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ESG effect

image credit: ESG capital flows
Chris Parker's picture
Principal Kingfisher Parker

Advisory & projects: Climate action, ESG, environmental markets, renewable energy, sustainability, CSR & conservation. Consultant to companies and nonprofits.

  • Member since 2020
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  • Nov 30, 2020
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When I started talking to people about ESG in 2014 the conversations went much differently than today. Five years ago the responses included “tree hugging”, “feel good” and “underperformance”. Today, it’s “exponential capital inflow”, “alpha generation” and “missing the boat”. Since then a very strong growth of ESG has been driven by investor demand. What began as a way for someone to align their money with personal social and environmental values is becoming an economy-wide comprehensive standard that a company needs to integrate throughout the organization in order to be competitive. A lot of the corporate C-suite have been caught off guard.

 

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Inflows in sustainable funds including ESG

On Wikipedia — “Environmental, Social, and Corporate Governance (ESG) refers to the three central factors in measuring the sustainability and societal impact of an investment in a company or business.”

The three ESG areas are referred to as pillars and there can be dozens of categories inside each. There is no one standard methodology for evaluating the ESG of a company. On the investment side, brokerage research and portfolio managers use different formulas and scorings, sometimes it’s a widely followed service, sometimes it’s proprietary. It’s common for a matrix involving hundreds of metrics, ratios and weightings to be reduced to a single ESG score on a company. These scores can be compared to closest peers, across a sector or an entire market. People always like to create and look at lists of rankings, so that’s usually the next step.

Executives and decision makers at companies that are getting evaluated, need to understand the different inputs to an ESG score and the increasing variety of ways their business is affected.

What’s inside?

Environmental — Probably the lead issue in all of ESG has been a company’s carbon emissions because of the direct connection to climate change and its “relatively” simple quantitative measurement. You are counting molecules of CO2 or another GHG. As ESG evolved, a comprehensive list and use of metrics has sought to show a company’s impact to the planet — landfill waste, water, plastic, paper, recycling, renewable energy, green financing, sustainability in the supply chain. A company’s progress and process for improvement can also have weight in an ESG score. An important emerging issue for ESG is biodiversity. What is a company’s operational impact to biodiversity? Today there is not an effective way to measure and report on this issue in a corporate format, but it’s on the way.

Social — 2020 lit a fire under S after the E usually got more attention. The effects of Black Lives Matter and COVID-19 have quickly swept through corporate policy on D&I (and the training for it), contribution to social equity, family wellness, leave flexibility & healthcare.

A lot of societal issues get evaluated; international human rights, access to career development and mobility, investment in communities, product and workplace safety, customer data privacy, paternity leave. An analyst can keep digging and digging to try and see how a company can help or hurt employees, consumers and society at large.

Governance — Ideally most of the G issues should be pretty boring, because when it’s not, a company may have a big problem. Probably the biggest case study during the era of ESG is when the fake account scandal blew up at Wells Fargo. The bank, which has an investment management division that does some ESG work, was fined hundreds of millions of dollars, lost a lot of customers and trust, resigned the CEO and fired 5300 employees after creating millions of unauthorized accounts. It was a governance failure at multiple levels across different divisions. The aftermath has plenty of social effects too.

A company wants governance policies and processes in place so it’s compliance and legal news feed is boring. It wants a diverse and independent board, a grievance mechanism free from fear of retribution, progressive shareholder rights, fair wage gaps, justifiable executive compensation, transparency in lobbying and public policy engagement and a structure to create and uphold ethical business practices and culture. Keep G out of the news.

The ESG effect

Shareholders, customers, lenders, employees and other stakeholders are telling companies how they want them to operate. Corporate leaders can proactively or reactively embrace the adoption and integration of ESG through their business or not. The effect of avoiding what the marketplace is telling them will always be the same — obsolescence.

 

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U.S. financial asset growth & ESG

“Those companies who are more and more focused on ESG strategies and stakeholder capitalism, they’re trying to get a higher P/E than some of the companies that are in denial.” Larry Fink, CEO of BlackRock Inc.

Shareholders are owners and they are increasingly voting for companies to act on climate, social equity, family health, conservation, transparency, accountability and stranded asset risk. Sometimes it’s to have company policy align with their values, but the real force is because of shareholder financial prudence. ESG is risk management. Institutional investment managers today are organized, loud and voting about the companies that they own to take verifiable action on ESG issues.

