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17 April 2021

ESG goes towards Human Rights and the Social becomes Concrete. Finally!

The COVID-19 pandemic and heightened concerns about climate change, racial injustice, and income inequality have injected fresh urgency into the need for more sustainable investing.

The pandemic’s devastating effects have laid bare how health and economic crises disproportionately affect families living in poverty, no matter where they live around the globe. Systemic racism and income inequality only aggravated the pandemic’s effects.

What the virus really showed was how inequalities, already existing, were often the basis for death and a plunge below the poverty line even in the Global North. It showed how not having universal health care, paid sick leave, equal access to social security (or access at all), having societies in which people are marginalized and without safety nets when things go wrong was a danger not only to the effected individuals or groups of individuals but societies broadly.

The idea of sustainability-focused enterprises is that they are built themselves, and help build societies, take on these challenges. They seek to advance solutions to poverty, equity, justice, climate change – in theory – and if prioritized and well guided, in practice – they address the gap between the ever-increasing amount estimated that the world needs to reach the SDGs and current investments.

It is a question to ponder: why is it that the amount of “ESG” investments are increasing and so is the amount needed to reach the SDGs? If the former really had an impact, the latter ought to decrease. The SDGs have not changed. The focus on investing, and calling investments, “sustainable” has.

BlackRock will question companies on human rights.

Over the past month the world’s largest asset manager, BlackRock, said it will ask companies in which it holds stakes to identify and show how they intend to prevent human rights abuses, and provide “robust” disclosures about those practices.

While they did not identify transparent expectations, time lines and consequences for company inaction on these issues, the message from the company seems to be clear – they are moving beyond considering only the environment when they consider sustainability factors and are putting a focus on human rights issues – potentially both internally and externally in the investees’ operations.

Germany moves ahead on human rights.

In a step ahead of the EU, Germany is set to introduce fines for companies procuring parts or materials abroad from suppliers who fail to meet minimum human rights and environmental standards, after the governing coalition reached agreement on a draft law. The same sort of regulation is expected by the end of the year or next from the EU.

Perhaps making investments driven by impact – real impact – has lagged behind, in part, because the concept lies between two traditional categories of where to put your money: market-rate returns or philanthropic grants. But making your investments based only upon ROI and then give away millions as a “generosity” or to “feel good” seems to perhaps be a thing, if not of the past, then at least something worth re-evaluating. One thing that needs to be clear is that, unlike for conventional investments, there are no agreed-upon benchmarks for mainstreaming a real sustainability driven financial return.

What is an “acceptable” target: public market equivalent, 5 percent, inflation, or even 0 percent? Is partial capital recovery acceptable? That will have to be decided upon in individual cases and by individual asset owners. What is certain though is that there is a possibility to go away from a charity model in which part of an absurd ROI is given away to people or projects who are not seen as active participating rights-holders, but rather talk about investing in enterprises where people are engaged and actively participating in creating returns.

Lack of professional ESG experience in the financial sector.

An ever-present concern these days, when everyone is starting to turn towards “sustainability” and “ESG” but with very few people in the investment sector actually having any professional experience in what the extra-financial implications and complexities are when an investment is made based on “sustainability concerns”, is that advisers and asset managers lack guidance on how to obtain, be faithful or even start to think about their clients’ impact objective.

In the conventional investment world, everyone understands fiduciary duty, an obligation of money managers to act in the best interests of their clients – typically centred on financial performance.

But without the integration of substantial and substantive professional support from the many areas of “sustainability” which is needed to understand the sustainability dimension of choices made regarding where, when and how much to invest, there will likely only be an ever-increasing amount of money invested in “ESG” product – and the paradoxically, or not so paradoxically, increase in gap between that and the amount needed to reach the SDGs.

