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What is ESG?

Short for “Environmental, Social and Governance,” ESG represents a more stakeholder-centric approach to doing business. For today’s institutional investors, an ESG plan looks beyond the balance sheet to consider the unique risks and opportunities facing today’s companies, both now and in the future; it also considers the impact a company has on its employees, customers and the communities within which it operates. As ESG increasingly becomes top of mind for directors, it’s important to also consider the global nuances that drive focus region by region. Companies that adhere to ESG standards agree to conduct themselves ethically in those three areas.

Multiple areas fit into the umbrella categories of environmental, social, and governance. Those can include:

  • Climate change
  • Human capital
  • Labor management
  • Corporate governance
  • Gender diversity
  • Privacy and data security

And more.

Relationship Between ESG and the Board of Directors

The relationship between ESG and the board of directors is still being defined. Discussions around the “G” (i.e., governance) are often spearheaded by the nominating & governance committee with involvement from the full board—particularly when assessing how these risks integrate with the ERM program or impact long-term strategy. In addition, more boards are incorporating the “S” (social considerations or corporate impact) into the strategy development process; according to PwC’s Annual Corporate Directors Survey, issues like health care cost, resource scarcity, human rights, and income inequality have all surged in importance.

When it comes to structuring oversight around the “E” (i.e., environmental issues), a recent global study by the Diligent Institute found that best practices are still largely undetermined. Fifty percent of the 447 survey respondents indicated some form of board-level oversight, either by the full board or a board committee, while 19% indicated that oversight lived within the organization. Another 35% percent indicated that environmental issues are “not overseen” by the company or that they “don’t know.”

The best approach to ESG oversight will vary by board and will be influenced by industry, company type, global footprint, existing committee structure, and so on. However the board decides to structure oversight, every board member should have a thorough understanding of (a) how ESG risks impact the organization and (b) what kind of disclosure is important to their investors.

How Boards Can Measure ESG

No standard set of guidelines yet specifies how boards can measure ESG. With the rapid rise of environmental, social and governance issues, investors and boards are now navigating a communication gap. Investors are pushing for more standardization, as the AFL-CIO’s Brandon Rees, Deputy Director of Corporations and Capital Markets, explains: “Companies are starting to provide [disclosure]—but because we don’t have uniform presentation of the information, it’s very difficult for investors to digest it when you’re relying on a CSR report as opposed to a uniform SEC disclosure.”

On the other hand, corporate issuers are finding that the types of ESG metrics that matter to one company may not matter to the next. Both boards and investors are increasingly turning to organizations like the Sustainability Accounting Standards Board (SASB), Sustainalytics or MSCI for reporting frameworks that offer some level of consistency and financial materiality among companies within a given industry.

Equipping Boards with the Right Data: Effective oversight of ESG will depend on whether today’s boards have the right information at their fingertips. In a research report by Forrester and Diligent, governance professionals indicated that “visibility into sustainability and ESG issues” was their greatest dissatisfier. 

Do you have the data your investors have? How does your board composition compare to your peers? What skill sets is the board lacking? What conflicts of interest might your investors have uncovered? Tools like Diligent Nominations provide quick access to information helps board members identify governance red flags raised by shareholders and activists.

Companies that follow ESG criteria are becoming increasingly popular as younger investors look to put their money where their values are. The most recent report from the SIF states that, as of 2018, investors held $11.6 trillion in assets chosen specifically because they conformed to ESG standards.

How ESG Criteria Works

Depending on the type of company being examined, different areas of the ESG standard might be given more weight. A mining company, for example, would have its environmental effects scrutinized differently than a solar energy company.

Ideally, a company will operate ethically across all three areas of ESG.

Environmental criteria might relate to what a company is doing to mitigate climate change. Do they have a minimal carbon footprint, or are they carbon neutral/negative? What are they doing to make sure their waste doesn’t contaminate the soil, air, and groundwater?

Environmental criteria might also influence a company’s treatment of animals, whether that be how livestock is raised or whether a cosmetics company tests on animal subjects. Other examples of environmental factors could be:

  • Use of electric vehicles
  • Powering buildings with greener energy
  • Purchase of carbon credits
  • How vulnerable a company is to the effects of climate change (e.g. natural disasters)

How closely a company complies with environmental regulations — and whether it exceeds them — can also work in their favor with ESG investors.

