For those who don’t know ESG from MSG, this short history on how the Environmental, Social and Governance (ESG) investment began might be a good place to start.
Famed anthropologist Margaret Mead once said: “Never doubt that a small group of thoughtful, committed citizens can change the world; indeed, it is the only thing that ever has.” Like Ms. Mead, a company or organization that is ESG compliant is part of a community of committed, forward-thinking people that are trying change the world for the better.
It is no longer new news to learn that the ever watchful eye of business and market tremors, corporate and institutional investors are starting to pay close attention to environmental and socially responsible issues. In fact, a significant cross-section of the investment community is now beginning to put its money in companies that are significantly upping their ESG compliancy efforts.
Nonetheless, we understand the frustration that comes with getting a new questionnaire or ESG rating in your inbox every day and not knowing if this one is more important than the ten others from last week. Not to mention, how do you really know these impact decisions from your current or potential shareholder base?
Let’s go back to the beginning to get a better handle on all (important) things ESG.
What is ESG Compliance and Why is it Important?
The term Environmental, Social, and Governance (ESG) first came out a study, entitled “Who Care Wins” in 2005. ESG is a set of standards that puts compliant firms on a higher ethical and eco-friendly commitment to society at large. This “higher pledge” includes: fair and responsible treatment of customers and electing non-corrupt leadership, open and collaborative work environments, and above-average recycling and green initiatives.
Taking this “higher pledge” to the next level, the Principles of Responsible Investment (PRI) created its own Task Force on Climate-related Financial Disclosures (TCFD) criteria to translate climatic data into tangible financial metrics. In addition, over 7,000 corporate signatories in 135 countries are on board with the priorities of PRI. Founded by former UN Secretary General Kofi Annan, PRI’s TCFD is a voluntary series of climate-related recommendations based on four categories: governance, strategy, risk management, and metrics. Over 500 corporations and financial institutions (with combined assets of nearly $100 trillion) publicly support TCFD’s initiatives in the marketplace. Our own research here at Clermont Partners supports the forward-thinking corporate and institutional support for the goals of TCFD.
While the “E” (for “Environmental”) pillar in ESG gets most of the attention in the press and elsewhere these days, the “S” (for “Social”) pillar is of equal importance. Investopedia defines the “social” component of ESG in relation to a company’s corporate history as “how it manages relationships with employees, suppliers, customers, and the communities where it operates.” Good “social” metrics include: consistency in progressive corporate values, ethnic and gender diversity in the boardroom, percentage of profits that contributed to the local community, level of employee volunteerism, and improvement in employees’ health and safety due to working condition upgrades.
How Does ESG Compliance Align with the Investment Community?
For prospective progressive-minded investors that are seeking to put their cash into companies that are doing good works, this set of standards can be very important. In fact, many mutual fund managers and noted brokerage firms offer specific investment packages which include these ESG-approved companies. Another reason these highly rated ESG companies are attractive to investors is that ethically and environmentally dubious firms are more likely to be vulnerable to lawsuits and other types of pricey litigation.
Investment in ESG companies and organizations seems to be growing steadily. According to a recent report, in 2018, investors held $11.6 trillion in ESG-compliant assets, which was up from $8.1 trillion just two years earlier. According to Morningstar, sustainable fund inflow totaled $8.9 billion in the first half of 2019, which greatly exceeded the $5.5 billion net flows for the entirety of 2018. Another Morningstar article states that there are 351 open-end and exchange-traded sustainable funds (equity, fixed-income, allocation, and alternatives) currently available, with record consecutive growth in net flows three years running.
Our own research here at Clermont Partners indicates that 67 percent of our investor respondents say that they consider a good ESG rating to be an important factor in making investment decisions, which was up from 47 percent just a year earlier.
The Battle for ESG Compliance Supremacy
But with the growing popularity of ESG investments, comes the inevitable competition between rating entities to define what specific factors make up what it means to be “ESG compliant.”
Here are the players you should know:
Last year, S&P Global launched its own “ESG Evaluation” criteria. “Our ESG speaks to the evolving view of ESG as a critical contributor to medium and long-term value creation for companies,” says Susan Gray, Global Head of Corporate and Infrastructure Ratings, S&P Global Ratings. S&P’s “Risk Atlas” evaluates environmental and social risks on a scale of 1 (low exposure) to 6 (high exposure).
