ESG - Achieving Equitable & Sustainable Growth
"The highest use of capital is not to make more money, but to make money do more for the betterment of life" Henry Ford
Everything is interconnected - our current Covid-19 crisis shows us that the ever-diminishing barriers between humanity and nature can lead to negative and potentially catastrophic consequences across all aspects of our lives, particularly across our economy, environment, society and those who govern them.
Continuing this example, from the above we can see the relative risk placed upon infectious diseases (noting also, the below-average likelihood). With Covid-19 potentially causing a $2 trillion dollar hit to the global economy and the FTSE 100 down 20% YTD, the impact to the UK (where the financial services industry contributes 6.9% or £132 billion in 2018), is highly significant, highlighting the pervasive nature of a crisis across the wider economy and the impacts upon many of the other risks highlighted, including taking resources away from the threat of climate change.
Minimising these risks via mechanisms such as Sustainable Investing is one strand in assisting the UK in meeting it's commitment to the Paris Agreement (keeping climate change to a 1.5c increase by 2030). With this commitment comes a growing emphasis on Environmental, Social and Governance (ESG), with companies now having to demonstrate how they are performing in these areas alongside existing financial measures. As investors are now more acutely aware of the necessity for companies to demonstrate how they are of benefit to the environment and society, we cannot afford to lose our current momentum and indeed, should use this period to ascertain how non-financial performance can help foster a prosperous world as we emerge from this crisis.
So what is ESG?
ESG is the integration of environmental, social and governance analysis in determining companies' sustainability performance within the investment decision-making process, often compiled by specialist ESG research firms, who attribute a score to various metrics. Coupling this with in-house research and analysis, leads to a final decision on whether or not to invest in or engage with an existing investee company. As we can see from the below, environmental considerations have become the most concerning risk (e.g. a company's efforts to reduce their pollution levels) within the sphere of ESG considerations.
ESG is often used alongside Socially Responsible or Responsible Investing (SRI - the choice of investing on ethical grounds e.g. deciding not to invest in a tobacco company) or Impact Investing (investments aimed at solving societal or environmental issues e.g. social impact bonds). All however, are themes under the Sustainable Investing banner.
To put this in the current context, a company who has repurposed their production lines to make PPE should score well on future social and governance factors of ESG.
The Business Case for ESG
ESG integration is the fastest growing element of SRI in the UK and Europe. Between 2015 and 2017 UK growth was 76%, managing €2.2 trillion of assets using ESG exclusions (UKSIF) and assets under management in ESG products have doubled from £17 billion in 2014 to £35 billion in the first three quarters of 2019 (FT Advisor).
Since the inception of investment frameworks such as the UN's Global Compact (whereby companies align strategies and operations with universal principles on human rights, labour, the environment and anti-corruption) and Principles for Responsible Investing (PRIs - a voluntary and aspirational set of investment principles that offer a menu of possible actions for incorporating ESG issues into investment practice), investors have extensive information surrounding corporate sustainability strategies and targets and as a result, are increasing their demand for investments that align profits with purpose.
The impact on the markets is such that across financial services, more firms are offering new products, organisations are adapting business practices and investors have become activists, advocating change via their investments and engagement, driving capital away from the likes of fossil fuels into environmentally-friendly companies who demonstrate strong governance and sustainable performance - evidenced by 2020 Q1 returns (Morningstar).
Given the pandemic we are now in, this prevalence for ESG is fast-becoming the future of investing, with companies needing to ensure they're performing across the board to ensure favourable sustainability ratings given that negative consequences could well be reflected in future share price or revenue.
Due to the subjective nature of current ESG profiling, it is imperative to take a pervasive view of sustainability across the organisation, embedding sustainability issues into wider corporate strategy, changing behaviour and developing ESG as an additional metric for performance. Though this requires considerable discussion to balance short-term risks with longer-term objectives (e.g. quarterly results vs 5 year plans), the opportunities outweigh the threats.