Customers also vote with their spending. 77% of consumers prefer to purchase from brands that prioritize efforts to fight global warming over brands that do not. — Sofidel, 2020. 81% of consumers feel strongly that companies have a role to play in improving the environment — First Insight, 2020. This part of the ESG effect is quickly understood in the head of sales.

ESG scoring is starting to be used by creditors and lenders in providing companies access to capital. The effect of a lower ESG rating might result in less favorable financing terms as the lending institution evaluates a company’s long term risks.

 

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IPAA member’s ESG webinar

In October 2020 the Independent Petroleum Association of America (IPAA) launched The ESG Center and held a webinar for their members called “Building an Authentic Approach to ESG”. The IPAA took this step because it’s companies are losing access to financing as banks come under increasing pressure from their own shareholders to reduce carbon emissions in their loan portfolios.

ESG is affecting HR departments in a couple of ways; internal and external. Inside — more and more employees are pushing management to make good on sustainability issues and to commit to more aggressive goals. Prior to the pandemic there were high profile public protects at companies like Google, Amazon and Microsoft for bigger and more concrete agendas for climate action. It worked. All of these companies have committed to new goals, including Microsoft’s carbon negative by 2030 program and Jeff Bezos’ recent first round of $791 million in environmental grants. It was a 21st century workers strike for better working conditions. In this case the factory floor is the whole planet.

Outside — For hiring the best young talent, companies need to show that they are actually working to solve many social and environmental concerns. These issues are real factors in Gen Z and millennial decision making for where they want to take their talent. By 2030 these generations should be around 70% of the global population. Take ESG’s original flagship issue, climate change, the younger the employee, the more their life will be affected by it. America continues to be more ethnically diverse, colorful and mixed. Job seekers expect an employer to look that way too.

The effect of other stakeholders — Despite Bank of America’s heavy ESG mandate, both operationally and in offered services, they choose not to pledge against financing oil and projects in the Arctic National Wildlife Refuge. One effect was losing the longtime business of The Conservation Alliance, a nonprofit that supports grassroots conservation across North America. This loss of business won’t make a blip on B of A’s earnings, but the alliance has over 250 member companies (big stakeholders) that include Patagonia, Clif Bar, REI and Under Armour who were all notified of the divorce.

 

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Arctic National Wildlife Refuge — Image: National Geographic

“Disclosing your plans can improve your credit rating, broaden your investor base, reduce your cost of finance, and economise on the fixed costs of meeting increasingly vocal investor requests for information” Andrew Hauser — BoE Executive Director for Markets

As if corporations didn’t already have enough incentive to properly account for and manage ESG risks in order to be competitive, they may have to from the hand of regulation. Recently the U.S. Federal Reserve and the Bank of England have taken significant steps to recognize risks from climate to markets and the financial system and how companies need to communicate these issues.

“It is vitally important to move from the recognition that climate change poses significant financial stability risks to the stage where the quantitative implications of those risks are appropriately assessed and addressed.” Fed Governor Lael Brainard

ESG is in full effect. A company can embrace, ignore or fight it. The marketplace will sort out the rest.

 

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Mapping UN Sustainable Development Goals to ESG pillars

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Matt Chester's picture
Matt Chester on Nov 30, 2020

 Five years ago the responses included “tree hugging”, “feel good” and “underperformance”. Today, it’s “exponential capital inflow”, “alpha generation” and “missing the boat”. 

I love this so much-- how much do you think that change is from new leadership representatives who had that mindset perhaps five years ago, and how much of it is the existing leadership  who has since 'seen the light' and come around? 

Rakesh  Sharma's picture
Rakesh Sharma on Nov 30, 2020

Chris, While the boom in ESG investing is undeniable, the concept itself has some way to go before it can make an actual impact. ESG investing is a pretty good buzzword but I am not so sure if there is much substance to it, in its current form anyway. There are no measureable criteria to quantify what counts as an ESG investment. It is also difficult to assign metrics for ESG investing in companies, especially in developing countries.

The motivations of ESG funds are also subject of debate. Here's an example: https://investor.vanguard.com/etf/profile/ESGV.

