Environmental, social, and governance (ESG) has become a burning issue for boards. Failure to consider environmental, social and governance (ESG) factors could also constitute a breach of duty of care resulting in legal actions. Below is a guide to ESG for board members and company directors.
What is ESG?
Put very simply, ESG is a company’s environmental impact (E), social impact (S) and Governance (G) structures.
Environmental impact includes the effects of a company’s operations on land, water, air, natural ecosystems and biodiversity.
Social impact relates to gender diversity, human rights protections, and human health and safety.
Governance is the accountability of the board, the transparency of critical information and the protection of shareholders rights – to name but a few.
While the concept of ESG has been around since the 1960s, when for the first time investors removed companies selling tobacco or those profiting from apartheid from their financial portfolios, it is only now that it is starting to gain real ground and has become a burning issue for boards around the world.
Melting polar icecaps and drastic weather changes are just some of reasons why new and younger investors are focused on choosing to vote with their wallets for companies with strong ESG policies.
For example, the Church of England’s investment arm – which controls a £8.7 billion fund – has warned companies that they need to do more to protect biodiversity and increase the ethnic diversity of their management teams or risk protest votes at upcoming shareholder meetings.
Company directors are beginning to understand that companies with strong ESG policies provide consistently higher dividends, are less exposed to idiosyncratic risks and experience less systemic volatility.
In May 2015, Volkswagen was removed from MSCI ACWI ESG Index due to weakening corporate governance structures and increased warranty costs. In September 2015 the VW emissions scandal broke leading to losses of nearly €30 billion and the firing of CEO Martin Winterkom.
According to a McKinsey survey on ESG published in February 2020, 83 per cent of c-suite leaders and investment professionals say they expect that ESG programs will contribute more shareholder value. Investors also indicate that they would be willing to pay about a 10 per cent median premium to acquire a company with a positive record for ESG issues over one with a negative record.
A guide to ESG – what does an ESG policy include?
Having a strong ESG policy in place doesn’t just translate into investing in green tech or supporting organisations that bring clean drinking water to societies that don’t have it. It means much more. ESG is your company’s 360 degree response to risk which involves the environment, society and governance.
For example, if your company deals with the sensitive public data, what are the measures your company has put in place to protect this? Do your measures go beyond enforcing a strong GDPR policy?
If your company outsources its work to a country with weak labour laws, what measures has the company taken to ensure that the rights of workers are protected? In addition, how will the company manage labour disruptions, shortages and reduce the risk of accidents on site?
Many companies today serve markets in multiple geographical locations. Do the boards and executive branch reflect a diversity of skill, gender, race, experience and knowledge to adequately serve these markets?
Companies that do well on ESG, evaluate their material risks, take opportunities to innovate to reduce that risk and implement solutions into their long term growth strategy.
What’s an example of good ESG?
Edward Life Sciences (ELS) is a medical device firm that specialises in manufacturing devices for structural cardiovascular disease and critical care monitoring. It is also one of the world’s front runners when it comes to ESG with a AA rating from MSCI.
In the medical devices industry the main ESG issues the firm faces are product quality and sustainability. ELS aims to improve this by operating on its core principle of integrity.
The company has a ‘Global Integrity Programme’ that starts with a chief responsibility officer (CRO) to oversee compliance of its ‘Titanium Book’ (governance handbook). Employees sign an annual compliance declaration and 24/7 helplines allow employees to speak up about non-compliant behaviour in the workplace.
In addition to this, the company carries out business dealings in strict compliance to that country’s medical device association’s code of conduct. It has a rigorous screening of suppliers’ facilities which includes surprise inspections to ensure that materials are sourced ethically and sustainably. In 2019, ELS had a total recall of four devices down from 14 in the previous year. It received no regulatory warnings in comparison to four in 2015.
