Are ESG Investments changing the shape of corporate behaviour?

Georg Kell, Chairman of Arabesque Partners and the founding Executive Director of the UN Global Compact opened GoodCorporation’s debate on ESG by suggesting that there is now a real alignment between sustainable finance and responsible business practice.

After decades of incremental progress around corporate responsibility, it is now clear that business operates very differently. The business case for responsible behaviour is becoming clearer and is being articulated at leadership level. Where previously the case for corporate responsibility was seen as something of an article of faith, empirical evidence is now emerging to illustrate the link between strong ESG performance and financial performance.

The idea of ESG investing began in January 2004 when Kofi Annan wrote to over 50 CEOs of major financial institutions, inviting them to participate in a joint initiative under the auspices of the UN Global Compact, with a view to integrating ESG into capital markets. A year later, a report by Ivo Knoepfel entitled Who Cares Wins made the case that embedding environmental, social and governance factors in capital markets makes good business sense, leads to more sustainable markets and better outcomes for societies.

According to Kell, the wake-up call took some time, bypassing even the financial crisis. But in 2014, academics and investment bankers produced the first major meta study to show the link between good corporate ESG performance and financial performance. Today ESG investing is estimated at $20 trillion in AUM.

Kell laid out three principle reasons why ESG investing is here to stay.

1. Technology

Technological change has given rise to greater transparency and reporting. Technology based on machine learning and big data is being used to give valuable insights that show how ESG data can be applied to conventional financial information. This looks set to evolve further and become more sophisticated, enabling investors to gain an ever-better grip on the wealth of disparate information available through the internet.

2. Natural boundaries

Natural boundaries will increasingly put a premium on low carbon and environmentally friendly practices as any kind of natural asset is bound to increase in value over time, given global demographic and consumption trends. As our human impact on the environment inevitably continues, good environmental stewardship will therefore command a market premium. In the next three years we will see significant developments with technology enabling meaningful engagement with consumers and employees about company practices and purpose.

3. Governance changes

All markets depend on the good will of political regimes to co-operate with each other, however governance changes in both the East and the West suggest we are heading for turbulent times. In addition, consumers everywhere are increasingly able to express their values and lifestyle choices through their purchasing and investment behaviour, which is likely to have an impact on market success. While Kell expresses confidence that the fundamental forces for good will win out, this is also the time for responsible business leaders to speak up and use their influence to defend the rules and values of the current system.

These trends are here to stay. The interaction between private enterprise and the public has changed. As a result, the hierarchical, top-down approach, which focussed on the need to minimise labour costs and regarded social and environmental impact as externalities, has given way to a more purpose-based model. As we move away from the old industrial era, businesses need to recognise these changes and adapt their practices to be fit for the future. This will also ensure they are best placed both to access finance and deliver returns.

Asked whether it was felt that ESG was changing the shape of corporate behaviour the majority felt that it was. The following reasons for the growing importance of ESG were cited: –

• ESG information is increasingly being incorporated into portfolio assessments as a means of evaluating whether competitive returns will be delivered.
• The investment community is becoming more engaged with the UN’s Sustainable Development Goals, recognising that they are fundamentally important. This recognition is starting to change the allocation of capital among asset owners.
• Money is increasingly being allocated in accordance with the Principles for Responsible Investment.
• Traditional financial information has ceased to provide an advantage as all investors have access to the same data. What investors are now looking for is some form of information advantage which ESG analysis can provide.
• There is growing pressure from Trustees who are asking asset managers about responsible investing.
• The more diverse a board is, the more it is likely to ask about ESG issues.
• Shareholders are also increasingly interested in ESG information – there can be a variation in value of up to 20% depending on ESG information.
• Businesses are increasingly engaged in the various means of evaluating and measuring ESG impacts using schemes such as the Workforce Disclosure Initiative and the Task Force on Climate-related Financial Disclosures among others.
• Businesses also stated that behaviours were starting to change to demonstrate that they were mitigating their impact on the environment and to reduce the risk of negative social impacts such as human rights abuses.

While all recognised that the analysis is being done, doubts were also expressed as to whether or not ESG is really driving change.

• Some felt that there are more important drivers of change in corporates. In particular participants mentioned the importance of a range of laws/regulations, B2G and B2B sales where the customer insists on higher standards by the supplier, individual managers fears about facing sanctions for making a mistake and the motivation of individual employees. All of these could be more influential than ESG funds in pushing for ethical change within corporations.
• Others questioned whether investors really are putting pressure on corporates to change, suggesting that ESG feels like an add-on with few ESG related questions being asked at roadshows or in conversations with CEOs.
• Some fear that ESG information is being manufactured to produce box-ticking information that is more ‘greenwashing’ rather than data that is pertinent to the business itself and its viability.
• ESG information must be carefully scrutinised to make sure that it is truthful and not just aspirational data.
• Investors are perceived not to ask ESG questions until there is a pertinent issue (often something goes wrong) and then it becomes an agenda item.
• There are challenges to measuring the different elements of ESG. Environmental impacts are much easier to measure and quantify, however, assessing social impact is particularly difficult and ESG measures are still weak.
• Businesses are identifying business opportunities in sectors where ESG investors are interested and the move to invest in new areas is driven by the businesses not by pressure from ESG investors.

The GoodCorporation View

ESG is here to stay and the recent fast growth of funds is an exciting development. The evidence is clear that there is an emerging opportunity for some corporates to organise and present ESG data in order to meet the needs of specialist ESG investors and thereby reduce the cost of capital. It is also likely that the growing size of ESG investment capital will start to have a more discernible impact on corporate behaviour. However, there is no doubt that more work is needed to simplify and strengthen ESG data to make measurement meaningful and useful to investors and corporates alike.