Why ESG is more important than earnings in 2019

There is a growing army of investors, both institutional and retail, betting with their conscience.

Instead of focusing solely on figures, they’re investing in companies making socially conscious and ethical business decisions that align with their own personal values.

Environmental, Social and Governance (ESG) parameters are being actively screened by fund managers, advisers and superannuation funds to accommodate this increasing demand for responsible investments. On the 30th January 2019, NIRI released a new policy statement on non-financial disclosure regarding ESG and highlighting its importance as part of the IR role. It emphasised the need for IR professionals to be more knowledgeable about their companies’ ESG practices and actively help to shape their ESG disclosures.

A 2017 study by online brokerage platform Motif found 83% of Americans surveyed indicated their personal values were somewhat or very important in making investment decisions, while 75% of women and millennials said they would change any investment decision that no longer met their personal moral values.

Source: LeggMason

Ethical equals higher value – for everyone

According to the Global Sustainable Investment Alliance (GSIA) the value of global sustainable investment assets reached $22.89-trillion in 2016, a 25% increase from 2014.

In Australia, responsible investment accounts for nearly half of all investments, totalling $633-billion in 2016. This investment will no doubt only increase in 2019.

Responsible Investment Association Australasia (RIAA) has revealed investors who put ethics before earnings are reaping the rewards, with responsible investments outperforming and returning greater benefits than mainstream competitors during the last one, three, five and ten years.

“In observing the significant and consistent growth in responsible investment we can say without a doubt that this isn’t just a passing trend, but an evolution of the entire sector that is now being driven strongly by consumer demand and engagement with where they invest and bank their life savings,” said Simon O’Connor Chief Executive of RIAA.

The association, whose members manage more than $500 billion in assets, has announced more than 50% of major super funds and eight of the top 10 fund managers have already committed to a more responsible approach in their investment choices.

In response to this changing climate, the Impact Investment Forum was launched in 2017 to support the development of the growing impact investment market in Australia and New Zealand. The forum acts as a hub to ‘connect and deepen the participation of organisations in this growing field’, which seeks to achieve measurable social and environmental impact alongside financial return.

Why companies are changing tactic

It is the consistent performance of ethical funds and evidence of reduced portfolio risks that has sped up the uptake of responsible investments by this new generation of investors, who choose, often exclusively, to place their bets on companies with solid records on values.

As a result, we are now seeing more companies actively embracing new ways of doing business, from improving workplace safety to reducing greenhouse gas emissions.

This can be as simple as investing in the wellbeing and retention of staff, which is already proving beneficial. Macquarie Group’s Employee Engagement Survey found companies with the most engaged workforces achieved higher returns.

Supporting these findings, a recent survey of academic literature on ESG by Deutsche Bank Climate Change Advisors, indicated strong ESG performance correlates with strong financial performance in over 80% of studies.

The whitepaper The Business Case for Corporate Investment in ESG Practices, acknowledges the link between ESG and strong performance is ‘far from disputed’ and cites several reputable studies which show ESG metrics directly translate into higher profits, lower cost of capital, stronger relationships with stakeholders, better reputation and greater innovation.

ESG leads to better performance

Source: Harvard Law School Forum on Corporate Governance and Financial Regulation

Communicating with Responsible Investors

The PwC report Sustainability Goes Mainstream: Insights into Investor Views provides valuable data into the types and sizes of institutional investors incorporating ESG issues into their investment strategies, and how.

It found that about 80% of responding investors had considered sustainability concepts in the past year. Both corporate social responsibility and climate change or resource scarcity were most relevant in shareholder/corporate engagement (75%), proxy voting (60%) and investment strategy (55%).

These investors also indicated they were likely to seek direct communication with companies about ESG matters, including 89% who said they were very likely to request more information from the companies in which they invest and 79% who would seek a meeting with management.

Most investors who identified sustainability issues as relevant say they’re likely to have some form of direct communications with their portfolio companies about these issues in the next 12 months

Source: PwC

Of concern, a majority of investors are dissatisfied with information currently available from companies on topics related to ESG. A total of 82% of investors wanted more information about how risks and opportunities were identified and quantified in financial terms, while 79% said greater comparability of sustainability reporting between companies in the same industries was needed.

Investors expressed a high level of dissatisfaction with the sustainability-related information being provided by companies

Source: PwC

Responsibility and Risk

So what exactly is driving Responsible Investing?

The Sustainability Goes Mainstream survey also asked this question, revealing risk mitigation is the main reason investors are considering sustainability issues (73%).

This was followed by wanting to avoid firms with unethical conduct (55%), enhanced performance (52%), cost savings (36%) and attracting new capital (30%).

Investors’ primary driver for considering sustainability issues is to mitigate risk

Source: PwC

The vast majority of investors also recommended periodic risk assessments for materiality on most environmental issues including climate change – regulatory risk (95%), labour rights (95%), human health (92%), climate change – market risk (89%), resource scarcity – water quantity (89%), resource scarcity – water quality (87%), climate change – physical risk (84%), and other social issues (74%).