Social criteria look at a company’s business relationships, with employees and suppliers as well as partners or shareholders. If you’re looking at a clothing company, for example, you’d factor in their supply chain. If a company says it only contracts with ethical manufacturers, you’d double-check to verify that.

Questions to ask could be:

  • How are their supply chain workers treated, especially in factories outside the U.S.?
  • Are their employees paid a living wage?
  • Does the company put some of its money toward helping others?
  • Are their manufacturing facilities regularly inspected?

You would examine how the company treats its employees at all levels, and whether or not it places an emphasis on their health and safety. Do they offer paid leave? Sick leave? Do they take their stakeholder’s interests into account when making business decisions?

Governance criteria have to do with how a company is run. Are they transparent about their decisions and practices with stakeholders and the public? Are stakeholders given an opportunity to vote on issues that affect the company?

Some companies may provide assurances that they avoid conflicts of interest in those appointed to the board of directors. You’d also want to make sure that the company didn’t accept money in return for favors or engage in any other illegal activities like insider trading or fraud.

Since some companies might not meet every single one of these criteria, it’s important that investors decide what’s most important to them and let that set of ESG criteria guide their decisions.

ESG criteria can also be a useful tool for screening out companies that don’t meet your values. An environmentalist, for example, probably wouldn’t want to invest in a company with ties to coal mining.

This type of investing goes beyond personal values, however. While companies that don’t meet ESG criteria might do well in the stock market in the short term, avoiding companies with known bad practices can shield investors from risk should a company experience a scandal as a result of those practices — think BP’s oil spill or H&M coming under fire for racist product promotion.

How ESG Investing is Growing and Changing

ESG investing began in the 1960s. While certain ethical concerns have changed, the principle remains the same. More and more investors are adopting ESG criteria as a tool to evaluate potential investments alongside traditional financial analysis.

According to a report by PWC, the practice of ESG investing has grown over the last few years. The report states that the ESG asset pool will continue to grow rapidly and become “an essential investment tool” in the coming years.

The growth of ESG investing can be boiled down to three reasons, according to financial firm MSCI:

  • The world as we know it is changing
  • The next generation of investors is changing the way investment works
  • Data and analytics have evolved to provide more information than ever

The World
The face of our planet is literally shifting as a result of climate change. Droughts, food insecurity, and rising temperatures have a domino effect on the environment that impacts multiple sectors.

New risk factors are cropping up for investors, and new regulations are being enacted to mitigate the effects of environmental damage. Mass migrations and displacement from climate crises are changing the demographic makeup of certain areas — and preparing for those crises is changing the way we live our lives.

The current pandemic is a powerful example of how society can be upended and entire industries can grind to a halt in our interconnected world. Rapid adjustments have had to be made and people are constantly having to adapt to new information.

As technology advances and becomes more widely available, data privacy and security have also become something companies can’t ignore. In the wake of high-profile data breaches, companies are wisely tightening their security protocols. As these companies adapt, investors might change their strategies accordingly.

Today’s generation of investors is on the receiving end of a massive wealth transfer from the Boomer generation — as much as $68 trillion according to one report by CNBC. And the people inheriting that wealth may think differently about how it should be invested than the generation they’re inheriting it from.

According to a 2016 Bank of America report on ESG investing, $15-20 trillion of that money could go into ESG assets in the next couple of decades. If that happened, it could roughly double the size of the U.S. market.

Millennial-aged investors, and women in particular, are holding the companies they invest in to a higher standard. 67% of them believe that investments are a way for them to express “social, political, and environmental value” as opposed to 36% of Boomers.

A few more statistics on the newest generation of investors as cited by MSCI:

  • Millennials are more than twice as likely to be interested in investments that are dedicated to solving societal or economic problems
  • 90% of millennials wealthy enough to do so want to increase allocations to responsible investments over the next five years
  • 84% of millennials surveyed in a study by Morgan Stanley said they were interested in more sustainable investing
  • The Morgan Stanley report also claims 71% of individual investors are interested in sustainable investing

Since its founding in 2016, the United Nations Principles for Responsible Investing (PRI) has steadily gained support, with 2,000 signatories as of 2018 according to their latest annual report.

