SMEs need to understand that Environmental, Social, and Governance (ESG) practices not only benefit society, but make their companies more resilient as well, according to research by David Veredas and Dimitrios Kolokas
In recent years, there has been increased expectation for businesses to incorporate more sustainable practices, especially as environmental, social, and corporate governance (ESG) is increasingly attracting the attention of regulators, consumers, investors, and academia. And this is not without just cause.
Between 1965 and 2017, according to the Climate Accountability Institute, it was estimated that more than 1.35 trillion metric tons of greenhouse gases had been released into the atmosphere, with over a third being traced back to just 20 large companies, with culprits including Chevron, Royal Dutch Shell, and BP, among others. Also, when it comes to companies responsible for plastic pollution, the top 20 large companies are responsible for more than half of throwaway plastic waste, at which Exxon Mobil tops the list.
Although large, mainly listed, companies such as those previously mentioned have faced much of the attention from regulators, customers, and the media in regards to sustainable practices, there is a dire need for more research on the sustainability of small and medium-sized enterprises (SMEs). Due to representing more than 60% of value-added and more than half of the labour employed, SMEs are the backbone of the European economy and have a large impact on the environment.
But how could it be possible for these smaller companies to have such a large impact?
Well, as an example, a 2016 report revealed there were 5.5 million registered businesses in the UK, but only around 7,000 of these were considered large companies with more than 250 employees, compared to 5.49 million SMEs. This means that, in total, SMEs employed more people than large companies; 15.7m compared to 10.8m, respectively. This suggests that SMEs have an important footprint, yet very little has been done to encourage or help them reduce their impact.
Essentially, society cannot make a holistic and effective transition to becoming more sustainable or achieve sustainability goals without the active participation of SMEs.
However, for smaller companies, ESG transformation can be expensive and uncertain, especially as results and benefits may not be seen for a long time due to the long-term nature of investing in ESG. Therefore, to convince SMEs to engage in ESG and sustainable practices, it is important for them to understand, not only how ESG practices benefit society, but also how they benefit too.
Measuring the resilience of SMEs
In a study conducted by the Centre for Sustainable Finance at Vlerick Business School, and financed by partner ABN AMRO Belgium, we measured the resilience of SMEs in terms of credit risk, analysing the impact of ESG performance on the credit risk of 350 Belgian SMEs. As part of this, we developed a model for SMEs that measures financial and ESG performance and scored each company on their ESG activities according to information on their websites and in sustainability reports.
Our findings suggest that investing in sustainability does benefit SMEs, as they become more creditworthy. In fact, on average, an 11% increase in an SME’s ESG performance will decrease its credit risk by 3.5%.
There are two main ways in which incorporating ESG practices into business can impact a company’s value and, therefore, financial performance:
The first is the generation of cash flows by increasing client base, expanding the business, and raising the productivity of employees, or by decreasing the discount rate by limiting risk exposure or expanding the base of investors.
The second involves considering shareholders, as some investors value ESG products and services in addition to financial products. This means many investors may value the ‘green’ companies more than non-sustainable companies.
However, despite the benefits, ESG projects possess a number of characteristics which make them capital intensive, requiring large sums in investments for businesses to achieve. The financial constraints in implementing these projects are related to their long-term nature and high uncertainty. The biggest obstacle for SMEs to invest in improving sustainability is the lack of available capital which is more prominent among less resilient SMEs with high credit risk.
In this context, greenwashing has emerged as a recent phenomenon. Greenwashing refers to the act of sharing disinformation to consumers regarding a company’s ESG practices or the ESG benefits of a product or service. For example, the fast fashion industry is well known for its impact on the environment, so various fashion companies and brands have been known to engage in greenwashing. In 2021, a report from the Changing Markets Foundation looked at clothing from major high-street fashion brands to check the truthfulness of sustainability claims and found 60% of claims were misleading and did not meet guidelines on avoiding greenwashing.
Also, most recently, research from the NewClimate Institute suggested that some of the world’s biggest companies are failing to live up to claims they will reach net-zero emission targets, only cutting their emissions by 40% rather than 100%. Among these are companies such as Amazon, Ikea, and Unilever. As you can imagine, individuals in the public as well as shareholders or investors would not be incredibly impressed if they discovered a company was involved in greenwashing. This may even lead to investors withdrawing financial investment.
Due to lack of capital and potential greenwashing, high-risk firms cannot translate an increase in ESG performance into a lower credit risk, and our results confirm this: while the average or low-risk SMEs (the most resilient) observe a reduction of their credit risk when engaging in ESG practices, the high-risk (less resilient) SMEs do not.
However, based on this finding, it is reasonable to assume that high-risk SMEs that somehow manage to allocate financial resources to ESG projects would be able to enjoy the perks of ESG and resulting positive stakeholder relationships leading to greater resilience.
By improving capital efficiency, having investors monitor and advise them, and creating a robust business plan, high-risk SMEs can convince investors to provide additional financial resources, increasing their liquidity.
Therefore, by successfully attracting and investing financial resources in ESG practices, high-risk SMEs can overcome both lack of capital and greenwashing. Our results reveal that the interaction of liquidity and ESG performance is required for high-risk SMEs to become more resilient through lower credit risk. This interaction is not necessary for average and low-risk SMEs.
In conclusion, SMEs become more creditworthy when they increase their ESG performance. However, low-resilience, high-risk SMEs do not enjoy the perks of ESG practices, due to their limited access to financial resources and temptation to engage in greenwashing. When the necessary financial resources are available, low-resilience SMEs can experience a significant decrease in their credit risk as a result of an increase in their ESG performance.
SMEs need to understand that ESG practices not only benefit society, but make their companies more resilient as well. This research is of great importance for lending institutions like ABN AMRO as well as for helping SMEs understand how and why to increase ESG practices. It confirms and quantifies the trend we have observed since the beginning of the pandemic that sustainability-driven SMEs are more resilient to large shocks, making them more creditworthy.
David Veredas is a Full Professor, Partner, and Director of the Centre for Sustainable Finance at Vlerick Business School. He has developed teaching and research expertise in risk management, sustainable finance, and insurance.
Dimitrios Kolokas is a doctoral researcher in accounting and finance from Vlerick Business School.