ESG – What is it and how will it affect my business?

‘ESG’ in a corporate context stands for Environmental, Social and Governance. These three key umbrella factors are used to measure a company’s sustainability and societal impact, and as a way for socially-conscious investors to screen potential investments.

There has been a global push since the end of the 20th century to improve the world’s focus on the environment by using both social and regulatory elements and to get people to act before a critical tipping point is reached. However, exacerbated by the COVID-19 pandemic and the focus on human rights through movements such as ‘Black Lives Matter’, all elements of ESG have moved up the agenda for investors, stakeholders and corporates. It is also a springboard to further push female and BAME board representation.

Regulation is set to be a key factor for ESG in 2021, with asset managers and private banks being required to disclose the sustainability of their investments from 10 March 2021.

In this article we discuss some of the background to ESG, before going on to talk about what it means for investors, financiers and corporates, and where is it heading in the future.

History

ESG as a concept was crystallised in 2000 by the UN Global Compact, a sustainability framework. The goal of the framework was to find ways to integrate ESG into capital markets. It was hoped that by embedding ESG factors into capital markets, it would lead to more sustainable markets, better governance and better societal outcomes. This was followed by initiatives such as the Kyoto Protocol in 2005, the UN Sustainable Development Goals in 2015, and The Paris Climate Agreement in 2016 – all implemented with the overarching aim to prevent ‘dangerous’ human interference with the environment and promote sustainability.

In relation to financial markets, the UN founded a network called the Principles for Responsible Investing in 2005. This global initiative has since grown with a view to understanding the implications of sustainability for investors. The Principles offer an array of possible actions for incorporating ESG elements into investment practices across different asset classes. Driven by the momentum of these initiatives, it is beginning to appear that ESG investing can have beneficial long-term results.

Financial products

One of the first financial products focussing on sustainability was a ‘Green’ bond issued by the World Bank to institutional investors in 2009. These green bonds are typically asset-linked and finance projects aimed at energy efficiency, environmentally friendly technologies and the mitigation of climate change. In recent years, green bonds’ popularity have increased dramatically, drawing in the likes of Tesla Motors and Toyota to issue asset-backed security to finance hybrid vehicles. In 2019, a record $257.7 billion worth of green bonds were issued. However, the requirement to link these bonds to acceptable ‘green’ projects limits their accessibility to the wider market.

As an alternative, debt finance is incorporating the use of ESG factors by way of sustainability-linked loans (SLLs). SLLs involve setting sustainability performance targets for the borrower (eg improvements in internal energy efficiency or reducing carbon footprint) and if these targets are met, the borrower is rewarded with a direct financial benefit, most commonly through the ratcheting down of the margin under the SLL. Whilst the proceeds of an SLL do not need to be allocated to green purposes, thereby broadening their use, borrowers are financially motivated to improve their ESG footprint.

In July 2020, the EU’s Taxonomy Regulation came into force and meant that those involved in the financial markets will now have to report on which economic activities and investments can be treated as ‘environmentally sustainable’. These reports are made public, so not only will borrowing under an SLL mean the potential benefit of lower interest rates, but it may also have positive reputational benefits (whilst failure to meet ESG targets could, conversely, have negative connotations). Monitoring of SLLs has also led to growth in the secondary market of verifying and monitoring systems to independently sign off on a borrower’s ESG progress, rapidly expanding a new economic sector.

Investment

ESG criteria is increasingly being used to determine investment and lending appetite and whether a business has a sustainable approach to the global environment. Between January and October in 2020, £7.8 billion was placed into responsible investment funds in the UK, which accounted for almost half of all net money placed into funds.

There is a growing body of evidence to suggest that companies with strong ESG policies perform stronger over the longer term; cope better with economic downturns; and are more resilient in dealing with issues arising from climate change. A UK study also showed that those adopting ESG initiatives enjoyed far longer client retention rates: 82 per cent of adopters recorded average client tenure in excess of 10 years, compared to 52 per cent of non-ESG adopters. BlackRock, in an open letter in 2020, also stated that sustainability and climate-integrated portfolios can provide better risk-adjusted returns to investors.

Research is showing that after successful implementation of ESG initiatives, corporates of all sizes have demonstrated improved accounting performance and governance, and appear to be more attractive to institutional investment, which is key for public companies, who are obligated to their stakeholders. Investment managers, as ESG stewards, have the right to use proxy voting power to push companies towards positive ESG changes.

Specifically, these investors are also putting pressure on companies to increase the representation of women and people from BAME backgrounds on boards and across executive leadership. Studies such as ‘When Women Lead, Firms Win’ by S&P Global have found that firms with female CFOs and firms with high gender diversity on their boards have been more profitable. Another study found that demographically diverse board are more likely to represent the composition of a company’s staff and shareholders, and are consequently more attractive as an investment opportunity. The evolution of ESG requirements and market sentiment across global economies means that corporates need to make appropriate changes if they are to retain long-term viability.

Reform

The UK Corporate Governance Code and the FRC Stewardship Code have both been amended in the last couple of years to include more focus on ESG. The Companies Act and various UK acts and regulations (all relatively recently made/amended) require ESG reporting in annual reports for companies (with additional requirements for listed companies and exemptions for small companies), eg gender pay gap reporting, supply chain reporting, strategic reporting (to include ESG factors), modern slavery statements, s172 reporting etc.

Regulatory reform for public companies in the UK is being pushed by the FCA. In a Consultation Paper published in March 2020, the FCA proposed to introduce a new rule for premium listed companies on the London Stock Exchange’s Main Market, requiring them to state whether they comply with the Financial Stability Board’s Taskforce on Climate-related Financial Disclosures. This increase in regulation also increases a company’s liability when conveying incorrect or misleading data. ‘Greenwashing’ occurs when a business deliberately describes an ESG output which is not genuinely reflected. This means that companies can attract scrutiny around ESG at the corporate disclosure and product levels. This is where the G in ESG – the governance of a business’ environmental and social strategy – takes a top down approach to ensure that a strategy is effectively implemented, maintained and improved over time.

An important milestone for ESG is 10 March 2021. The EU Sustainable Finance Disclosure Regulation is imposing mandatory ESG disclosure obligations for asset managers, private banks and other financial markets participants to expressly disclose information regarding the sustainability of their investments and associated risks. This will require substantive action by all relevant parties prior to the deadline. Notwithstanding the regulatory divergence due to Brexit, the UK’s ability to (i) access global markets and (ii) avoid potential reputational damage, will mean that the UK will need to adhere in some manner to the EU’s regulations in this area and the increasing focus on ESG.

According to Goldman Sachs, millennial spending power has risen by 17% over the last 3 years. The rise of social media and heightened attention to climate activists such as Greta Thunberg and Sir David Attenborough has ignited a movement within millennials to focus heavily on this type of investing. Research suggests that millennials are more likely to seek out ESG-progressive businesses and view investing as a means to express their values.

Conclusion

The natural market reaction to uncertainty is to shorten investing horizons. However, evidence is growing to suggest that sustainability is at the centre of a business’ resilience. Companies with higher ESG ratings have shown greater market stability over the past year of the pandemic. It is clear that the importance of ESG is growing in the global financial markets and that there is now an expectation of visible change being led by investors and stakeholders. The top down legal and regulatory imposition, as well as the social media focus, will continue to drive improvements and all those involved should pro-actively consider their approach to ESG before it becomes a requirement.