PRI signatories agree to abide by six main principles, one of which is the incorporation of ESG principles into their investment practices. Another is seeking disclosure of ESG principles from companies they invest in. As of 2017, the PRI had $68.4 trillion in assets under management.

There appear to be three main reasons investors are seeking out more ESG companies:

  • They believe it will increase their returns in the long run. Research increasingly shows that companies that adhere to ESG principles have fewer instances of corruption than others and are better run. That, in turn, makes them lower-risk investments.
  • They want their investments to reflect their personal values. These investors are less concerned with economic returns and more interested in finding companies that match their beliefs.
  • They want to make a difference in the world. These investors want to aid companies working on environmental or social challenges by directing capital to them.

Data and Analytics
Better data-gathering technology allows investors to examine companies in a much more granular way than they could in the past. Massive amounts of information can be harvested and used to drive objective, quantitative decisions.

Companies can be gathered and ranked according to how well they adhere to ESG principles. Investors can even see which principles they adhere to most closely, and change the criteria to have different weight depending on the industry. Having that kind of data publicly available also puts pressure on companies that aren’t adopting ESG principles to do so, or risk losing out on capital.

Companies themselves can better track their own performance relative to ESG standards using big data. In September 2020 the World Economic Forum released a report detailing a new set of ESG standards. Among those standards were guidelines for governance.

Today’s data tools allow companies to set benchmarks and measure how well they’re adhering to ESG standards like ethical internal governance. Diligent has several tools to help businesses in this area:

  • Diligent Compliance lets businesses track and improve their progress towards ESG goals via comparison to a comprehensive library of standards. Risk management, improvement planning, and internal audit solutions are all built in.
  • Diligent’s governance analytics programs examine your company data, including executive salaries, and flag any discrepancies in areas like diversity and compensation. This service is offered through Diligent partner CGLytics.
  • Diligent Governance Intel monitors news and stakeholder sentiment to gauge the mood of your governance methods with key populations. Users can automatically track news on ESG standards, trends, and regulations from thousands of sources, keeping a finger on the pulse. This can also be useful for identifying “red flags” and keeping board members informed of anything that needs to be addressed or changed.

Companies can also use this wealth of data to determine their exposure to ESG risk factors and calculate how resilient they’ll be over time. A business can hone in on the risk factors specific to their industry, identify those that are most important, and take action on them if they haven’t already.

Third-party entities can use data to rank companies independently, comparing facts from multiple sources to come up with a more holistic picture than they’d have with the information given to them by the company itself.

ESG and Corporate Sustainability

Investors increasingly want to see that a company can meet the needs of the present without compromising future generations. Adhering to ESG principles is one way companies can do that. The more sustainably a business can operate, the more attractive it becomes as an ESG investment.

More people today are starting to see corporate sustainability not as unrealistic, but as an attainable and important part of running a business. Operating in a genuinely sustainable way has intangible benefits that are hard to quantify but nonetheless invaluable in the long run.

For example, the best emerging talent is likely to be attracted to companies that they feel are making a difference in the world. Sustainable goals that adhere to ESG principles give companies larger goals to focus on that can involve the whole company.

Corporate sustainability can also foster public goodwill. In the eyes of many, large corporations are shady operators that don’t value people or the environment — the stereotypical image of a corporate entity is one that values profit over all else. If you can show people that your company honestly cares, and is tangibly working to benefit the world and the people in it, you can counteract that image. In doing so, you’ll differentiate yourself from the competition in a positive way.

Many global business practices have developed around cost-cutting. If ESG investing keeps growing in importance, however, we could see a shift in that dynamic.

True sustainability isn’t easy to accomplish. It involves every facet of a company and how it operates. It means holding everyone from manufacturers to retail outlets accountable, but the benefits are worth it in the long run.

Does ESG Investing Hurt Your Portfolio?

The short answer? No.

People used to believe that ESG investments were a sacrifice — an investment more morally than economically motivated. Today that isn’t necessarily true.

In fact, according to a report by the US SIF Foundation, ESG investing grew at a rate of more than 38% between 2016 and 2018. Assets grew from a total value of $8.7 trillion to $12 trillion.

