ESG is now mainstream and holistic Corporate Governance now drives brand value. But exactly what is ESG? We look at its origins in Responsible Investing and the principles thereof, various interpretations of ESG and its evolution towards complete acceptance by the investment community of the effect of holistic corporate governance on sustainability (in the widest sense) and hence brand value.
Brief history of “responsible investing”
In 2000, a UN sponsored initiative was launched called the Global Compact, which encouraged businesses to sign up to a set of ten principles of socially and environmentally responsible behaviour and sustainable strategies. These principles cover human rights, labour practices, environment and anti-corruption. They urge businesses to take strategic actions to advance broader societal goals with an emphasis on collaboration and innovation. There are now some 12,000 signatories in 170 countries.
Principles of Responsible Investment
The Global Contract initiative led to a further move to draw the investing community into the responsible behaviour movement, and a few years later the Principles of Responsible Investment (PRI) was formed under the auspices of the UN, and in 2016 celebrated its 10th anniversary. The PRI says:
“As institutional investors, we have a duty to act in the best long-term interests of our beneficiaries. In this fiduciary role, we believe that environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios (to varying degrees across companies, sectors, regions, asset classes and through time).”
It has six principles, the first three of which are:
“We will incorporate ESG issues into investment analysis and decision-making processes.
We will be active owners and incorporate ESG issues into our ownership policies and practices.
We will seek appropriate disclosure on ESG issues by the entities in which we invest.”
So Responsible Investing is now focused on ESG.
In answer to the question is Responsible Investment the same as Socially Responsible Investment or Impact Investing, the UN says “NO”. It says it has similarities with socially responsible investing (SRI), impact investing, sustainable investment, ethical investment, and green investment. But it distinguishes these five forms of investment as aiming to combine financial return with a moral goal, whereas investors who are purely seeking a financial return should also be guided by ESG factors, because they have an effect on risk and returns, and this is what constitutes responsible investing.
What is ESG?
As of now, there is no accepted detailed definition of what constitutes ESG, though there is a broad understanding of each element.
Thus PRI says that examples of ESG factors “are numerous and ever shifting” and include:
environmental: climate change, greenhouse gas (GHG) emissions, resource depletion, including water, waste and pollution, deforestation
social: working conditions, including slavery and child labour, local communities, including indigenous communities, conflict, health and safety, employee relations and diversity
governance: executive pay, bribery and corruption, political lobbying and donations, board diversity and structure, tax strategy
Rating agency MSCI has a very detailed analysis, but its approach can be summarised as:
environmental: climate change, natural resources, pollution and waste
social: human capital, product liability, stakeholder opposition, social opportunities
governance: corporate governance, corporate behaviour
FTSE Russell Index lists:
environmental: climate change, biodiversity, pollution and resources, water use
social: labour standards, human rights and community, health and safety, customer responsibility
governance: anti-corruption, corporate governance, risk management, tax transparency
environmental: energy use, waste, pollution, natural resource conservation, animal treatment, environmental risks which might damage the company’s name and how it is managing those risks
social: business relationships, do its suppliers hold the same values that the company claims to hold, does the company donate a percentage of profits to the community or perform voluntary work, do working conditions show a high regard for the employees’ health and safety, are the stakeholders’ interests taken into consideration
governance: does the company use accurate and transparent accounting methods, are the common stockholders allowed to vote on important issues, do they avoid conflicts of interest in choice of board members, do they indulge illegal behaviour or use political contributions for favours
So there is a broad consensus as to the areas to be addressed by companies in order to achieve good scores in ESG by the rating agencies.
CRG v ESG: the US exceptionalism
The United States, being oriented towards rules-based governance, uses CRG (Compliance, Risk and Governance) to address broader corporate reporting. The very name sheds light on the legal orientation of the approach, and is primarily focused on the shareholder relationship. However, the limitations of CRG may be evidenced by the fact that Enron was fully CRG compliant until it went spectacularly bust, resulting in jail terms for key employees for criminal behaviour.
Most of the rest of the world has been evolving and adopting ESG which takes both a broader and a more stakeholder inclusive approach to governance, and is much more concerned with the longer term sustainability of the company.
The jury is out regarding whether the US approach will prevail or the ESG approach which has been promoted by the UN and adopted in Europe and the Commonwealth and many other emerging countries. Our bet is that ESG will prevail, at least outside the US.
Recent change in attitude of investors to SRI and particularly ESG
From the introduction of a Corporate Governance Code in the UK following the publication of the Cadbury Report in 1992, listed companies affected by the new Code and investing institutions concerned with returns have sought to determine whether implementing the new Code created new value. Put differently, did companies implementing the Code as it was intended perform better than companies with a worse corporate governance record?
For the first decade or more, there was a great deal of academic research, but no real consensus. Believers in the application of the Code and good corporate governance generally interpreted findings as supporting their beliefs, and sceptics found reasons to challenge them. But in the past few years there has been a rapid acceptance by analysts that the evidence is now quite compelling that good corporate governance is reflected by out-performance in share prices. This is demonstrated by, for instance, MSCI’s indices which distinguish between the performance over a number of years of funds which contain companies which perform well in regard to the ESG criteria and portfolios which ignore ESG, the former out-performing the latter by significant amounts.
This is now widely accepted by the investing institutions to the extent that the major active investment funds will use ESG as a primary filter before making their investment decisions. Moreover, the huge passive investment institutions will use the published indices by organisations like MSCI when placing their index-tracking investments.
Impact on brand equity and hence corporate value
The logical conclusion is that it is becoming mainstream opinion now that companies which conduct their business with an holistic approach to corporate governance, and take account of the ESG elements, will exhibit sustainability and generate long term value. Moreover, this fact is increasingly recognised by the investing institutions, resulting in increasing demand for the shares in those companies.
So we have a two stage value enhancement here: firstly that good corporate governance of itself increases the value of a company through its being run more effectively towards the achievement of its goals, and secondly that the ESG element creates a “halo” effect which contributes to that intangible, but measurable element, “brand value”.
ISO 10668 defines brand value as capable of being assessed in relation to the following elements: transparency, validity, reliability, sufficiency, objectivity and financial, behavioural and legal parameters.
It says that in this assessment, common stakeholders are customers, consumers, suppliers, employees, potential employees, opinion leaders, shareholders, investors, governmental authorities and non-governmental organizations.
So it is clear that ESG is regarded as a very important approach to assessing Corporate Governance, and contributes significantly to a boost in brand value, both of itself, and in terms of the way brand is measured by the global provider of standards, the ISO.
Here, then, we have a virtuous circle: holistic corporate governance, incorporating the key elements of ESG, drives a company’s brand value up in the eyes of the analysts. This in turn increases the company’s attractiveness to investors, which, in turn, drives the demand for its shares. And that, in turn, drives up the share price, and hence raises the corporate value. The greater the investment in holistic corporate governance and ESG, the better the ESG performance; hence the better the brand is rated and the greater the resulting value uplift.
Now, after many years, the investing community is recognising that holistic corporate governance, not compliance of itself, creates sustainability and hence long term value, and is putting its money into companies which follow these principles. And holistic corporate governance and ESG have become mainstream.