By Madeline Combe and Pablo Berrutti
What is ESG?
ESG stands for environmental, social and (corporate) governance, which spans a diverse range of issues from climate change, biodiversity and pollution (E) to human rights, diversity and employee engagement (S) to remuneration, board composition, and risk management (G).
While investors asses ESG issues in various ways, attention often goes to assessments by large ESG research providers who aggregate hundreds of factors in to a single rating — reminiscent of the Hitchhikers Guide to the Galaxy meme that the answer to the ultimate question of life, the universe and everything is 42. However, like valuation and financial analysis, complex and diverse ESG issues cannot be summed up into a single rating. Further challenges stem from each provider having their own approach that can results in a completely different rating for the same company.
How can companies manage all these issues that are assessed in so many ways?
Box ticking can land a company a good ‘ESG score’, but this does little to mitigate controversy. Company objectives are unique, as are their impacts on stakeholders and the environment. Consequently, the relevance (materiality in financial jargon) of certain ESG issues are also unique — it is these issues that should be the focus. Good management of material ESG issues requires a deep understanding and consideration of its stakeholders, like employees, customers, communities and shareholders, along with the environmental impacts it has across the life-cycle of its products or services.
Employees and stakeholders recognise when a company’s efforts are disingenuous; the protection of cultural heritage sites or preventing incidents of sexual harassment is not only determined by having policies in place. Good practice in these areas is as much a function of corporate culture, and although difficult to capture in an ESG rating, these qualitative aspects are critical consideration for long term investors.
How did ESG become such a huge phenomenon?
In some sense, this shift was inevitable; responding to issues like climate change, the collapse of biodiversity or the gender pay gap impacts investors too. Looking back, however, an ‘ethical’ investing approach can be traced to Quackers banning investment in slaves as early as 1758. Events like the anti-apartheid divestment movement signalled an awakening of the broader industry, but it was not until 2006 and the establishment of the UN backed Principles for Responsible Investment (PRI) that ESG started going ‘mainstream’.
In the years that followed regulators have increasingly focused on these issues with legislation in place in the UK and EU, to the US where the SEC has an increasing focus, to Asia where Singapore and Hong Kong both have emerging disclosure standards.
NGO action also grew, reflected by increased shareholder advocacy and litigation. Overtime shareholder resolutions which once received few votes now regularly receive majority support.
The work of groups like the Responsible Investment Association of Australasia (RIAA) has helped increase consumer awareness with significant growth in an increasingly diverse range of sustainability focused funds.
As we move into 2022, the drive to improve the credibility and impact for both investors and companies will continue.
Is ESG the same as Sustainability?
The short answer is no. As the industry evolved there was an important difference between ESG and sustainability, which today is often conflated and is the source of ‘greenwash’. ESG are a set of criteria, mostly focused on company practices, whilst true sustainability relates to outcomes. While logically adhering to the criterion should result in sustainable outcomes, this is not the case. For example; highly polluting companies can receive strong ESG scores because they have strong policies, systems and reporting in place despite their products causing harm.
In this sense assessing ESG is often seen as a risk management consideration for the company, as highly polluting companies should have excellent practices for managing pollution and avoiding accidents to avoid costly regulation and litigation, whereas more sustainably minded investors will be as concerned with the impact the company has on people and the environment, including the sustainability of the products and services themselves. While these two dimensions create a feedback loop, the risk to the company vs the risk to people and planet are often treated differently depending on the investor’s focus.
What impact did COVID have?
COVID has sharpened the focus on social issues and reinforced the roles of governments in managing large scale crises. It has reminded us that our globally interconnected economy and society touches every life on the planet (both for good and bad) and that the sustainability of supply chains are important for building resilient businesses. It also demonstrated how quickly we can adapt when faced with challenges; the idea of what is possible in confronting sustainable development challenges has expanded.
The disappointment from a sustainability perspective has been the lack of focus on vaccine equity and distribution although, this has more recently been taken up by investors working with the Access to Medicines Foundation engaging with global pharmaceutical companies. The pandemic also showed that even during such a historic global crisis, issues like climate change and human rights refused to recede into the background.
Where to now?
The regulatory focus on ESG and sustainability will increase. This will partly be to combat greenwash and false claims but also as policy makers recognise that the risks to companies and investors from these issues continues to grow. It is also a recognition that the transition to a zero carbon economy or the eradication of modern slavery cannot happen without the investment and influence of private markets.
In Australia, those on the wrong side of the transition to a more a sustainable economy will find the forces of shareholder, consumer, regulator and NGO focus will put increasing pressure on their business models and operations. Meanwhile, for high-quality companies that are contributing to more a sustainable future, the opportunities have never been greater.
This article originally appeared in the Australian Shareholders’ Association magazine.
Stay updated
Stay updated on the latest sustainable finance research by joining Altiorem, a community built, freely available library that supports its members to create a sustainable and ethical financial system.
Become an Altiorem member and follow us on Twitter and LinkedIn.
