ESG Essentials for Corporates #1: ESG – what’s in the name?

04 August 2020

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With a market volume of over $30 trillion globally[1], ESG investments have shed their niche status. The concept of integrating environmental, social and governance factors into investment processes as well as into corporate decision making is not only here to stay, but is undoubtedly becoming the dominant guiding principle for achieving a more sustainable economy and society.

This first article of our series looks at the history of socially responsible investing and corporate social responsibility, introduces the sustainability initiatives of the modern era, details the E, S and G in ESG and outlines how ESG affects corporate financial performance.

Jargon Buster

ESG: Environmental, Social and Governance factors that determine a company’s positive or negative impact on society and affect corporate performance and the performance of investment portfolios

UN Global Compact: The world’s largest voluntary corporate sustainability initiative with over 13,000 corporate and other participants and in over 170 countries {link)

SDGs: In 2015, all United Nations members adopted 17 Sustainable Development Goals as part of the 2030 Agenda for Sustainable Development, a blueprint to achieve an inclusive, sustainable and resilient society and planet.

SASB: The Sustainability Accounting Standards Board helps businesses around the world identify, manage and report on the sustainability topics that matter most to investors.

Who cares, wins

In June 2004 a group of 18 financial institutions published a report by the UN Global Compact with the bold title: “Who Cares Wins: Connecting Financial Markets to a Changing World.” The companies had followed an invitation from then United Nations Secretary-General, Kofi Annan, to develop guidelines on how to better integrate environmental, social and corporate governance issues in financial markets.

For many, the report marked the birth of ESG investing and a corporate ESG approach, and it delivered a compelling message: embedding environmental, social and governance factors makes good business sense, leads to more sustainable markets and creates better outcomes for societies.

While ESG was a new term, the idea behind it, for investors and corporates to act in a socially responsible way, has a long history. Socially responsible investing (SRI) dates back over 3,500 years with the major world religions advocating ethical investing in their main writings. Fast forward to the 17th century, when social investing came to the forefront with the Quakers casting out companies that profited from slavery or war. Religious groups followed in the early 1900s, urging people to steer clear of investing in companies linked to gambling or selling alcohol as well as lenders that charged excessive interest.

Equally, evidence of businesses’ concern for society, today known as Corporate Social Responsibility (CSR), can be traced back to the Industrial Revolution. In the mid-to-late 1800s, growing criticism of the emerging factory system, working conditions, and the employment of women and children were brought to light. The consensus among reformers was that unfair employment practices were contributing to social problems, including poverty and labour unrest.

The late 1800s also saw the rise of philanthropy. Industrialist Andrew Carnegie, who made most of his fortune in the steel industry, was known for donating large portions of his wealth to causes related to education and scientific research.

In 1953, American economist Howard Bowen introduced the modern concept of Corporate Social Responsibility in his book “Social Responsibilities of the Businessman”, which advocated for business ethics and responsiveness to societal stakeholders[1].  

The quest for a sustainable society

In September 2000 world leaders came together at the United Nations Headquarters in New York, lifting the concept of social responsibility onto a global platform by adopting the United Nations Millennium Declaration. The Declaration committed nations to a new global partnership to reduce extreme poverty, and set out a series of eight time-bound targets – with a deadline of 2015 – that have become known as the Millennium Development Goals (MDGs).

The final MDG report found that the 15-year effort had produced the most successful anti-poverty movement in history, motivating the UN “to go the last mile on ending hunger, achieving full gender equality, improving health services and getting every child into school.”[2]

This ambition culminated in the United Nation’s Agenda for Sustainable Development in September 2015, with all UN members adopting 17 Sustainable Development Goals, ranging from “No Poverty (SDG 1), “Zero Hunger” (SDG 2) and “Decent Work and Economic Growth” (SDG 8) to “Sustainable Cities and Communities” (SDG 11) and “Climate Action” (SDG 13). 

Fast forward to 2019, when Greta Thunberg became the face of “Fridays for Future”, demanding – together with other climate change activists such as “Extinction Rebellion” – immediate action to prevent the consequences of global warming and climate change. The publicity Greta Thunberg garnered cemented climate change in the public psyche, changing expectations and attitudes of customers and employees, now more urgently querying whether or how companies and other organisations are helping to combat climate change.

While the E in ESG moved into the spotlight in 2019, the shock and the dramatic consequences of the COVID-19 pandemic this year threw the S in ESG into sharp relief, reinvigorating the debate about corporate purpose: Do companies solely exist to maximise profits and shareholder value? Should they serve society in other ways than solely paying taxes? How do they care for their employees during such a crisis – are they willing/should they be willing to take on additional responsibilities to look after their staff?

Clearly, the last two years have marked the moment when the ESG movement entered the mainstream.

ESG – so what exactly are stakeholders looking for?

Whether investors, customers, employees or other stakeholders, a strong ESG proposition delivers proof that a company is doing or developing strategies to do “the right, responsible thing”.

In addition, investors will look at ESG data to calculate future earnings risks and future value creation.