Purpose and Transparency
So how can ESG be successfully incorporated? More importantly, how can ESG be successfully incorporated and leave an organisation better positioned to cope with future crises?
Most importantly, Board and C-Suite level understanding and buy-in is essential. Strong governance informs corporate behaviour, which must be centred on sustainability - wholesale change, led from top-down into management and investment teams to deliver ESG performance. With the latest Edelman update reflecting that businesses are not being seen to meet the challenges presented by Covid-19, leadership must identify priority ESG approaches (e.g. ensure the well-being of employees or assisting their supply chains), focussing on improving material issues relevant to their organisation - what they can do to improve and influence their social, environmental and economic impacts.
This will in turn influence stakeholder engagement (given greater leadership buy-in = greater accountability), driving the conversation more thoroughly and consistently not only across scheduled shareholder meetings, but ad hoc throughout the year. Building this direct engagement not only ensures a deeper understanding of the investee organisation (its purpose and wider activities), it ensures continuous ongoing dialogue to facilitate positive progress and meaningful outcomes, with Boards' understanding that shareholder support should not be taken for granted when the risk of divestment is increasingly consequential to organisations wider sustainability ambitions - as many are finding out, particularly across oil and finance.
In support of engagement, many organisations utilise proxy voting providers to vote on their behalf at shareholder meetings - an efficient mechanism, often benefitting from the providers own ESG research (especially in the UK with the updates to Shareholder Rights -SRD II, regulation). This default position does however risk falling into the lackadaisical trap of failing to properly address investors' issues and thereby ending up with shareholder rights represented by an oligopoly of third parties own views. It's therefore essential the combination of good governance, engagement and voting is backed up by detailed reporting, avoiding the pitfalls of ESG inertia and stamping out corporate greenwashing.
By understanding your business and taking ownership of your data, a full picture of your organisation and its non-financial performance can be consolidated for reporting purposes -with integrated reporting the most effective for investor's ESG information, linking qualitative and quantitative performance data across the six capitals, with organisational strategy, rather than sleek slogan-laden decks. In addition, various regulatory and reporting mechanisms exist across financial services to attempt to streamline corporate reporting (SRD II, PRIs, GRI, TCFDs et al), yet many are voluntary and no legislative standardisation is as yet enforced throughout the industry. All have their benefits and are valuable tools to emphasise sustainability, yet with further proposals in the pipeline (or nearing finalisation, such as the EU Taxonomy), time will tell how ESG disclosures develop and which becomes the investor and market preference, however with these current variations comes inconsistency (across both ESG scoring and reporting, e.g. Is Tesla an ethical investment?), thus improving your transparency is one core way to ensuring you own the ESG story for your organisation, reduce the potential for subjective ambiguity and create value - after all, it's better to aim for 100% and hit 90%, than being happy to aim for and achieve 20% in all target-setting.
In our current global pandemic, along with the immediate need for climate change mitigation, companies who lead with strong governance, clear goals and an open-mindedness towards partnerships will prosper. Collaboration is proving successful already, with a who's who of various multi-national CEO's pledging their support to the economic (and sustainable) recovery, with B4IG companies committing $38billion~ to strengthen equality of opportunity, reduce territorial inequalities, promote diversity and inclusion and reduce gender inequality. These measures are supportive of the UN SDGs and also provide the companies involved with clear ESG measures to focus upon, which in turn circles back to investor decision-making.
Given the unpredictable nature of our futures, in the immediacy we thus look to what we can control - aiming to deliver cohesive improvement by galvanising business leaders to focus on ESG-related data, build pervasive transparency for all stakeholders and cooperating with your wider community for potential sustainable growth and common purpose. As ESG understanding grows and improves its uniformity, so organisational capability improves and evolves, translating to positive environmental and societal contributions delivering cyclical improvements and benefits, including one hopes, a greater resilience to human-led crises until we can learn to live in harmony with nature.