Some studies have even suggested that companies with good ESG practices had lower cost of capital and lower volatility. They also displayed lower instances of bribery, fraud, and corruption over time. These results suggest that, in the long run, ESG investments are more stable and can even outperform other companies.

In a recent study, MSCI investigated the ties between ESG investments and the stock market, to see if there were any financially significant effects. The study used a three-channel model to look at how ESG data embedded in stocks gets transferred to the equity market.

The study found that, after examining idiosyncratic and systematic risk profiles for the companies involved in the study, ESG had an effect on many of those companies’ valuations and performance. Companies with higher ESG ratings showed:

  • Higher profitability: ESG companies with high ratings showed abnormal returns and were more competitive. This often led to higher profitability and dividend payments — especially when contrasted against low ESG companies.
  • Lower tail risk: High ESG rated companies experienced fewer idiosyncratic risk events like major drawdowns. Companies with low ESG ratings were more likely to experience these incidents.
  • Lower systematic risk: High ESG companies had less volatile earnings and less systematic volatility. They also had lower betas and lower costs of capital than low ESG rated companies.

ESG investing can also cut risk in emerging markets. There is research to suggest that companies adhering to ESG principles have a lower chance of tail risk — the risk of unlikely events that lead to catastrophic damage.

ESG Investing Trends: What We’re Seeing in 2020

As problems like climate change and the global pandemic worsen and have a larger impact on society, we see ESG principles becoming more important. Certain areas, in particular, are being emphasized more now than ever before, driving a change in the way companies operate and the way people invest.

Trends indicate that we’ll see a change in five areas, according to MSCI:

  • Climate innovation
  • Corporate finance
  • Real estate
  • Human capital
  • Stakeholder capitalism

While ESG investing is more long-term by nature, these five trends will likely become especially significant through the end of this year and into the future.

Climate Innovation
The effects of climate change are becoming increasingly hard to deny. In light of that, investors will be looking to support companies that are environmentally conscious. They’ll also want to back companies actively working to solve the climate crisis.

Investors will be able to use data analytics to determine which companies — both new and established — are environmentally conscious. For example, investors can spot which companies are working on solutions to a carbon-free economy by seeing which ones have a high number of low-carbon patents or bring in a high amount of green revenue.

Corporate Finance
Corporations are changing who they put their money behind and what causes they support in response to public pressure. For example, last year the New York Times reported that several large U.S. banks were pressured to cut funding to gun manufacturers. Investment in green energy solutions is also on the rise.

ESG investors are making environmental initiatives a part of the language of their investment deals. As financiers bind ESG principles into the terms of their capital agreements, more large corporations will have to put their money where their mouths are.

Real Estate
What real estate is considered valuable will likely change as natural disasters make certain areas less safe. Property that sits on the Gulf Coast, for example, would be considered increasingly high risk due to the constant danger of catastrophic hurricane damage.

Investors will also have to contend with increased regulation in many high-value real estate markets. Many of the most attractive properties to invest in are located in cities making their way toward zero carbon emission standards. Going forward, incorporating green properties into their portfolios will go from a nice-to-have to a must-have for real estate investors.

Human Capital
Rising automation and integration of technology into the modern workforce is creating a demand for a new set of skills. Both workers and management will need to train themselves in those skills in order to navigate the jobs that will come to exist over the next few years.

As higher levels of skill are balanced with lower levels of physical labor intensity in many fields, certain groups of workers will likely be laid off while others specializing in newer skills get hired. Corporations will have to choose whether to lay off or retrain large portions of their staff.

Stakeholder Capitalism
Through ESG investing, stakeholders are gradually gaining more power to hold companies to account. Savvy investors are teaming up with willing shareholders to see which companies actually practice what they preach when it comes to the ESG principles listed in their corporate mission statements.

A New Standard

What once was seen as a less profitable, niche area of investing is moving to the forefront. The rise of green energy, the need to combat climate change, and growing public knowledge of the supply chain are all driving consumers to brands that adopt ESG finance and operations principles. And investors are following suit.

Because of that, companies like J.P. Morgan and Goldman Sachs are tracking ESG investments closely, taking them more seriously than ever before. If you’re interested in learning more about this growing area of investing, visit our site today to see Diligent’s ESG solutions.

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