Sector News

Chemicals and capital markets: Growing sustainably

April 24, 2022
Borderless Future

The chemicals industry has always been at the forefront of creating new or improved materials to meet the needs of society. Historically, this has shown itself as delivering products with the right physical or chemical properties. Currently, the focus is on delivering products and materials with a lower environmental impact, including (but not limited to) lower carbon footprints. As industries increasingly shift away from fossil fuels and transition to renewable sources, chemicals will play a central role in moving the economy to net-zero emissions.

Today, the chemicals industry creates significant Scopes 1 and 2 emissions and is central to the question of plastics waste. Moreover, the industry consumes substantial amounts of fossil fuels such as natural gas, crude oil, and, increasingly, coal. These environmental factors already contribute to the public perception of chemical companies. In addition, many institutional investors have set sustainability targets for their portfolios. The combination of these two factors has led management teams to consider how investors value sustainability in the chemical industry and what actions they should take to maximize value creation in the future.

Objectively, measuring the “greenness” of a chemical company (or any company, for that matter) is not straightforward. The environmental, social, and governance (ESG) metrics typically used to determine a company’s sustainability profile often encompass a broad list of criteria around the latter two categories. Investors and stakeholders are also skeptical of greenwashing and see little or no correlation between ESG ratings and financial performance in the chemicals industry. This should not come as a complete surprise, because many ESG criteria have only an indirect impact on cash flow. Yet there are ways to create value out of ESG.

Ultimately, what matters to investors are future cash flows. Therefore, sustainability efforts can be tailwinds for the industry in three ways: increased customer willingness to pay, sourcing advantage, and the rapid growth of products and end markets exposed to sustainability trends.

This article illustrates how capital markets are increasingly recognizing sustainability, and it details five steps companies can take to act upon capital-market expectations: growing market-back opportunities for green growth, safeguarding value and managing risk, continuing to turn over their portfolios, decreasing emissions, and remaining agile enough to adapt decision-making processes as new opportunities arise. Companies that take these steps will be better positioned to keep up with the sustainability transition and therefore more likely to stay competitive in the years to come.

Sustainability and what matters to investors
Our research shows that absolute ESG ratings do not correlate to financial performance. Yet, interestingly, chemical companies that improved their ESG combined score by more than five percentage points from 2016 to 2019 were, indeed, rewarded by capital markets.

Of course, correlation isn’t causation, and we can only conjecture that improvements in ESG ratings may be linked to performance improvements, such as lower emissions or water usage, better process controls, or increased transparency. It’s not difficult to see how these factors could translate to improved or more sustainable cash flows or how they could ensure the future “right to operate.” As a recent McKinsey article demonstrates, future cash flow and financial performance (as measured by ROIC and growth) are the only relevant metrics that lead to significantly improved capital-market performance.

To understand how sustainability in chemicals is actively driving valuation, we segmented our sample of chemical companies along two dimensions:

  1. those with “greener” product portfolios—defined as more than 25 percent of revenues in biologic, recyclable, or low-carbon product portfolios
  2. those with exposure to end markets supporting sustainability tailwinds, such as electric vehicles (EVs), energy storage, water reduction, energy efficiency, natural ingredients, or circular packaging

In both segments, we see a clear correlation between improved total shareholder returns and an improved sustainability profile (Exhibit 1). Although there are many ways to define “sustainability,” our research shows positive correlations with both sustainability measures. The number of companies included in each definition is not the same. There are companies that are classified as sustainable according to dimension one or two, and there are also a few companies identified as “green leaders” that fall into both categories.

Exposure to end markets with sustainability tailwinds is highly correlated with growth or margin premiums. However, Scopes 1, 2, and 3 emissions currently have limited correlation to current or future cash flows, and as a result, they do not drive valuation of ESG scores. Similarly, pine chemicals are highly sustainable because they are a coproduct of renewable tree harvesting, yet customers are not willing to pay premium prices for them because of their applications, which are typically in road construction or adhesives. As a result, chemical companies see little valuation benefit, while biobased materials start to see premium uplift.

Regarding carbon intensity, there is currently no correlation between Scopes 1, 2, and 3 (upstream Scope 3 emissions are a relevant contributor for many players in the chemicals industry) and TSR, although we expected to find such a correlation. This may be because many relevant players do not yet report Scope 3 emissions, and not all reported Scope 3 emissions are presented in a form that allows for comparison. Therefore, the capital market does not take these into account.

The impact of sustainability becomes even more apparent when looking at green leaders, which are typically companies that combine both sustainability dimensions (a green portfolio and exposure to end markets with sustainability tailwinds). In fact, green leaders doubled their TSR compared with green laggards (Exhibit 2). READ MORE

by Obi Ezekoye, Hugues Lavandier, Chantal Lorbeer, Werner Rehm, and Jeremy Wallach

Source: mckinsey.com

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