Environmental, social and governance are the buzzwords of 2019. But what do they actually mean? IFLR explains in the latest instalment of our free-to-read primer series
What is ESG?
Environmental, social and governance (ESG) are the three key factors used to measure the sustainability and ethical impact of an investment in a company or product.
The environmental element considers how a company performs in terms of its impact on the natural world. This includes whether it makes investments in unsustainable areas such as oil, or a company that has high plastic use.
Meanwhile, social principles consider how a business manages its relationships with employees, suppliers, customers, and the communities where it operates. Does it build affordable housing for its employees? Does it make unethical choices, such as doing business with a supplier notorious for using sweatshops?
See also: ESG: why it matters to general counsel
Last but not least, there is governance. This benchmark considers a company’s leadership, executive pay, audits, internal controls, and shareholder rights. Does this company do enough to ensure women can get in to top positions? Has it implemented a flexible working policy that allows all employees to manage their time beyond a standard 9-5?
“ESG is a broad, global momentum shift that is moving societies and economies into a more focused, inclusive view of the world,” says Michael Doran, partner at Baker McKenzie. “It actively promotes and asserts environmental, sustainability, governance and ethical standards.”
In recent years, the notion of ESG activity has transferred from something that is nice for companies to have to something that companies have got to have. According to research by theGlobal Sustainable Investment Alliance, global sustainable investment grew by 25 percent between 2014 and 2016 to 22.89 trillion US dollars.
Investor activism has been a major driver for ESG’s heightened profile. This includes screening out companies that fail to meet a baseline of standards on values such as the environment.
In other areas, the aim is to exert positive influence by engaging with companies and influencing them to use best practise. A recent case included an investor coalition putting pressure on banks to enhance their social responsibility standards and ensure that they respect indigenous community rights.
ESG engagement has had a positive impact on both firms and their investors. Research undertaken by Friede, Busch & Bassen found that investing in ESG initiatives has long-term financial benefits and can promote stability.
While it once sat on the fringes of the finance world, this year ESG has taken off rapidly, with more areas of the financial sector engaging with it than ever before.
What is an ESG bond, how do you comply with one and what are the standards?
The market has been interacting with ESG bonds in various forms for a decade now. The first, a green bond, was issued by the European Investment Bank in 2007 as a method of funding climate related projects.
This was followed by the World Bank, which issued what many commentators view as the blueprint for green bonds in 2008. It led the way for the International Capital Markets Association’s (ICMA) launch of the Green Bond Principles (GBP).
The World Bank has since raised $13 billion from more than 150 green bonds, which have been distributed in 20 currencies to institutional and retail investors worldwide.
Thus far, green bonds have had a monopoly in the market over other ESG products.
“There is a greater recognition among companies and issuers that climate change is happening,” Doran says. “This recognition exists on both the sell and buyside of bonds. Issuers find it easier to get their heads around them.”
One of the problems is that there aren’t any codified global standards. Differing interpretations of what green is are rife.
See also: Green bonds need certification to thrive
Of course, that isn’t to say that organisations and supranational bodies haven’t been working to introduce regimes that companies can adhere to in their drive to be more considerate.
ICMA’s GBPs are some of the most widely used; Climate Bonds Initiative (CBI) certification is also generally expected. The GBPs are typically updated annually to align with the development and growth of the green bond market.
To comply with the voluntary GBPs, bond issuers must select a category, which can include pollution prevention (reduction of air emissions, waste recycling and others).
Transparency is encouraged by ICMA in reporting standards. Issuers are encouraged to make, and keep readily available, up-to-date information on the use of proceeds. This is to be renewed annually until full allocation, as well as ad hoc in light of any potential material developments.
See also: IFLR’s primer on green bonds
What does ESG offer stakeholders?
A primary concern among companies has always been reputation. For example, the Deepwater Horizon oil spill in 2011 greatly damaged BP Oil’s stature and left the company indelibly linked with what is estimated to be the US’ largest environmental disaster.
In comparison, by engaging with ESG, companies can see their relationships improve with customers and investors.
“ESG carries significant PR value for companies,” Doran says. “Customers and consumers like it, especially millennials.”
With the rise of teenage activist Greta Thunberg and countries such as Britain looking to ban single-use plastics as of next year, it makes sense for financial players to enter the ESG market now to ensure they don’t suffer from the future regulatory environment.
Doran added that, apart from the PR value, ESG offers corporates an improved community relationship.
For example, cosmetics company Lush has built its reputation on a commitment to environmental causes and community projects. It has divested from product chains where child labour is used and sells products that see 100% of sales go towards grassroots projects aimed at tackling human rights abuses and animal protection, among other areas.
Lush was an early adopter of ESG, but now practically every company in the world is exploring the benefits of a social purpose.
How are financial services responding?
Financial markets have generally responded well to ESG principles. According to Axioma, companies with better ESG standards typically outperform their benchmarks and record stronger financial performances than their counterparts.
“Capital markets have responded well to the ESG momentum shift,” says Doran. He points out that markets have shown adaptability and pragmatism, and acknowledged that ESG-related bonds are a rapidly evolving product.
With total issuance increasing year-on-year, there is a general understanding from all sides that there will be financial repercussions ahead if movement does not happen fast.
“Banks have also acknowledged that this is an area whose time has come,” continues Doran. There’s also the simple recognition that there’s money to be made, and that the promotion of ESG activities will ultimately help banks and investors make more money.
Deutsche Bank has been one of those to make a thorough commitment to ESG activities. Gerald Podobnik, global head of capital solutions and sustainable financing, tells IFLR that the bank has committed to not financing any new coal power projects, and has agreed to reduce its thermal coal mining portfolio by 20% by 2020.
In addition, sources at BBVA say that “the financial industry is joining forces in the fight against climate change through sustainable finance”.
They also point to sustainable loans as a key tool, stating that banks can play a decisive role when they act as sustainable agents for these loans.
What is the outlook for ESG?
Once upon a time, the ESG momentum remained firmly in Europe. However, now that’s changing.
“We have regions such as China, which has decided it is going to green its economy, which will be a challenge. It’s currently a pretty brown economy,” says CBI chief executive Sean Kidney. “It has a long way to go, but the ambition is voluble.”
Doran says that ESG is here to stay.
“The paradigm shift is clear,” he says, predicting that the pace of change over the next 10 years is going to rapidly surpass that of the last five. “We are in the early days, but what we can expect is a huge expansion of focus and activity in this space.”
This will include more rapid commitments from countries to the Paris Agreement, strengthening of regulations in the EU via the EU Taxonomy Framework, and through the UN’s 2030 Sustainability Goals.
“There is still much work to be done to make this a coherent, cohesive marketplace,” says Doran. “There are potential flaws that need to be amended but moves will be undertaken fast to address this. We are still in the foothills of the ESG mountain.”