ESG is Inflationary

As the global economy rebounds, the likelihood of inflation has become the dominant economic story. You can’t watch the financial news for long without hearing about inflation. At the same time, environmental, social, and governance (ESG) initiatives continue on an inexorable march to greater public perception. However, despite both issues occupying ever more column inches, one consideration has been underexplored; ESG will add to inflationary pressures. Yes, ESG is a new source of inflation that was not so present in the previous cycle and cannot be overlooked when forming a view on this cycle’s inflation outlook.

As companies and individuals adopt sustainable practices, we believe the potential exists for inflationary consequences in the short and medium term.  Here we will go through a few examples for each E, S and G.

Environmental 

Perhaps the most tangible way ESG considerations influence inflation is via the environmental arm. The pressure exerted on corporates to make significant reductions to their environmental footprints is unlikely to abate, and the number of companies committing to net zero-carbon pledges is rapidly increasing. While generating a positive outcome, such a policy is guaranteed to engender higher costs. 

For example, companies will incur higher costs through increased research and development spending as they try to make processes more efficient and to investigate new technologies to reduce their emissions, such as carbon capture. 

We should also consider that as companies upgrade their offices and transport to greener alternatives, there will be increased capital expenditure to finance any transition. Although this switch might reduce costs over the long term, customers will likely bear the costs via price increases. Similarly, with sustainable packaging in manufacturing industries, the higher costs incurred by businesses could easily be passed on to the end consumer, especially as recent studies have found that the majority of consumers are willing to pay more for environmentally friendly packaging.

Social

As companies and organisations strive for more equality and diversity in their workforces, the costs associated with recruitment and retention will likely rise. For firms striving to reach gender equality, establishing how best to retain women, especially post-maternity leave, is a necessity. As witnessed in the US during COVID-19, a disproportionate number of women have left the workforce. One could speculate that the sheer costs and complications of childcare were a factor in many working mothers choosing to leave their job. If companies are to achieve gender parity, they must explore alterations to their practices to recruit and retain new mothers. Again, there are likely to be significant costs associated with doing so. 

Likewise, efforts by corporates to bolster representation by recruiting and promoting workers from ethnic minorities, poorer socio-economic backgrounds and employees with disabilities may be cost inflationary. Firms will have to spend money on recruitment drives, skills training and retention initiatives, and this will be an ongoing expense that businesses will face.

Furthermore, those companies with supply chains in the developing world could face increased pressure to mollify social conditions in the countries in which they operate: for example, by implementing fair pay initiatives for all workers in their supply chain and ensuring no child labour is used, even in the businesses of their suppliers. Therefore, higher labour costs will likely accrue to companies, with consumers ultimately footing the bill. Likewise, ensuring no child labour is used at any stage of a supply chain will require companies to spend money on rigorous oversight and controls, adding further overheads. 

Governance

Organisations are facing increasing demands for reporting, whether from governments or requests from stakeholders. As a result, companies will need to dedicate greater resources solely for governance, requiring larger teams, new hires and bolstering Corporate Social Responsibility committees. 

Also, as companies sign up to more initiatives and pledges, whether the UN Sustainable Development Goals or the Climate Pledge, further associated costs with monitoring and reporting (on top of implementation) are inevitable. The likelihood of additional regulation increases, which could potentially have a productivity cost. Similarly, with companies adopting new technologies and processes to improve their sustainability in the long term, this could create inefficiencies in the short term.

Even companies that don’t embrace ESG will face price pressures. For instance, companies that fall behind the crowd or those in “dirty” sectors could see their access to capital markets turned off. As a result, their cost of capital would be higher; a cost likely passed on to end consumers. 

On the flipside, companies falling short on the sustainable front could fall out of favour with a section of their client base. Would prices then have to increase so those businesses can remain profitable?

There is little hard data out there at the moment, and companies are probably unlikely to give a detailed breakdown of any price changes. However, during Q1 earnings calls, various companies indicated their intent to pass on price increases generated from their supply chains to end consumers. Accordingly, we think any costs increases associated with ESG will ultimately get transferred to consumers.

That said, there is every possibility that inflation from ESG proves transitory in the long term (ultimately everything is transitory! ). Lower running costs of electric vehicles, increased productivity from having a diverse workforce and stable energy prices bestowed by renewable energy sources are all plausible beneficial effects created by companies adopting a more sustainable posture. However, we believe that organisations adopting better ESG behaviours will, on balance, create inflationary pressures in the short and medium-term.