June 10th, 2021
Environmental and social governance (ESG) has become a burning issue for boards. Failure to consider environmental, social and governance (ESG) factors could also constitute a breach of duty of care resulting in legal actions. Below is a guide to ESG for board members and company directors.
Put very simply, ESG is a company’s environmental impact (E), social impact (S) and Governance (G) structures. Environmental impact includes the effects of a company’s operations on land, water, air, natural ecosystems, and biodiversity. Social impact relates to gender diversity, human rights protections, and human health and safety. Governance is the accountability of the board, the transparency of critical information and the protection of shareholders rights – to name but a few.
While the concept of ESG has been around since the 1960s, when for the first-time investors removed companies selling tobacco or those profiting from apartheid from their financial portfolios, it is only now that it is starting to gain real ground and has become a burning issue for Irish and UK boards.
Melting polar icecaps and drastic weather changes are just some of reasons why new and younger investors are focused on choosing to vote with their wallets for companies with strong ESG policies.
For example, the Church of England’s investment arm – which controls a £8.7 billion fund – has warned companies that they need to do more to protect biodiversity and increase the ethnic diversity of their management teams or risk protest votes at upcoming shareholder meetings.
Company directors are beginning to understand that companies with strong ESG policies provide consistently higher dividends, are less exposed to idiosyncratic risks, and experience less systemic volatility.
According to a McKinsey survey on ESG published in February 2020, 83 per cent of c-suite leaders and investment professionals say they expect that ESG programs will contribute more shareholder value. Investors also indicate that they would be willing to pay about a 10 per cent median premium to acquire a company with a positive record for ESG issues over one with a negative record.
Having a strong ESG policy in place does not just translate into investing in green tech or supporting organisations that bring clean drinking water to societies that do not have it. It means much more. ESG is your company’s 360-degree response to risk which involves the environment, society, and governance.
For example, if your company deals with sensitive public data, what are the measures your company has put in place to protect this? Do your measures go beyond enforcing a strong GDPR policy?
Many companies today, serve markets in multiple geographical locations. Do the boards and executive branch reflect a diversity of skill, gender, race, experience, and knowledge to adequately serve these markets?
If your company outsources its work to a country with weak labour laws, what measures has the company taken to ensure that the rights of workers are protected? In addition, how will the company manage labour disruptions, shortages and reduce the risk of accidents on site?
Companies that do well on ESG, evaluate their material risks, take opportunities to innovate to reduce that risk and implement solutions into their long-term growth strategy.
Growth: A strong ESG practice shows that a company operates with integrity. This translates to certain governing authorities awarding greater access, approvals, new licences with higher frequency and with fewer delays. In a massive public private infrastructure project in Long Beach California, for example, the companies that won the bid were evaluated on their approach to sustainability.
In 2018, a Nielson study of chocolate, bath and coffee products found that those making environmental claims seemed to sell a minimum of four times faster. An example of this would be Unilever’s Sunlight dishwashing liquid which was advertised to need less water. In markets which had water scarcity the product outperformed category growth by 20%.
It will help you save money: ESG will push your company to rethink the way it has always done business. Innovation will be required for product sustainably which will impact supply chains and push your business to consume fewer resources on a day-to-day basis. A metric developed and used by McKinsey to measure the energy, water and waste produced found a strong correlation between resource efficiency and financial performance.
Fewer regulatory interventions: On average, irrespective of geography, nearly one third of all business profits are dependent on some approval from the government be it licences, standards, and approvals. In other words, the financial health of your organisation greatly depends on the State and can be at risk due to state or legal interventions. A strong ESG policy can improve government relations and get you government support. The consumer goods industry has a relatively low risk to state intervention at 25-30%. However, tech, automotive and banking are a few of many industries where 50-60% of their income is at stake in the event of state intervention.
Higher employee productivity: A strong ESG practice gives employees a higher level of workplace satisfaction, purpose, and a sense of contributing to the greater good. In a study by London Business School, the companies that repeatedly made ‘100 best companies to work for’ lists generated higher stock returns. Companies that communicated their ESG policies well had fewer strikes and disruptions due to labour anger. ESG’s productivity does not just end with employees within the company but has far-reaching benefits for people involved in the supply chain. For example, Mars has helped create model farms that introduce new technologies to farmers within its supply chains and help them obtain a financial stake in these initiatives.
Before entering the ESG arena, boards need to understand this – there is a vast communication gap between what investors want and what the company provides.
This exists due to:
Different investors look for different things: Individual investors, fund managers, and financial institutions have different ESG priorities as per the industries they operate in.
For example, Fund A may invest in a mining company based on the company’s use of sustainable mining practices however Fund B may choose not to invest in the same company because it only operates in countries with weak labour laws and uses it for financial gain. It can often be confusing for an organisation to decide what investors are looking for and how to publish the data. In the end the data that is published is often confusing, inconsistent, and scattered.
Structural obstacles: Structural obstacles exist on both sides – the investor and the organisation. Many investors appoint stewardship officers to overlook ESG priorities. However, these officers have little contact with companies and when they do their authority is undermined as they are not portfolio managers or chief investment officers. On the company side, companies have a sustainability group or manager however they may not be a part of strategy team and so do not impact long term value creation. In addition to this, many companies have the view that having strong ESG standards equates to a lot more work that would encourage uncomfortable discussions with increased scrutiny and undermined valuation.
ESG is not CSR: When investors bring up questions on the ESG spectrum, they are often directed to the person in charge of CSR. However, ESG is not employee volunteers in soup kitchens, it is the company’s response to future risk such as high employee turnover rates, carbon footprints, boardroom diversity, cyber security etc. It is the responsibility of the company to understand that ESG is a big part of a company’s risk profile and cannot be completely covered by state required annual CSR contributions.
You can lose control over the ESG narrative: With different investors asking for different things a company may feel the pressure to provide information on everything often resulting in poor quality information. Investors look to third party data to fill in the gaps which often could lead to the spread of unverified inaccurate information.
The new reality boards need to understand is this – there is no one way to tackle ESG and so the metrics to measure it are still in their infancy.
There are approximately 30 notable ESG rating agencies and data providers around the world. The following ESG rating agencies cover global large-cap firms and are the most used by asset managers and investors.
Some firms choose to invest in creating their own tools to assess their own ESG policies and identify areas of improvement.
Start small: As discussed before there are varying opinions on best ESG practices based on individual preferences on your board and executive. Servicing all of them would not result in any meaningful outcomes. The best way forward is to identify no more than five objectives based on the nature of your company and the industry in which it operates. If your company is in construction your ESG policy could focus on ethical supply chains to improve material quality or a prison reform program to provide gainful employment to convicted felons at the same time ensuring a steady flow of labour.
Base it on facts: Introduction of ESG measures should be presented in terms of performance targets. Anything less may fail to leave an impact and could be perceived as unimportant. The in-depth analysis would be required to understand the current value chain and changes that could have a maximum result in terms of sales and revenue. It would also help the company’s case to collaborate with industry experts, research best practices in your industry for ESG and cross-check results with internal findings. Start preparing ESG information based on assurance, certifications, and description of potential control processes etc and disclose the findings with investors.
Stay true to your company’s values: Reality is that ESG policies carry a great risk. A few ESG policies however well-intentioned could have adverse effects on sales and investment. Before taking a decision, it is important to be transparent on the risks to all stakeholders involved, keep in mind long term value creation and if there is consumer backlash from the move, damage control should be executed according to your company’s core values.