“There is mounting evidence that funds which observe environmental, social and governance (ESG) standards in their strategies tend to outperform those that don’t by a significant margin.”
Financial Times, Sept 3rd 2017
Activist investors such as growth-orientated hedge funds have woken up to environmental, social and governance (ESG) concerns. There is nothing philanthropic about such awareness.
In simple terms, stakeholders are following the money. In emerging markets for example, as the ever vigilant FT points out, ESG driven investments now do better than conventional benchmarks:
It’s increasingly in the interests of mainstream investors to pay attention to (ESG) factors. Financial giants such as Bloomberg, Morgan Stanley, and Goldman Sachs are all busy expanding their ESG product and service offerings.
And in the coming years, women and millennials will start to manage a greater share of global wealth. They’ll also want to align their actions with their values about fairness, the environment and human rights.
ESG is now part of investment jargon. It describe the performance of investment and fund portfolios using environmental, social and governance criteria.
The quality of these portfolios can be measured against specific ESG factors and duly reported to shareholders.
ESG analysis can provide important insights into the long-term prospects of companies. Investors can find new market opportunities with companies placing the management of ESG factors at the core of the business.
“Almost three-quarters of investment professionals worldwide (73 percent) take environmental, social, and corporate governance — ESG issues–into consideration in the investment process. Only 27 percent do not consider ESG issues.”
CFA Institute ESG Survey, August 2015
While under pressure from so many diverse sources, senior executives are encountering yet a new kind of demanding investor. These are activists wanting higher returns who have realised that the route to this is through integrity and ethical business performance.
Such investors may not be experts on leadership. Yet they know what to look for in company leaders. They expect to encounter ones who talk regularly about integrity and then demonstrate it through daily performance.
More specifically they want signs that a business leader knows how to reduce the risks associated with ethics or compliance failures.
Demand for risk reduction comes within a context fraught with significant levels of uncertainty.
High profile cases such as VW or Wells Fargo are already part of business history. Devastating weather events continue to make their presence felt. The relentless decline in the coal industry has meant investors have lost 85 per cent of their money since June 2014. Once a sure money loser, renewables now look a sound bet.
These are storm force gales, whose waves continue to batter the investment shores. In consequence, the pull of ESG has reached critical mass.
For instance, Swiss Re, one of Europe’s biggest insurers, now benchmarks its entire $130bn portfolio against ESG indicators.
The ESG phenomenon continues despite an absence of detailed, globally agreed definitions of either ethical leadership or what constitutes ESG standards. Meanwhile the overall trend to take into account ESG continues to bring ethical leadership in business into ever sharper focus.
As a source of profits is ESG real, or mere mirage?
Sceptics argue the current enthusiasm for investing which takes into account ESG factors stems from a mere statistical distortion. This they say, combines with a vanity urge to be part of the latest investment bandwagon.
Yet consultancy Create-Research, reports 60 per cent of investors say they plan to increase their allocation to responsible investment over the next three years. That’s a lot of investors living an ESG delusion.
“…ESG has affected the valuation and performance of companies both through their systematic risk profile (lower costs of capital and higher valuations) and their idiosyncratic risk profile (higher profitability and lower exposures to tail risk.)
Other studies too have consistently shown how ethical leadership and its form of decision-making fosters employee morale, boosts brand reputation, encourages loyalty in customers and employees, and improves a company’s bottom line.
In summary, ethics and ethical leadership are more than the right thing to do: it’s also the smart thing to do.
Broadly the E of ESG means the environment which includes
- Globalization effects – e.g., exploitation, child-labour, social and environmental damage anywhere in the world
- Corruption, armed conflict and political issues
- Staff and customers relations – for instance education and training, health and safety, duty of care, etc.
- Local community
- And other social impacts on people’s health and well-being
Business needs leaders able to make sense of these diverse factors. Rather than ignore them, as many businesses still seem prepared to do, ethical leaders embrace the challenge. They also often take a highly personal interest in the implications.
To be an ethical leader is therefore to be concerned with the organisation’s own culture and environment in which employees work. This shows up in the increased interest in employee engagement as a clear route to financial success.
The S of ESG
In January this year (2018), CEOs of the world’s largest public companies received a letter from Larry Fink, CEO of Blackrock. It’s one of the largest asset and risk management firms, so a letter from Fink was at least likely to be read.
He urged his fellow CEos to give priority to their company’s social responsibilities. The S of ESG refers to how a company treats its labour and how it responds to the human rights of the people and communities it touches. Various international instruments define these rights. They include the Universal Declaration of Human Rights and the eight Core Conventions of the International Labour Organization.
