An Introduction to ESG

By Alex Kruzel

Elevating ESG to corporate growth

The momentum is clear: Environmental, Social, and Governance (ESG) investment is here to stay. And, business leaders must understand ESG on two levels: (i) its investment management strategy and (ii) how it can elevate ESG decision-making to corporate growth strategy. The second level, especially, is a missed opportunity for most large corporations. Being responsive and including stakeholders in decision-making goes by many names. The one thing that is evident and all leaders must understand is this approach is no longer a “nice to do”, but a “must do.” It’s where the world is going.

Historically, though, there has been widespread concern about ESG-type investment. Business leaders believed that mixing an examination of environmental and social issues into financial decision-making could lead to a negative impact on returns. Data regarding ESG investment growth and performance has flipped this notion on its head.

In the US alone, about half of individual investors have adopted sustainable investing, while 80 percent of asset-owner institutions are integrating sustainability considerations into their investment processes.[1]

To demonstrate ESG’s momentum further, an estimated 200 new funds in the US with an ESG investment mandate are expected to launch over the next three years, more than doubling the activity of the previous three years.[2]

Business leaders, regulators, researchers, and the public are gaining consensus in the conclusion that traditional financial metrics only tell part of a company’s story. A company’s ability to demonstrate how environmental, social, and other trends impact its strategy, operations, and long-term growth is important to meeting the needs of both shareholders and stakeholders.

What does ESG really mean?

The trendlines may be clear, but we understand that the definition may not be. So what is ESG? ESG (Environmental, Social, and Governance) investing refers to a class of investing this is also known as “sustainable investing.” This is a broad, widely used term for investments that look to garner positive returns and long-term impact on both the environment and the performance of the business. It recognizes that businesses operate beyond a bubble and therefore must take value-chain considerations into their strategies. For exemple, natural resources are finite and the broader business community has collective interest in long-term environmental and social health.

Tentative leaders may wonder what they should expect in terms of financial performance. Up until the pandemic, performance of sustainable and non-sustainable funds broke even. A 2019 white paper produced by the Morgan Stanley Institute for Sustainable Investing compared the performance of sustainable funds with traditional funds and found that from 2004 to 2018, the total returns of sustainable mutual and exchange-traded funds were similar to those of traditional funds.

What’s more, during the current pandemic, the Institute has noted that sustainable funds have consistently out-performed conventional portfolios. Their analysis of more than 1,800 US mutual funds and exchange-traded funds (ETFs) shows that sustainable equity funds outperformed their traditional peers by a median of 3.9 percent in the first six months of the year, according to the report. During the same period, sustainable taxable bond funds beat their non-ESG counterparts by a median of 2.3 percent.

Quantitatively, what does the E, S, and G actually represent? Although there are an infinite number of metrics that demonstrate a company’s commitment to addressing ESG risks and opportunities, each company should consider which strategies are most important for its business and then determine the most effective way to measure progress and report them. As we’ll discuss later on, there is currently no one way of doing this successfully. However, to get you started on your path, here’s a breakdown of what these categories mean and how they are measured.

Environmental

Risks created by business activities that have actual or potential negative impact on air, land, water, ecosystems, and human health. Company environmental activities considered ESG factors include managing resources and preventing pollution, reducing emissions and climate impact, as well as executing environmental reporting or disclosure. Environmentally positive outcomes include avoiding or minimizing environmental liabilities; lowering costs and increasing profitability through energy and other efficiencies; and reducing regulatory, litigation, and reputational risk. There is an important evolution taking place in this category, in which sustainability will not be sufficient. Regeneration and making things better than how the company found them will be a growing requirement. Example metrics include:

Carbon emissions
Number of water-intensive operations in locations of high baseline water stress
Percentage of reduction in energy used in facilities
Percentage of products sustainability sourced/manufactured
Amount of management pay tied to climate response targets
Sensitivity of earnings to price on carbon aligned to the Paris Agreement
Tons of toxic waste
Natural resources regenerated
Carbon asset liability

Social

Risks that refer to the impact companies can and do have on society. They are addressed by company social activities such as promoting health and safety, encouraging labor-management relations, protecting human rights, reversing the gender gap, and focusing on product integrity. Social positive outcomes include increasing productivity and morale, reducing turnover and absenteeism, and improving brand loyalty. Example metrics include:

Types of employee wellness initiatives
Percentage of employees digitally upskilled
Median hourly gender pay gap
Percentage of employee retention
Percentage of employee retained after automation impact on their positions
Percentage of gender and racial/ethnic group representation for management and all other employees
Number of suppliers identified with high-risk labor conditions and actions taken
Employee health and safety (injury/absentee rate)
Skills provided to employees for the future

Governance

Risks concerning the way companies are managed. Governance addresses areas such as corporate brand independence and diversity, corporate risk management, and excessive executive compensation, through company governance activities such as increasing diversity and accountability of the board, protecting shareholders and their rights, and reporting and disclosing information. Governance positive outcomes include aligning interests of shareholders and management and avoiding financial surprises. Example metrics include:

Anti-corruption measures
Number of female directors
Board oversight of climate issues
Number of minority directors
Executive compensation
Protected ethics advice and reporting mechanisms
Net economic contribution to communities

Where is there most ESG traction?

