Nidhi Chadda, founder and CEO of boutique firm Enzo Advisers and speaker for the upcoming Women in Asset Management US Summit answers questions around the demand for responsible investing, the impact of COVID-19 and the role of diversity in ESG.
ESG has been around for a while – why has it become such an important “buzzword” now?
ESG has been gaining momentum these past few years, as indicated by the explosive growth we have seen in assets under management directed towards ESG-focused funds. The events of 2020 will ensure that ESG is not just a buzzword but rather quickly becoming an integral part of company’s overall business strategy. While responsible investing dates back decades — with the first sustainable fund launched in the 1970s — the focus at that time was on negative screening, which is the exclusion from a fund or plan of certain sectors or companies involved in activities deemed unacceptable or controversial.
ESG today is more of a catch-all phrase that encompasses a wider range of fiduciary mandates. We focus on ESG integration as a risk management tool and incorporate ESG factor analysis to identify material risks and opportunities to help companies build sustainable business models and assist the broader investment community in improving long-term risk-adjusted returns.
Much of the obscurity around ESG, and why many people continue to have doubts about ESG integration and investment, is that it can be an abstract concept, as some aspects of ESG are relatively easier to quantify / measure (e.g., a company’s greenhouse gas emissions) but defining a company’s commitment to advancing social issues such as diversity and inclusion and measuring accountability is less concrete. Increasing focus around disclosure and standardization have helped push ESG into the limelight. The market is faced with an avalanche of information that is costly for companies to produce and lacks comparability, reliability, and timeliness for investors. Inconsistency in the way different companies report ESG data is a commonly cited challenge when trying to analyze the effects of ESG investment and performance, which also has further repercussions on benchmarking compared to the peer set.
In order to combat the intricate nature of ESG issues, organizations such as the Sustainability Accounting Standards Board, the Global Reporting Initiative, and the Task Force on Climate-Related Financial Disclosures have developed standards that provide more concrete reporting guidelines on disclosure requirements. These disclosures result in more consistency and standardization of ESG reporting across industries to ensure that companies, investors, and all stakeholders are receiving relevant and material information. Transparency in ESG reporting is key in achieving uniform standardization.
Global sustainability goals such as the United Nations Sustainable Development Goals, and the Paris Climate Agreement have also pushed ESG issues into the spotlight. These high-profile pacts underscore the need for global climate action plans to mitigate the risks of the climate crisis, which can be achieved by ESG awareness and compliance. One key driver of ESG has been the regulatory regimes across both the US and EU, ensuring that policy interventions are in place to facilitate commitments to sustainable investing. Together, these reporting initiatives, global goals, and regulatory requirements have given companies, investors, regulators and the whole plethora of stakeholders involved in business a common language to talk about ESG.
What role has COVID-19 played in the heightened state of ESG discussions?
The COVID-19 pandemic has further accelerated the shift towards a more serious focus on ESG strategy and discussions. “S” within the ESG construct is taking center stage as investors evaluate corporations’ responses to the pandemic, and overall demand for stakeholder capitalism continues.
Prior to COVID-19, corporations were alerted to a changing sustainability landscape. In 2019, Blackrock announced sustainability would be the “new standard” for investing and “climate change has become a defining factor” in their companies’ long-term prospects. Business Roundtable also refined its statement of purpose outlining a new statement for corporate responsibility, taking a broader view on corporate purpose to create long-term value and support all stakeholders.
Now, the pandemic has only elevated the importance of these conversations in board rooms and investment committee discussion, alike. Black swan risks such as disaster preparedness, business continuity/contingency planning, employee treatment (e.g., health and safety risk, insurance/employment benefits, workforce productivity) and supply chain disruption are not just timely issues but also areas of material risks and opportunities.
We should expect to see companies consider ESG issues around longer-term strategic planning efforts, including the re-evaluation of existing organization structures (e.g., supply chain and systemic risk management procedures) as well as human capital issues such as employee health and safety. The top three social issues post-pandemic appear to be diversity, employee health and safety, and data security and privacy.
