ESG – why now?
Arguments against companies addressing their environmental and social responsibilities have been soundly trounced, argues Josh Dowse, Principal, Dowse CSP, not so much by moral imperatives, but by the business case for engagement with environmental, social and governance (ESG) issues.
Sustainability is a dreadful word. It originated as business’s answer to the global policy push to sustainable development – leaving future generations with the same or better opportunities as past ones. But this morphed into ‘corporate sustainability’, was abused to mean ‘sustainability of the corporate’, then petered out into a morass of acronyms and general suspicion of dogooders wanting to take the oomph out of capitalism.
So let’s ignore the word, and focus instead on what it offers in 2012, and why. Quite a few interesting strands of investment theory, corporate governance and industrial history come together, with sometimes surprising results.
In recent years, the financial community has sidestepped the S-word by introducing ‘ESG’ – the environmental, social and governance or ‘non-financial’ performance factors of a firm. And investors are becoming increasingly impressed by these factors, and their revealed impact on financial performance.
Firms need healthy markets
The value of good corporate governance is relatively well understood. You wouldn’t want to invest in a company that gave you little comfort that it would spend your money wisely and accountably. The company may destroy value, in the parlance. In this case, your cash. But what if the company was risking or destroying value elsewhere? What if it were running down social or environmental capital? What if it were relying on those ‘externalities’ to underwrite its own business model?
That might not concern the company’s shareholders, if they had only that single identity. But they don’t. They may hold shares in other companies that may in turn depend on that social and environmental capital. As individuals or institutions, they may see their taxes being spent to protect or restore social and environmental capital. As individuals, they may themselves benefit from that capital, or acknowledge that their families depend on it, and will do so for generations.
BP’s 2010 Deepwater Horizon disaster in the Gulf of Mexico is an extreme example of an all too frequent case. Incalculable social and environmental harm has been ‘rounded down’ to BP’s US$20 billion compensation fund, its US$3.2 billion clean-up costs, and its US$60 billion loss of equity. Could an investor have predicted such losses? Perhaps not. But they could have known that BP oil refineries had accumulated 760 ‘egregious willful citations’ from the US health and safety authority in the three years prior. Quite a lot. The rest of the US industry, together, had only one. That statistic rang alarm bells among some ESG-led investors, but not enough.
In fact, with a little thought, most companies realise that they themselves depend on the health of the economies, societies and ecologies in which they operate. People don’t buy much in broke, anarchist desolation, however good a backdrop for Mad Max 5 it may be. In the long run, if you rely on cheap social and environmental externalities, you run down your own markets.
Firms that support healthy markets do better
Investors are taking a closer look at such risks. Repeated analyses are showing that a company that manages its social and environmental issues well outperforms the market, all else being equal. So across portfolios, funds that take these factors into account outperform their peers.
Institutional investors are very comfortable with this. They take a portfolio-wide view: if a company creates no real value by ‘winning’ only at the expense of another, there is no net gain to their portfolios. Accordingly, they are demanding more information on firms’ ESG performance through the Principles of Responsible Investment, the Equator Principles, the Carbon Disclosure Project, the Water Disclosure, the Enhanced Analytics Initiative, and myriad other investor-led calls for disclosure.
Governments are also comfortable with this. They take a similar economy-wide view: if a company ‘wins’ only by not paying for a public or environmental good, society has to pick up the tab. Accordingly, they are reviewing corporations law to clarify that directors should take social and environmental issues into account in their decisions. In the UK, this is now a positive obligation under the Companies Act. In addition, most legislation since 1992 has had ‘sustainable development’ in its objectives clause, so that those who partner with, or supply to, a government entity may have to show that they are supporting that objective.
Employees are also comfortable with this. As well as employees, they are investors, citizens and consumers. Ideally, they could align the interests of these split personas. Accordingly, companies that transfer costs to others – notably tobacco companies – have to pay far more than market rates for people to work for them.
Objections have been overcome
Among each of these stakeholders, there have been strong voices reacting to what they see as ‘the imposition of irrelevant responsibilities’. It hasn’t been the shrill calls of external do-gooders that have silenced these doubts; rather it’s the business case being repeatedly proven. By better managing social and environmental issues, risks are being avoided, and opportunities are being taken.
