With a market volume of more than $30trn globally, environmental, social, and governance (ESG) investments have dropped their niche status.
The notion of integrating ESG 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 article by NatWest Markets examines 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.
Terminology
- ESG Environmental, social and governance criteria 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 corporate sustainability initiative with more than 13,000 corporate and other participants and in over 170 countries
- SDGs In 2015, all United Nations members adopted 17 Sustainable Development Goals as part of the 2030 Agenda for Sustainable Development, a blueprint to attain an inclusive, sustainable and resilient society and planet
- SASB The Sustainability Accounting Standards Board helps companies around the world identify, manage and report on the sustainability topics that matter most to investors
Be better, perform better
In June 2004 a group of 18 financial institutions published a report by the UN Global Compact with the audacious 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 build guidelines on how to better integrate environmental, social and corporate governance issues in financial markets.
For many, the report heralded 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 fresh 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 central texts. Fast forward to the 17th century, when social investing came to the fore with the Quakers casting out companies that profited from slavery or war. Religious groups followed in the early 1900s, urging people to avoid investing in companies linked to gambling or selling alcohol as well as lenders that charged excessive interest.
Equally, evidence of businesses’ duty towards society, today known as corporate social responsibility (CSR), can be traced back to the Industrial Revolution. In the mid to late 1800s, increasing 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 adding to social problems, including poverty and labour unrest.
The late 1800s also witnessed the rise of philanthropy. Industrialist Andrew Carnegie, who made much 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 popularised the modern concept of CSR in his book Social Responsibilities of the Businessman, which advocated for business ethics and responsiveness to societal stakeholders.
The pursuit of a sustainable society
In September 2000, world leaders came together at the UN headquarters in New York, placing the concept of social responsibility on to a global platform by adopting the United Nations Millennium Declaration. The declaration committed nations to a new global partnership to reduce extreme poverty, and initiated 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 endeavour 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”.
This ambition resulted in the UN’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).
Four years later, 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 Thunberg gathered 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 coronavirus pandemic this year drove 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 simply paying taxes? How do they take care of their employees during such a crisis – are they willing/should they be willing to take on additional responsibilities to look after them?
Clearly, the last two years have characterised the moment when the ESG movement entered the mainstream.
ESG: so what exactly are stakeholders expecting?
Whether investors, customers, employees or other stakeholders, a strong ESG proposition is confirmation that a company is doing or developing strategies to do ‘the right, responsible thing’.
Additionally, 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 discover what a firm is doing to minimise environmentally harmful practices. Environmental examples 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 aimed at a company’s relationships with internal and external stakeholders: How does a firm treat its employees? Does it encourage gender equality and diversity? Do working conditions assure and proactively support employees’ health and safety? Another focus is 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 enable volunteering opportunities for staff?
The ‘G’ aspect of ESG is often lost in the public coverage of ESG, but there’s consensus that good corporate governance is essential to yield corporate returns. Common 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, enabling risk to be assessed and managed? And does the company competently engage with its shareholders and stakeholders?
Whether investors, customers, employees or other stakeholders, a strong ESG proposition is confirmation that a company is doing or developing strategies to do ‘the right, responsible thing’
Faced with long lists of ESG-related questions, some companies are anxious that meeting the comprehensive information demands could mean a substantial amount of work for an only limited value. A PwC study, however, recently revealed 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.
To help corporates disclose relevant ESG data in a cost-effective and practical format, ESG accounting initiatives have developed industry-based standards.
ESG positively impacts financial performance
Over the years, research reports have highlighted the positive halo effect of ESG, with many studies revealing a strong positive correlation between corporate action following ESG principles and a better financial performance.
- Companies with robust ESG credentials have, on average, outperformed by 5.2% in developed markets from June 2013 to February 2018.
- ESG-focused indices frequently either match or exceed the returns made by their standard counterparts, amid comparable volatility. ESG portfolios also reveal more resilience in market downturns.
- Companies with more fragile 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.
- Aggregated data from more than 2,000 empirical studies 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 build value? There are four key reasons:
- Mitigating risk: the use of ESG principles aids firms in evaluating future risks and avoiding regulatory and legal intervention.
- Reducing costs: apart from lower capital costs due to lower risks, applying ESG principles directs firms to review and modify corporate processes, such as 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 developed. Consumers have begun scrutinising the sustainability credentials of the brands they buy.
- Improving productivity: a strong ESG proposition helps to attract and retain high-calibre employees as well as enhancing employee motivation and productivity overall.
Combining 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 with the challenge of launching a product in a mature market with naturally high entry barriers.