The Importance of ESG
For many executives and investors, the acronym ESG (environmental, social, governance) is inextricably bound up with issues of the environment and climate. These are both crucial considerations of corporate ESG policy but are by no means the only ones. ESG also covers a broad range of other issues related to data security, talent acquisition, labor relations, and product safety. It is about much more than the company’s broader commitment to sustainability.
ESG, however, remains mired in mystery. Corporate executives often do not have a full comprehension of what the concept entails, its importance, or even how to implement various aspects of it in their company.
At a fundamental level, ESG is about managing risk. Company directors need to take to principles contained in ESG and then channel them to enhance the success of their organizations. Ideally, the ideological element should be absent. While some directors will love the idea of progressive politics filtering down into the business world and others hate it, ESG is a contextual reality for companies. They must react to the changing nature of social norms in whatever capacity they can or face elevated risks.
What Are The Advantages Of Being ESG-Aware?
You could choose to ignore ESG factors and continue with business as usual, but doing that will likely put your firm at a disadvantage. Being ESG-aware, as executives are now discovering, comes with a plethora of benefits. We’re entering a world in which being “socially aware” and having “social purpose” is a driving force behind business success.
ESG was once a fringe concept, tied up with brands that focused exclusively on sustainability, like Tesla, but it is now filtering down into practically every corner of the economy. Whether you love or loathe the political ideology driving these changes, there’s no doubt that it presents substantial opportunities to company owners and executives. ESG is becoming an important set of issues to consider when making strategic decisions at the board level.
Company leaders, however, shouldn’t interpret ESG policy as yet another drag on the profitability of their firms or yet more regulations with which to comply. While that is the distinct tone of the ESG, it tends to work in a company’s favor to take account of environmental, social, and governance issues when making decisions, as you’ll see below. Adopting a pro-ESG stance can help firms enormously.
Here are some of the advantages of being ESG aware:
Investors Are Becoming More Concerned About ESG Issues
If you want to raise equity with modern investors, you need to convince them that your company is, overall, doing good in the world. The more you can prove your ESG credentials in the marketplace, the higher the premium you’ll garner for each share you sell, all things held equal.
Thus, the people investing in your company want to see evidence that you’re taking steps to protect the environment, look after your employees, and protect customer data. They don’t appreciate cavalier capitalism that prioritizes shareholder returns above all else. Investors would often prefer to take a small haircut than work with executives who single-mindedly focus on the bottom line.
Companies With High ESG Scores Can Get Capital Cheaper
You might believe that complying with the spirit of ESG is costly and that it will ultimately undermine the profitability of your company, but that isn’t always how it works. In reality, the most progressive companies are those with the lowest borrowing costs, not the other way around. Data from Bank of America Merrill Lynch puts the cost of borrowing for the most ESG-compliant firms at under a third of that of those with the worst records.
ESG-Related Scandals Can Lead To Cratering Stocks
Loss avoidance is a crucial pillar to secure portfolio returns over time. Investors don’t want to go on a rollercoaster ride, year to year, as new scandals about your firm filter their way into the public consciousness.
Failing on ESG issues, however, makes losses inevitable. Data from Bank of America suggest that ESG-related catastrophes over the last decade led to public equity losses of more than $534 billion, with affected companies averaging a 10-point share value decline from baseline.
Climate Change Threatens Company Assets
Whether you accept the scientific community’s consensus on catastrophic climate change or not, it is an active concern among corporate asset managers. Money managers want to see companies taking steps to protect their assets against the ravages of atmospheric temperature increases, habitat destruction, and rising sea levels.
Money Managers Have Bought Into ESG Wholeheartedly
Like it or not, the people who inject capital into your enterprise are now ESG-aware. More companies in the S&P 500 produce sustainability reports than ever before. At the start of the decade, it was below 20 percent. Now it is above 80 percent.
ESG Adds To Your Human Capital
ESG proponents have long argued that investing in people (and generally treating them well) will help generate higher returns, not hinder them. Data from BAML appears to confirm this argument. It suggests that companies with the highest employee satisfaction ratings have dramatically outperformed the benchmark over the last six years, with the most recent data indicating 40 percent higher relative performance.
Lower Earnings Volatility
Executives need to be aware that investors are increasingly using ESG scores as predictors of earnings risk. Data from BAML suggest that companies in the best ESG quartile have around a fifth of the earnings volatility of those in the worst quartile.
Better ESG Scores May Help Prevent Bankruptcy
BAML’s Global Wealth and Investment Management survey discovered companies who scored poorly on measures of ESG progressivity were much more likely to go bankrupt than other companies in the S&P. Of the seventeen bankruptcies between 2005 and 2017, fifteen companies had significant failures on the environmental, social policy, or governance in the five years before filing.