In the context of the E in ESG, company stakeholders want to find out what a firm is doing to minimise environmentally harming practices. Environmental criteria include a company’s carbon emissions and other pollution it may cause; its energy use and waste management as well as its possible impact on biodiversity.

The S in ESG is directed at a company’s relationships with internal and external stakeholders: How does a firm treat its employees? Does it promote gender equality and diversity? Do working conditions ensure and proactively support employees’ health and safety? Another focus lies on the firm’s supply chain: Does it work with suppliers that hold the same values and subscribe to the same principles and practices, and how are suppliers being vetted? And how does a company engage with its community – does it offer volunteering opportunities for staff?

The G aspect of ESG often seems to fade into the background in the public coverage of ESG, but there’s consensus that good corporate governance is essential to yield corporate returns. Typical questions include: Does a company have an effective board and a clear strategy that promotes long-term sustainable success? Does a framework of effective controls exist, which enables risk to be assessed and managed? And does the company effectively engage with its shareholders and stakeholders? 

Faced with long lists of ESG related questions, some companies are concerned that meeting the comprehensive information demands could mean a substantial amount of work for an only limited value. A PricewaterhouseCoopers study[1], however, recently showed that the most successful companies not only consider those ESG questions to be useful “early warning” signals of what stakeholders expect of them, but also proactively test ESG policies, continually identify more efficient ESG targets and key performance indicators and build better ESG management systems to ensure a strong ESG proposition.

In order to help corporates disclose relevant ESG data in a cost-effective and practical format, ESG accounting initiatives have developed industry-based standards.  Our next article will look in more detail at such ESG reporting standards.

ESG positively affects financial performance

Over the years, research reports have documented the positive halo effect of ESG, with many studies showing a strong positive correlation between corporate action following ESG principles and a better financial performance:

  • Companies with strong ESG credentials have, on average, outperformed by 5.2% in developed markets from June 2013 to February 2018[2].
  • ESG-focused indices consistently either match or exceed the returns made by their standard counterparts, amid comparable volatility[3]. ESG portfolios also show more resilience in market downturns.
  • Companies with the weakest ESG credentials tend to trade with the widest credit default swap spreads; an indicator that an ESG focus reduces a firm’s risk and therefore its cost of debt capital[4].
  • Aggregated evidence from more than 2000 empirical studies[5] about the correlation between ESG and financial performance shows that the vast majority confirmed a positive correlation, with less than 10% reporting a negative finding.

But how exactly does a strong ESG proposition create value? There are four main reasons: 

  • Mitigating risk: The use of ESG principles helps firms to evaluate future risks and to avoid regulatory and legal intervention
  • Reducing costs: Apart from lower capital costs due to lower risks, applying ESG principles leads firms to review and modify corporate processes, such as for example building more efficient supply chains or using resources more efficiently, hence reducing costs on the way.
  • Increasing attractiveness with consumers resulting in top-line growth: The public consciousness has changed. Consumers have begun scrutinising the sustainability credentials of the brands they buy.
  • Improving productivity: A strong ESG proposition not only helps to attract and retain high caliber employees, but also enhances employee motivation and productivity overall.

Linking positive financial outcomes with the aim to make a difference, a new breed of businesses - such as social enterprises, green and clean-tech start-ups - is now emerging, recognising that the transformation to a sustainable economy is a unique opportunity to develop new solutions for a market of gigantic size. This new market also allows for much easier selling compared to the effort of launching a product in a mature market with naturally high-entry barriers.

Know your ESG

The following articles in our “ESG Essentials for Corporates” series will offers an insight into the E, S and G, shining a spotlight on climate and social initiatives, sustainable cities, clean mobility, the future of energy and sustainable supply chains.

We’ll also look in more detail what governments and regulators are doing to instigate changes in corporate behaviour, how the financial markets can help to scale up climate action, and we introduce industry bodies and corporate networks supporting businesses across the globe on their path to sustainability.

With our economy fast advancing to become greener, more emphatic, fairer and inclusive as well as more rigorously governed we want to help you Know Your ESG.

 

Corporate clients who would like to discuss this topic further should contact:

Dr Arthur Krebbers, Head of Sustainable Finance, Corporates or

Varun Sarda, Head of ESG Advisory

[1] http://www.gsi-alliance.org/wp-content/uploads/2019/03/GSIR_Review2018.3.28.pdf

[2] https://www.accprof.org/ACCP/ACCP/About_the_Field/Blogs/Blog_Pages/Corporate-Social-Responsibility-Brief-History.aspx

[3] https://www.un.org/millenniumgoals/

[4] https://www.pwc.com/us/en/services/governance-insights-center/library/esg-environmental-social-governance-reporting.html

[5]https://www.msci.com/documents/10199/f3f252a7-0dbd-035b-e67c-964a87fbcd03

[6] https://www.blackrock.com/us/individual/insights/blackrock-investment-institute/sustainability-the-future-of-investing

[7] https://www.hermes-investment.com/ukw/insight/fixed-income/bonded-em-credit-and-esg/

[8]https://www.tandfonline.com/doi/full/10.1080/20430795.2015.1118917

ESG/Sustainability


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