We discuss the ESG standards and its impact on businesses that need to balance social responsibility while still bringing value to their shareholders.
Businesses today often have dual aims: to maximize shareholder value, while also maintaining strong governance standards in environmental and social sustainability. Until recently, those disparate goals have been in conflict—but that's starting to change.
In the past, a company’s commitments to sustainable aims could work against its shareholders’ aim of maximizing profits. The added costs of complying with environmentally-aligned policies—which could include changing supply contracts and adopt more rigorous compliance and reporting—could be significant. Meanwhile, the benefits of adopting such standards were often intangible. Beyond some positive public relations boost, it was sometimes difficult to point to any upsides, whether directly financial or otherwise.
To understand how this has changed, it's first key to understand the current definition of sustainability, captured in the acronym "ESG" or Environmental, Social, and Governance factors.
What is ESG?
The three underlying components of the measurement known as "ESG" include:
- Environment: the externalities, both negative and positive, that company policies create on the environment, whether locally (such as pollution) or more broadly (such as carbon emissions).
- Social Factors: a company’s impact on society—both internally through its workforce and more generally through its impact on communities in the locations in which it operates.
- Governance: oversight and stakeholder management. In a well-run business, stakeholder incentives will align with the business’s success.
These three components are summarized in the concept of sustainability. If a company’s policies are thought to be sustainable in terms of its environmental and social impact, then that is a sign that its ESG governance is working well.
The Change: ESG as a Means to Profitability
Today, adopting ESG standards is seen as less of a net cost, and more a necessity of doing business in the modern economy.
First, today there are much greater costs of non-compliance. That might come in the form of reputational damage and lost business for businesses that don’t fulfill a minimum level of ESG compliance. Also, as ESG standards become almost universal within the corporate world, the cost of complying is no longer seen as a levy on those that choose to adopt such policies. Now that the costs have been adopted by nearly all, the playing field has become more level, and there's no longer a competitive disadvantage for the progressive few. It's also now easier to meet ESG standards than ever before because they have been adopted across the board and down the supply chain.
That said, there still exists a “fear” of being labeled a poor corporate citizen. On the other hand, companies that can convince consumers of their commitment to sustainability can see enhanced revenues from a growing consumer base that is motivated to buy ESG brands.
And there are benefits beyond simply boosting sales and revenues. Being recognized as a strong advocate of ESG policies helps companies in the war for talent, too. New employees are likely to be sensitive to ESG brand attributes when considering a potential employer.
Challenges in the New ESG Landscape
ESG factors can be difficult to quantify in terms of hard financial metrics (which can create frustration within corporate risk and finance departments). The more subjective areas of ESG—such as the value-added to communities in which companies operate—can make it difficult to manage ESG programs within an organization, much less to know if ESG is being achieved. ESG as a measurement is still strongly subjective.
This issue is further complicated by the fact that there is no consensual agreement on third party evaluations of ESG. Whereas in terms of credit, the rating agencies have been accepted as the arbiters of such risk, there is no such similar agreement when it comes to ESG. There is not even agreement on the most important metrics that companies should report; there is currently no mandatory ESG reporting categories in company accounts. Part of the reason for this is that ESG issues vary widely between companies in different industries.
There has, however, been some progress. The United Nations has begun to align global ESG standards and, in the U.S., organizations such as the Sustainability Accounting Standards Board have begun to get market traction around their ESG qualification criteria. The Task Force on Climate-Related Financial Disclosures (TCFD) also offers a path to industry-agnostic reporting by focusing on carbon footprints—a solution to one part of the ESG challenge.
Growing ESG Liquidity
Despite these challenges, the move among corporates to classify themselves as ESG-compliant is set to endure—not least because of the growth in investor appetite for ESG investments. The 2018 Global Sustainable Investment Review suggested that at the beginning of that year there were $30.7 trillion of assets under management, an increase of 34% over two years.
According to the U.S. SIF Foundation, total U.S.-domiciled investments using sustainable, responsible and impact (SRI) strategies reached $8.72 trillion, an increase of 33% from 2014 and a 14-fold increase since 1995—and is now equal to 17% volume of all U.S. investment.
If anything, that trend is accelerating. In January 2020, the world’s largest active asset manager, Blackrock, committed to increasing fund flows to ESG-compliant investments. Blackrock’s chairman and chief executive, Larry Fink, said: “Our investment conviction is that sustainability—and climate-integrated portfolios can provide better risk-adjusted returns to investors. And with the impact of sustainability on investment returns increasing, we believe that sustainable investing is the strongest foundation for client portfolios going forward.”
Investment research and consulting firms like Sustainanalytics and MSCI have already developed indices that measure and rank companies based upon ESG criteria. The investment funds and ETFs that benchmark these indices are raising trillions of dollars to invest in companies that are regarded as ESG leaders.
Such growth in ESG credit markets offers many advantages for companies that can tap these pockets of liquidity: it diversifies the company’s investor base and can lead to cheaper debt. That's especially true for specific bonds that can be marketed as “green bonds”—which will be an increasing part of the corporate debt structures in the future.
Takeaways for Business
ESG is a macro trend that company boards and management teams need to embrace to attract and retain customers and employees—and compete more aggressively in the funding market. Companies that recognize the importance of adapting to changing socio-economic and environmental conditions are better able to identify strategic opportunities and meet competitive challenges.
Consider the Following Strategies to Optimize Corporate ESG Policies for Your Business:
- Focus on three to five measurable ESG criteria that are appropriate to your industry, your target consumers, and are aligned with your corporate strategies.
- Research the criteria for inclusion (and exclusion) in a few leading ESG funds or ETFs. From there, map the criteria that most closely aligns to your corporate strategy and to the priorities of your shareholder base.
- Once your company has determined the appropriate criteria for its ESG framework, establish metrics, measure them on a regular basis, and share progress publicly
- Communicate from the top: companies that are truly committed to executing their ESG policies make them a priority for the CEO, and often link executive compensation to ESG metrics. All reports and communications should include updates on ESG goals, as well as progress towards meeting them. This might be through the annual CEO letter, in the proxy, annual reports, internal corporate communications, as well as annual sustainability reports on the corporate website.
ESG still has a long way to go before it hits industry maturation, but its long-term market adoption is no longer in question. It has also evolved beyond the point where the adoption of ESG policies threatens to conflict with the company’s shareholders’ goals of maximizing short-run profits. The advantages for companies in adopting ESG policies across a range of issues are, if not yet precisely quantifiable, increasingly and unquestioningly positive.