While originally developed for governments, these standards now affect the business context. They provide a strong foundation on which to clarify the scope and meaning of a company’s “social” performance. Fink’s appeal was emphasised the role of public companies in growing economic inequality.
He argued for long term value creation since ethical companies have a better financial performance in the long run.
“It’s the right thing to do”
E- and G-factors of ESG have achieved considerable traction with both investors and business executives. In contrast, the S-factor, has yet to make a lasting impact. This is against a backdrop of rising economic inequality and mounting evidence of the negative forms of many business practices.
So it’s entirely relevant to ask: can business deliver value in today’s global economy in ways that work for people and communities around the world?
Once CSR, or Corporate Social Responsibility seemed like the start of a sustained shift. It seemed to herald a move by business to showing a genuine social concern for the company’s effects on environmental and social wellbeing.
In practice, CSR has acquired a serious credibility gap. There remain few examples where CSR has delivered measurable business gains, let alone sustained benefits for the community. See Goodbye to CSR, welcome to Social Commitment.
The current lack of interest by some business leaders in the “S” of ESG partly reflects a disbelief that social commitment can pay. Many still view it as a check-the-box exercise, one where investors and companies only appear to comply with rising consumer expectations.
Despite this roll call of negative forces constraining social investment, leading corporate CEOs do emphasize for example, positive reasons they are considering human rights in their business models and operations:
“…we firmly believe that if we focus our company on improving the lives of the world’s citizens and come up with genuine sustainable solutions, we are more in sync with consumers and society and ultimately this will result in good shareholder returns.”
Unilever’s CEO Paul Polman
Others argue that sustainability and human rights investments have led to increases in their company’s ability to recruit and retain outstanding employees, They also point to improved quality control, and better worker retention throughout their supply chains.
Yes as the Centre for Business and human rights comments, more work is needed to :
“…reconcile the myriad approaches that currently exist for defining and measuring social performance.”
The G of ESG
Corporate governance was once merely a response to corporate scandals. Now it is making important inroads on leadership accountability, especially in Europe.
Corporate governance has shifted from the wings where is was seen narrowly, in a legalistic sense of rules and regulations that must be obeyed. Today it has evolved into a whole new approach. This now includes general support for better run companies and in particular support for sustainability.
Sustainability is one of those phrases that can mean what you will. In practical terms it means looking at social, environmental and economic impacts and making decisions using a broader perspective than in the past.
Using the sustainability lens to view governance changes how the organisation approaches issues such as:
- Land use, energy, water, and emissions
- Human rights, equal opportunity, and health, safety, and wellness
- Charitable giving and volunteerism
- Systems and strategies for engaging with stakeholders,
- Product development, procurement, and innovation
- Board composition and compensation
- Ethics, standards, and codes that apply within an organization and to its value chain.
With these multiple factors to consider, how can leaders make sense of the current ESG landscape?
How can they better include such information into their approach to business?
The sheer diversity of the ESG landscape explains why governance tends to be its least understood aspect. Yet at its core, governance prompts business leaders to pay attention to the culture of the organisation.
Investors too increasingly recognize that companies practicing good governance as part of a larger ESG-aware strategy will be more likely to see these factors translate into improved long-term investments. What that means in practice is up for debate. For example, some critics say we need a complete overhaul of corporate governance:
“I can’t find a single corporate governance model that works well,”
Bob Garratt, Visiting Professor at Cass Business School
The direction of change would put more weight on directors doing their job responsibly and professionally. This would include developing corporate governance to include a social audit–in simple terms more focus on the E and S of ESG.
Better governance would also mean more focus on new challenges such as cyber security and the shift to digital.
Nobody invests in governance for its own sake. Instead stakeholders look to ethical leaders who will place a high priority on good governance as a way of achieving long term financial benefits.
- Giese, Executive Director, Applied Equity Research
- Has ESG affected stock performance? MSCI, May 2017
- L.Portado, Activists look to the ethics route for higher returns, FT 27th December 2017
- Kynge, The ethical investment boom, FT, Sept 3 2017
- Ethical Leadership Around the World, AND why it matters, ECI 2017
- Jackson-Obot, Ethical investments still on trend, FT Adviser Nov 2017
- O’Connor and S.Labowitz, Putting the “S” in ESG: Measuring Human Rights Performance for Investors, Centre for Human Rights, March 2017
- Explaining the G: Putting Governance in ESG, FlexShares, Jul 31, 2017
- ESG Investing: Should Start with the “G”, Magni Global Asset Management
- Hale and J Glase, Sustainable investing trends for 2018, Morning Star, 21st December 2017
- R Sullivan, Which direction for corporate governance?, Board Agenda, February 2018
- A. Filabi, Prioritizing Social Responsibility in Companies: A coming firestorm? Ethical Systems, 17th January 2018