Environmental, social and corporate governance (ESG)

What is ESG?

ESG is an acronym which stands for Environmental, Social and Governance and is an umbrella term capturing a broad range of factors against which investors can assess the performance of the entities they are considering for investment.  However, ESG also has broader application.  The overarching concept of ESG investing is a shift in emphasis from short-term profit maximisation as the primary objective of corporations, towards a more sustainable business model where significant weight is given to a range of ESG factors such as the environment, employees, the supply chain and the wider community in which the business operates.

ESG covers a wide range of factors and the following table sets out some examples:

Source:  Growing a culture of social impact investing in the UK, 2017

Why is ESG important?

ESG is a rapidly evolving area and in recent years it has moved up the corporate agenda and companies are under increasing pressure – from investors and regulators – to improve their ESG performance.  A number of factors are at play including:

• An increased focus from governments and regulators on mandatory ESG reporting standards which build upon the non-mandatory frameworks that have been published by industry groups, NGOs and other international organisations.  
• The rise of ESG investing with the creation of ESG benchmarks and indices, the increasing shift from passive to active investing and the creation of ESG funds which have attracted record inflows of capital.  More investors than ever are screening companies for ESG criteria when making investment decisions.
• There is increasing academic evidence to suggest a link between strong ESG performance and higher investment returns. The share price performance of sustainable companies tend to outperform their less sustainable counterparts.

Strong ESG performance is therefore increasingly becoming a material factor influencing asset valuations and investment decisions. Those companies that do not take steps to implement good ESG performance face a number of risks including reduced access to capital, reduced longer term operational and financial performance, reduced shareholder returns, reputational damage and employee and stakeholder dissatisfaction.

Implementing ESG

Given the importance of ESG, companies cannot afford simply to treat this as a box ticking or window dressing exercise.  Instead, companies should be developing their ESG policies and procedures and factoring ESG criteria into their decision-making processes and procedures across all levels of the business.
However, companies face a number of challenges when it comes to implementing ESG including the following:

• The ESG landscape is constantly changing and there are a multitude of voluntary ESG frameworks and increasing numbers of mandatory reporting requirements that are being implemented across different jurisdictions. This lack of standardisation means that companies face a daunting task to navigate through the different standards and effectively prioritise issues that are material and relevant to the business.
• Investors increasingly want to see companies measure ESG data which can then be compiled into annual reports from where, in turn, ESG data providers can extrapolate the data and generate ESG ratings. However, given the current lack of standardised reporting and data collection standards, there are challenges around the quality, consistency and reliability of the ESG data that companies collect.  
• Smaller companies face additional challenges, as they will not have the same level of financial and operational resources and sophisticated data collection systems that larger companies have. Smaller companies may therefore initially need to rely on support from external ESG consultants and data collection tools.