This concern increases when considering that human rights, and rights derived from other relevant branches of law, is by no means a professional competence integrated in the senior teams of most asset managers or investees. In order to be able to do due diligence on human rights issues, as well as in order to set strategic objectives and report on them, it is crucial to understand what human rights are all about, where they stem from, what effective and meaningful implementation means, including in complex sectors and settings. If this knowledge is not in house – and with a level of seniority which makes it robust – most efforts will at best be futile, at worst damaging.

Traditionally a majority of people may do some charity and leave it there. Social investment, as ESG investing generally, has historically been based on negative screening – i.e. ruling out investments in certain types of businesses such as fossil fuels or tobacco.

Contrary to broader ESG investing, where the focus to a great extent has been on investing “green”, social  investment  is still in its adolescent stage. With potentially some of the problems that come with being an adolescent – being a bit unruly and not really good at rules. But its potential impact is enormous. And the part about not being good about the rules may in great part be due to the aforementioned fact that very few asset mangers or ESG investors are consummate sustainability professionals with senior level experience in implementation of social SDGs globally.

But there is no doubt that the very nature of the business is changing. No longer will the most successful funds be those that have negative screens, i.e. that assert they do not invest in certain businesses.

It will be more about how do you mainstream your social sustainability in all your investments and engage your investee to create both return as well as further sustainability. It has been argued that “when a corporation is able to credibly commit to contracting with its stakeholders on the basis of mutual trust and cooperation and a longer-term horizon – as opposed to contracting in an attempt to curb opportunistic behavior – then the corporation will experience reduced agency costs, transactions costs, and costs associated with team production”.

The source for this is Robert G. Eccles, Ioannis Ioannou, and George Serafeim in “The Impact of Corporate Sustainability on Organizational Processes and Performance”, but interestingly they refer to sources from respectively 1995, 2007 and 2011. Perhaps now is the time for this to become more widely not only recognized but also actively promoted by investors and ESG investment advisors, as well as truly  implemented.

For many though, the main concern of responsible business is no longer how to mitigate negative externalities of business practices, but rather how to find ways in which businesses can anticipate and prevent negative impact in the first place. This precautionary turn means a significant step towards increased responsibility of firms, which goes beyond symbolic efforts and implies a major change to the overarching business model.

Given their nature as financial intermediaries, responsible enterprise takes on a specific form for asset managers. The impact of asset managers is not only measured through direct operations in offices and branches, but also through investments, which can lead to involvement in unsustainable practices. As asset managers often provide the majority of external finance to companies, they can require firms to embrace sustainable business models.

Part of the social responsibility movement has to be to remove the profit-only-driven paradigm on all corporate/business decision making and offer a new incentive for creating alternative metrics to determine corporate success. But it has to be more than that, because business will still need to, have to and want to create profit, even to a lesser extent. But it is also a question of how to approach sustainability, on the societal aspects, with professionalism and cross-sector fertilization of professional competence. Because if we need to make profitable and socially responsible investment and practices mainstream we need people who know how to create ROI and people who know how to put in place both safeguards from negative social impact as well as advance positive practices on a very concrete and practical level.

There are going to be certain programs that create less profit or that for a time may even eat into profit and thus do not create a financial return on investment. That’s a reality investors and financial advisors must face and recognize as well as get comfortable with.

While investors make efforts to combine profit and ESG goals, they seem to do so to a limited extent. Non-financial measures are not widely included in remuneration, also because most in-house staff grapple in to actually include them considering their professional expertise and experience lies elsewhere, while products and services have a two-dimensional nature. Stakeholder engagement, a tool that can help align incentives, is often quoted but lacks sufficient credibility in most reports.

The article “The Impact of Corporate Sustainability on Organizational Processes and Performance” noted above, outlines that what is referred to as “High Sustainability" firms also appear to be more long-term oriented: these firms "have an investor base with a larger proportion of long-term oriented investors and they communicate more long-term information in their conference calls with sell-side analysts. Since information is a crucial asset that a corporation needs to have for effective strategy execution by management, as well as the effective monitoring of this execution by the board, [the authors] find that High Sustainability firms are more likely to measure information related to key stakeholders such as employees, customers, and suppliers — and to increase the credibility of these measures by using auditing procedures." The authors also find that "High Sustainability firms not only measure but also disclose more nonfinancial (e.g., environmental, social, and governance) data."

