There’s a slow but steady change afoot in the investment world, namely an increasing awareness of, and interest in, environmental, social and governance (ESG) factors as investment-relevant indicators of management quality. Some companies acknowledge this shift but many still believe that ESG factors are only of interest to specialist ‘sustainability’ investors.
They are wrong. An emphasis on investing for the long term, changing client and societal expectations, and better data, reporting and research have all influenced a steady mainstreaming of ESG considerations by investors. We expect this to gain momentum, which has implications for boards.
The ESG lens
Like the rest of the business world, the investment profession has its own language. In the case of ESG considerations this has created a language barrier between investors and companies. Most companies would not talk about their ESG risks and opportunities. Governance – how the company is led and managed – has long been accepted as an area of interest to, and for discussion with, investors given its clear influence on long-term shareholder returns. But ‘E&S’ is not how business leaders necessarily think about their day-to-day activities. They are more likely to talk about strategic and operational factors, some of which may have an environmental or social component.
For example, a company whose production process is heavily dependent on water and which is operating in a water-distressed location is going to invest to ensure its production is as efficient as possible. This is not necessarily in response to environmental concerns but because of the business reality that water scarcity challenges its ability to operate. The mainstreaming of ESG factors reflects an enhanced awareness investors have of the impact such considerations can have on long-term financial returns because the companies that manage them well generally have high-quality management striving for operational excellence.
What’s driving the change?
Investors are data-driven. The many initiatives focussed on increasing corporate transparency of ESG factors have improved the availability and quality of the information for investors. Those such as the Global Reporting Initiative and the International Integrated Reporting Council provide a framework for reporting that provides comparable, quality data over time. That has further prompted investment research providers to create ESG-oriented reports and tools for their clients. As corporate disclosures have been repackaged to be readily used in investment decision-making, and technology makes other public data more accessible, it has become clearer to investors how to use ESG factors in assessing management quality.
Despite these developments, the quality of reporting by most companies falls a long way short of providing a clear narrative of the strategic and operational impact of the relevant ESG factors inherent in a business. The regulatory framework for such reporting is piecemeal, inconsistent across markets and seldom enforced. There is no globally recognised reporting framework comparable to the International Financial Reporting Standards, resulting in a laissez-faire approach. It took decades to establish a robust financial reporting framework. The work of the Sustainability Accounting Standards Board, among others, to create a comparable system for corporate reporting of relevant, sector-specific ESG factors means we should expect investor use of such data to increase as quality improves.
How do investors factor in ESG?
Investors will have a range of approaches to how they factor ESG considerations into their investment strategies. At BlackRock, we have three main approaches – impact investment strategies, ESG integration and stewardship.[1] We offer clients who have clear objectives for investing for both financial and E&S outcomes a set of specific investment products that are constructed to meet that end.
To enable investment analysts on our active portfolios to take relevant ESG factors into consideration in their investment analysis, we have integrated ESG data into our risk and investment management platform. That data, corporate reporting and third-party research is also used by our investment stewardship team to engage with companies on their governance and how they manage the environmental and social risks and opportunities in the business.
The implications for directors
The likely implications for directors are three-fold:a greater need to understand operational excellence as it pertains to ESG factors, a stronger focus on ESG reporting, and a different set of skills required in the boardroom.
The role of the corporate board director has evolved steadily over the last few decades. The focus on corporate governance, often spurred by the implementation of market-level codes, has led to increased expectations and scrutiny of directors. A recent survey of US directors indicated an average annual time commitment of about 250 hours per board.[2] This is likely to increase, as only 41 per cent of respondents felt that their board was strong on addressing long-term risks related to economic, technological, geopolitical and environmental trends.
If investors are monitoring corporate performance on ESG and other factors that have an economic consequence in the long-termer, directors will need to have a deeper understanding of how these factors are being managed. Among other things, this may require site visits, additional board meetings with a focus on those factors so directors can hear from operational management about how they are being addressed, or the formation of a dedicated board committee. Directors might also seek out the research that investors are using to assess performance on the ESG factors relevant to the company and ensure they understand how it is used by investors and how management views the analysis.[3]
Directors need to be more focussed on the quality of corporate reporting on ESG factors. Done well, such reporting should provide a strategic narrative around ESG factors, supported by data, that explains for investors the business risks and opportunities and
how these impact operations, strategy and long term financial returns. Directors should also ensure that the board has a crisis response plan consistent with supporting management to remedy adverse events.
“THE QUALITY OF REPORTING BY MOST COMPANIES FALLS A LONG WAY SHORT OF PROVIDING A CLEAR NARRATIVE OF THE STRATEGIC AND OPERATIONAL IMPACT OF ESG FACTORS INHERENT IN A BUSINESS”
A heightened focus on ESG factors may also affect board composition. Directors need to be fluent enough in the issues to oversee and counsel management. Fluency will also be expected by investors interested to engage with directors to understand how the board oversees and counsels management on key strategic and operational decisions that have a social or environmental component.[4] Directors should bring a range of skills and experience to the boardroom. However, just as there is now demand for experienced business leaders with cybersecurity knowledge to join boards, it seems likely that demand will increase for directors with experience of E&S factors, such as supply chain control, climate risk or human capital management. Those boards that don’t currently have sufficient expertise on relevant E&S matters may need to undertake a comprehensive evaluation and succession exercise to remedy the shortfall.
Anticipating the future
Boards play an important role in shaping the long-term economic success of companies. With a greater scrutiny of how companies do business, board directors will need to demonstrate that they are savvy about ESG factors. As in many significant shifts in practice over time, the pace of change seems painstakingly incremental until suddenly everyone is of the view that ‘we’ve always done it this way’. The adoption by investors of ESG factors as indicators of management (and board) quality is slowly gaining momentum. Directors who anticipate this change and ensure that they and their boards are prepared for it will be doing themselves and their companies a great service.
Footnotes:
2. PwC, The Swinging Pendulum: Board governance in the age of shareholder empowerment, October 2016.
3. For examples, see research from MSCI ESG Manager, Sustainalytics, UBS, HSBC (on climate especially), GS Sustain or Bank of America Merrill Lynch.
4. For more on board engagement on ESG matters, see www.ceres.org/resources/reports/view-from-the-top-how-corporate-boards-engage-on-sustainability-performance