We’ve discussed some of the financial and public relations benefits of becoming more ESG-friendly. Now let’s take a more in-depth look at the ESG categories themselves and what they mean.
Green activists consistently promote the idea that humanity is depleting the planet of resources, dangerously warming the atmosphere, and causing widespread species extinction and habitat destruction. Many of their ideas have political underpinnings. Those ideologically opposed to free enterprise often use environmental arguments as a pretense to curtail the activity of businesses.
Companies, therefore, are responding by considering the environment when making decisions at the strategic level. Firms need to show that they are accommodating externalities generated while carrying out their operations and cleaning up afterward.
Many major corporations are responding to the pressure of activist groups. Apple Inc., for instance, now gets the vast majority of its energy from renewable sources. Clothes manufacturers like Bam Bamboo Clothing is looking to reduce its impact on land and water use by making clothes from bamboo instead of traditional cotton and synthetic fibers. Industrial companies, including power generators, now take great care to ensure that dangerous sulfur-containing compounds do not make it into the atmosphere.
There is, therefore, a significant movement towards containing the environmental damage done by commercial operations. Executives at the head of progressive firms want to ensure that they create sustainable futures – ones in which they can generate profits over the very long term. They worry that if they do not take action now, the Earth’s ecology will no longer support a vibrant economy, and everyone, including their customers, will be much poorer as a result.
“Social risks” are the second pillar of ESG and one that is, again, becoming increasingly crucial for businesses that wish to succeed over the long term.
At the core of this ESG element are the concepts of health and safety: practices that companies undertake to protect their people. In 2020, both investors and employees want to see evidence that firms take worker welfare seriously.
For staff, the appeal of excellent safety policies is obvious: workers do not want to work in environments that put their health or lives at risk. Investors are also highly concerned too. They want to see evidence that companies are taking steps to protect their people too, both because they care about the ethics of the businesses in which they invest, and also because they know that poor health and safety increases the risk of legal liability and brand damage. Companies that preside over repeated injuries to staff often find themselves punished by consumers.
On the labor front, ESG also concerns itself with promoting positive labor relations. What precisely this entails is mostly at the discretion of management, but in general, it means maintaining favorable working conditions and reducing the chances of negative publicity.
Many ESG-aware firms focus on leadership techniques that combine worker wellbeing with high levels of productivity. “Transformational” leadership has become something of a buzzword, but it fits into the ESG framework well. Here, you’re not trying to merely transact with employees (such as providing them bonuses in accordance with how much work they do). Instead, you’re aiming to foster a sense of mission and purpose, in which workers are gladly giving of their time and effort to produce results they believe are valuable. Big tech firms like Apple, Tesla, Microsoft, SpaceX, and Google are masters of this approach.
Human rights protection is another primary concern of the ESG movement. Proponents of “ethical” business practices argue that companies should prevent the abuse of human rights in their dealings, especially when conducting business overseas. Being ESG-aware, therefore, means keeping an eye on company supply chains and ensuring that everybody in the structure of production has adequate protection. It means regularly auditing suppliers to ensure that they do not exploit child labor or endanger the health of workers with poor working conditions.
Furthermore, it also increasingly applies to the digital realm. Companies must make sure that they uphold their customers’ rights to privacy and abide by data-protection laws. Home care providers, for instance, need to ensure that they treat their clients with dignity and ensure that their data does not fall into unauthorized third-party hands.
The UN Guiding Principles on Business and Human Rights provides more information about how companies should conduct themselves on the global stage, primarily how to operate in jurisdictions in which there may be no local laws guaranteeing minimum standards for working conditions.
Finally, “social risks” include product integrity – or the risks posed by the product itself. Many companies face significant challenges in the product realm. Any firm that uses plastics, for instance, runs the risks of brand damage because of the current plastics backlash in the media, progressive circles, and environmentalists. Businesses that sell controversial products such as drugs, guns, tobacco, personal loans, gambling services, and services that help people avoid tax also face serious social risks under the ESG paradigm. Affected companies must either modify their business plans or attempt to move into new product areas that progressives see as less damaging to society. Tobacco enterprises, for example, are making the shift into allegedly less health-harming products, such as e-vaping.
Companies that excel in the “social risks” aspect of ESG can experience a variety of benefits. Perhaps the most compelling on the consumer side is “brand loyalty.”
Most people have, unfortunately, accepted the idea that businesses solely exist to seek a profit and that those who run them are ruthless monsters who care only about private gain at public expense. Firms, however, who market the fact that they do care about employee wellbeing and product integrity can buck the trend, differentiating themselves from their competitors. Consumers love businesses that put welfare and virtue above financial considerations and, ironically, will reward those that do with higher revenues. Examples of companies that have benefitted from the virtue premium include Tesla, 3M, Ecolab, and VF Corp.
