Environmental, social and governance (ESG) factors – non-financial factors that influence the value created by companies – have become increasingly important in recent years. Sustainability factors are now taken into consideration alongside traditional financial analysis of companies by investors, with climate change and social inclusion key considerations. But how can ESG be incorporated into company strategy and operations? Trialogue Head of ESG Advisory Matthew le Cordeur investigates the trajectory of ESG considerations, from reporting through investing to embedding, and analyses how value creation for all stakeholders occurs when companies go beyond compliance.
The changing ESG landscape
ESG factors are used as an investment lens to enable capital providers to assess a company’s likelihood of creating, preserving or eroding short-, medium- and long- term enterprise value creation, as well as the impacts companies have on the world. By understanding the long-term resilience of companies, investors are better able to allocate their capital using industry-specific evaluations of ESG risks and opportunities, and forward-looking impact scenarios.
Socially responsible investing, which preceded the concept of ESG, gained global traction in the 1960s, when investors responded to the Vietnam War (against investing in defence contractors), Apartheid in South Africa (any business associated with doing business here), and ‘sin’ stocks that were seen as unethical, such as alcohol, gambling and tobacco. However, there were no clear metrics or frameworks in place to monitor or measure sustainability across sectors or regions.
This changed in 1997, when investors and environmentalists came together in response to the 1989 Exxon Valdez oil spill to launch the Global Reporting Initiative (GRI). The aim was to “create the first accountability mechanism to ensure companies adhere to responsible environmental conduct principles”, which expanded to include ESG issues. This became – and remains – an important guiding framework for companies to manage and measure their sustainability factors and report publicly on their performance.
The concept of ESG was introduced by the United Nations (UN) Global Compact in a report titled ‘Who cares wins’ (2004), in which the organisation urged companies to integrate ESG factors into investment decisions to support the implementation of the Global Compact principles. ESG issues were then included in the 2006 UN Principles for Responsible Investment (PRI) report, where ESG criteria were required by companies.
The Global Compact report cited the Johannesburg Stock Exchange (JSE) as a leader in the field, as it was the first emerging market and stock exchange to launch a Social Responsibility Index in 2004. This index assessed JSE-listed companies in the FTSE/JSE All Share index against ESG and economic factors every year. The methodology matured over time, taking into consideration global and local advancements in sustainability codes, standards and principles, including revisions to the King report (King III in 2009) on corporate governance. The index was replaced by the FTSE/JSE Responsible Investment Index in 2015, when the stock exchange partnered with global ESG index provider FTSE Russell.
Examples of ESG issues (common issues measured by Refinitiv, MSCI, Bloomberg, FTSE):
Environmental | Social | Governance |
Resource use | Workforce | Corporate governance |
Carbon emissions | Human rights | Corporate behaviour |
Climate change effects | Discrimination | Executive compensation |
Pollution and waste | Diversity | Shareholders’ rights |
Renewable energy | Community relations | Independent directors |
Resource depletion | Political contributions | Management |
Environmental opportunities | Product responsibility social opportunities |
These developments were critical for the ability of stakeholders to measure and monitor ESG performance in companies. The connection between companies that were not managing their ESG risks and value erosion soon became evident. Fifteen out of the 17 S&P 500 bankruptcies from 2005 to 2015 were in companies with poor ESG scores five years before these events, according to the Bank of America Merrill Lynch. It found that major ESG‑related controversies by large US companies resulted in the erosion of half a trillion dollars in market capitalisation between 2013 and 2019.
ESG growth
When the UN PRI launched its ESG criteria in 2006, 63 investment companies signed up with $6.5 trillion in assets under management incorporating ESG issues, according to Forbes magazine. By 2021, it had 5 000 signatories with about $120 trillion in assets (see graph below).
While the above graph highlights total assets under management of PRI signatories, it does not specify the value of assets that aligned to ESG principles. Data from Bloomberg Intelligence shows this more clearly. In 2016, global ESG assets under management stood at $22.8 trillion, ramped up to $30.6 trillion in 2018 and surpassed $35 trillion in 2020. Bloomberg Intelligence predicts it may go over $41 trillion in 2022 and then hit $50 trillion by 2025, which would make up one-third of all assets under management.