The pandemic has clear links to the climate crisis which represents another systemic risk to the global economy and human health. This crisis will also result in around $2 trillion spend (in line with the pandemic impact) to keep temperatures from rising 1.5 degrees Celsius above pre-industrial levels in line with the Paris Agreement. There will likely be a greater focus on the circular economy, as the pandemic and its material human, economic, and financial costs only further support the notion that the environment, public health, and the global economy are intertwined, and there are more ongoing considerations including linking stimulus packages to climate change goals. As we rebuild post-crisis, the link between sustainability and business model resilience has never been more clear.
Sustainability is not just an add-on feature but rather about building a competitive advantage integrated into the overall business model while addressing material risk factors. Companies can drive better returns on investments by embedding sustainability into the operations of a company, which further reinforces the competitive advantage.
Have there been any other influencers? What are they and why?
Aside from the pandemic, there are three primary influencing factors accelerating the ESG discussion: a) materiality b) market demand and c) regulations.
The first factor is materiality. There is growing academic evidence and increasing recognition within the financial community that ESG factors often play a material role in determining risk and return, and ESG funds continue to outperform in the public market. Even during the course of the pandemic, based on a Morningstar analysis, a comparison of 26 sustainable index funds with those of conventional index funds covering U.S. equities, 24 outperformed the conventional funds. Also, 44% of sustainable funds ranked in the top quartile of their respective categories, and 70% ranked in the top half for Q1 2020. Review of prior downturns also indicates that ESG has been an effective risk-management tool; over 70% of ESG-focused funds outperform in downturns, irrespective of the circumstances seen in past cycles. Furthermore, increasing academic evidence has showcased that integration of ESG principles contributes to long-term value creation by driving top-line growth, improving cost efficiencies, and lowering cost of capital.
Market demand is another key influencing factor. Even prior to COVID-19, there were growing demands from beneficiaries and investors for greater transparency from companies about how and where their money is being invested, including increased demand from the millennial population in particular. This type of transparency can only come from more comprehensive ESG reporting and management participation in driving ESG and CSR initiatives from within. Stakeholder engagement is also becoming top of mind for many companies as many are now evaluating their long-term sustainability strategies alongside key stakeholders’ preferences.
The third influencer is regulation. Over the last several years, the European Union has been spearheading the regulatory efforts on the ESG front with sweeping sustainability regulations for corporations including the Non-Financial Reporting Directive implemented in 2017, the Green Deal in 2019, and the most recent Taxonomy requirements pending for end of 2020 or early 2021. We have also seen an increase in the number of recent announcements linking various frameworks together, which helps to offer some consistency in approach to investors and corporations alike. The recent announcement linking SASB metrics to UN SDGs is also very critical to taking more aspirational goals and linking them to measurable targets and metrics to better evaluate progress over time. There is also an increasing focus amongst banks, insurance companies and across the real estate industry to incorporate sustainable goals into their lending and underwriting practices as well (i.e., the onset of sustainability – linked loans/financing) which may be the inflection point needed to accelerate the focus on ESG in the U.S. markets.
In your opinion, what are the companies doing well and what are they not doing well, when it comes to ESG and compliance?
As the pandemic and other influencing factors noted above have contributed to the recent explosive growth of ESG, what companies are doing well right now is taking some time to educate themselves on key ESG issues and trends in the marketplace, deciphering the volume of information available. Companies that either establish managerial roles (e.g., Chief Sustainability Officer) or enlist more conversations with ESG-focused advisors and investors are demonstrating an early firm commitment to acknowledge the breadth of ESG issues that need to be addressed. However, there is still a fair bit of skepticism, as companies are still trying to understand the value creation generated from an ESG-focused approach.
Companies familiar with the overall ESG landscape and with reporting standards are also publishing annual CSR reports that have helped facilitate the global conversation on ESG. Those companies that are doing well are ones that have not only taken a thoughtful approach to understanding how key ESG risk and opportunities impact their business models long-term, but also are beginning to provide disclosure metrics consistent with reporting standards such as SASB to help stakeholders track performance relative to these frameworks and aspirational goals. The EU, which has generally been ahead of the curve versus the U.S., remains at the forefront of sustainability reporting as they have had to report under the NFRD framework and will soon be required to report under the pending EU Taxonomy requirements.
