Based on the increasingly political coverage of ESG (environmental, social and governance) in the media, controversial SEC climate-risk regulation, and national dispute over ESG investing, one might conclude that ESG is a distracting future compliance headache. Regardless, one would miss the point—which is that at its heart, ESG is a tool for value creation. ESG enables firms to identify, systematically manage and transparently communicate the full set of risks and opportunities that are material to their business. If this is sounding a lot like simply doing good business—that’s because it is. In the process of doing good business, ESG confers social and environmental benefits, but the main reason firms should practice ESG is to develop and strengthen behaviors that set them up for long-term success.
ESG Controversy
ESG is hard to define and complicated, but put simply, the problem is that ESG means different things to different people. In a recent speech by SEC Commissioner Mark Uyeda, he referred to ESG as “Everything, Everywhere, All at Once,” which sums up the problem succinctly. From the SEC’s perspective, ESG is a means of de-risking aspects of business tied to environmental, social and governance, improving communication of those risks, and reducing market volatility. To BlackRock CEO Larry Fink, ESG “is capitalism…driven by mutually beneficial relationships between [an organization] and the employees, customers, suppliers, and communities” it serves. In economic terms, ESG is a way to correct certain market failures by holding firms accountable for negative externalities.
ESG’s Value Proposition
The version of ESG Stern subscribes to, which is less controversial and more actionable, is that ESG is the set of characteristics and behaviors that help determine a firm’s sustainable, long-term success. In other words, ESG is a tool for value creation that should be consistent with a firm’s business model. If leveraging ESG as a tool for value creation sounds abstract, let’s unpack that a bit more. Many sources of value are important to firms—by investing in talent, firms drive sustained innovation; by creating a more diverse and welcoming workplace, firms boost productivity and stem attrition; by demonstrating their commitment to sustainability, firms attract longer-term, more stable investors; by improving their quality control processes and mitigating risk, firms unlock strategic partnerships with industry leaders; through improvements in operational efficiency, firms drive healthier margins; and by proactively tackling environmental, social and governance topics firms mitigate against activist investors and proxy battles. ESG tackles each of these potentially material issues, from quality management to diversity, rewarding firms with these and other tangible business benefits.
Biotech is one of the industries most in need of ESG and with the potential for significant gain. The investment landscape for biotech is built on expectations of high-risk and high-reward. The journey from startup to commercialization for most biotech firms is arduous—securing multiple rounds of funding, and often going public, before generating substantial revenue is common. Investing in biotech firms, for this reason, is considered risky. Biotech firms that leverage ESG unlock multiple benefit streams by improving their operations and business model to be more sustainable and signaling lower risk to investors—a win-win.
Now is the Time for ESG
If you’ve been watching the market, you’ll have seen ESG transform from niche to mainstream over the past two years. Two years from now, it will be ubiquitous. In other words, we are at an inflection point—while ESG is highly visible today, it is growing at an increasing rate. Several drivers will contribute to ESG’s continued rise in the near-term, especially for the biotech industry.
First, leaving normative judgements aside, it is a fact that the SEC will soon mandate ESG disclosure by public firms. As early as April 2023, the Enhancement and Standardization of Climate-Related Disclosures for Investors rule will come into effect, setting a clock in motion counting down to the date when firms will have to measure their GHG emissions, conduct climate risk assessments, and publicly disclose the findings. While the SEC’s current ESG rules deal only with environmental disclosures, social may not lag far behind. A portent of things to come, the European Commission has had both environmental and social non-financial disclosure mandates in place for several years, and is expanding those to include most firms over the next several years. While SEC mandates do not apply directly to private firms, they too will start receiving pressure from investors, suppliers, customers and other stakeholders who themselves are mandated reporters and have an incentive to push the firms they work with to become more sustainable. Firms in the biotech industry often consume relatively little energy compared with big pharma and the average corporation. For this reason, as an industry, biotech is behind the curve on ESG and will have to sprint faster to meet coming regulatory requirements.
Second, asset managers are exerting incredible pressure on their portfolio companies to undertake ESG. Over the last six months, a whole industry has emerged around private equity firms and asset managers either mandating, or strongly encouraging their assets to participate in ESG programs run by the managers themselves, or by third party vendors. This change has been so aggressive that many firms are pushing back on the ESG offerings, objecting to perceived conflicts of interest or mediocre value products, in favor of hiring consultants of their choosing or taking the process in-house. Here’s the rub—for small to mid-size firms, taking ESG in-house is not a sustainable option—time and labor constraints combined with the challenge of keeping pace with changes in the ESG industry make in-house ESG a costly distraction for most. In the biotech industry, where early-stage firms especially are lean and low liquidity, it is all the harder to manage ESG in-house—meaning these firms will be increasingly reliant on ESG providers to launch and grow their ESG programs.
A third driver of ESG will be the harsh economic realities of the market for going public at present. Stating that 2022 was a lackluster year for IPOs, especially in biotech, would be an understatement—IPOs and SPACs alike imploded last year, and it is not clear we’ve recovered yet. Biotech firms in the lead-up to IPO must deploy every strategy available to differentiate themselves in the market, attract attention from the type of investors they seek, and signal lower risk. Of all the biotech firms that aspire to go public in the next 12 months, a fraction will succeed—de-risking in a public and credible way can help provide the boost firms need to make it to the finish line. For those that succeed, ESG will help them maximize valuation, attracting a stable investment base to sustain that value over time. Especially for firms on the long march to commercialization, ESG is a powerful tool to reduce risk, improve the odds and generate revenue earlier.
Finally, large-cap firms will increasingly be forced to launch ESG programs just to keep pace with industry norms and not be seen as laggards. For mega-cap firms, ESG is already ubiquitous—it would appear a notable absence to find a Fortune 500 website devoid of ESG messaging and disclosures. While expectations are not at this level for mid-sized firms yet, they will be in the near future. Forward looking public firms, from micro to large-cap should be launching their ESG programs in 2023—but doing so in a way that makes economic sense. ESG solutions must be tailored to meet the individual needs of firms if they are going to pencil out economically and drive real value for the firm. Right-sizing ESG will be an ongoing challenge for the industry in the near-term.
Looking Forward
Our outlook for ESG and the biotech industry is optimistic if firms learn to leverage ESG as a tool for value creation. Instead of seeing ESG as a compliance headache or burden, firms must learn to embrace ESG to identify, manage and communicate risk, in a proactive and transparent manner, unlocking benefit streams that will help them thrive.
Molly Podolefsky, Ph.D. (she/her/hers)