Some investors relied on financial theory to argue that imposing any ESG constraint would limit the investment universe, and so necessarily reduce returns. Cannier investors were happy to limit their investment universe by preferring good managers. Investors that incorporate ESG factors well also see lower risk for the same returns. Superannuation funds are a special case here. Their trustees recognise that they’re investing for their beneficiaries over 10 to 40 year time frames, and that superannuation contributions are mandated by society through the voice of its legislature. It makes sense then that superannuation fund investments take into account the longer-term social and environmental effects of their investments.
Some directors (or those claiming to speak on their behalf) claimed it was their legal duty to maximise the profitability of the firm, so that considering ESG factors may breach that duty. Lawyers quickly replied that, in fact, their duty was to the best interests of the company as a whole, and that included future shareholders. Further, while directors should use their business judgment to determine what to do about social and environmental issues, ignoring them may be extremely poor risk management, possibly in breach of their duties.
Some conservative thinktanks spent energy in the 1990s attempting to influence public policy against the consideration of social and environmental issues by corporates. They have been singularly unsuccessful since, as noted above, it is the free market that has decided to incorporate ESG factors, not governments.
Some employees have felt constrained from engaging on social and environmental issues, or have actively rejected the notion as a distraction from their core business, which is hard enough already. But, once they’ve seen that management will support sensible initiatives, employees at all levels have been among the strongest advocates of social and environmental engagement. With tacit or explicit approval, they can sensibly apply their firm’s resources to relevant social and environmental issues, to benefit the firm, the issue and their own professional development.
Curiously, CEOs have been among the quickest employees to accept the value of ESG efforts. Their responsibility includes looking beyond the horizon to the emerging business environment, and they can see how social and environmental issues are constraining their firms, and providing it with opportunities. Compared with middle managers, they are more likely to be good systems thinkers — to see how one thing leads to another — and also have the freedom to consider and act on those second-, third- and fourth-order effects over a longer time frame.
Intangibles link ESG to financial performance
The evidence shows that wise social and environmental engagement pays the firm financial dividends. Employee engagement is one of many connecting rods. What are the others, and how do they work? In 2000, McKinsey & Co analysed international equity markets to show that, of a firm’s market value, an average of 55% represented the market’s evaluation of the firm’s core intangible assets, with the remainder being an evaluation of the firm’s physical assets and financial performance, its continuing net profit after tax and cash flows. The figure varied between industries, being as low as 20% for capital-heavy industries such as mining, and 80% or more for service industries such as media and banking (see ‘What is the market telling you about your strategy?’ McKinsey Quarterly, June 2000). These intangible assets are not simply existing intellectual property and contracts. They are four: the firm’s brand and relationships, and the productivity and innovation capacity of their people. These four deliver future financial performance, which is of course of more interest to investors than past performance.
More recent studies show that, as our economies become more service-based, the average value of the non-physical assets has risen from 17% in 1975, to 68% in 1995, to 81% in 2009 (see Ocean Tomo, 2010, Intangible Asset Market Value Study). This is what happens in maturing economies, where physical goods are commodified, consumers seek brands, services and experiences, and firms depend more than ever on their people to deliver.
Most CFOs readily accept these figures. It’s then not a stretch to suggest that wise engagement on social and environmental issues can bolster reputations and relationships, and help drive an innovative and productive corporate culture.
Reputation or brand?
Yes, solid social and environmental performance helps qualify a firm for more opportunities and a lower cost of capital, attract customers, and enables it to become an employer of choice.
Yes, engaging on significant social and environmental issues with governments and other firms creates new relationships and strengthens existing ones. As it does personal relationships within the firm. In both cases, there is time to build understanding and appreciation, outside the pressures of purely commercial transactions.
Yes, ESG engagement means looking at new problems from different perspectives. The solving technology is never far away. ESG provides the financial rationale and will. New products, services and markets follow.
Yes, this is the strongest driver. People are satisfied with their job if it gives them a decent income, friends at work and some professional development. But if they’re contributing and developing in other ways, then their productivity and capabilities increase.
What firms do matters
From an historical perspective, a firm’s enlightened ESG engagement and people’s reactions to it make sense.
For better or worse, firms and their markets are the way societies now organise their most powerful productive forces – it’s the way we get things done. If, for whatever reason, we have a social or environmental problem, there is no way it will be resolved without firms being part of the solution.