Addressing social factors brings other benefits too. Companies that do best on the labor relations front have the highest level of employee satisfaction and the lowest absenteeism rates. They also reduce staff turnover, dramatically slashing their recruitment costs and enhancing their ability to add to their existing human capital (instead of having to source it from outside the firm at great expense).
The “governance” aspect of ESG refers to how companies are run. Managers are under increasing pressure to adopt progressive ideals in the way that they manage their companies, instead of relying on traditional values.
Executive compensation is at the top of the list of current governance concerns. Many people in the business world are becoming increasingly worried about the growing disconnect between executive pay and the performance of companies that they run. Executives in S&P 500 firms often earn hundreds of times the compensation of the average worker. Yet, the money that they return to shareholders has not gone up by a comparable figure.
Excessive executive bonuses also create public relations issues with both staff and the wider population. While the vast majority of people agree that people at the top of businesses should be paid more than the average employee because of the high level of responsibility and skill required to do the job, they don’t like it when compensation appears to bear no resemblance to corporate performance.
High executive pay can also create labor relations issues. If employees have to make do with a three percent pay rise while the board averages fifty percent, then it can disincentivize people to work hard towards the benefit of the company. Talented individuals may even leave to find better opportunities elsewhere.
Good corporate governance is also increasingly coming to mean employing people from a diverse range of backgrounds. Throughout the history of free enterprise, company executives tended to hire people who were just like them in personality and appearance. Progressive thinking argues, however, that monocultures are not a strength but a weakness. Diversity along ethnic, religious, gender, and political lines, they claim, are vital to the success of organizations in the long term.
Being ESG-aware in this context, therefore, means finding governance strategies that enable the creation of more diverse teams. How far you take this depends on the values of your firm. Some organizations, for instance, may want to put in place interview strategies that remove the potential for “unconscious bias” – or the idea that we are all fundamentally bigoted – to enter the decision-making process. Others will want to engage in affirmative action. The decision ultimately rests with the board and senior management.
Protecting the interests of shareholders is another significant component of an effective governance strategy. Shareholders are, ultimately, the owners of the firm. Non-equity-holding senior managers and executives are mere stewards, looking after the interests of owners. Management, however, can sometimes take liberties, believing that it is entitled to more compensation or control than the owners permit.
Investors are becoming increasingly aware of so-called principal-agent issues. They know that when owners don’t have full oversight of operations at firms, managers can start taking matters into their own hands and work against their interests. Active investors, therefore, are becoming increasingly interested in companies that offer transparent governance structures that allow them to see precisely what is going on inside the company. The days when owners were willing to rely solely on quarterly earnings reports are largely behind us.
Prioritizing governance brings a variety of advantages. For instance, it helps to align the interests of shareholders with managers through improved reporting and disclosing of information. It also protects shareholder rights: after all, these are people who have forgone income to maintain their equity stake in the firm. Companies with good governance tend to have much higher transparency, making unpleasant financial surprises much less likely.
The Steps Companies Are Taking To Improve ESG
Evidence from academics such as George Serafeim, Bob Eccles, and Ioannis Ioannou suggests that “high sustainability” companies dramatically outperform “low sustainability” companies. To back up their claim, they produce a paper that shows the evolution of a dollar-value of equity in 1992 in ESG-aware companies compared to those who did not prioritize it. They found that one dollar invested in 1992 was worth 23 dollars in 2010 in a high-sustainability portfolio compared to just 15.5 in a low-sustainability alternative. Companies, therefore, that take the tenets of ESG seriously tend to perform better over the long run and grow their equity.
What follows are some simple, actionable steps you can take to enhance your ESG performance.
Step 1: Identify The ESG Criteria For Your Industry
When it comes to the implementation of ESG, every industry is different. For service sector companies, the focus will be overwhelmingly on governance and social. For industrial companies, there will be more application of strategies to improve climate and the environment (or at least, develop a public relations activity that makes them seem like going concerns).
Substantial overlap, however, is to be expected. Google, for instance, is primarily a service-providing company. Still, because it relies heavily on data centers, it also needs to take account of the impact of its operations on the environment. (Google currently implements machine learning to reduce the energy consumption of its server banks).
When identifying the ESG criteria for your business, try to limit yourself to five key areas or less. Focusing too broadly will dilute your campaign and may ultimately undermine your efforts.
Companies in the automotive sector might want to focus more heavily on the “E” and “S” in ESG. Car manufacturers, for example, may wish to reduce their reliance on energy and material resources while implementing initiatives to improve worker safety.
Your choice of ESG matters a lot. Starbucks struggled enormously to penetrate the Chinese market at first. The American coffee brand just wasn’t popular. It then focused on the “S” part of ESG by offering healthcare cover to the parents of employees. Before long, it gained notoriety, and people began flocking to the brand’s shops. The company now operates more than 2,000 outlets in China and has enjoyed rocketing sales growth over the last five years.
