When I started talking to people about ESG in 2014 the conversations went much differently than today. Five years ago, the responses included “tree hugging”, “feel good” and “underperformance”. Today, it’s “exponential capital inflow”, “alpha generation” and “missing the boat”. Since then, a very strong growth of ESG has been driven by investor demand. What began as a way for someone to align their money with personal social and environmental values is becoming an economy-wide comprehensive standard that a company needs to integrate throughout the organization in order to be competitive. A lot of the corporate C-suite have been caught off guard.
In Wikipedia — “Environmental, Social, and Corporate Governance (ESG) refers to the three central factors in measuring the sustainability and societal impact of an investment in a company or business.”
The three ESG areas are referred to as pillars and there can be dozens of categories inside each. There is no one standard methodology for evaluating the ESG of a company. On the investment side, brokerage research and portfolio managers use different formulas and scorings, sometimes it’s a widely followed service, sometimes it’s proprietary. It’s common for a matrix involving hundreds of metrics, ratios and weightings to be reduced to a single ESG score on a company. These scores can be compared to closest peers, across a sector or an entire market. People always like to create and look at lists of rankings, so that’s usually the next step.
Executives and decision makers at companies that are getting evaluated, need to understand the different inputs to an ESG score and the increasing variety of ways their business is affected.
Environmental — Probably the lead issue in all of ESG has been a company’s carbon emissions because of the direct connection to climate change and its “relatively” simple quantitative measurement. You are counting molecules of CO2 or other GHGs. As ESG evolved, a comprehensive list and use of metrics has sought to show a company’s impact to the planet — landfill waste, water, plastic, paper, recycling, renewable energy, green financing, sustainability in the supply chain. A company’s progress and process for improvement can also have weight in an ESG score. An important emerging issue for ESG is biodiversity. What is a company’s operational impact to biodiversity? Today there is not an effective way to measure and report on this issue in a corporate format, but it’s on the way.
Social — 2020 lit a fire under S after the E usually got more attention. The effects of Black Lives Matter and COVID-19 have quickly swept through corporate policy on D&I (and the training for it), contribution to social equity, family wellness, leave flexibility & healthcare.
A lot of societal issues get evaluated; international human rights, access to career development and mobility, investment in communities, product and workplace safety, customer data privacy, paternity leave. An analyst can keep digging and digging to try and see how a company can help or hurt employees, consumers and society at large.
Governance — Ideally most of the G issues should be pretty boring, because when it’s not, a company may have a big problem. Probably the biggest case study during the era of ESG is when the fake account scandal blew up at Wells Fargo. The bank, which has an investment management division that does some ESG work, was fined hundreds of millions of dollars, lost a lot of customers and trust, resigned the CEO and fired 5300 employees after creating millions of unauthorized accounts. It was a governance failure at multiple levels across different divisions. The aftermath has plenty of social effects too.
A company wants governance policies and processes in place so it’s compliance and legal news feed is boring. It wants a diverse and independent board, a grievance mechanism free from fear of retribution, progressive shareholder rights, fair wage gaps, justifiable executive compensation, transparency in lobbying and public policy engagement and a structure to create and uphold ethical business practices and culture. Keep G out of the news.
The ESG effect
Shareholders, customers, lenders, employees and other stakeholders are telling companies how they want them to operate. Corporate leaders can proactively or reactively embrace the adoption and integration of ESG through their business or not. The effect of avoiding what the marketplace is telling them will always be the same — obsolescence.
“Those companies who are more and more focused on ESG strategies and stakeholder capitalism, they’re trying to get a higher P/E than some of the companies that are in denial.” Larry Fink, CEO of BlackRock Inc.
Shareholders are owners and they are increasingly voting for companies to act on climate, social equity, family health, conservation, transparency, accountability and stranded asset risk. Sometimes it’s to have company policy align with their values, but the real force is because of shareholder financial prudence. ESG is risk management. Institutional investment managers today are organized, loud and voting about the companies that they own to take verifiable action on ESG issues.
Customers also vote with their spending. 77% of consumers prefer to purchase from brands that prioritize efforts to fight global warming over brands that do not. — Sofidel, 2020. 81% of consumers feel strongly that companies have a role to play in improving the environment — First Insight, 2020. This part of the ESG effect is quickly understood in the head of sales.
ESG scoring is starting to be used by creditors and lenders in providing companies access to capital. The effect of a lower ESG rating might result in less favorable financing terms as the lending institution evaluates a company’s long-term risks.
In October 2020 the Independent Petroleum Association of America (IPAA) launched The ESG Center and held a webinar for their members called “Building an Authentic Approach to ESG”. The IPAA took this step because its companies are losing access to financing as banks come under increasing pressure from their own shareholders to reduce carbon emissions in their loan portfolios.
ESG is affecting HR departments in a couple of ways; internal and external. Inside — more and more employees are pushing management to make good on sustainability issues and to commit to more aggressive goals. Prior to the pandemic there were high profile public protects at companies like Google, Amazon and Microsoft for bigger and more concrete agendas for climate action. It worked. All of these companies have committed to new goals, including Microsoft’s carbon negative by 2030 program and Jeff Bezos’ recent first round of $791 million in environmental grants. It was a 21st century workers strike for better working conditions. In this case the factory floor is the whole planet.
Outside — For hiring the best young talent, companies need to show that they are actually working to solve many social and environmental concerns. These issues are real factors in Gen Z and millennial decision making for where they want to take their talent. By 2030 these generations should be around 70% of the global population. Take ESG’s original flagship issue, climate change, the younger the employee, the more their life will be affected by it. America continues to be more ethnically diverse, colorful and mixed. Job seekers expect an employer to look that way too.
The effect of other stakeholders — Despite Bank of America’s heavy ESG mandate, both operationally and in offered services, they choose (at the time of his writing) not to pledge against financing oil and projects in the Arctic National Wildlife Refuge. One effect was losing the longtime business of The Conservation Alliance, a nonprofit that supports grassroots conservation across North America. This loss of business won’t make a blip on B of A’s earnings, but the alliance has over 250 member companies (big stakeholders) that include Patagonia, Clif Bar, REI and Under Armour who were all notified of the divorce.
“Disclosing your plans can improve your credit rating, broaden your investor base, reduce your cost of finance, and economise on the fixed costs of meeting increasingly vocal investor requests for information” Andrew Hauser — BoE Executive Director for Markets
As if corporations didn’t already have enough incentive to properly account for and manage ESG risks in order to be competitive, they may have to from the hand of regulation. Recently the U.S. Federal Reserve and the Bank of England have taken significant steps to recognize risks from climate to markets and the financial system and how companies need to communicate these issues.
“It is vitally important to move from the recognition that climate change poses significant financial stability risks to the stage where the quantitative implications of those risks are appropriately assessed and addressed.” Fed Governor Lael Brainard
ESG is in full effect. A company can embrace, ignore or fight it. The marketplace will sort out the rest.