
A business model can also be viewed in a practical ‘modelling’ sense – a simplified conceptualisation of the business itself and its environment, with the important features included and the irrelevant aspects excluded. The model can then be used for practical tasks, such as simulating or forecasting what will happen if certain inputs change (for example, see the diagram below of a system dynamics approach to business modelling).
Figure 1: Schematised business model using system dynamics, from Groesser & Jovy (2015), showing aspects of a cut flower delivery business. Even this highly simplified model shows features of interest to an ESG investor such as employee loss rate, product attractiveness (which could be affected by negative ESG publicity) and operational costs (which could well be affected by climate change).
This kind of model can be hugely valuable for firms and their investors. Firstly, the model can be used to simulate future events, such as environmental or social shocks, that are normally difficult to conceptualise or evaluate for inclusion in a risk or opportunity register. For example, as part of a climate scenario analysis to assess the magnitude of climate risks, the business model could be subjected to varying inputs to represent different future climate scenarios. But more fundamentally, the business model can itself be tested and its sensitivity to ESG influences measured as a quantitative expression of a firm’s overall sustainability.
What makes a business model sustainable or unsustainable?
On one level, a sustainable business model can simply be one that doesn’t cause harm in a manner that will render itself obsolete. For example, a business which is heavily reliant on extracting limited resources, or produces a product which injures its customers, is unlikely to be considered sustainable. We can see this in the intuitive screening-out of coal and tobacco investments from the most basic ‘sustainable’ portfolios, and so identifying these red flags in a business model is not difficult.
However, many cases are more subtle. A business’ products or direct inputs may not be obviously harmful, but it often unclear at first glance what their depth of dependency is on unsustainable activities upstream or downstream in the value chain. The question then becomes, “can this business or industry transition quickly and credibly away from its problematic aspects, or is it locked into an unsustainable pathway?”. This is often not an easy problem to answer, because it depends on assumptions about future factors such as technology, consumer demand and legislation which will influence the viability of different pathways. But business models can be examined and reimagined to try and answer these questions.
However, there are business models that are not only resilient or flexible, but stand to actively benefit from wider growth in a sustainable and ethical economy. Indeed, even the perception of likely future growth in the green economy is enough to boost valuations today. For example, investor enthusiasm means Tesla stock trades at a P/E ratio of 1,100, implying it would take over a thousand years of current earnings to recoup its share price. Would seeing a business model for Tesla, using probabilistic forecasts of future energy prices and electric vehicle demand, allow us to make a more objective valuation?
What does this mean for ESG Investing?
ESG investors can engage with investee business models on several levels. It’s worth noting that business modelling to evaluate companies’ sustainability is still in its infancy, and so any work should be undertaken carefully and with appropriate quality assurance. Guidance such as the Scenario Analysis Technical Supplement from the Taskforce for Climate-related Financial Disclosure (TCFD) is very helpful, particularly to understand the range of possible future scenarios that a business could be subject to. However, the initial work of mapping and verifying a company’s existing business model is a specialist field in its own right.
Figure 2: Suggested approach to using business models for ESG evaluation
For newcomers to the concept, we suggest focussing on the highest risk and opportunity investments in your portfolio. You can undertake a ‘light touch’ ESG risk and opportunity screening study, quickly identifying potentially problematic investments and giving insight to the best areas to focus resources for more substantial investigation. You can also ask investees for the outputs of any business modelling and ESG scenario and sensitivity analysis they have already done.
For investors aiming to lead the way in sustainable investment, there is huge potential to map and use existing and prospective investee business models. You can build up a library of business model ‘blueprints’, schematics of how your most sustainable investments work operationally and strategically, and make the creation and use of investee business models a standard part of your due diligence and monitoring, as well as strategic value creation.
If you are interested in these concepts and would like to incorporate them into your work then we would be very happy to discuss with you, using ESI Monitor’s significant experience in business analysis and ESG evaluation and reporting. We help investors, managers and administrators assess the environmental and social risks and opportunities of their investments, using our accomplished team of experts and specialist technology to acquire data and provide insightful analysis. For more information or to discuss your needs, please get in touch with us at email@example.com
Amit, R. and Zott, C., 2001. Value creation in e‐business. Strategic management journal, 22(6‐7), pp.493-520
Groesser, S.N. and Jovy, N., 2016. Business model analysis using computational modeling: A strategy tool for exploration and decision-making. Journal of Management Control, 27(1), pp.61-88
Kennedy, S. and Bocken, N., 2020. Innovating business models for sustainability: An essential practice for responsible managers. In Research Handbook of Responsible Management. Edward Elgar Publishing
Richardson, J., 2008. The business model: an integrative framework for strategy execution, Strategic Change, Vol. 17, pp. 133–144
 Richardson, 2008 in Kennedy & Bocken, 2020
 Amit and Zott, 2001