May 25 2020
There used to be a time in which an investor’s main objective was to maximise the return on their investment without any regard for factors concerning the environment (E), social (S) matters, or governance (G). These times are over.
Now there is an increasing awareness of these so-called ESG criteria among the general public and it is thus not surprising that this awareness is reflected in people’s investment choices. Asset owners want to know where their money is going and they are holding companies accountable for the way they do business. For example, a 22-year-old teacher whose money is invested in a pension fund wants to ensure that by the time he or she retires the world will still be intact and their money will still be worth something.
This development in turn makes asset managers rethink their investment strategies. This global trend towards a more sustainable finance industry is not only driven by pressure from the asset owners. Nowadays, there is wide agreement among experts that paying attention to ESG is an essential part of effective risk management since it reduces the risk of interruptions in the supply chain caused by environmental disasters or social unrest. Therefore, asset managers factor in ESG risks in their assessment of a company. Lower ESG risk equals lower financial risk and thus leads to more stable and higher long-term returns for investors. For this reason, credible information on E, S and G progresses from corporations is highly relevant not only for equity but also for debt relations.
At the same time, as investors are increasing pressure on companies, governmental regulations regarding ESG are getting stricter and stricter to support the climate goals set by the global community. So, what can companies do to remain on the radar of major investors and to avoid unnecessary fines? Be transparent about their business activities, demonstrate year-by-year progress on ESG and communicate their sustainability strategy clearly. The simplest way to achieve this is a comprehensive ESG-report. However, the majority of companies do not know where to start this process and oftentimes the sustainability reports that are produced lack credible information. In other words, external help is needed.
There is no escape from ESG ratings
There are a number of reasons why ESG-reporting should be a priority for every business. The first and arguably most important one was already briefly outlined above: investors pay attention to ESG scores. So how are a company’s ESG efforts assessed? Most often investors look at ESG ratings compiled by rating agencies like MSCI and Sustainalytics. These rankings are based on how well a company is doing in various ESG aspects and how well they report those facts. This self-reporting is then supplemented by third party information (e.g. media, information published by NGOs). Most importantly, companies are being rated whether they want to or not! Less transparency typically means a lower score which – worst case scenario – can lead to major shareholders divesting. Proactive ESG communication will prevent this from happening and instead lead to a score that truly reflects a company’s sustainability efforts.
Don’t underestimate the significance of proxy advisors
Another aspect particularly relevant for publicly traded companies is the AGM voting recommendation issued by proxy advisors to institutional investors. These recommendations are the result of an analysis of the respective company on the basis of predefined criteria provided by the commissioning investor. As was pointed out above, these investors are increasingly interested in a company’s ESG management so that ESG criteria receive more and more weight in the voting recommendations of proxy advisors. As these recommendations are typically followed in order to avoid unwelcome surprises at the AGM, listed companies are well-advised to ensure regular, transparent and comprehensive reporting on all matters ESG. It would be a big mistake to underestimate the impact proxy advisors have on voting outcomes as they can provide or prevent a majority.
The relevance of ESG for non-listed companies
How does ESG affect non-listed companies and why should they bother disclosing their ESG data? In today’s globalised world, listed as well as non-listed companies are part of the same supply chain. Being ESG-compliant is especially important for suppliers of larger (listed) companies because the latter might insist that all suppliers guarantee (and prove) a supply chain that conforms to ESG norms. If a supplier cannot reliably demonstrate where and how they are sourcing their own supplies and materials, there is a risk they might lose their contract or even worse, become the subject of a boycott.
On top of that, companies without a solid ESG record might struggle to get favourable financing conditions. Due to the lower risk associated with companies with a high ESG score, they will often get better conditions when negotiating loans. A good ESG management can also open the door to completely new financing avenues. In order to finance environmentally-focused projects, companies can emit so-called green bonds which are again rated by rating agencies and incorporated into other green financial products (e.g. green bond indices and subsequently funds and ETFs that map those indices). When communicated properly, these projects can then contribute to a higher ESG score – a cycle that will ultimately lead to better investment rates and a wider range of financing options. For instance, some banks issue sustainability-linked loans whose (lowered) interest rate is linked to the company’s ESG performance.
These are only some of the ways in which companies benefit from good ESG reporting. There is a need for action in the business community and it is important that all companies, listed and non-listed, start communicating their contribution to a sustainable future. ESG reporting is no longer a nice add-on to financial reporting. In successful and forward-thinking companies, the two go hand in hand.