ESG as a part of an organisation’s impact strategy
ESG (in terms of issues relating to the Environment, Society and Governance) is headlining in the media, and in the investment and corporate worlds, but it’s not new – nor should it be treated as something separate to the rest of business. It’s a useful acronym but in essence focusing on performing well in these areas is just good practice for any investor or business organisation.
Why you can’t ignore ESG – now or ever
The underlying issues for society, the environment and good governance, have been with us a long time, as have the clearly negative impacts of ignoring these areas or not addressing them properly. Many companies and banks have been hit by huge fines or share price falls over the decades due to their poor governance, environmental damage or unethical practices, and these outcomes are bad for all stakeholders. These are not trivial amounts and certainly can’t be seen as “just a cost of doing business”. In 2010 the total compensation paid out by BP for the Deepwater Horizon oil spill was a mind-boggling $65BN! (see some of the largest fines here)
It can’t be sound business or investing practice to ignore ESG-related issues; now or at any time in the last few decades.
UK law isn’t a barrier
UK corporate law already states that organisations are fully responsible for all their actions. It is a myth that the legal duty of companies is to pursue only profitability and shareholder returns. This may have been the main corporate pursuit for decades but it doesn’t mean it was the law; or that it was right. Company leaders already have a fiduciary duty to the long term health of the business; and sustainability is a critical part of that (see Section 172 of the Companies Act 2006).
Also, as per the Principles of the Corporate Governance Code set out by The Financial Reporting Council (FRC) Principle A: A successful company is led by an effective and entrepreneurial board, whose role is to promote the long-term sustainable success of the company, generating value for shareholders and contributing to wider society.
These clauses aren’t perfect. I support current efforts to go further; to tighten up the language, be much more proactive with efforts to be good corporate citizens, and further emphasise the importance of stakeholder responsibility. But a legal platform for good corporate behaviour already exists, at least in the UK. E.g. Better Business Act.
ESG as opportunity not just risk management
It’s not just about risk. There are profitable opportunities for organisations who use their business competencies for social or environmental good. A data consultancy helping to fight fraud; a bank using its technology and networks for greater financial inclusion; a retailer driving out human slavery and poor working conditions from its supply chain whilst increasing quality and security of supply. There are many examples and too many for here so this will be the subject of my next blog. In short, companies who look at solving the world’s problems, encapsulated in the Sustainable Development Goals (SDGs) as a framework for change, have the chance to grow revenues, and do good.
So what’s new? What’s driving the ESG obsession now?
A number of things of course. What’s really different is the high profile for ESG across Boardrooms and the media, the widespread acceptance of the urgency for more climate action, and the growing evidence to show that strong performance in ESG-related factors doesn’t mean sacrificing investment returns but can actually lead to higher returns. In addition, because of these factors, we have seen a rapid increase in the number of new “ESG funds”; asset managers are responding to both market demand and stakeholder pressure, and these new funds add to the big ESG inflow figures over the last few years.
It also makes economic sense. Companies which perform badly on ESG factors are seeing a reduction in their value; most notably those with big carbon footprints, those with unacceptable behaviours in their organization or by their suppliers, those with weak governance of customer data, or countless other examples of poor ESG-related practices. That weakness in ESG performance seems to have a more direct impact on share price, reputation and investor sentiment than ever before; and therefore a higher risk for a company’s investors.
In search of trust
I think there is another wave in the evolution of ESG which is extremely current right now. That is, the growing pressure to be genuine about ESG and cut out ESG-washing. Not just in the superficial “dressing up” as funds as being ESG focused but also highlighting a gap between words and actions at leadership levels. This includes instances when a corporate leader or investor preaches about the importance of protecting the planet and vulnerable people but the reality of business practices in their own organisation tells a different story. There are many examples, with one of the most prominent being the recent complaints of harassment at Blackrock which don’t fit well with the demands from Larry Fink, CEO of Blackrock, for robust and ethical corporate practices from any company wanting Blackrock’s support.
There’s also a strong commercial interest at play which may underpin much of the ESG fund growth and accusations of ESG-washing. ESG funds generally have higher fees. They are a lucrative line of business especially if little additional work is done to identify positive impact companies or put pressure on those with ESG-related issues. For example, reports show a big misalignment between many portfolio companies in an ESG fund and the Paris climate targets – in this case 71% of the broad ESG equity funds assessed.
ESG and Impact; different and yet…
A point often missed is that assessing impact is not simple or quick . Not only do we need to assess the change in outcomes over a number of years to identify evidence-based progress but we also need to invest in additional due diligence upfront. Impact investment funds tend to be private market focused and often commit to this added level of interrogation required; but it seems unlikely that the rapidly expanding number of “ESG funds” follow suit. Although ESG and impact are not the same, with the latter intending to create a positive change in outcomes through targeted investment rather than a broader satisfaction of ESG criteria, they do appear to be merging at least in the general usage of the terms. In my mind, ESG factors should fall within an overall impact strategy for a company or investor because as we have seen in the above examples, performing well or badly against ESG measures heavily influences the net impact of a fund or company on people, or the planet.
Robust impact assessment requires many things. Following the IMP (Impact Management Project) principles for example, we can ask: what is most material in terms of impact for that company and its sector?; where is the genuine additionality from its own actions?; and how are positive and negative impacts being measured effectively across the business? As the recent letter from the FCA suggests, many fund owners are unlikely to be investing the resources, tools and expertise needed to fully justify their claims of impact and positive ESG performance. Do they want the extra margin and brand kudos without the costs of the in-depth assessment required?
Where are we now on the ESG journey?
From a market niche as long ago as the 1970’s, we are now moving through the waves of media noise, growing stakeholder expectations, the search for better data and greater scrutiny. More trust in the underlying claims of ESG funds and corporate promises is needed but we will then see unstoppable traction in the market, and ESG becoming the norm.
So, revolution or distraction?
I’d say it’s been a long evolution that has accelerated very quickly in the last few years. And with this growth has come much froth and confusion as well as genuine progress towards responsible business and investing. What’s clear is that ESG is on an upward trajectory and if we can ensure authenticity, and improve the quality of ESG practices in terms of evidence-based performance, it will be a good thing for everyone.