A guide to ESG for directors
- Growth: A strong ESG practice shows that a company operates with integrity. This translates to certain governing authorities awarding greater access, approvals, new licences with higher frequency and with fewer delays. In a massive public private infrastructure project in Long Beach California, for example, the companies that won the bid were evaluated on their approach to sustainability.
According to Schroder’s 2019 Global Investors Study that surveys 25,000 people annually, 60% of people under the age of 71 believed ALL investment should consider ESG factors. In addition to this, in the next 30 years there will be the inevitable $30 trillion shift in wealth from baby boomers to millennials who prioritise sustainable businesses in their purchase decisions.
In 2018, a Nielson study of Chocolate, bath and coffee products found that those making environmental claims seemed to sell a minimum of four times faster. An example of this would be Unilever’s Sunlight dishwashing liquid which was advertised to need less water. In markets which had water scarcity the product outperformed category growth by 20%.
- It will help you save money: ESG will push your company to rethink the way it has always done business. Innovation will be required for product sustainably which will impact supply chains and push your business to consume fewer resources on a day-to-day basis. A metric developed and used by McKinsey to measure the energy, water and waste produced found a strong correlation between resource efficiency and financial performance. Unilever has saved $1 billion in cutting down its water, energy and materials usage. Fed-Ex aims to convert its entire fleet of 35,000 vehicles to electric or hybrid engines. So far it have been successful in in converting 7,000 vehicles saving it money spent on over 50 millions gallons of fossil fuel.
- Fewer regulatory interventions: On average, irrespective of geography, nearly one third of all business profits are dependent on some approval from the government be it licences, standards, and approvals.In other words, the financial health of your organisation greatly depends on the State and can be at risk due to state or legal interventions. A strong ESG policy can improve government relations and get you government support. The consumer goods industry has a relatively low risk to state intervention at 25-30%. However tech, automotive and banking are a few of many industries where 50-60% of their income is at stake in the event of state intervention.
- Higher employee productivity: A strong ESG practice gives employees a higher level of workplace satisfaction, purpose and a sense of contributing to the greater good. In a study by London Business School, the companies that repeatedly made ‘100 best companies to work for’ lists generated higher stock returns. Companies that communicated their ESG policies well had fewer strikes and disruptions due to labour anger. ESG’s productivity doesn’t just end with employees within the company but has far-reaching benefits for people involved in the supply chain. For example, Mars has helped create model farms that introduce new technologies to farmers within its supply chains and help them obtain a financial stake in these initiatives.
- Investment: In 2012, the signatories of the UN’s Principles for Responsible Investment numbered 1,050. Today there are over 2,400 funds controlling over $86 trillion in capital. In addition, the world’s top funds including Swiss Re, Allianz, CDPQ, CalPERS and Pension Danmark have pledged to transition their portfolios to being carbon neutral by 2050. Whether you’re a big organisation or a small one, in order to continue in the future, your business will need to consider a strong ESG program to land investment.
- ESG can help turn your company around in a crisis: Yashili, a China-based infant formula company came under fire when its product was found to have Melamine in it. It was able to recover the loss in reputation and business by adopting strong ESG policies. It changed out local suppliers of milk powder in favour of imported high quality ones, installed a food quality and safety advisory committee a first for the industry, recruited a chief quality officer and put in place strict new standards. A consequence of this was that Carlyle which had a 29% stake in 2009 when the scandal broke was able to sell its stake for 2.3x return of $388 million just three years after the scandal broke.
What do boards need to know about ESG?
Before entering the ESG arena, boards need to understand this – there is a vast communication gap between what investors want and what the company provides.
This exists due to:
- Different investors look for different things: Individual investors, fund managers, and financial institutions have different ESG priorities as per the industries they operate in. For example Fund A may invest in a mining company based on the company’s use of sustainable mining practices however Fund B may choose not to invest the same company because it only operates in countries with weak labour laws and uses it for financial gain.