Professors Eccles, Ioannou, and Serafeim further find in their study that “High Sustainability firms also perform better when we consider accounting rates of return, such as return-on-equity (ROE) and return-on-assets (ROA) and that this outperformance is more pronounced for firms that sell products to individuals (i.e., business-to-customer [B2C] companies), compete on the basis of brand and reputation, and make substantial use of natural resources. Finally, using analyst forecasts of annual earnings we find that the market underestimated the future profitability of the High Sustainability firms compared to the Low Sustainability ones.

Transparency is a pre-condition for assessing and improving sustainability practices. You cannot judge without transparency, it is as simple as that. Transparency builds on the idea that an open environment in the company as well as with the community will improve performance. The only way for companies to accomplish transparency is through open communications with all key stakeholders built on high levels of information disclosure, clarity, and accuracy – as well as an openness to recognizing faults and improving practices.

Narrow views on corporate governance emphasize legal and accounting compliance, with a focus on shareholder returns. Broader views of corporate governance include ESG issues, as well as responsibilities to wider stakeholders groups. Transparency and Corporate extra-financial Responsibility is more effectively achieved through improving the quality of corporate governance, rather than mandating specific disclosures. It is here that corporate governance converges with ESG responsibiliy, and the legal and moral liability of managers and directors come together.

Forward-thinking companies.

The financial world today is moving towards all things ESG quickly. Forward-thinking companies, as demonstrated by several studies by now, almost always have a much lower financial risk, insurance risk, liability risk. When a company runs a clean operation respectful of labour rights and with stakeholder engagement then inspections, regulatory requirements, and any environmental or social worries will be integrated and cease being a worry. This will result in fewer inspections, less fines, less hassles, less complaints and less negative press or pressure from consumers.

We have seen this before to the point where regulatory agencies use clean, environmentally friendly facilities as comparisons when visiting other facilities. Clearly this is also going to be the case with societal and general governance issues.

The trend is clear – the societal part of sustainability is becoming ever more prominent. Broadly speaking risks of NOT being sustainable – and being able to show it – range from: Penalties/fines as a result of breaches of regulations (e.g. EU SDFR); Litigation – see e.g. Shell having a case litigated in the UK even if the damage was overseas; Loss of social / regulatory licence to operate; Reputational cost in a society where consumers are ever more demanding that the products they have access to are sustainably produced; Competing with firms who will obtain increased revenues/profit from “responsible” products/services, and who will have improved risk management as well as access to capital compared to those who do not operate and show to be operating sustainably; Risks related to the inability to make repayments due to environmental/ social costs and simple loss of value; Potential direct liability for investors – who will want to avoid that risk when they make investment decisions: the danger of damage to reputation through association with polluting, exploitative or ‘unethical’ investees – which they will want to avoid thus funnelling their investments elsewhere.

If you ARE sustainable there will be: Increased and sustained shareholder value; Employee attraction and retention; Customer attraction and retention/increased market share; Improved risk management; Preserved licence to operate; Enhanced brand and reputation; Improved access to capital; Increased revenue.

Sustainability-sensitive Investors.

More and more stakeholders are making decisions based on companies’ sustainability performance, as reflected in the growing market share of sustainability-sensitive investors, the proliferation of codes of sustainable business conduct, and the widening acceptance of voluntary standards for reporting sustainability performance. The focus on the societal and thus the human rights aspects are ever increasing. Finally.

If you are NOT amongst those who are at the forefront of this, investors will look for those that are – responding to both asset owner pressure as well as consumer and regulatory pressure.