The top holdings for this fund are from the tech sector (approximately 30%) and include Microsoft, Amazon, Facebook et al. Whether that investment is driven by their commitment to the environment or social initiatives (the tech sector has pretty much led the way in these initiatives even before they became part of mainstream finance vocabulary) or the prospect of fat profits (valuations in the tech sector have skyrocketed in the last couple of years and during the pandemic) is open to question.

Companies in the energy sector and utility sector, which could make a substantial difference to climate change with increased funding, comprise less than 2% of the fund's holdings. Transportation, another big polluter, does not even find a mention.   

Chris Parker's picture
Chris Parker on Dec 1, 2020

Rakesh, ESG is is a process and can't solve all corporate related issues.  It's been a big step of progress compared to the traditional standard methods.  Thanks. Here is a piece regarding Vanguard.  https://www.bloomberg.com/news/articles/2020-12-01/blackrock-vanguard-sh...

Rakesh  Sharma's picture
Rakesh Sharma on Dec 1, 2020

Chris, my understanding is that ESG funding is supposed to provide companies the means to make a transition to a more equitable and environment-friendly future. But if these funds keep pouring money into stocks of companies that are already ahead on the ESG curve (and have access to tons of cash from public markets due to trillion dollar valuations), then what is the purpose? If you followed the stock market during the pandemic, you'd have noticed that performance of ESG funds mimicked those of companies from the tech sector. ESG is a good concept but I doubt if it is making a substantial difference in its current form. Your link just proves my point. Blackrock CEO Larry Fink wrote a much-covered letter to shareholders at the beginning of this year that stated climate change would mean a "fundamental reshaping of finance." Obviously, that reshaping will take some time. 

Dan Yurman's picture
Dan Yurman on Dec 1, 2020

A key to the credibility of ESG ratings is adherence generally accepted standards for reporting them. For information on these standards, see the Sustainability Accounting Standards Board (SASB)
https://www.sasb.org/ for industry by industry metrics

Rakesh  Sharma's picture
Rakesh Sharma on Dec 1, 2020

Hey Dan, I subscribe to the SASB newsletter but I doubt if they are accepted as an industry standard. But, yes, it is a step in the right direction. 

Dan Yurman's picture
Dan Yurman on Dec 2, 2020

Well ok, technically correct, but from a business perspective, consulting firms that prepare ESG reports for companies can license SASB IP for the purpose of embedding their defintions in the reports.  It goes to credibility if nothing else. Which ESG report would you use - one that used SASB or one that didn't?

Gary Hilberg's picture
Gary Hilberg on Dec 4, 2020

Dan - I am a certified Global Reporting Initiative (GRI) Reporter - which is one of the ESG frameworks.  Currently I am working on two ESG plans for customers.  

I would say that your statement is close to being correct as SASB provides the standards that many investors mandate compliance with when they make material fiancial claims associated with ESG - trying to be like GAP.  One approved SASB method to report the compliance with SASB is through their GRI report which has more categories to report on, GRI & SASB are now working to make their frameworks work together.  Neither of of these frameworks require specific audits or certifications, but they do have mandates or "musts".  There are processes by which companies select their GRI topics and their methods, SASB has industry required topics and are a bit more prescriptive.  But unlike ISO there are no auditors for either GRI nor SASB.  

The SASB refers to the GHG Protocol for the GHG calculations which then is a bit more prescriptive and they do have some calculators to do the GHG calculations.  This should lead to more consistency to the GHG portion of SASB.    

In general the ESG frameworks are about transparency and open reporting not about specific targets.  So just because a company completes a ESG report does not mean they are more OR less "good". They do have to provide management metrics and objectives to improve - they are just being transparent.  The good news is that when the reports are completed properly, all of the data is there relative to their history AND in many cases to their industry.  GRI has an a database of over 35,000 submitted reports, so they are public and this drives some level of integrity.   

Matt Chester's picture
Matt Chester on Dec 2, 2020

Great conversation here-- and some more great thoughts recently shared by Rakesh on the topic here: https://energycentral.com/c/um/esg-investing-change-paradigm-or-business-usual

Mark Silverstone's picture
Mark Silverstone on Dec 3, 2020

Thanks very much for bringing up this subject Chris.  CEO´s often make the mistake that ESG is more about common sense than any “real” discipline.

I would hope that  prospective investors and their advisors try not to oversimplify ESG issues by trying to come up with some kind of simple score to weigh investment decisions. 

