ESG’s Impact Is Emerging on Net Earnings Before Interest, Taxes
ESG’s Impact Is Emerging on Net Earnings Before Interest, Taxes
Shifting toward sustainable operations requires capital expenditures that many companies, particularly in the private sector, have struggled to prioritize. The last few turbulent years, marked by a pandemic, supply chain issues, inflation, and energy disruptions linked to military conflict, have only increased that struggle.
However, the advent of meaningful federal climate legislation has brought the promise of $394 billion in energy and climate funding in the form of tax credits over the next decade. Of the available funds, $216 billion is expected to go to large corporations, while over $120 billion in loans and grants has been earmarked for small business owners and underserved or overburdened communities.
Businesses of all sizes and sophistication levels desire access to these funds to lessen the burden of environmental, social, and governance (ESG) related capital expenditures, modernize their businesses, and build in resilience for the future. These investments will increase enterprise value by reducing long-term recurring operating expenses, improving the quality of normalized net earnings before interest, taxes, depreciation, and amortization (EBITDA).
As business leaders push forward to make investment decisions using an ESG framework, their companies have transformed. Below are some common ESG initiatives that have been implemented to deliver ESG shared value to stakeholders:
- Energy transition to net zero carbon emissions
- Greenhouse emissions reduction for decarbonization
- Pollution and waste management
- Natural resource conservation and biodiversity
- A sustainability office to lead environmental initiatives
- Labor and human rights through diversity, equity, inclusion, and belonging (DEIB), and even the creation of a DEIB office
- Data security and privacy
- Community relations
- Board composition and diversity
- Executive compensation
- Risk management and transparency
- Shareholder rights and engagement
- Ethical business practices to preserve reputation and brand value
Determination of Normalized Profitability
Although sustainability disclosures continue to gain traction from consensus around the standardization of risk reporting, there is no single, widely adopted standard format for reporting on the value of ESG initiatives.
That said, nearly all of these initiatives have a quantifiable effect that flows through to a firm’s financial statements, impacting underlying profitability consisting of the reported net EBITDA and ultimately changing its valuation. For example, in the initial stages of an investment process, an assessment typically is made on the return of that investment.
For mergers, acquisitions, and divestitures, financial due diligence will typically include a quality-of-earnings assessment. This aims to provide interested parties with an objective analysis of a company’s underlying financial performance consisting of the reported EBITDA, plus or minus any identified adjustments. It’s also useful for presenting a normalized view of the operating EBITDA of the company.
Typically, these identified adjustments consist of any significant activity that would have affected the typical operations of the company and adjusted EBITDA. Some of the common quality-of-earnings adjustments may align into these categories:
- One-time, non-recurring, and/or non-operational business activities
- Integration and/or separation considerations, if there have been structural changes to the business such as standalone and/or stranded costs
- Value creation through synergies and cost savings — these can come from ESG and/or structural changes to the business
- Pro forma considerations that might not be included in the historical financial information based on the forward-looking operations of the company
However, the concept of ESG-related adjustments traditionally hasn’t been a part of the quality-of-earnings assessment, nor has the impact of ESG initiatives been quantified since there hasn’t been a large-scale adoption of a formal reporting framework.
The Securities and Exchange Commission is expected to publish disclosure reporting requirements for large, accelerated filers reporting under U.S. Generally Accepted Accounting Principles, impacting their FY23 annual reports and International Sustainability Standards Board released guidance affecting companies that report under International Financial Reporting Standards.
Intersection of ESG and EBITDA
EBITDA adjustments can come from various sources, such as management or third-party advisers, and have a variety of classifications. When making EBITDA adjustments during diligence, the impact of ESG initiatives on operating income, and therefore earnings, more appropriately may be separately classified as ESG EBITDA adjustments.
Here are some examples of ESG-related adjustments that companies could make to their operations, along with their quantifiable potential impacts to help companies arrive at an EBITDA that has been adjusted for impacts related to ESG:
- Establishing a sustainability or DEIB office within the company would impact headcount (hiring and retention), driving period-over-period differences in payroll expense, and any one-time costs around setting up their operations
- Enacting energy/carbon reduction plans, such as transitioning to lower carbon alternatives, might cost capital up front but could lead to longer-term cost savings from lower utility and carbon emission costs
- Changing executive and board compensation would consistently impact models in period-over-period analyses
- Shifting ownership structure through employee stock ownership and other employee ownership options could provide a broader and more diversified ownership base
The growing importance of ESG considerations in the investment landscape is driving companies to implement ESG initiatives and integrate them into their financial reporting, which will have an effect on EBITDA. As the ESG framework expands and becomes more comprehensive, it will continue to shape business practices, investment decisions, and financial assessments, leading to a more sustainable and responsible approach to capital allocation with long-term value creation.
Written in collaboration with Luis Galarza of ERM. Originally published in Bloomberg Tax.