ESG: what’s in a name?

It might be popular and come with a sexy acronym – then investment sector loves an acronym – but what does ESG really mean? Kaushik Sridhar explains.

In a field replete with acronyms, one, ESG, has quickly become part of the lexicon of long-term investors. From an investment perspective, ESG presents a win-win proposition for institutional investors and companies.

But while there is more awareness of environmental, social and governance (ESG) issues these days, there is also much confusion over the many standards out there. There is what I call an alphabet soup of different disclosure guidelines.

I truly believe that one of the primary causes of the painfully slow pace of “mainstreaming” (but by no means the only one) ESG is the confusion and conflation between and among the various acronyms. The sad result has been the stigmatisation of most if not all of them by mainstream asset owners and their traditional advisors and asset managers.

So what is this relatively new acronym? Words matter, and if ESG concerns could be shorn of their historical, ideological, and emotional baggage — on all sides — we’d all be a good deal further ahead, and so would global environmental and social conditions, not to mention investors’ risk-adjusted returns.

The first step is to think about ESG risk in similar terms to how we think about credit risk. It is a risk (or a set of risks) that could influence the long-term sustainability of a business – we might disagree on how important these risks are but it’s hard to argue against their existence.

In practice, there is no universally agreed upon way to assess a company’s ESG credentials. But let’s, for the sake of this argument, assume that there is. This is a big assumption but, reassuringly, if it fails, it actually strengthens some of the points I ultimately want to make.

Then, it should hopefully be easy to see that ESG risk is analogous to credit risk (different set of risks but the same idea).

After all, just think about some of the powerful global mega-trends that are currently radically reshaping the competitive landscape for both companies and their investors:

• The dramatically increased complexity, transparency, and velocity of change in companies’ business environments, which places an unprecedented premium on strategic management and innovation skills, as well as corporate adaptability and responsiveness.
• An inexorable shift in the world’s economic centre of gravity and dynamism towards emerging markets, where sustainability-driven risks and opportunities are inherently greater.
• Substantially increased demand for energy, as well as water and other critical natural resources, driven by a combination of explosive population growth, urbanisation, industrialisation, demographic shifts, and growing consumer affluence and consumption, particularly in emerging markets.
• A general decline in both the credibility and financial capacity of governments worldwide, with a corresponding increase in the necessity for corporations to shoulder greater responsibility for tackling environmental and social challenges.
• Substantially increased stakeholder expectations for improved ESG performance from both companies and investors, accompanied by much greater information transparency with which to assess that performance, and more effective communications tools with which to disseminate criticism.
• The emergence of a new fiduciary paradigm for investors, requiring much greater transparency and attention to sustainability issues. Now, few if any thoughtful investors would dispute either the existence or the direction of these megatrends.

Taken together, these megatrends are creating a competitive environment that demands new capabilities and even mindsets from companies. The competencies that may have served them well historically are no guarantee whatsoever of future success; indeed, some of what used to be positive attributes have now become liabilities.

Under these new, rapidly evolving circumstances, how are investors to distinguish between future corporate winners and losers? While most investors, when pressed, would acknowledge that these tectonic changes are indeed taking place, few have actually translated that general awareness into a modernised, forward-looking approach to their investment strategies. Some will undoubtedly claim they are already taking them on board.

But we’re talking here about taking them on board in a meaningful, consistent, and systematic way. This means, inescapably, at least two things: new analytical models and tools, and company-specific research on a new set of risk and value drivers — not just on an occasional, ad hoc basis, but comprehensively across a substantial potential investment universe.

Indeed, the current orthodoxy of fiduciary responsibility needs to be turned 180 degrees on its head; it seems to me (and a growing body of other observers) that one would be a miserably derelict fiduciary if one didn’t take into account factors which could manifestly be directly material to the long-term returns of potential investee companies.