Chris is quite correct when he states:

 

What began as a way for someone to align their money with personal social and environmental values is becoming an economy-wide comprehensive standard that a company needs to integrate throughout the organization in order to be competitive. A lot of the corporate C-suite have been caught off guard.

These days it takes a very significant input of resources to accomplish even minimal ESG performance.  Some of the very biggest and brightest of organizations have been exposed as fake “champions” of ESG values. 

 

A series of questions come to mind:

1. What is the purpose of measuring ESG performance? If it is for the purpose of justifying a foregone conclusion, then forget it.  Such is the stuff of corporate disasters. Unfortunately, it is often the case.  For example, internet companies that were keeping the dirty little secret of the power they were consuming, with the resultant GHG emissions,  got caught with their pants down.

2. Against what standards is ESG performance to be measured?  If there is no standardization across companies, then it is unlikely to be a valid and convincing evaluation.  Without standardization, performance measures get skewed toward the optimistic, not the realistic.

3. Is just one aspect, e.g. greenhouse gas emissions, what really matter to the investor? If so,  then they are setting themselves up to getting bitten by another aspect down the line.

 

I suggest that people who are interested in applying ESG standards to companies use recognized tools. One such tool – or suite of tools – is available from the IFC.

IFC and the United Nations Sustainable Stock Exchanges Initiative (SSE) are teaming up with an initiative aimed at strengthening ESG disclosure and reporting requirements for companies in emerging markets—and supporting stock exchanges in these countries as they look to upgrade these requirements.

Adherence to IFC standards may serve as a starting point for evaluating ESG performance.

 

A simple question to ask of any company is to document the extent to which a prospective project adheres to IFC standards in the preparation of ESG Impact Assessments.  Those that cannot answer that question or won´t, should probably be downgraded. 

 

Finally, I would suggest that at the rate times are changing, these IFC standards apply equally to companies operating in any part of the world, not just the developing countries.  It was once possible to assert that companies operating in the Permian Basin of the US  or even on Main Street in the US “automatically” adhere to real environmental, social or safety standards.  The assumption that the US government enforces some standard of ESG performance may once have had some credence.  It is a measure of what has occurred over the last four years that the US no such credence now.  The European countries do have some credence in these areas, though they are far from where they need to be.  For example, at least they are taking seriously the overall role of methane emissions in global warming. Whether or not it will result in action is yet to be determined.

 

In any case, a measurement of compliance with IFC standards would be a step in the right direction for evaluation of a company´s ESG performance..

 

 

Matt Chester's picture
Matt Chester on Dec 3, 2020

The assumption that the US government enforces some standard of ESG performance may once have had some credence.  It is a measure of what has occurred over the last four years that the US no such credence now.

I don't even know how much confidence I'd have 5+ years ago that U.S. companies were required to meet any meaningful minimum standard. There have been plenty of voluntary opportunities, but those who didn't want to spend on ESG goals have long been free to do so, able to redirect those funds to PR to sweep any pesky issues due to that under the rug-- a more affordable proposition! Though hopefully moving forward that will get harder and harder-- both from a regulatory perspective and as investors are moving their dollars around to divest from the worst offenders

Dan Yurman's picture
Dan Yurman on Dec 3, 2020

For a CEO of say a firm with revenue under $500M, getting a tuned up, credible, ESG report, is an open invitation to ESG investors to put money into the firm so tha it can grow, e.g., machinery, hiring, acquisitions, etc. The ROI for investing in an ESG effort is to be more attractive to this kind of investor.  

Gary Hilberg's picture
Gary Hilberg on Dec 4, 2020

Mark - a large number of corporations and entities use the Global Reporting Initiative (GRI) Standards for ESG, as I mentioned in an earlier comment, they are aligning with SASB.  Most ESG reports also work to align with the UN SDG's.  I will look at IFC, see if they align.  To your comment on GHG only, both GRI and SASB have a section for GHG, but is only one of many environmental sections which include materials, waste, water, and many others.  GRI has 33 topic areas with more in the works.  Also many of social and economic sections are just as important - safe work place, living wages ....  

Ryan Kiscaden's picture
Ryan Kiscaden on Dec 7, 2020

Hi - would you be able to provide a higher resolution version of the Figure 1 chart?

Chris Parker's picture
Chris Parker on Dec 9, 2020

Ryan, you should be able to take it from this.  https://chrisparker4000.medium.com/esg-effect-a0962311f8

Thanks  Chris

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