Step 2: Rank Your Business Against Competitors
The next stage is to figure out how your company ranks against your competitors. You want to know how you perform against peers and where you can make up lost ground, if necessary.
At present, several organizations offer services that rank corporate ESG initiatives. These include:
- The Global Initiative For Sustainability Rankings (GISR)
- The Sustainability Accounting Standards Board (SASB)
- The Global Reporting Initiative (GRI)
These organizations will provide you with a breakdown of your ranking and the reasons for their decision. All of them have slightly different priorities when it comes to ESG. Each takes into consideration issues such as the climate, the ability of firms to audit and control their supply chains, the state of labor relations, and natural resource scarcity.
These organizations also recognize that different industries have different ESG priorities, so take this into account when ranking your business and providing comparative metrics.
Once the ESG ranking organizations have collected data on your company and ESG policy, you’ll then receive a ranking that will serve as a bellwether of your company’s performance. Clearly, the goal should be to rank higher in subsequent years on industry-standardized metrics.
Step 3: Contact Sustainable ETF Managers And ESG Money Managers
Becoming more ESG-aware isn’t just about making a difference on the ground; it’s also about improving your standing with shareholders and driving company value.
Often passive sustainable ETF investors and ESG money managers are your highest quality investors, with you for the long haul. Proving your ESG credentials encourages them to plow their money into your company, leading to lower stock volatility and greater ability to raise funds should the need arise. If your company is publicly listed, it is in your interest to research how the ETFs and fund managers evaluate your firm.
Step 4: Tie Compensation To ESG Metrics
As any business leader will tell you, incentives matter. You can browbeat all you like, but unless there’s a compelling reason for people to change their behavior, they won’t.
If executives and managers believe in taking ESG metrics seriously, then they must tie compensation to environmental, social, and governance performance. In some companies, taking this step will require consultation with existing shareholders to get them on board with the idea. Executives should avoid forcing ESG metrics into the operations of the company. Instead, they should collectively present the case to owners and then leave it for them to judge the evidence. After reviewing the material, most shareholders will agree (and the opportunity for cutting risk) to go ahead with changes to compensation.
The metrics that the organization ultimately chooses depend on the specific ESG goals. Companies that use a lot of server equipment, for instance, might want to focus primarily on their carbon emissions or energy usage. Firms that have large labor forces, especially those in finance and retail, may instead choose to use labor relations metrics.
Step 5: Be Transparent And Market The Changes You’ve Made
Consumers and individual investors need to know the steps that you’ve taken towards a more comprehensive ESG policy if you want to experience the benefits outlined above. How you approach telling them, however, can be the difference between a successful campaign and one that damages your brand.
Your top priority at all times is to appear authentic. You do not want activists accusing you of “greenwashing” – pretending to be concerned about ESG issues but not doing anything concrete about them.
So what should you do? An authentic ESG policy puts in place robust strategies that have real-world impact and alongside tools to measure them. You want to be able to point to evidence that the changes you’ve made are having a real effect before sharing that knowledge with the rest of the world.
Once you’ve done that, you are free to publicize the changes. For consumers, the changes shouldn’t look like something you’ve just “tacked on” to your existing processes or branding. The most successful ESG-aware companies make the environment, social, or governance an integral part of their brand identity.
Lego, for instance, had a brand crisis on its hands a few years ago. Not only is its product entirely centered around plastics, but it also had a close relationship with Shell Global and partnered with them for their drilling in the arctic. The company, however, received an enormous amount of bad publicity for its actions, driven by the green activist lobby, and soon saw that it was damaging its brand. It needed to change its ESG attitude.
The company then undertook a 180-degree turnaround in policy. It abandoned its longstanding relationship with Shell and committed to using 100 percent renewable energy by 2030. The company is also looking at making its famous bricks out of sustainable materials, not just regular plastic.
Conclusion: How Companies Benefit From ESG
Several times in this article, we’ve alluded to the fact that ESG-aware companies tend to perform better than their peers. Research from the study ground Axioma confirms this. The group found that portfolios weighted in favor of companies with better ESG scores outperformed the market benchmark by between 81 and 243 basis points, with ESG companies in some markets, like Europe, performing consistently higher.
In general, ESG has been performing well as a tool that businesses can use to improve their performance. It’s not something that departs from capitalism and free enterprise – quite the reverse. ESG firms have smoother internal operations, fewer environmental risks, and more scope to attract talented people. These factors combine to produce higher profitability and more equity.
Data from the Boston Consulting Group, one of the world’s leading professional services, found that among the world’s 300 largest banking, oil and gas, consumer goods and tech companies, those with ESG priorities had the highest profits.
Of course, it does not necessarily follow that adopting ESG principles will help business. As yet, however, there is little evidence that it harms companies and may well be a strategy innovation that secures higher profitability in the future.
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