Everything you need to know about ESGs
by Joshua Fraser
After the last year or so, humanity at large needs few reminders of how disruptive, discombobulating and fundamentally disconcerting the world can be. The Covid-19 crisis has swept through all of the global connections that brought us together, both socially and economically. It, as so many virologists and public health experts predicted it would, hijacked our sophisticated international infrastructure and appropriated it for its own transmission and, ultimately, contagion. After this global shared experience, it is easier than ever to understand why Environmental, Social and Governance (or ESG) guidelines, which are explained below, are essential.
However, this phenomenon of our own infrastructure being subverted by, and closely affiliated with, a natural crisis is not restricted to the Covid-19 pandemic alone. Indeed, since 1899, we have known about man-made climate change, and, as the years have passed, we have increasingly recognised our potential to not just alter the world at such a macro level as the climate, but also the danger we court by doing so. As it stands now, we know that, if we don’t change our irresponsible, carbon producing ways, we have a limited time frame before our quality of life decreases, and, at the more dramatic end of the spectrum of predictions, our civilization as we know may collapse.
While not necessarily an existential crisis, like the above two examples respectively, how many people in today’s world are being treated is a major issue. In general, especially when compared to historical trends, societies are beginning to become more and more conscientious about human rights and the sanctity of human life. This has often been supported by the claim that the modern world is, and is continuing to become, a much safer place than it was in the past, with lower (adjusted) mortality and fewer deadly wars. However, these statistics are misleading, as, for some areas of the world, they simply aren’t true. Research in 2020 shows that wars aren’t becoming less deadly and less frequent in many poorer parts of the world. Instead, the trend of deadly and frequent wars is holding steady or worsening, and, with worldwide determinants such as the aforementioned Climate Change looming on the horizon, the likelihood is that knock-on environmental pressure will worsen conflicts globally, especially in vulnerable developing countries. Another shocking statistic is that slavery is more common today than it was in the time preceding the American Civil War or indeed at any time in recorded history.
Like the first two examples of Covid-19 and Climate Change, wars and modern slavery are dependant on the manner in which modern society is conducted and constructed. Moreover, due to the interconnected nature of our modern civilisation, it is unsurprising that the way we conduct business in one area of the world has profound impacts and effects on the business, day-to-day living and prosperity of another part of the world. Much of this line of thinking naturally arrives at the phenomenon of the global wage gap, where a minority of the worldwide population holds a considerable majority of the wealth. Often, this is borne off the back of forced labour and worker exploitation in poorer countries. This presents a stark challenge and a greater responsibility to the economic and business leaders of the world. This challenge can be summarised as one of balancing the demand for a larger amount of higher quality goods with sustainability and fair business practice. Considerations of this nature are becoming increasingly common, as the younger generation of investors have keen interest in placing their money responsibly while keeping their morals onhand when considering their financial choices.
Yet, we should not forget that moral considerations have been a part of financial conduct for some years now. Indeed, a major part of the mergers and acquisitions (M&A) field of law has centred on the practice of due diligence – a systematic way of analysing a potential purchase or merger as to mitigate any risk or negative consequence that might occur from the financial action in question. Often due diligence centres on financial and legal quandaries and potential issues that might arise out of these areas. For example, a business may have considerable outstanding debts in excess of its projected future value, might have an outdated business model that would need a considerable and expensive overhaul to stay competitive or the business may even have ongoing litigation that is projected to result in costly damages. All these considerations have to be taken into account in order to avoid business strategy errors, and businesses spend a huge amount of money hiring law firms to aid them in this process. This being said, the financial, legal and strategic elements of M&A are not the only concerns of businesses. Of course, there would be a potential legal and financial penalty for merging with or acquiring a business which has connections to forced labour or worker exploitation in sweatshops. However, there is also a serious moral implication present also. Businesses, and crucially their employees, do not want to be connected to organisations that exploit other human beings, have a negative impact on our society or simply make the world a worse place to live. This concern, and the moral drivers behind it, are a major aspect of the due diligence process in these high stakes transactions.
However, even on the comparatively micro level, an amount of due diligence is required. While usually far less risky than a merger with, or the acquisition of, an entire business, the purchasing of stocks often requires a form of truncated due diligence. Any sensible bullish investor knows that buying into a company that is likely to lose value, due to foreseeable future circumstances, is a bad idea. Even doing so with the expectation that the companies’ share price will rise again is a risky decision. A substantial amount of money can be lost in a holding position of loss, where a rebound in share price never comes or comes in an underwhelming manner. Nonetheless, we see moral considerations taken into account. Fossil fuel producers and companies linked to forced labour are often avoided by investors (especially younger ones) who do not wish to finance, indirectly or otherwise, unsavoury practices.