Well, in short, although it initially took hold in Europe, this investment strategy is now omnipresent and being codified into regulation everywhere. Globally, the largest amount of sustainable investing assets is in Europe, which totals $14.1 trillion USD.[3] However, the largest holdings of ESG-aligned assets are in Europe, the world’s recent growth can be attributed to investors’ increased interest in the US. ESG assets continue to grow rapidly, with expectations that ESG-mandated assets could make up half of all managed assets in the US by 2025.[4]

As ESG investment goes mainstream, many firms are becoming comfortable with incorporating ESG into their portfolios and there are increasing concerns about the transparency and quality of ESG disclosures. Some institutional investors petitioned the Securities and Exchange Commission (SEC) in the fall of 2018 for rules to harmonize ESG investments. Without a consistent framework to govern ESG principles, investors are left to navigate through a quickly evolving landscape of definitions, standards and updates. Once consistent definitions are agreed on domestically and internationally, ESG will generate even greater efficiency in the ESG data value chain and drive more effective investor engagement.

Global regulatory bodies have been demanding more depth and transparency from public firms regarding their environmental impact. Bringing uniformity to the ESG taxonomy is a shared goal across many geographies. EU regulators have taken the lead in developing a common ESG taxonomy to facilitate sustainable growth financing and investing.[5]

In Asia, regulators have determined that increasing disclosure requirements about sustainability practices encourages foreign investment.[6] Look to Singapore as the region’s early adopter of ESG-related standards in the region, which had a positive effect on the development of its capital markets. Investor confidence in the quality of ESG data was established in Singapore after sustainability reporting was mandated in 2016.[7]

In Africa, there is considerable work to be done. While African companies are some of the fastest-growing the world, their attitudes toward ESG imperatives have not developed at the same pace. However, as companies hit reset in mitigating the pandemic’s impacts and planning for long-term growth, now is the time when we are seeing a greater sustainability mindset on the continent. The World Economic Forum is calling this opportunity the “Great Reset”—a unique window of opportunity to shape the recovery and build a new social contract that honors the dignity of every human being on the planet.[8] African businesses have the opportunity to lead in a way they haven’t in decades past.

What Frameworks can I use?

Ultimately, all investors stand to benefit from greater transparency of ESG factors in the investment process. Frameworks such as those created by the Sustainability Accounting Standards Board (SASB) can help companies report material information related to ESG in a consistent manner. Similarly, International Financial Reporting Standards (IFRS) have recently gained endorsement from BlackRock for a sustainability standards board to assess fragmentation in the area of corporate sustainability reporting.[9] BlackRock has reported that it will continue to advocate for reporting aligned with the Task Force on Climate-related Financial Disclosures (TCFD) and SASB. It also addressed the topic of climate risk and financial statements, saying that financial reporting should reflect “reasonable assumptions about the impact of climate risk and the transition to a low carbon economy on the company’s profits, liabilities and assets.”

Companies that act today to transition from siloed ESG product offerings toward enterprise-level implementation will be much better prepared to capture a greater percentage of future ESG asset flows. When companies see the opportunity of ESG and elevate it to a corporate growth strategy level—what we at Telesto call a shared growth model (read more here)—they can create intrinsic value and additional feedback loops back to shareholders by managing key risks and cultivating opportunities.

How do I get started?

To activate this opportunity, leaders must recognize how sustainability and circularity touch every element of their business. Functional leaders need to convene at the highest level of the organization and ask critical questions:

Board

How does the board drive commitment to long-term vision and purpose and deliver on the promise of a shared value growth model?
CEO

How can we evolve our business and institute a sustainable and circular operating model, one that drives action and delivers positive value to shareholders and stakeholders? How do I ensure that ESG concepts are elevated to and incorporated in our corporate strategy?
CFO

How does this inclusive growth strategy create additional feedback loops to shareholders and demonstrate financial returns and long-term financial health?
COO

How can we operate our business model more effectively and experiment with collaborative models? How do we achieve a regenerative approach to our physical operations?
CRO

How do we build resilience to business disruptions caused by climate change and resource scarcity? How do we recognize and manage these risks at the highest level in our organization?
CMO

How can social and environmental concerns and our activities help differentiate our products and services? How can purpose and a commitment to shared growth model increase our market share?

Where do you stand in your journey toward sustainability, climate leadership, and ESG investment/reporting?

For those looking for more information and an assessment of opportunities, we would be happy to support. Please reach out to our team with questions: info@telestostrategy.com

[1] Morgan Stanley Institute for Sustainable Investing

[2] Deloitte, “Advancing environmental, social, and governance investing”

[3] Global Sustainable Investment Alliance (GSIA), 2018 Global sustainable investment review, April 1, 2019

[4] Deloitte, “Advancing environmental, social, and governance investing”

[5] Deloitte, “Sustainable finance, EU keeps the lead: New guidelines on yearly disclosures, ESG taxonomy and expert reports published,” June 20, 2019

[6] Jacqueline Poh and Mariko Ishikawa, “China set to lead ESG disclosure to lure foreign investments,” Bloomberg, June 20, 2019

[7] World Business Council for Sustainable Development, “New research on corporate reporting in Singapore: ESG disclosure helps identify risks and opportunities,” October 15, 2018

[8] The Great Reset | World Economic Forum (weforum.org)

[9] ESG roundup: BlackRock backs IFRS standards board proposal | News | IPE