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The Rise of ESG In Response to Investor Demand

Corporate governance sometimes is the subject of “fads,” or initiatives that gain traction with dubious evidence-based justifications.  Sometimes companies engage new theories or strategies because they “sound good,” or give corporate leaders a way to avoid or mollify tackling hard issues or difficult tasks.

Corporations are quickly embracing Environmental, Social and Governance (ESG) issues.  Whether this is “right” or the most effective use of corporate resources, the jury is still out.  There are many important aspects of ESG initiatives that advance important principles of corporate accountability, responsibility and proactive measures that re-orient corporate decision making and essential governance questions.

The growth of ESG, however, is not self-generated but is responsive to investor (and public) demands.  Investors are conditioning large capital investments on the existence and quality of a company’s ESG program.  ESG is a broad enough concept that it includes corporate attempts to build a strong corporate brand and promote long-term growth.

This focus, by definition, has to include a focus on effective ethics and compliance programs.  To go back to my broken record speech, companies with positive ethical cultures perform better financially over the long-run.  As a result, any corporate ESG program has to encompass an effective ethics and compliance program.

ESG Investors

Environmental, Social and Governance issues should be a priority for Boards and management. The advantages of proactively tackling ESG issues are significant. A robust ESG program can open up access to large pools of capital, build a stronger corporate brand and promote sustainable long-term growth benefitting companies and investors. There was a time when a public stance on ESG issues was a public relations tactic. That’s no longer the case.

Let’s go back to the investor demand for ESG programs.  These investors are sophisticated capitalists who are seeking long-term returns on their investments instead of the quarterly short-term investor.  As investors demand more from companies on the ESG front, they also are willing to partner and help companies address these important issues.

In 2019, ESG investment funds increased by $70 billion while traditional equity funds saw an outflow of $200 billion.  ESG investments continue to increase in comparison to “traditional” equity investments and ESG investments are performing better than traditional equity funds.

Major institutional investors are clearly communicating their expectation that companies institute a proactive ESG program and policies.  An effective ESG program attracts additional capital and is a way to embrace fast-arriving millennial demand for ESG values.  Employees want their companies to embrace ESG principles as a price for their loyalty and commitment to a company’s intangible reputation for social awareness, ethics and shared values.

Institutional  investors are increasing their commitment to “impact” investing, using sustainable and responsible criteria.  Investment research firms have developed measurements to rank companies based on ESG factors.  This rapidly growing approach will continue over the next few years.

Companies have to prepare for this scrutiny and the impact on its access to capital.  ESG initiatives have to be designed for board and management execution.  Activist investors have used governance problems and weaknesses to leverage their strategies through proxy contests and campaigns.

How to Embrace ESG

The E component of the ESG is taking on increasing important in response to demands that companies address climate change.  This rising interest in climate change is reflected in investment strategies implemented by major investors.

COVID-19, however, has underscored the importance of the “S” factor – social considerations of ESG strategies.  Companies are being scrutinized for how they treat employees, engage with customers and manage their supply chains.

Companies have to develop policies and controls designed to identify appropriate ESG criteria for their specific industry and their company.  It is easy to get lost in a variety of issues under the ESG umbrella and a focused approach is critical.  In this respect, companies should pick at most five issues to develop that are important to the company, investors and consistent with overall corporate strategies. 

An oil and gas company that relies on fracking has to measure waste management and impact on the environment and natural resources.  A service company may want to focus on diversity and inclusion to advance customer acceptance of company operations as an important reflection of social diversity.

Once defined, companies should benchmark their performance relative to other companies under availability sustainability ranking indices, including Global Reporting Initiative, Sustainability Standards Board, Global Initiative for Sustainability Rankings.  These organizations, analyze a broad range of ESG for certain industries.  Companies have to establish relationships with ESG investment funds and promote their commitment to ESG principles. 

A company commitment to ESG has to be sustained.  If it is window dressing, a company can suffer credibility damage.  An ESG program has to be measured, compared and disclosed to the public.  It has to be a priority for senior management and should be monitored by the board.

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