It can often be confusing for an organisation to decide what investors are looking for and how to publish the data. In the end the data that is published is often confusing, inconsistent and scattered
- Structural obstacles: Structural obstacles exist on both sides – the investor and the organisation. Many investors appoint stewardship officers to overlook ESG priorities. However, these officers have little contact with companies and when they do their authority is undermined as they aren’t portfolio managers or chief investment officers. On the company side, companies have a sustainability group or manager however they may not be a part of strategy team and so don’t impact long term value creation. In addition to this, many companies have the view that having strong ESG standards equates to a lot more work that would encourage uncomfortable discussions with increased scrutiny and undermined valuation.
- ESG isn’t CSR: When investors bring up questions on the ESG spectrum, they are often directed to the person in charge of CSR. However, ESG isn’t employee volunteers in soup kitchens or the company’s AIDs fund contributions it is the company’s response to future risk such as high employee turnover rates, carbon footprints, boardroom diversity, cyber security etc. It is the responsibility of the company to understand that ESG is a big part of a company’s risk profile and cannot be completely covered by state required annual CSR contributions
- You can lose control over the ESG narrative: With different investors asking for different things a company may feel the pressure to provide information on everything often resulting in poor quality information. Investors look to third party data to fill in the gaps which often could lead to the spread of unverified inaccurate information.
ESG and UK boards – how to manage the metrics
The new reality boards need to understand is this – there is no one way to tackle ESG and so the metrics to measure it are still in their infancy.
A board could take the UN’s sustainable development goals or SASB’s industry sustainability standards as guide to assess the company’s current ESG profile. However, if the board is looking for something with more rigour a rating like R-Factor by SASB and State Street Global Advisors (free), B Lab’s Global Impact Investing Rating System, EcoVadis’ sustainability Scores or Refinitive ESG Scores could serve as a better tool to assess where the business lies in regards to ESG. However ESG rating is still in its infancy and while there are many players in this area non have appeared to have become an industry standard.
Unhappy with the current market offering, some firms choose to invest in creating their own tools to assess their own ESG policies and identify areas of improvement such as TPG who worked with Bridgespan Group to create Impact Multiple of Money (IMM).
Getting these scores may serve your firm well, but how can a board push organisations towards ESG over the familiar tried and tested ESG model:
- Start small: As discussed before there are varying opinions on best ESG practices based on individual preferences on your board and executive. Servicing all of them wouldn’t result in any meaningful outcomes. The best way forward is to identify no more than five objectives based on the nature of your company and the industry in which it operates. If your company is in construction your ESG policy could focus on ethical supply chains to improve material quality or a prison reform program to provide gainful employment to convicted felons at the same time ensuring a steady flow of labour.
- Base it on facts: Introduction of ESG measures should be presented in terms of performance targets. Anything less may fail to leave an impact and could be perceived as unimportant. The in-depth analysis would be required to understand the current value chain and changes that could have a maximum result in terms of sales and revenue. It would also help the company’s case to collaborate with industry experts, research best practices in your industry for ESG and cross-check results with internal findings. Start preparing ESG information based on assurance, certifications and description of potential control processes etc and disclose the findings with investors.
- Chief risk officer and sustainability team: Start the recruitment process for a CRO and a sustainability team to identify risk and areas of improvement. Ensure that these teams have adequate weight in the strategic decision-making process. Encourage them to develop cross-functional relationships within the company to help them understand better the current business practises and future risk opportunities.
- Stay true to your company’s values: Reality is that ESG policies carry a great risk. A few ESG policies however well-intentioned could have adverse effects on sales and investment. Before taking a decision, it is important to be transparent on the risks to all stakeholders involved, keep in mind long term value creation and if there is consumer backlash from the move, damage control should be executed according to your company’s core values. Dick’s Sporting Goods lost $150 million in sales in 2018 when it announced that it would restrict gun sales. After the initial slip in the stock market, the company’s stock climbed 14% in less than a year.