Firms demand a lot from their employees and, of course, give a lot in return. It can be an all-encompassing relationship. If people feel that that relationship is working on the social or environmental issues that matter to them (or at least it’s not against them), they invest more of themselves in that relationship.
These are growing expectations. Consider Maslow’s hierarchy of needs (see Abraham Maslow’s 1954 book Motivation and personality). Once we have basic physical needs and safety in place, we want to belong, and to gain confidence and respect. At the peak of that hierarchy is creativity, problem-solving and, dare one say it, morality.
As a society, we are well aware that social and environmental problems exist, always have and always will. Having invested enormous amounts in education and social stability, what we have now though are many more tools to deal with those issues (and perhaps create more) through innovations in technology, information and business models.
With these tools, non-government organisations, governments, customers, investors, employees and future employees expect firms to do something about those issues that concern them. Those firms that do so have been very pleasantly surprised. No less a student of corporate strategy than Michael Porter has documented how they have benefited, and the competitive advantage they have earned (see his article ‘Strategy and society: the link between competitive advantage and corporate social responsibility’, Harvard Business Review, December 2006).
Deciding what to do
If expectations are building for your firm’s ESG performance, and there are benefits from your doing so, what should you do?
It’s not an easy question, for the number of ESG issues that are relevant to your firm are numerous. Research firms that rate the ESG performance of listed companies keep track of over 1,200 different metrics, everything from the independence and diversity of boards, to gigalitres of water, to freedom of association. The most prominent voluntary reporting standard, the Global Reporting Initiative, makes do with 130. Some of these might be relevant, some not.
What matters to your firm are the issues that have a potentially material effect on its business or intangibles. That’s a list still too long to be actionable. Consider then issues your firm can influence, drawing on its particular assets and capabilities. It helps that your people are interested, more so that an action supports your existing corporate priorities. We’re getting closer. The answers won’t be obvious, but there are ways of working them out.
One such way is a valuation tool that can calculate the value at risk from ESG issues, and the potential financial returns from any particular action to address them. If there’s a public good or ‘externality’ your firm relies on, cost it in to your business model and see how exposed that model may be. There are rigorous approaches, but they’re available.
ESG, sustainability, CSR, ‘internalising the externalities’. Call it what you will. It’s worth a closer look.
Josh Dowse, Principal
Dowse CSP (see www.dowse-csp. com.au, and www.thedowsegrill. com) are advisers on sustainable business and investment. This article was first published in the May 2012 issue of ‘Keeping good companies’, the journal of Chartered Secretaries Australia. Reprinted with kind permission of the publisher.
SIDEBAR: Should ESG reporting be mandatory in Hong Kong?
Reporting on ESG is increasingly becoming a regulatory issue around the world. Denmark, France, South Africa, Australia, China, Sweden, the Netherlands, Norway, Spain, the US and the UK have introduced some form of mandatory ESG reporting. Since 2008 mainland China has required its largest state owned enterprises to produce CSR reports. In parallel to mandatory obligations, many voluntary reporting standards have been produced, such as the Global Reporting Initiative framework, introduced in 2000.
Currently ESG reporting is voluntary in Hong Kong, but the Companies Bill under review by the Legislative Council contains a proposed requirement for companies (subject to certain size criteria) to include in their reports a business review which must address ESG issues. These issues include the company’s environmental policy and performance; compliance with relevant laws and regulations; and key relationships with employees, customers, suppliers and others that have a significant impact on the company.
Moreover, Hong Kong Exchanges and Clearing (HKEx) launched a new initiative last year to encourage wider adoption of ESG reporting in Hong Kong. Its ESG Reporting Guide was subject to a public consultation between December 2011 and April 2012, and HKEx hopes to finalise the guide later this year. Initially the guide’s ESG reporting recommendations will not be mandatory, they will be equivalent to ‘recommended best practices’ in Hong Kong’s Corporate Governance Code. However, the long-term vision is to upgrade the requirements to ‘comply or explain’ provisions, equivalent to ‘code provisions’ in the Corporate Governance Code.
The draft ESG Reporting Guide and other guidance materials are available on the HKEx website (www.hkex.com.hk – see Rules and Regulations/ Rules and Guidance on Listing Matters/ Environmental, Social and Governance).
The Global Reporting Initiative website (www.globalreporting.org) has a wealth of information on ESG reporting, as well as the GRI’s most recent generation of Sustainability Reporting Guidelines (G3.1).