ESG refers to three main factors namely environmental, social and governance which are considered when measuring sustainability and the ethical impact of investments. It takes a more holistic view that sustainability extends beyond just environmental aspects. Sandy Gill, director at the Lysis Group stated that “ESG is a core set of values that firms consider as part of their strategic decision-making process.”
The environmental component of ESG refers to how firms interact with their environment and the size of the carbon footprint left on their natural surroundings. The social component of ESG refers to firms demonstrating that they have the interests of the community and people at the heart of their policies and cultures. For example, do they have a diversity and inclusion policy? Is the board made up of an equal number of men and women from diverse backgrounds? The governance aspect of ESG points to a firm having an effective framework in place to achieve the set targets of governments regarding climate change. This includes having a culture in place which ensures that a firm’s policies are rolled out effectively to demonstrate that it is in fact addressing the ESG agenda.
How this all started
The initiative stems from the Paris Agreement on Climate Change that was entered into in 2015 by several countries. From there, COP26 has been enhanced and raised the world’s awareness of the impact of climate change driven by our everyday demands upon the environment and the way that we live.
There have been two key pieces of legislation that have been implemented in Europe. The Sustainable Finance Disclosure Regulation (SFDR) and The Taxonomy Regulation. In the UK, due to Brexit, the EU regulations no longer apply but Rishi Sunak, Chancellor of the Exchequer at the time, unveiled the UK’s equivalent of the SFDR which was called The Green Finance Roadmap.
The SFDR legislation sets out the requirements for firms that both make and advise on financial products. For example, fund managers must disclose how they have considered sustainability risks during the investment process. In addition, they must also disclose how they have considered any negative factors with regards to sustainability.
The Taxonomy regulations amended the SFDR legislation and are essentially a classification system that has six environmental objectives. Firms must contribute to at least one of the objectives and ensure that they “Do no significant harm” to the other objectives. These objectives include:
1. Climate Change mitigation.
2. Climate Change adaptation.
3. Sustainable use and protection of marine and water resources.
4. Transitioning to a circular economy.
5. Pollution control and prevention.
6. Protection and restoration of ecosystems and biodiversity.
Gabriel, director at the Lysis Group indicated that there are four main drivers of the ESG agenda in firms which include investors, consumers, employees, and the executive management, where the first three are actively influencing the decisions taken by executive teams. He stated that, investors are definitely more aware of the impact of ESG, and more and more consumers also have a say as to where they invest their money, with the employees, as the third driver taking a stance on what their employers stands for. All these aspects are pushing executive management to demonstrate how ESG principles are applied in decision making but the executive management is often more concerned with the bottom line than with implementing the ESG agenda.
“However, peer pressure will become a major driving force for firms to implement ESG principles because executive management decisions are driven by the board and the board is steered by investor interests. Should firms choose to actively pursue the implementation of ESG principles, as part of their strategic objectives, it can provide them with a competitive advantage because they will entice specific client profiles, and this becomes very attractive to investors”, Gabriel explained.
He clarified by saying that “Going forward, it is very likely that we will see more firms insisting on only doing business with other firms that have similar, clear, and articulated ESG policies and agendas.”
Sandy added that “Generation Z and Millennials are especially keen to ensure that they purchase items and make investments that are sustainable and therefore it is important for finance firms to ensure that they are selling the right products in the right way to attract the right workforce and clients. This is due to younger people becoming very selective about the firms they want to work for and invest in and they expect these firms to implement ESG principles.”
A practical approach to ESG
According to a recent article in the Financial Times, there seem to be two different schools of thought when it comes to the classification of ESG. The first includes individuals’ perception that ESG is all about how investments are calculated to demonstrate statistically that investments are aligned with ESG principles. The second school of thought is more focussed on how ESG is regulated. To demonstrate this on a more practical level, the article asked the question of whether an oil company will always be unsustainable when in fact they can demonstrate that a large percentage of their revenue is generated from renewable resources.
The article also indicated that it seems as if fund managers currently apply their own subjective calculations to ESG principles to demonstrate which investments are indeed green investments vs. non-green investments. Therefore, the article highlights the need for a standardised set of ESG criteria that can be used to categorise green investments in a more tangible manner.
Gabriel added that “Although regulators can play an important role in standardising and enforcing the ESG agenda, there are other ways to encourage firms to adopt ESG principles. From a practical compliance point of view, an ESG assessment could be incorporated into the Know Your Customer (KYC) process which could serve as a competitive advantage to firms. Also, a firm’s risk rating methodology drives many other processes within the compliance space and ESG principles could form part of the risk rating process.”
Gabriel concluded by saying that “The ESG agenda is here to stay and will have a major impact on firms’ reputations and bottom lines going forward. Therefore, ESG principles must be included in all business decisions, including compliance decisions.”