While ESG started in equities, sustainable debt has increased exponentially, with issuance exceeding $1.6 trillion in 2021, according to Bloomberg Intelligence data, which states that the transactions bring the total market to more than $4 trillion since inception. South Africa has also seen an exponential rise in sustainable bonds, rising from R1.5 billion in 2014 to R13.8 billion in 2021, according to Prescient Investment Management.
Driving growth in ESG investments includes a demand by investors for ESG funds; technology-based product innovation that assists fund managers in assessing ESG performance in companies; maturing investment research frameworks focused on sustainable outcomes; new risks and opportunities emerging from the energy transition; and an increase in policy interventions at global and government level, according to JP Morgan.
In South Africa, ESG performance has been linked to better gross returns and investment performance for leaders in the space. Between 2007 and 2022, large and mid-cap JSE-listed companies on the MSCI South Africa ESG Leaders Index consistently outperformed their peers in terms of gross returns.
The FarSight ESG Leadership Quality model’s assessment (see graph below) shows that companies scoring in the top quintile of their index improved their share price by 190%, while the bottom quintile lost 48% over four and a half years. “It shows that firms with good leaders (that respond to ESG) typically outperform those with poor leaders,” according to FarSight.
A meta study, which analysed the results of over 2 000 studies on the impact of ESG propositions on equity returns, showed that 63% of companies that “paid attention” to ESG saw an increase in
value creation, according to McKinsey.
The PRI says benefits include top-line growth providing greater access to resources, operational efficiencies and cost reductions through lower energy consumption and water intake, regulatory and legal interventions that can lead to deregulation and a licence to operate, productivity uplift through better attraction and retention of employees, competitive brand positioning and reputation, investment and asset optimisation, and risk reduction.
ESG assets in South Africa are made up of companies in the financial sector (37.21%); materials such as mining and gas (18.58%) and the consumer sector (17.63%), according to the MSCI South Africa ESG Leaders Index.
A key driver of ESG performance in South Africa is a focus on diversity and inclusion principles, according to Refinitiv, a provider of financial markets data. Their index shows that funds focused on diversity and inclusion have outperformed the market over time, with the former seeing annualised returns over five years of 6.56% compared to 4.65%.
Criticism of ESG
Criticism of ESG focuses on the inconsistent implementation of ESG frameworks and the ability of big companies to overreport and thus receive better ESG scores. There is also an argument that financially material ESG matters are already factored into a company’s strategy to maximise financial return, and so a focus on
ESG is not required.
These points are supported by evidence that the market capitalisation of all ESG scoring companies represented 78% of the total market capitalisation in the world in 2020: 95% in the US, 89% in the EU and 78% in Japan. According to a 2020 Organisation for Economic Co-operation and Development (OECD) report entitled ‘ESG Investing: Practices, Progress and Challenges’, this highlights a bias towards large, capitalised companies, who are more in tune with fund managers’ ESG requirements and “have ample resources to invest in disclosing information concerning their ESG scores”.
Cases relating to corporate governance failures have dented the image of ESG. In South Africa, examples include Steinhoff and Tongaat-Hulett, both well-respected JSE-listed companies. At Steinhoff, “weak accountability and a culture of highly creative accounting meant that many dubious investment deals, excessive debt levels and the poor financial performance of several of the businesses went undetected for a long time”, according to a USB Management Review special report in 2018. At Tongaat- Hulett, executives cooperated to backdate land sale agreements. “The backdated sale agreements … resulted in the company’s profits being overstated over a number of years. This led to the loss of value to our shareholders and many of our other stakeholders.”
The ability of companies to seemingly manipulate the system has resulted in a high inconsistency when comparing ESG ratings to companies’ market performance, according to South African ESG research firm FarSight, which focuses its research on determining a leadership score for ESG issues.