While ESG and CSR reporting is growing accreditation and is taking off on the global stage, many of these reports have only scratched the surface in terms of the granular nature of sustainability reporting. Good corporate governance practices appear to be more table stakes, while companies have yet to hone in on improving disclosure across the environmental and social aspects. Many times, companies are unable to provide a broad level of detail because of the lack of standardization of ESG reporting standards and/or the limited bandwidth to allocate resources to in-depth work. The plethora of ESG ratings agencies and their various methodologies are also sources of confusion, and many companies’ seemingly low ratings are sometimes a function of company management not addressing the misinformation and inconsistency in data that these ratings agencies collect.
What does best practice look like and how can we get there?
I view best practices as showcasing evidence of integrating ESG strategies into building a long-term sustainable business models that account for creating value for all stakeholders, as well as transparent and consistent communication with stakeholders. At the core of best practice is comprehensive ESG reporting. Much of the ESG reporting we see today in the U.S. is voluntary, and companies that do produce annual CSR reports use accredited standards such as SASB and/or GRI.
However, with the plethora of standards and frameworks, companies are still grappling with how best to provide disclosures that are consistent with these reporting standards. In the EU, most companies are already required to produce ESG reports under NFRD, and eventually under the EU Taxonomy requirements, but some provide just enough information to fulfill minimal requirements. Regardless of geography, most of the best practices we see on the issue of ESG reporting and ESG integration typically come from companies that communicate material information to stakeholders, which are integrated across filings, and extend beyond a CSR report, and integrate sustainable practices throughout the company’s value chain.
There are a few preliminary steps that any business can take in order to move towards best practices and developing a more structured ESG approach. The first step would be to thinking through material ESG risks and factors, and how they are currently integrated into business models, as well as addressing any rating inconsistencies and misinformation across data providers. The second step would be to become educated on the various reporting standards and frameworks to understand how they are aligned and determine what disclosure metrics could be provided to show progress against these standards. Lastly, a company should decide on how best to communicate its sustainability practices, ideally not only through a CSR report but also integrated into filings.
Does diversity play a role in ESG? If so, how?
Diversity is at the core of the ‘S’ in ESG and has always been an integral part of the ESG conversation. There have been numerous studies that have broadly indicated how cognitive diversity drives improved team productivity, decision-making, and innovation. Across the board, many reporting standards ask companies to disclose employee diversity and inclusion metrics, executive and board-level diversity, as well as company policies that inform investors and stakeholders how the company intends to be held accountable on these efforts. For companies, diversity is crucial in sustaining and creating long-term innovation as many studies have shown that more diverse companies at the employee, executive, and board-level are more likely to identify and promote long-term growth opportunities.
Investors are also increasingly considering diversity questions when they consider how best to allocate their capital. They play a crucial role in maintaining pressure on companies to increase the representation of women and people of color on board, C-suite, and executive positions as well as advocating for diversity opportunities. As the pandemic unfolded during the 2020 proxy season, we saw a pick-up in focus in terms of more diversity-focused topics at the forefront of this voting season. Investors are pressing companies on their diversity and inclusion policies, on their board compensation, and on employee compensation practices. A number of prominent asset managers have also engaged with companies on addressing systemic racism by asking companies to: a) provide information to more accurately assess their racial diversity (at both the employee and managerial level); b) provide pay equity disclosure across race and gender; and c) publicly state what they are doing to combat racism, as we have seen a slew of announcements from companies across sectors launching new initiatives to support female founders and minority-owned businesses and employees. State Street Global Advisors recently announced it will be asking companies in its investment portfolio to articulate risks, goals, metrics, strategy, and overall board oversight related to racial and ethnic diversity and to make relevant disclosure available to shareholders beginning in 2021.
The national conversation on racial injustices and gender parity in the workplace has shifted more of a focus on “S” and the role of diversity in institutions throughout the US. Investing in and committing to diversity on all accounts is an actionable way of generating positive returns for all stakeholders involved.
