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. It’s not just regulators that are driving this trend. It is being driven by investors themselves – both institutions and private individuals.
Unlike the “exclusion investing” of the past, adopting an ESG approach does not necessarily mean acceptance of lower performance. This is because -- in theory at least -- companies that demonstrate their awareness of ESG principles are more likely to have higher standards of corporate governance, which should translate to improved resilience in adverse economic conditions.
This move towards ESG is also possible because there is now access to substantial pools of data and technology that can help make these decisions.
Last year, Blackrock, the largest asset manager in the world, said: “We believe that sustainability should be our new standard for investing”. It called for chief executives to disclose more clearly how they are managing sustainability – and warned that companies who do not respond to sustainability risk will be on the losing side of a significant reallocation of capital.
Larry Fink, BlackRock’s chief executive suggested that, over time, companies and countries that ignore sustainability risks will see problems mounting in other areas. He has argued that this will lead these businesses to encounter growing scepticism from the markets, and in turn, higher borrowing costs when they approach a bank for financing.
ESG and the Covid-19 sell-off
Evidence that companies with higher ESG scores see their shares perform better in a crisis emerged last year in the pandemic-related sell off.
George Serafeim, a professor at Harvard Business School, analysed the share-price fall of more than 3,000 companies all over the world as Covid-19 spread.
He found that companies with strong ESG credentials experienced less negative stock returns during the market collapse. Even more strikingly, there was an even more pronounced effect in industries that were badly hit by the pandemic such retail, restaurants and airlines.
Of course, we are still in the early stages of implementing ESG factors into investment decisions. There are still no universally-adopted standards for how companies can measure and report on their sustainability performance. Instead, a large number of NGOs are working independently to develop standards for sustainability reporting. This is likely to create complexity and confusion for both companies and investors. The good news is that discussion about a global standard are well underway.
Global standards coming
In September, the IFRS Foundation proposed the creation of a parallel Sustainability Standards Board. The IFRS Foundation is well-placed to make this proposal because of its expertise in the standard-setting process. The organisation’s legitimacy in the corporate and investor community is high – and already has support from regulators all over the world because of the application of its accounting standards.
In March, the IFRS Foundation said it was continuing to work towards setting up an international sustainability reporting standards board. A final determination about any new board will be made ahead of the November 2021 United Nations COP26 conference in Glasgow, where countries will make firm commitments to slash their output of emissions.
Already, 120 countries use the IFRS Standards as the foundation for company financial disclosure, making it more than likely that these countries will endorse and require companies to use the new ESG standards.
As more investors choose ESG benchmarks over traditional indices, the difference between being an ESG “winner” and “loser” could become much more meaningful.
ESG not about generating a “feel-good factor”. These issues will become more financially material over time. As the data becomes more standardised, executives will see evidence that ESG can create real value for their business, coupled with the enthusiasm younger investors have about the issues means this trend looks unstoppable. Investors ignore the rise of ESG in their own financial peril.
The global move towards better environmental standards is another theme that has been accelerated by the Covid-19 pandemic. Most of the world’s major economies are now implementing massive investment programmes in green energy, to create jobs and futureproof their infrastructure. The investment opportunities created by the acceleration of the energy transition away from carbon should also provide many more opportunities for investors considering ESG factors.
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