Instead of weighing ESG issues by the negative impact they cause, the FarSight ESG model recognises the harm caused, but assigns weight only by the extent to which society can impose costs on the business for incurring that harm. “It is up to society to recognise the increase in harm and advocate for more responsible management through, for example, taxes, legislation or falling demand,” FarSight’s Rob Worthington-Smith has pointed out in the Financial Mail.
Double materiality and changes to codes, standards and regulations
While ESG requires a focus on material issues, there has long been a bias on a company’s ability to remain financially sustainable and profitable. The criticism of this bias has seen a shift to recognise material issues that impact people and planet. The response includes a focus on double materiality, which is the union of impact materiality and financial materiality. Impact materiality focuses on ESG issues that have an impact on people or the environment, while financial materiality focuses on ESG issues that could trigger financial effects. This shift comes at a time of regulatory change, as well as a consolidation and enhancement of codes and standards.
In 2022, the Sustainability Accounting Standards Board (SASB), Integrated Reporting Framework, CDP and Climate Disclosure Standards Board (CDSB) were consolidated and incorporated into the International Financial Reporting Standards (IFRS) Foundation to support the new International Sustainability Standards
Board (ISSB).
These frameworks’ principles and metrics have been used in the development of the ISSB’s draft IFRS Sustainability Disclosure Standards, as well as the Climate-related Disclosures, which draws on the Task Force on Climate-Related Financial Disclosures (TCFD) recommendations. The above bodies, frameworks and standards
all focus on ESG’s enterprise or financial materiality, representing investor-focused capital market standards.
The GRI, which focuses on the impact materiality of ESG, and which is designed to meet multi-stakeholder needs, formed a partnership with the IFRS Foundation in 2022 to coordinate their work programmes and standard-setting activities.
South African listed companies are bound by the JSE Listings Requirements, which require adoption of the King IV Report on Corporate Governance for South Africa (King IV) and adherence to the Companies Act. King IV stipulates that companies should produce a report following the Integrated Reporting Framework. As the IFRS Foundation’s standards are seen as a building block approach, South Africa will likely retain its format of
Integrated Reporting.
Locally, many asset managers and asset owners are signatories to the Code for Responsible Investing in South Africa (Crisa), which was launched by the Institute of Directors South Africa in 2011. Organisations such as Just Share has criticised the code for not holding the sector accountable for poor ESG outcomes.
Crisa 2, which was released in September 2022 and comes into effect in February 2023, has a greater focus on ESG outcomes. Companies will now be required to show how their ESG inputs create positive ESG outcomes, with a focus on ESG integration, diligent stewardship, capacity building and collaboration. While this is a step in the right direction, the fact that the code is still voluntary means it will still face the same criticism that it doesn’t enable accountability.
While companies are free to choose from the above codes and standards, the JSE released its own sustainability disclosure guidance in June 2022, which takes a double materiality approach, fusing the ISSB-based standards with the GRI, as well as incorporating guidance from other stock exchanges globally. While the guidance is voluntary, the document provides companies with a chance to get their house in order, in case any of the global standards do become compulsory. This move follows a global trend of stock exchanges developing guidance.
In August 2022, the China Securities Regulatory Commission (CSRC) published voluntary ESG reporting standards that broadly align to the ISSB’s standards, according to Bloomberg.
Globally, the US Securities and Exchange Commission (SEC) and the EU’s European Financial Reporting Advisory Group (EFRAG) have published proposed sustainability disclosure rules that are undergoing public consultation before the rules are adopted. The SEC issued a proposed climate disclosure rule that would require nearly all companies filing with the SEC to report on their climate-related risks, while EFRAG released guidance as part of the EU Corporate Sustainability Reporting Directive (CSRD).
Stakeholder activism
The non-profit sector and shareholder activists have played a growing role in advancing the focus on ESG from an impact materiality perspective, through annual general meeting proxy engagements, shareholder proposals, regulatory complaints and litigation.
Shareholder resolutions in the US, which aren’t legally binding, have seen an exponential rate of success. ESG resolutions passed at US companies increased from 5% in 2018 to 22% in 2021, according to RBC Capital Markets. According to the International Financial Law Review, this was made up of 800 shareholder resolutions in 2021, “with the majority of these focused on diversity and climate change as opposed to traditional areas like governance, financial performance, and strategy”.
