Environmental, societal and good governance (ESG); a new paradigm for investment

 

Richard Burge is an adviser on international affairs, sustainability, and trade regulation and facilitation. He is the senior adviser on diplomatic engagement to the City of London, senior partner at ESG Validation (www.esgvalidation.com), and he sits on the new international advisory board of the London Institute of Banking and Finance.  He has been Chief Executive of the Commonwealth Enterprise and Investment Council (CWEIC) from 2017-2019.  For the previous 8 years, he was Chief Executive of Wilton Park (a Foreign and Commonwealth Office agency for conciliation and dialogue on global issues).

 

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Purpose and responsibility in investment and business is the growing undercurrent in corporate strategy.  Other than change created by technological advance, it is arguably becoming the most impactful shift in investment and commercial ideology since Milton Friedman claimed that for a company to pursue anything other than legal profit would be “pure and unadulterated socialism”.

 

The shift away from the Friedman doctrine started with corporate social responsibility (CSR), which originated in the charitable activities of corporations.   Under increasing public pressure for corporations to address the social and environmental problems that their businesses created, CSR funds became departments in corporations with strategies and goals.  But at their heart, they did not address the problems, they simply found ways of offsetting some of the ills created, or mitigating part of the damage.    They did not change the nature of the business itself.

 

ESG is focused on three areas of business impact.  First, the environmental consequences of conducting the business; for instance unsustainable use of renewable and reliance on non-replenishable resources, the production of untreated pollutants, the emission of greenhouse and ozone depleting gases, and waste to landfill.  Secondly, social concerns such as exploiting poor labour laws and low wages.  Thirdly, poor quality corporate governance which focuses solely on short term benefit for shareholders or senior managers regardless of the  long term interest of the wider range of stakeholders relying on the company’s sustained success.  This extends to corrupt activity such tax evasion, modern slavery and false accounting.

 

Radical change started to come from two directions.  Firstly, governments finally cottoned onto the fact that profit was being increased by companies externalising the true costs of production.  If your waste products were processed by state facilities funded by the taxpayer, then you increased profits.  If you emitted greenhouse gases, then it was “the future” that would pay the price of remediation, while in the present you reaped the benefits of reduced cost.  If you harvested a wild product for free (especially beyond its capacity to replenish) or moved production to a country with slack labour laws, the direct cost to the business was lower.   Demands were made for triple bottom line accounting, governments tightened up with increased regulatory control and taxation was used to push externalised costs back onto the company.

 

Gradually, ESG criteria are being used more comprehensively, most prominently in greenhouse gas emissions.  We are close to the reporting requirements developed by Mark Carney’s Task Force on Climate Change Financial Disclosure (TFCD) becoming a trans-national accounting requirement.  Modern Slavery monitoring is moving from simple annual statements of good intent to proof of action and mitigation measures.  UK pension funds are now required to make annual ESG statements to their investors.

 

But the second and most decisive change has come from the investment community in its broadest sense.  Very wealthy individuals have started to demand that companies account for, and then reduce, remove, mitigate and compensate for the environmental, social, and poor governance that they may have ignored or tolerated in days gone by.  Senior executives have pointed out that companies need a licence to operate – no matter what they do.  And that licence requires them to exercise social and environmental responsibility.  Major corporate leaders have made this point forcible over the past few years.  Companies must have a purpose beyond the generation of profits, not just because it is demanded of them, but because it makes them better companies.  They “do well by doing good”.  Larry Fink of Blackrock said “without purpose, no company or individual can achieve its full potential ….. they will lose their licence to operate from stakeholders”.  And from Meryn King from South Africa, “businesses have to acknowledge that they stand at the junction of society, economy and the environment, and they have to seek to have a positive impact on all three”.

 

As companies have started to change the way they behave, so a whole new class of investment has appeared that directly intends to create social and environmental goods as a profitable business venture.  There has been a proliferation of funds to allow people to invest in good.  Some social impact funds are little more than philanthropic donations which incentivise the delivery company to achieve or exceed stated targets.  Some are genuine investments with a competitive financial return. Some hit the middle ground; offering a reduced financial return alongside a measurable social or environmental benefit.  Some are mixed investment funds, where the manager commits to investing in stocks or projects that conform to a particular green or social focus.

 

But these investment vehicles are not what ESG is about.  ESG criteria apply to all businesses and all business activity.  ESG does not measure the target of the investment; ESG addresses the consequences of every business using accounting principles to measure company ESG performance and corporate ESG viability.

 

So where does all this go?  Cyrus Taraporevala recently said “… (ESG) investment will become business as usual. In 2029, we will no longer be talking about ESG in terms of standalone investment strategies. The quality and consistency of such data and analytics will advance to the point where they will be fully incorporated by portfolio managers into their investment processes across all asset classes.”  And this is where companies such as ESG Validation come in; assisting business to develop their ESG risk appetites and ESG strategies informing and guiding their financial investment strategy; making ESG and financial performance two sides of the same corporate reporting coin.

 

We now face two challenges.  The first is the absence of clear metrics on ESG issues.  There are lots of commercially speculative attempts but no agreement yet.  The EU is working hard on what they call the “taxonomy” of sustainable criteria that may offer us the best chance of comparable and verifiable data against which companies can report.  The second is finding enough accountants, lawyers, managers, engineers, and business leaders with the ESG skills to run companies as the final nails are banged into the coffin of the Friedman economic dogma.

 

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Richard Burge

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