Societal expectations of businesses have drifted drastically over the past decades. Not too long ago, companies were only expected to offer quality products or services to customers while creating great returns for shareholders. Of course, companies were also responsible for following the law – but society did not otherwise expect them to adhere to a code of ethics or to consider how their actions would affect the wider community or the environment.
This attitude began to change around the middle of the 20th century, with a rising interest around Corporate Social Responsibility (CSR). It encouraged companies to consider the impact of their actions on society and held companies morally responsible for those actions. CSR includes a wide range of issues including product safety, diversity, and human rights. Environmental, Social, and Corporate Governance (ESG) criteria formally emerged in 2014, with the release of the proposal by the UN Secretary-General Kofi Annan. Many see the ESG as a set of criteria that broadens CSR considerations to cover more issues, such as the company’s environmental impact.
ESG Criteria
ESG criteria are a set of standards for a company’s operations that socially conscious investors use to screen potential investments. These can be divided into three respective groups:
- Environmental criteria consider how a company’s actions affect the environment around them.
- Social criteria examine how a company manages relationships with employees, suppliers, customers, other stakeholders, and the wider community.
- Governance criteria deal with a company’s leadership, executive pay, audits, internal controls, and shareholder rights among other things.
In order to assess a company based on ESG criteria, investors look at a broad range of behaviors, including…
Environmental
Energy use
Does the company manage its energy use and invest in energy-saving methods?
Waste and pollution
How is the company’s waste managed? Does the company take reasonable action to ensure it has a minimal waste and pollution impact?
Treatment of animals
If the company works with animals, do they adhere to animal rights?
Environmental risks and mitigation
Any environmental risks a company might face and how the company is managing those risks (for example, its compliance with government environmental regulations).
Social
Company’s business relationships
Does the company work with suppliers that hold the same values as it claims to hold?
Giving back to community
Does the company donate a percentage of its profits to the local community or encourage employees to volunteer?
Health and Safety
Do the company’s work conditions show high regard for its employees’ health and safety?
Client relationships
How well does the company treat its clients?
Governance
Transparency
Does the company use accurate and transparent accounting methods?
Voting Policy
Does the company give stockholders an opportunity to vote on important issues?
Board management
Does the company attempt to avoid conflict of interest in their choice of board members?
Business advantages of ESG investment
ESG framework is a great way to express your values through your investment. More importantly for many investors, there are many business advantages that come with ESG investing.
Risk Mitigation
Using the ESG standards can help investors avoid companies with bad practices. ESG-driven companies are usually more transparent – which translates into the market as a lower risk for investors. An example of the correlation between transparency and the ESG criteria is the Equifax scandal, where Equifax was involved in a huge data breach. Months prior to the breach, as the Telegraph reported, investment index company MSCI gave Equifax its lowest possible ESG rating. While several issues were noted, MSCI specifically called out that the company “faces a high risk of data theft and associated reputational consequences”.
Financial Aspect
In the past, investors would associate ESG investing with loss of profit. Nowadays, it is clear that it’s not the case. While some companies still see ESG as a risk, many others see it as a business opportunity. More research is being done correlating ESG performance and financial metrics. According to Oxford University Professor Robert Eccles, companies that are doing a good job with their ESG criteria show “superior financial performance over time”.
Case Studies
I will now cite two case studies to illustrate how ESG practices and financial performance can be related. The first scenario demonstrates how bad ESG practices negatively affect financial performance, and the second scenario highlights instead how good ESG practices positively affect financial performance.
YUM’s (business that owns KFC, Taco Bell, Pizza Hut, among others) entire reputation was hit hard in 2012 when a third-party agency disclosed that they had been using 18 different antibiotics and chemicals (some of which were banned) to make their chickens grow faster. In 2014, a reporter in China also revealed that one of their meat suppliers had been falsifying expirations dates. On both occasions, their stock price took a huge hit and their financial performance significantly decreased. This proves that customers care about these issues and will change their business preferences if a company does not adhere to ESG criteria.
In contrast, the Middleby corporation (provider of Subway’s bread, and pastries in Starbucks, among others) has shown action to improve food quality, save water, and comply with ESG criteria. Middleby has been able to far outgrow the pace of the fast-food industry and are going at twice a rate of any competitor.
ESG growth over the last years
Soon after its formal proposal, the ESG framework was still not widely adopted by investors. In recent years, however, it can be seen that this form of investing has shifted to the mainstream. Investors increasingly want to put their money where their values are. Studies show that there are three groups who appear to be especially interested in ESG-driven investment: Women (who increasingly act as the heads of households), high-net-worth individuals, and millennials.
Millennials are the generation who are going to start investing and generating wealth over the next decades. Mirjam Staub-Bisang (BlackRock CEO and leader in sustainable investment) believes that there is a huge difference in the way millennials invest compared to their “baby boomer” parents. Younger investors have a very strong interest in making a difference: “they live differently, they work differently and they will invest differently”.
Furthermore, the current crisis around climate change and racial inequality has boosted investors’ interest in investing in something that holds the same value as they do. Interest in sustainable investing jumped by 85% in 2019 (among the general population of investors). As a result, a record of $45.6 billion went into the Global Sustainable Fund in the first quarter of 2020.
I believe it is clear at this point that there is a rapidly changing environment where customers care more and more about the footprint that companies leave. This change in consumer preference encourages ESG compliance. However, the best companies will go beyond compliance: they will figure out what their customers care about and change their strategy according to that, finding smart ways to invest in opportunities to grow while keeping their profits up and maintaining a competitive advantage. Businesses that do not address the ESG criteria should expect serious challenges.
Climate Change and Coronavirus
In January of 2020, the CEO of the world’s largest money manager (BlackRock) released a letter to its investors encouraging the promotion of long term value and claiming that “climate change has become a defining factor in companies’ long term prospects”. He added as well that “Climate risk Is Investment Risk – Our investment conviction is that sustainability – and climate – integrated portfolios can provide better risk-adjusted returns to investors.”
As the Corona crisis began, many started wondering whether the ESG would be set aside, as the climate crisis was the biggest reason investors chose to consider ESG criteria. In reality, ESG has become even more central. Companies are more than ever being held responsible by investors in how they deal with physical and mental health, how they handle working from home, etc. Mirjam Staub-Bisang from BlackRock claims that in certain markets institutional investors used the crisis and drop in assets to shift from traditional assets to sustainable assets. Mirjam states: “the crisis has helped the S in ESG”.
Conclusion
ESG criteria have grown to be increasingly significant for today’s investors, and as a result, businesses. Acting on this was important even before the COVID-19 pandemic and will be yet more critical after it. With rising issues such as climate change, COVID-19, social inequality, data breaches, and all of the rising awareness around these, businesses must adhere to ESG criteria – both toaddress customer needs and to adapt to investors’ values, as their investments will be based around those same values. Businesses that show an innovative approach to maintain a high ESG rating will be most likely to succeed in this rapidly changing environment.
Sources:
- https://www.youtube.com/watch?v=4LPRQaG83Ls
- https://www.youtube.com/watch?v=fno1QIuA6EQ
- https://www.theimpactivate.com/data-security-breach-equifax-and-the-i
mportance-of-actively-monitoring-esg/ - https://www.youtube.com/watch?v=OQ1cliM0b0Q
- https://www.youtube.com/watch?v=Rx1A-COXbjU
- https://www.youtube.com/watch?v=dHemlq_QOzE
- https://www.youtube.com/watch?v=bB7S62Jeg2Y
- https://www.youtube.com/watch?v=gYBsUsa7Rck
Author: Maya Sainani