Thus, we see a precarious balancing act occur, one poised between the maintenance of profitability and economic growth and the competing interests of sustainability and ethical standards. Out of this conflict comes the concept ESG practices, otherwise known as ‘Environmental, Social and (Corporate) Governance.
What is an ESG?
When defining and delineating an ESG, we must first briefly return to the concept of due diligence. Often organisations advising companies and businesses on transactions formulate what is known as a ‘due diligence strategy’. This usually consists of a number of strategic steps, phases or stages through which due diligence is methodically conducted. These serve the dual purpose of keeping the due diligence process at a manageable timeline with a clear direction and in ensuring that no areas are left unconsidered or unchecked, as might occur with a less organised and rigorous approach to due diligence.
ESGs belong in the category of due diligence strategies. They are, in essence, a heuristic for both business strategy and ethical consideration.
How did the ESG originate?
The creation of the ESG is owed to former UN Secretary-General Kofi Annan. In January of 2004, Annan started an initiative by writing to over 50 chief executive officers of various different commercial institutions, offering them an invitation to take part in an initiative of UN Global Compact, supported by the International Finance Corporation. This initiative focused on integrating and assimilating the tenets of the ESG into the business practices of the capital markets.
If Annan can be considered the ‘father’ of the ESG, then Ivo Knoepfel is the man who made the ESG famous. In 2005, shortly after Annan’s invitation and initiative, the ‘Who Cares Wins’ report was authored by Knoepfel. This report laid out the values, methodology and intention behind the prospective ESG initiative. Its impact is hard to be understated, as, in 2006, the Sustainable Stock Exchange Initiative or ‘SSEI’ was launched with the aim of propagating the ESG. Since this point, the ESG market has rocketed up in value and activity. As an example, in 2019, a surge of approximately $17.67 billion in capital was placed into ‘ESG-linked products’- an increase of 525% since the level of ESG-linked investment seen in 2015.[xi]
Why are ESGs significant?
ESGs, as a strategy for due diligence and transaction consideration as a whole, represent a departure from the overly profit-centric conception of business that has been in play since the late 20th century and in the early years of the 21st century.
As evidenced in the ‘Who Cares Wins’ report, the four fundamental goals of ESGs are as follows:
- Stronger and more resilient financial markets
- Contribution to sustainable development
- Awareness and mutual understanding of involved stakeholders
- Improved trust in financial institutions
As can be seen, the ESG’s criteria has long term goals beyond moralising the way we conduct business. The central aim is to improve the resilience and trustworthiness of our business structures to make them more reliable and beneficial to humans everywhere.
This is the key takeaway from ESGs, their ability to pre-emptively reduce what economists term ‘moral hazards’, instances where inimical behaviour, on the part of market actors, are not punished by natural consequences but are sheltered by protectionary measures, such as government bailouts. This kind of instance can be seen in the 2008 crisis and the Deepwater Horizon (BP) oil spill. The fundamental issue with moral hazards is that these companies, which are often termed ‘too big to fail’ as they would have profound impacts on the employment market, capital market and the industry in which they operate, should they become insolvent, are tacitly ‘insured’ by the government in situations of crisis, due to their extreme importance to the functioning of the economy and society. As a consequence, there is little to no incentive for these firms to exercise long-term caution, as they know they have a substantial safety net in place. However, all public listed companies (of which these behemoths are often a part) require shareholder confidence to function.
Armed with ESGs, prospective M&A transactions and investors of all kinds can assess:
- The environmental aspects, such as a companies’ sustainability and impact upon the environment
- The social aspects, such as the ethics of a companies’ supply chain and its policies toward discrimination, sexism and racism
- The governmental aspects, such as the corporate transparency of a business and its structural diversity
As a result, prospective stakeholders and shareholders alike can make more informed and methodical conclusions about the organisation they are poised to invest in.
Current market valuations show that ESG-investing is worth $20 trillion AUM (asset under management).[xxi] It is clear that ESGs are immensely popular, and it is no wonder why. The rise of mass media has allowed the world to see how their behaviour, however isolated, impacts those around the globe and the globe itself. While this is often a reassuring and heartwarming truth, there is also a darker side of knock-on exploitation and environmental destruction. These regrettable consequences are mostly the responsibility of business practices from trans-national corporations. However, perhaps the fastest way to remedy the undesirable byproducts of unreserved profiteering is to signal to those corporations best poised to prevent it that they must or risk financial ruin. Here, the ESG allows for and incentivises a better way of business, one which can, one day, result in a better world.