Along with pandemic recovery and inflation, sustainability, with an emphasis on climate change, is a top preoccupation of governments, investors and businesses around the globe today.
As a growing number of investors apply non-financial sustainability factors -- Environmental, Social and Governance (ESG) -- to identify risks and growth opportunities in their investment decisions, sustainability is becoming a more and more powerful force in financial markets. Already, there are assets under management of more than $35 trillion in funds incorporating ESG principles. It is estimated that one in every three investments in the world will be ESG-mandated by 2025—with assets projected to reach $53 trillion. In 2020, according to a report by S&P Global, large funds with ESG criteria outperformed the broader market.
There are reasons for the rise of ESG as a paradigm for business and investing. Contrary to the traditional perception until a few years ago, that businesses following sustainable practices - those that devote resources to creating a positive environmental and social impact - for example by decarbonizing or generous HR practices, do so at the expense of profitability and growth, there is now evidence that sustainability efforts, do indeed benefit companies and investors. The prevalent wisdom now is that pro-environmental actions, good governance, good labour and customer protection practices can help mitigate risks and are rewarded in the market. Thus, ESG practices can help lower capital costs, drive investment flows and generate higher returns.
The current focus on sustainability and ESG also marks a shift in globalisation. Sustainability is among the few issues gaining traction globally, while many others are in decline --- global trade as a portion of global GDP appears to be in retreat, trade lines are being redrawn, and cross border migration of people is increasingly curbed as countries put up trade and other barriers.
So, what is ESG? ESG is a way of evaluating businesses based on sustainability factors. In the ESG paradigm, business is no longer just about profits for shareholders but accountability to a much wider ecosystem of stakeholders; within the enterprise -- management, staff, temp hires, the entire value chain from supply sources to markets, the integrated or affected communities in areas of operation and markets, and the environment itself. As the ESG system of criteria and metrics has evolved, companies are being held accountable in the way they make money, based on their actions around three main factors:
E- for Environment, which checks the degree to which an enterprise's activities affect the natural environment; its carbon footprint, its impact on natural resources, climate change, pollution, biodiversity, among others.
S - is for Social, and looks at businesses' engagement around human capital and social issues; in their workforce, customer base, as well as communities in which they operate or market. Fair treatment of workers, consumer protections, human and animal rights are factored.
G - stands for Governance. It looks at how a business upholds and promotes internal integrity and fairness. Factors here include issues like executive vs employee compensation, discrimination, and corruption.
Evolution of ESG
How has ESG made such rapid progress in recent years?
While ESG awareness, factored into business, has been around for some time now, in recent years, costs from climate change events or socio-political developments leading to supply chain disruptions, business interruptions, outright property damage, not to mention human costs, have risen dramatically, impacting revenues and profits adversely.
By one estimate, the costs of severe weather and climate disasters totalled $91 billion in 2018 in the US alone. The 2019 Australian bushfires caused more than $4.4 billion in damage. In 2019, the world’s largest reinsurance firm blamed global warming for $24bn of losses in the California wildfires.
In terms of social factors, civil unrest and riots from Chile to China have also come at colossal economic and social costs. In Chile, marches and protests in 2019 were estimated to have caused $4bn in property damage claims with insurers bearing the brunt. One example of extreme commercial disruption in these protests was Walmart, whose Chilean subsidiaries suffered significant losses – more than 128 of its 400 supermarkets looted. Similarly, in 2019, more than $HK 66 million were spent repairing public facilities damaged in the Hong Kong protests.
Internal conflicts in companies on governance and issues of workers' rights, diversity, and corruption have also extracted heavy costs from enterprises and governments.
All these factors are adding momentum to the ESG paradigm. And while headline generating signals for ESG such as the above have given it the biggest push, over time, technology, media, and consumer awareness have also played an important role. In fact, conscientious consumers, social and climate activists, and investor groups have become some of the most important drivers of the shift towards the ESG.
There are several frameworks for ascertaining companies' ESG performance, based on which investors make their analyses.
Various approaches and multi-data point measures for sustainability have existed for decades, and evolved over the last two. The Global Reporting Initiative (GRI) was established in 1997 to create an accountability framework for businesses to communicate their impact on governance, climate change, and social good to stakeholders; and it is one of the most widely used.
Formally, the ESG criteria were first contained in the UN's 2006 Principles for Responsible Investment (PRI) report, where for the first time, these factors were required to be incorporated in the companies' financial evaluations for developing sustainable investments. In 2015, the UN Sustainable Development Goals (SDGs) provided a further impetus.
From a largely voluntary base, ESG actions, compliance and reporting by companies are moving towards a universality driven more by market pressures than regulation. However, the plethora of standards and forums on sustainability reporting has also led to a certain amount of frustration and confusion among businesses.
It is partly to address this, that in 2019-20, the World Economic Forum at Davos, alongside the Big Four accounting firms, established the “stakeholder capitalism” approach aligned with the UN2030 agenda. The WEF framework has a set of standardised measurements of 22 specific metrics, which are focused on goals within a company’s own capabilities. Additionally, another expanded aspirational set of 34 metrics has been developed that encompasses a wider value chain around a companies' operations, supply chains, and markets. With the Big Four consulting firms taking the onus to develop and promote this framework, this is bound to become further embedded in the business landscape.
Scoring and Metrics
Not surprisingly, an industry has mushroomed around ESG metrics and ratings. The Global Responsibility Initiative’s Sustainability Standards (GRI) are considered to be the most widely adopted standard for sustainability reporting.
In general, by several reports, some of the top universal ESG metrics commonly sought by investors are:
⦁ A formal policy and overview of a company’s objectives and position on ESG, and its integration in the enterprise.
⦁ Clear identification for ESG responsibility within the management team and a corporate guide for carrying out the ESG objectives.
⦁ A formal environmental policy to track and address the company's environmental costs.
⦁ System for estimating the carbon footprint of the company and its value chain.
⦁ Health and safety record in the company's areas of operation and influence.
⦁ Diversity among employees, management and board members.
While various frameworks have their own approaches to scoring companies on ESG, studies have found that an industry-specific weighted approach on the three parameters, gives the strongest financial performance.
In most ESG metric systems, E, S and G are clubbed together. However, the E (Environment) in ESG tends to be the most dominant. This is because environmental risks often have the most immediate and visible impact on companies' revenues and profits, which in turn, affects returns.
ESG has rapidly evolved to become a global influencer in business and investing. One of the challenges and critiques of current ESG metrics is that often, more value is attributed and directed to practices that help garner better scores than on real value addition on sustainability. But this greenwashing is being increasingly questioned.
Further, mere compliance and benchmarking are no longer enough. Big companies are being forced to commit their utmost to ESG goals. The recent ruling against Shell Oil Company in Europe forcing it to significantly up its commitment to decarbonization, and activist shareholder actions against Exxon, are examples of how seriously this is being taken. Influential asset manager BlackRock is pushing companies in its portfolio to take greater responsibility on social issues. Recently global retailers like Zara have come under questioning for their sourcing practices related to the treatment of Unghur Muslims in China. Even tech leaders like Facebook and Amazon have come under fire for their workforce practices and diversity issues.
This is a strong indication that for companies looking to grow and to attract global funds, attention to ESG will require more than token corporate philanthropy or corporate social responsibility programmes. A company's ESG statement is on its way to becoming as central and strategic to its health and prospects as its financial statements.
Thus far, to a large degree, the push for ESG has been driven by G-7 nations but it is deepening its presence in emerging markets as well. As investors become savvier and the competition for funds intensifies, companies everywhere, including India, will have to step up on ESG.
Part II of this series will look at ESG in emerging markets and India.