The drive towards demonstrating high standards of ethical conduct in business and a commitment toward sustainability and social justice is sufficiently strong in our society. In fact, firms now feel obliged to respond to this drive.
- An Introduction to ESG
- Factors influencing the ESG movement
- Developing an ESG policy
- ESG and competitive advantage
- The future of ESG
An introduction to ESG
In very simple terms, ESG is an acronym for Environmental, Social and Governance. To better understand what these three components mean for financial firms, we will unpack each of them.
Environmental
This element of ESG is concerned with ensuring investments and operations are geared towards increasing sustainability, reducing pollution through promoting renewable and clean energy sources and reducing climate change and the associated risks.For firms in the financial sector, there are several areas where their activities can indirectly influence these environmental considerations. Banks, for example, could lend to businesses that continue to promote practices that are harmful to the environment.
Another example is the investment management sector. Two challenges could present themselves. Firstly, to maximise returns, they need to consider firms with poor environmental management records or breaches (such as shipping accidents and oil spills). At the same time, investment managers need to respond to the increasing demands of investors for ethical investment options. Socially responsible investors favour businesses with strong environmental management records.
Social
This element describes how businesses support the principles of fairness, diversity, ethics and tolerance both internally and in their business services. Essentially, a firm's social responsibility involves managing its relationships with different parties.
Think about a firm and its employees, directors, customers, suppliers and shareholders—all of these relationships need to be managed effectively to meet differing expectations. Poor corporate practices can include failing to recognise diversity considerations in employment practices, pay differences based on gender, a lack of commitment to media and shareholder relations and poor employee engagement.
These are all signs of a business not managing its social obligations properly. Firms such as these are likely to generate negative media coverage, potentially reduce market values, and are unlikely to attract as much interest from investors and fund managers.
Governance
The concept of corporate governance is not new; however, there is an increasing focus on ensuring governance arrangements are transparent. This increase in holding firms accountable implies that a company treats all stakeholders honestly and fairly.
A well-governed firm demonstrates an ability to maintain a stable board composition and make sensible decisions about its future direction and business growth. This type of firm maintains solid relationships with regulators, avoids regulatory sanctions where possible and generates significant future value. The latter consideration is especially important for investors and managers.
Factors influencing the ESG movement
The pressures on firms to show that ESG is taken into account in their operations can come from many different sources. Some of them are societal, some political, but the major areas of concern for financial services firms are the desires of investors, consumers and regulators.
Investors
In the case of investors, they want to invest with fund managers that can demonstrate they are investing funds ethically. This type of investment is in businesses committed to areas such as preventing climate change and avoiding investment in territories with poor human rights records.
Clients
Clients are also a major driver of ESG. Particularly in the investment industry. Retail and institutional investors look for solutions where value is generated from sustainable businesses. Whilst investors are not prepared to sacrifice value altogether in pursuit of ideals, fund managers understand how these desires are dovetailing with a greater social conscience when it comes to investing.
Regulators
In the case of regulators, whilst there are no specific rules on ESG, firms are finding themselves subject to several disparate requirements in the area of ESG, and these are increasing. Regulators are emerging as one of the main drivers of ESG.
This presents a challenge in the short term since piecing the regulatory requirements together will be a difficult task. It would be easier if they produced an "ESG Rulebook" with all the regulations in one place. With the increased regulatory focus, creating this rulebook is not a bad idea for the future.
Developing an ESG policy
ESG, as a concept, has impacted financial service businesses, and this rate of change has accelerated with the global pandemic. An ESG policy is a documented business approach to ESG issues. This policy needs to be built around the three pillars of ESG, outlining its purpose and responsibility to its stakeholders.
The principles of ESG will likely gather momentum fast. Whether the driver is investor demands, shareholder pressure, or the need to keep up with competitors, ESG will be one of the main factors influencing business change in the immediate future. Therefore, developing an ESG policy is important for business sustainability.
ESG & business
Investors and customers are generally the first drivers for change toward more ESG-focused policies. The trend toward "ESG-savvy" investors is increasing, and fund managers have responded by providing more investment options focused on sustainability and ethical practices.
There has been a significant increase in ESG investing in the UK in recent years. In 2021, ESG assets under management in the UK reached £2.7 trillion, up from £1.7 trillion in 2020. Furthermore, there is no sign that this trend will reverse any time soon, so fund managers continue to add more sustainable funds to their ranges.