Investors strongly believe that companies should periodically assess multiple types of risks for materiality

Source: PwC

Reporting Responsibly

More than 1,500 global companies have adopted Integrated Reporting globally, with countries such as Japan and South Africa already making it mainstream.

Source: GRI

To support Australian companies in meeting the ASX Corporate Governance Council’s Principles and Recommendations, the Global Reporting Initiative produced the publication ‘A Resource for ASX Listed Companies’ in collaboration with CPA Australia and KPMG Australia.

The report states the most prominent sustainability related update to the ASX Principles is Recommendation 7.4 which requires disclosure of ‘material exposure to economic, environmental and social sustainability risks and, if it does, how it manages or intends to manage these risks’.

“The introduction of Recommendation 7.4 represents a considered decision by the ASX Corporate Governance Council that organisations should address how aspects of sustainability interact with organisational risk assessment and management processes. The Council explicitly rejected suggestions that sustainability issues relate more to ethics than to risk, noting in the Consultation Response for the Third Edition of the ASX Principles that many investors primarily see sustainability as an issue of risk going into their investment decision, not as an issue of ethics. Recommendation 7.4 has received strong support from institutional investors, and is reflective of a broader appetite for greater disclosure of organisational exposure to sustainability risks.” – A Resource for ASX Listed Companies, The ASX Principles

Importantly the recent 2019 fourth iteration of the consultation draft for Corporate Governance Principles and Recommendations, continues to highlight the importance of item 7.4 for listed entities.

GRI Standards, the first global standards for sustainability reporting, are enabling Australian companies to standardise reporting on critical sustainability issues such as climate change and human rights.

To meet Australian investor needs, GRI recommends investor communications should articulate the context within which the company operates, go beyond short-term risks to establish the criteria for judging long-term risks, articulate how the organisation has judged the threshold for materiality, and be clear on the links between sustainability risks and impacts, and the commercial relevance of taking action on sustainability.

The cost of ignoring ESG

The ASX Corporate Governance Council warns business choices impact a range of stakeholders, so sustainability becomes a major issue that can impact society and the environment in the long term.

In fact, most major fund managers are signatories to the United Nations Principles for Responsible Investment which means their analysis of companies will almost certainly incorporate ESG issues into investment analysis and decision-making processes.

With so much attention on non-financial specifications, it is little wonder more companies are hopping on the ESG bandwagon. But for those who don’t, ignoring the ESG movement is proving costly.

RIAA’s chief executive Simon O’Connor said several ASX listed companies were already losing shareholder value over mismanaged ESG issues.

The Australian Council of Superannuation Investors and the Financial Services Council developed an updated ESG Reporting Guide for Australian Companies in 2015 to complement the ASX Principles and Recommendations, which sought to highlight the ‘minimum information and reasonable data requirements that are needed for member organisations to successfully price, analyse and manage ESG investment risks’.

It said that ignoring stakeholder interests could create reputational and brand damage, product boycotts, regulatory hurdles and increased costs.

The Green Reports™ Initiative

Some blue chip Australian listed companies have taken note and have been communicating their ESG credentials for many years through Sustainability Reporting and utilising the Green Reports™ carbon offset initiative for their reporting. Companies such as Woodside, Westfield, Norman Disney Young and Colonial First State have offered engaging and interactive reports and also ensured they were carbon offset with the Green Reports™ initiative. The Green Reports™ initiative is designed to ensure that corporate communications minimise the environmental  impact and help build a more sustainable future for the community. It sends a strong and visible message to stakeholders that the company cares about its environmental impact and is working to minimise its carbon footprint wherever it can.

The future of ESG

Traditionally, sustainability issues were not part of investment analysis as industry saw no correlation to profits. The new wave of thinking is changing all that, with the finance sector taking strong positions on issues like tobacco and fossil fuels, and consumers voting in favour of cleaner and greener ways of living.

Climate change and greenhouse gas emissions are now of high global significance, and the international community is quick to condemn any sign of non-conformance.

In June 2017, The Global Sustainable Investment Alliance – a collaboration of leading national sustainable investment bodies from Europe, US, UK, Netherlands and Australasia, expressed disappointment in the Trump Government’s decision to withdraw from the Paris Agreement on climate action.

The alliance – representing $12 trillion of assets managed, banked or advised globally – said the decision was ‘at a critical moment when global capital is moving to play its part in financing the transition towards a low carbon economy’ and urged the government to change course.

Global calls to address ESG issues are getting stronger by the day and investors are demanding more transparency so they can assess investment risks with more clarity and authority.

Companies are realising sustainable and responsible business ethics are no longer just a feel-good factor, but critical to the success of company operations.

Please note Interactive Investor Pty Ltd is not an investment or share trading company and does not provide any form of financial advice or offers to participate in IPO’s or share trading.