What is ESG?

Change

Probably the most significant emerging feature of 21st century business life is the increasing demand from regulators, shareholders, and the general public for companies to deliver a range of public benefits and impact alongside the profitability of their companies.  This evolution is increasingly reflected in the investment expectations and choices of a range of investors, from retail to institutional, around the globe.

ESG Validation, a London-based firm, aims to address a major gap in the current architecture of global capital markets that will be critical in advancing ESG-aligned business leadership and investment management: the presence of a trusted, neutral, and competent authority to provide a view on the ESG claims, measures and practices of corporates and companies around the globe.

Originally referred to as “Corporate Social Responsibility” (CSR), this construct of the broader accountabilities of business is falling into dis-use, evolving into the current framework called “Environmental, Social and corporate Governance” or ESG.

This has been a positive change initiated and welcomed by business leaders themselves.  Far from being reluctant, the language of ESG has given them means by which they can describe how a business does better by having “bottom line” ambitions unrestricted by narrow definitions of shareholder value and reward.  ESG has emerged as a model for successful business management; an approach that secures the public “licence to operate”, enables long term business success and growth, and rewards sustainable investment.

ESG-influenced business management, and related investment choices, are in close alignment with the rising sense of responsibility and accountability that underpins a drive to increase fair trade, hold company executives accountable for business practices across global supply chains, and otherwise raise standards of behaviour in the pursuit of commerce. What was once a choice at the fringes of company leadership is quickly becoming mainstream, translating into an important differentiator, a means of enhancing brand value and a distinguishing characteristic in the assessment of investment alternatives and the deployment of capital.

Over the past three decades, the perception has grown that business has avoided bearing its share of the collective imperative to ensure that environmental resources are used sustainably, and that social gains are delivered and shared fairly and with probity.

Good governance concerns rose out of a growing sense that the fundamental nature of business, and its relationship with the societies it serves (and within which it thrives) ought to be re-examined and redefined. Mistrust in business leadership resulting from corporate malfeasance, Board room abuse of power and information, and generally amoral conduct justified by a misguided focus on the narrow “bottom line” have combined to motivate some fundamental questions about the nature of business and the definition of success. This is equally true for CEOs, boards, lenders and investors.   

For all three arenas – environment, society, and corporate governance – it has become clear that legislation and regulation is not enough.  The law can create a baseline, but a cultural change in business leadership and management is required to change the way business and its purpose is understood. Business needs owners and managers who believe it is right to secure environmental and social benefits from their operations and, moreover, see them as indivisible from financial profit and growth in value.

It is fair to say that business leaders with that perception are in the ascendant, and equally fair to note that investors seeking to do well by doing good are equally on the rise. These evolutions in business and in capital markets require a proposition such as the one developed by ESG Assessment and Validation LLP.

While some quarters of commerce have seen ESG as being hurdles to climb over, an increasing majority have perceived ESG as issues that can add value to their business model.  They have been actively searching not for the lowest cost means to satisfying regulators, but for ways of gaining competitive advantage from having exacting ESG policies and positive ESG impacts from their business.

A consequence of the lack of trust in business has been the demand for increased accountability for actions and greater transparency of information and data.  Political pressure has promoted regulatory interest in governance processes and business reporting with the emergence of rising compliance requirements.

There has also been an exponential growth in tools available to business for measuring their ESG impacts – for good or ill. 

Some come from regulators but these only infrequently set targets, they are mostly concerned with reporting, or are compliance levels to prevent negative impacts (such as environmental damage).  The providers of positive ESG measurements, reporting, and performance tables have been consultancy businesses who provide the measurement system and the consequent marking, then sell their advisory services to help improve performance against their own measurements.  The others are charities and campaigning organisations.  They use the results of these rankings to expose poor performance in campaigns, or they run financially successful certification schemes that have become core to their purpose.

This sounds like a catalogue of cynicism.  But it is not.  Employers are finding out that their staff are increasingly motivated by high ESG attributes in their employers.  It has become far more difficult for companies to under-cut their competitor by externalising the environmental and social costs of production.  Boards that are governed well tend to be happier places and deliver more successful business results.

“Corporate purpose is producing profitable solutions to the problems of people and planet….Profit, in other words, flows from the pursuit of a broader social purpose”

Professor Colin Mayer

So what is the problem?

The investor community is operating in a complex and tangled ecosystem of ESG assertions, recognitions and compliance.  It is very difficult to tell if a potential investment has realistically considered the ESG consequences, opportunities and benefits, and the potential risk that has on the value of the business.   Where do investors go to secure independent, objective and neutral assessment and validation of the claims of their potential clients?  How do asset and investment managers reflect the ESG-aligned nature of their investment choices to their own clients and stakeholders? Where do pools of capital collected from public sector sources go to secure trusted advice on the degree of ESG-alignment of the investments they are making?

There are over 400 sustainability reporting instruments worldwide but there is no standardised approach to assessing and validating economic, social, and good governance (ESG) criteria in the private sector.  Nearly 50% have appeared in the last few years and that rate of growth has not slowed down.  Sixty-four countries use these instruments.  There has been an explosion of ESG ratings and scoring service companies, mostly using in-house methodologies designed to create sales and commitment to ESG products.  But there are no benchmarks, an absence a shared lexicography, and no standard definition of what an ESG strategy should look like.

ESG measurement and validation processes tend to reflect the campaigns and concerns of the organisation that owns them rather than serving the purpose of the investor. In short, there is no standardised approach to assessing and validating ESG criteria in the private sector.

That is not to say these approaches have no value, but the majority are highly specific and can create perverse incentives which encourage commendable behaviour in one sector only to undermine it with below threshold performance in another.  The use of an ad hoc cocktail of measurements will not give an investor an accurate picture of the ESG opportunities and risks.

“Investors need to be clear about what the methodology they choose is actually measuring, and why. Otherwise ESG scoring risks creating a false sense of confidence among investors who don’t really understand what lies behind the numbers—and therefore don’t really understand what they’re buying.”

Financial Times 6 December 2018

“Most investors use their own cocktail of common frameworks… the market needs plumbing”

Elizabeth Littleford