As the market develops, fund managers and wealth management firms will find that providing sustainable options that support ESG objectives will be a "must-have" in their client propositions. This will be critical for firms to maintain their competitive position.
Challenges for management
The challenges for managers are not necessarily around selecting businesses and assets that meet the necessary criteria in terms of their environmental and social stances. Investors will not only continue to demand strong returns, but they will expect asset selections for the longer term rather than the short term.
Managers will still need to apply appropriate due diligence to their stock selection processes and avoid picking investments because they meet certain ESG criteria at the time. The key is to avoid creating sustainable funds for the sake of creating them. This ultimately risks failure in a few years due to persistently poor returns.
Another challenge is that not everyone in the industry fully supports the trend toward ESG. There are indeed strong views on both sides of the debate.
BlackRock publicly declared its stance on ESG, stating that the risk-adjusted returns for investors are better using this approach. But some in the industry are sceptical. In one case, a firm described ESG investment as "a complete fraud" (Chamath Palihapitiya, CEO, Social Capital). The root of the criticism is in the subjective nature of ESG stances. Businesses can essentially paint a picture of themselves as ethical and sustainable without necessarily contributing to social and environmental issues such as climate change.
ESG & competitive advantage
When building an ESG policy, firms should consider leveraging the continued growth in ESG awareness.
In other words, can ESG be used to gain an advantage over competitors and play a part in the sustained growth of businesses in the future?
The core question here is: can offering products or investments based on sustainability be a solid foundation for a future business strategy?
The answer lies in whether adopting an ESG stance is done to keep pace with the competition or leveraged to create a genuine distinction between business competitors.
Establishing a competitive advantage
A paper produced recently by Harvard Business Review stated that sustainability practices have a habit of converging over time, making it difficult to stand out from the crowd.
The same paper concluded that such convergence was more likely in industries dominated by social or environmental concerns, as opposed to governance. Therefore, ESG will cease to exist as a distinct concept over time. Instead, it will become a part of the business DNA. However, this does not mean that firms cannot generate short-term benefits by anticipating future movements in investor preferences regarding ESG.
According to research carried out by YPO, in 2020:
- around 2,700 funds classed as "sustainable investments" were available
- in Q2 that year, inflows to these funds rose by 76%
ESG investment is definitely in a growth phase, with the same research showing almost three-quarters of millennials are interested in investing in businesses with the right approach to ESG.
An ESG policy is future-proof
The challenge is to tap into this ESG demand, at least in the short term. For some firms, this may be analysing possible gaps in market propositions relating to ESG, such as in hedge funds or other structured products.
However, potential growth areas could include Real Estate Investment Trusts with a specific focus on social impacts (i.e. the needs of tenants and local communities). Other opportunities could include the continued interest in specialist funds with a particularly narrow ESG focus, such as those promoting low-carbon growth or reducing activities such as deforestation.
Either way, ESG is here to stay. Whether the motivation is a fear of missing out or a desire to build value propositions proactively, firms need to think seriously about how ESG considerations will influence their internal practices and how they position themselves to their investors and their clients.
The future of ESG
Environmental, social, and governance concerns are increasing, and firms are building ESG strategies.
These strategies incorporate addressing climate change concerns more closely, promoting fairness or providing more disclosures in annual reports about these activities. No firm can avoid these three areas.
Society and communities play their part in the drive towards ESG. Business reputations can be affected by engaging in local, national, and global initiatives. The concept of social responsibility is only going to increase in future. Retail clients, investors and analysts alike will be taking careful note.
Another factor in the drive towards ESG is the ever-increasing threat of financial risk arising from climate change. This threat is of particular importance to insurers who want to protect themselves from the risk of damage to physical assets from fire, flood, etc.
ESG as a key component of business strategy
ESG is set to feature more prominently in business and governance models and policies in the future.
The influence is set to filter from the boardroom to the product design, marketing and communications teams. From there, its influence can be expected in the control functions, such as risk and compliance, which will have to deal with increasing regulatory demands and assess the ESG risks to their businesses.
To sum up, there is a lot for businesses to start thinking about regarding ESG policy if they have not already done so. ESG will need to be thought about not as much as a fad or a buzzword but as a normal and integral part of how business is carried out in the future.
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