84  Valuation of ESG and Digital Initiatives A Common Framework Before we dive into the details of ESG and digital valuation, it’s worth point- ing out that valuing these strategies or projects follows the same principles that apply to all investment decisions: use discounted cash flows, and com- pare scenario cash flows with a base case. Often, what is most critical for this analysis is the definition of the base case. Sometimes executives argue that hard-to-quantify investments are neces- sary because they are “strategic,” or that their benefits can’t be measured. This is rarely the case. The logic error is often in defining the base case. Take the decision by a bank to invest in a mobile-banking app. How would you quan- tify the value of this investment? The key is the base case. If all of a bank’s competitors have mobile apps and the bank doesn’t invest in one, its market share will likely fall over time as it loses customers (or fails to attract new ones). Therefore, the base case would be a decline in profits and cash flows, not stable profits and cash flows. Companies are often reluctant to create business-as-usual projections that show declines in profits and cash flows. Yet such declines are what will most often happen when companies avoid change. Companies must become comfortable with declining-base cases; if they don’t, they will have difficulty quantifying the value of many investments in ESG and digital. Quantify- ing the value is essential to making smart choices. It allows you to compare these initiatives against other investments that may be competing for scarce resources. And as in the example of the mobile-banking app, it may cause you to think about how much to invest in particular initiatives. It’s not good enough to look at advancing technology or increasing demand for sustain- ability and act blindly, based on an uninformed sense of obligation to keep up with outside forces. Environmental, Social, and Governance (ESG) Concerns Every business is deeply intertwined with environmental, social, and gover- nance (ESG) concerns:1 • Environmental criteria include the energy a company takes in and the waste it discharges, the resources it needs, and the consequences for liv- ing beings as a result. Some of the most significant measures are carbon emissions and climate change. 1  This section on ESG is an adaptation of an article coauthored by one of this book’s authors: W. Henisz, T. Koller, and R. Nuttall, “Five Ways That ESG Creates Value,” McKinsey Quarterly (November 2019), www.mckinsey.com. Environmental, Social, and Governance (ESG) Concerns  85 • Social criteria address the relationships a company has and the reputa- tion it fosters with people and institutions in the communities in which it does business. Important criteria include labor relations, diversity, and inclusion. • Governance is the internal system of practices, controls, and procedures a company adopts in order to govern itself, make effec- tive decisions, comply with the law, and meet the needs of external stakeholders. These individual elements are themselves intertwined. For example, social criteria overlap with environmental criteria and governance when companies seek to comply with environmental laws and broader societal concerns about sustainability. The combining of these reputation and business risks and benefits has more executives thinking and acting on ESG in a proactive way. As we dis- cussed in Chapter 1, the U.S. Business Roundtable in August 2019 issued a statement strongly affirming businesses’ connection with a broad range of stakeholders, including customers, employees, suppliers, communities, and shareholders.2 Investors are becoming more interested in a company’s ESG performance, and ESG-oriented investing is on the rise. ESG-related invest- ment funds now top $30 trillion—up 68 percent since 2014 and tenfold since 2004.3 The acceleration has been driven by heightened social, governmental, and consumer attention to the broader impact of corporations, as well as by the investors and executives who realize that a strong ESG proposition can safeguard a company’s long-term success. The weight of accumulated research finds that companies that pay atten- tion to environmental, social, and governance concerns do not experience a drag on value creation.4 Better performance in ESG also corresponds with a 2 The stakeholder-minded approach is elaborated upon in Witold J. Henisz, Corporate Diplomacy: Why Firms Need to Build Ties with External Stakeholders (New York: Routledge, 2016); J. Browne, R. Nut- tall, and T. Stadlen, Connect: How Companies Succeed by Engaging Radically with Society (New York: PublicAffairs, 2016); and C. Mayer, Prosperity: Better Business Makes the Greater Good (Oxford: Oxford University Press, 2019). 3  Global Sustainable Investment Review 2018, Global Sustainable Investment Alliance, 2018, www .gsi-alliance.org. 4 W. J. Henisz and J. McGlinch, “ESG, Material Credit Events, and Credit Risk,” Journal of Applied Cor- porate Finance 31 (July 2019): 105–117; M. Khan, G. Serafeim, and A. Yoon, “Corporate Sustainability: First Evidence on Materiality,” Accounting Review 91, no. 6 (November 2016): 1697–1724; and Z. Nagy, A. Kassam, and L.-E. Lee, “Can ESG Add Alpha? An Analysis of ESG Tilt and Momentum Strategies,” white paper, MSCI, June 2015, msci.com.