MSCI (formally Morgan Stanley Capital International), a publisher of global financial indexes and analysis, has four distinct ESG indexes that create benchmarks to weigh ESG values of a specific company verses the financial objectives of individual (or institutional) investors. In fact, MSCI is the fastest growing creator of new ESG indexes, to meet the growing demand of investors seeking to invest in index funds, exchange-traded funds (ETF), and 401k funds that reflect ESG values, and project a genuine and intentional social conscience. In 2017, the firm launched MSCI ESG Metrics, a new tool that measures environmental, social, and governance data for 8,500 companies worldwide, reflecting the growing demand for ESG policy-driven investments.
Another firm, Sustainalytics launched its own ESG “Risk Ratings” system, which quantifies five levels of risk: negligible, low, medium, high, and severe, which can be used for “investment analysis, index and fund creation, voting and engagement, and screening and benchmarking.” Major institutional investors, such as Putnam, State Street Global Advisors (SSGA), T. Rowe Price, and others has publicly disclosed that they use Sustainalytics data.
Then there is ISS, which now has a suite of ESG ratings products that range from company-specific scores to sustainability bond ratings and carbon risk ratings. The ESG Corporate Rating is similar to that of MSCI and Sustainalytics’, where analysts review a company’s ability to manage ESG-related issues. ISS is a SASB Alliance Organization Member, in which,” ISS ESG aims to educate asset owners and asset managers on the importance of ESG materiality and the inclusion of performance information for a successful ESG integration.”
The Global Reporting Initiative (GRI) is another international organization that helps businesses and governments better communicate their individual initiatives pertaining to climate change, human rights, and fighting corruption. Launched in 2000, GRI’s ESG reports are widely distributed to multinational corporations and organizations, governments, NGOs, and industry groups in over 90 countries.
The Carbon Disclosure Project (CDP), a non-profit organization based in the United Kingdom, has been collecting ESG data on over 6,000 companies who publish their environmental actions via public records. Founded in 2002, CDP’s motto is “Disclosure. Insight. Action.”
Founded in 2011, the Sustainability Accounting Standards Board (SASB) is a non-profit organization that solicits input from both businesses and institutions to develop solid social and environmental accounting standards for disclosure as it pertains to publicly traded U.S. companies.
United Nations Global Compact, which was first announced in 2000, is a non-binding pact which encourages global businesses to adopt environmentally and socially friendly policies. The plan is based on ten simple principles, centered on human rights, labor, environmental, and anti-corruption benchmarks. Presently, over 12,000 companies in over 160 countries have signed onto these principles.
RobeccoSAM is an international organization that focuses on sustainability investments in clean water, renewable energy, climate control, eco-friendly agriculture, with an emphasis on healthier living. Founded in Zurich, Switzerland in 1995, the firm’s private equity funds invest in green energy generation and storage, clean water and air technologies, pesticide-free agriculture, and recycling industries. Moody’s and Fitch – move over!
Which ESG rating entity gives my business the best bang for the buck?
If the corporate stakes weren’t so high, just aligning a firm with one or two of these ESG rating organizations might be enough. But with investors stating loudly that they categorically want to invest with forward-thinking, environmentally and socially friendly companies, the stakes have gotten much higher – hence, the increased number of agencies and participants. Each of these ESG firms have different priorities and competing agendas, but are to date, utilized by both active and passive investors when making buying and selling decisions, so having a pulse on them all is important as you create an ESG program that is right for your business.
Now What Do I Do?
The short answer is…you need to do what works best for you and your company’s long-term business goals. Consider these players when building your ESG program, yes, but make sure you don’t lose sight of the core of your business and the material environmental and social impacts that could influence its long-term success. If you do this right, not only will you be looking out for the best interests for all of your stakeholders, but your firm will be much more attractive to ESG minded investors as well.
If you’re ready to start building an ESG strategy best for your business, the advisors at Clermont Partners are ready to help. Contact us today to learn how we can guide you in effectively communicating and getting credit for the environmental, social, and governance practices that investors care most about.