The Rise of ESG In Response to Investor Demand

Corporate governance sometimes is the subject of “fads,” or initiatives that gain traction with dubious evidence-based justifications. Sometimes companies engage new theories or strategies because they “sound good” or give corporate leaders a way to avoid or mollify tackling hard issues or difficult tasks.

Corporations are quickly embracing environmental, social and governance (ESG) issues. As to whether this is “right” or the most effective use of corporate resources, the jury is still out. But there are many aspects of these initiatives that advance important principles of corporate accountability, responsibility and proactive measures. These collectively reorient corporate decision-making and essential governance questions.

The growth of ESG, however, is not self-generated. It is a response to investor demand–which in turn responds to the demands made by a given company’s market base and the public at large. Investors are conditioning large capital investments on the existence and quality of a company’s ESG program. ESG is a broad enough concept that it includes corporate attempts to build a strong corporate brand and promote long-term growth.

This by definition must include a focus on effective ethics and compliance programs. To go back to my broken record speech, companies with positive ethical cultures perform better financially over the long run. As a result, any corporate ESG program has to encompass an effective ethics and compliance program.

How ESG Compliance Adheres to Investor Demand

Environmental, social and governance issues should be a priority for boards and management. The advantages of proactively tackling these issues are significant. A robust program addressing them can open up access to large pools of capital, build a stronger corporate brand and promote sustainable long-term growth benefitting companies and investors. There was a time when a public stance on ESG issues was a public relations tactic. That’s no longer the case.

Let’s go back to the investor demand for ESG programs. These investors are sophisticated capitalists who are seeking long-term returns on their investments instead of the quarterly short-term investor. As investors demand more from companies on this front, they also are willing to partner and help companies address these important issues.

In 2019, ESG investment funds increased by $70 billion while traditional equity funds saw an outflow of $200 billion. These investments continue to increase in comparison to “traditional” equity investments, and they are performing better than traditional equity funds.

Major institutional investors are clearly communicating their expectation that companies institute a proactive ESG program and policies. These will attract additional capital and generate a way to embrace fast-arriving millennial demand for ESG values. Employees want their companies to embrace these principles as a price for their loyalty and commitment to a company’s intangible reputation for social awareness, ethics and shared values.

Institutional investors are increasing their commitment to “impact” investing, using sustainable and responsible criteria. Investment research firms have developed measurements to rank companies based on ESG factors. This rapidly growing approach will continue over the next few years.

Companies have to prepare for this scrutiny and the impact on its access to capital. ESG initiatives have to be designed for board and management execution. Activist investors have used governance problems and weaknesses to leverage their strategies through proxy contests and campaigns.

How to Embrace Environmental, Social and Governance Compliance

The “E” component of ESG is taking on increasing importance in response to demands that companies address climate change. This rising interest in climate change is reflected in investment strategies implemented by major investors.

COVID-19, however, has underscored the importance of the “S”–or social–factor. Companies are being scrutinized for how they treat employees, engage with customers and manage their supply chains.

Many have to develop policies and controls designed to identify appropriate compliance criteria for their specific industry and their company. It is easy to get lost in a variety of issues under the ESG umbrella; a focused approach is critical. In this respect, companies should pick at most five issues to develop that are important to the company, comply with investor demand, and are consistent with overall corporate strategies.

An oil and gas company that relies on fracking has to measure waste management and impact on the environment and natural resources. A service company may want to focus on diversity and inclusion to advance customer acceptance of company operations as an important reflection of social diversity.

Once defined, companies should benchmark their performance relative to other companies under availability and sustainability ranking indices, including the Global Reporting Initiative, Sustainability Standards Board and Global Initiative for Sustainability Rankings.  These organizations analyze a broad range of ESG for certain industries. Companies have to establish relationships with investment funds that favor this compliance.

A company commitment to ESG must be sustained. If it is window dressing, a company can suffer credibility damage. A program responding to these issues has to be measured, compared to others and disclosed to the public. It has to be a priority for senior management and should be monitored by the board.

This article was republished with permission from Michael Volkov’s blog, Corruption, Crime & Compliance.