In South Africa, organisations like Just Share, the Centre for Environmental Rights and the Raith Foundation have made significant impact on ESG outcomes. While there was a focus on remuneration and board composition for a number of years, organisations and individual activists such as Theo Botha have brought climate change to the top of the agenda at companies like Standard Bank and Sasol, pressurising the companies to better disclose and manage climate impacts going forward.
The stakeholder activist ‘toolkit’ that has enabled this progress is now being adopted by institutional investors, who are using them methodology to improve ESG performance within their portfolios, according to Herbert Smith Freehills.
Litigation is also on the rise. For example, climate change litigation is moving to the top of corporate risk registers, according to law firm CMS, adding that NGOs are using litigation to force corporate and governmental adherence to ESG regulations, targets and principles. “Climate change claims have now been filed in over
40 countries,” CMS pointed out.
From glossy reporting to integrated thinking
The evidence outlined above indicates that an integrated thinking approach to ESG has positive outcomes for value creation. However, many companies view ESG as part of corporate reporting, which often falls under the spotlight of public relations and marketing departments, who are sensitive to bad press and naturally averse to self-disclosure of poor practice. ESG issues reported are not always actively managed, leading to reporting that defers to qualitative descriptors, inconsistent measurement standards and sporadic data.
What remains lacking is the widespread consistency of credible balanced reporting that is trusted and used. Investors and other stakeholders need to look beyond noble policies and stated intentions and push for hard comparable numbers that show relative strengths and weaknesses in performance. We need to move from tick-box analysis to interrogation of the facts, so that poor performance and ESG risks are exposed, while good performance is recognised and rewarded. This is not only important from an investment perspective but necessary if business is to gain the trust of all of those interested and affected by its operations.
Corporate reporting has primarily been relied on to demonstrate transparency and responsible business practice. But this is tantamount to putting the ‘cart before the horse’. In the financial world, strategy and action come first and reporting profitability follows. The world of ESG should be no different. In principle it is simple. An integrated thinking process flows from an understanding of the operating context and material impacts on
society, which is then backed with a mandate from leadership to invest and respond in a responsible manner. Systems and structures then build accountability, with metrics and action to drive change. This then culminates with a process of tracking and managing performance. Only then should the focus fall on communications and reporting.
While this sounds intuitive, and indeed it is, our work in the, ESG field has uncovered a frenzied patchwork of activities, undertaken in no structured order, stirring up froth and yielding underwhelming results. We see adoption of codes and standards without an understanding of business rationale, graphic business models that play no actual part in business planning, reporting to committee structures on items that have little relevance or in ways that make proper oversight near impossible, and award-winning reports that disguise corporate malfeasance. The next frontier of the world of ESG reporting has to be founded on true integrated thinking. It is a conceptually simple process, but complex and lengthy in implementation
Adapt or cease to thrive
Equipped with better resources to understand ESG performance, providers of capital are taking action against companies who demonstrate poor management of sustainability factors, or who have not adapted their business model to either improve their impact or limit their damage on people and planet. Those who are left behind will feel the pain financially and will increasingly lose out on opportunities linked to ESG factors. They will also face legal and regulatory penalties, both from governments and activists, which will impact their reputation, and their bottom line.
While the turbulence of the transition of companies moving from a profit-centric mindset to one that focuses on profit, people and planet has alarmed many companies, the journey going forward should not be complicated. There are practical steps using Trialogue’s integrated thinking principles to assess, plan and move forward with intent, in a way that is sustainable to the company and the world around us.
Further reading:
- Boffo, R. and Patalano, R. (2020). “ESG Investing: Practices, Progress and Challenges”, OECD Paris.
Accessible at: https://www.oecd.org/finance/ESG-Investing-Practices-Progress-Challenges.pdf - The Evolution of Sustainability Disclosure, 2022. Accessible at: https://www.sustainability.com/globalassets/sustainability.com/
thinking/pdfs/2022/comparing-the-sec-efra-and-issb.pdf
Source: The Trialogue Business In Society Handbook 2022 (25th edition)