Not a week goes by without an article or event discussing Environmental, Social and Governance (ESG) and last week was no different as I attended a seminar hosted by Clifford Chance.
ESG is just another form of risk and as treasurers managing risk, it’s an area that treasurers can take a lead – bringing together a variety of risks across their organisation.
Research shows that ESG focused businesses have a Return on Equity that is 5% higher than peers, experienced fewer swings in earnings volatility and had a better chance of a credit rating upgrade. In addition, investment managers are aware that millennials and other activist shareholders expect more from their investments and are taking further steps to provide suitable products for this small but growing community of savers.
There was much discussion about how the ESG agenda has evolved from being a niche philanthropic endeavour to a broader responsible investing activity that has a wider reach of engaged stakeholders. As interest has grown, it has moved from a purely compliance-based process to one now firmly rooted in the wider risk management framework. Insurers, asset managers and regulators are all applying an ESG lens and considering at a fundamental level, how organisations are run. Key risks they want to understand include:
- Are the activities of the company directly negatively affecting the environment in a way that will ultimately affect its ability to continue to do business?
- Are the activities of the customers and suppliers negatively affecting the environment in a way that will ultimately affect their ability to continue to trade?
- Is the welfare of staff being looked after such that staff remain attracted to work there?
- Does the company operate an effective Diversity and Inclusion programme that ensures that it attracts talent and remains in touch with its markets?
- Is the governance framework effective enough to ensure that key risks are being identified and monitored and that programmes such as whistleblowing are in place?
One of the new terms I came across was Impact Investing. This is sometimes confused with ESG but essentially the difference is that Impact Investing focuses on investing in companies with products and services that can generate measurable and beneficial social or environmental impact alongside financial return whereas ESG focuses on using environmental, social and governance factors in an entity’s operations with a view to enhancing risk management. ESG considers the operations of the company, while impact investing focuses on the products and services the company is producing. The company still has to have good ESG. It still has to have sound environmental, social and governance practices in its operations. But to qualify itself as an “impact company”, it has to be selling solutions, products, and services that help in the world and achieve its sustainability goals.
ESG has a wide range of stakeholders and it is becoming increasingly clear that they are looking beyond the environmental agenda towards a more holistic view where there is talk about the health of the share price – a concept that includes non-balance sheet metrics.
ESG typically focuses around Environmental and it’s often the area that gets most media coverage. The event I attended was moderated by a partner specialising in human rights which I at first thought odd but as I listened more to the “S” in Social it made more sense. Social can be described as:
- Employee relations, diversity and inclusion
- Working conditions, including child labour and slavery
- Local communities; explicitly funding projects or institutions that serve poor and underserved communities globally
- Health and safety
Social extends beyond an organisation to across its entire supply chain. As this area takes on greater focus, organisations and risk managers will need to do more to understand and monitor the risks across their overall supply chain.
As the ESG agenda has grown in both importance and breadth, there was a recognition that many organisations have lots of positive activity going. However, the challenge is how to bring them together under a broad framework that can be easily articulated to shareholders, staff, communities and regulators. KPMG has produced a useful guide including the extract below:
A few things to watch out for
- The UN Guiding Principles on Business and Human Rights which includes, in Principle 11, that business enterprises should respect human rights. This means that they should avoid infringing the human rights of others and should address adverse human rights impacts with which they are involved. This covers the entire supply chain!
- Non-financial reporting of ESG activities is growing exponentially with a wide range of organisations now caught. For example Sweden applies its rules to all types of companies with over 250 employees, Luxembourg sets the minimum employee threshold to 250 employees for Public Interest Entities, and Greece where companies with over 10 employees and a net turnover of over EUR 700,000, and balance sheet total of over EUR 350,000, must report on environmental performance and employee matters. Furthermore, in certain jurisdictions, parent companies are caught! The net is clearly widening.
- The EC adopted a series of measures in May 2018 focusing on
a. a unified classification/taxonomy system
b. ESG disclosure obligations on institutional investors and asset managers
c. creating low-carbon and positive carbon impact benchmark
There were a couple of predictions about climate change that suggested a need to take the issue more seriously:
- In three years’ time, ESG considerations will be the norm and not applying ESG principles will be what’s written about; and
- Within six years, governments and regulators will set real targets for climate change and given the long term nature of many capital expenditure projects, companies need to start building ESG considerations into their development projects before it becomes too late.