Stakeholders including investors, clients, customers, employees and communities increasingly want businesses to focus on the environment, their social impact, and good governance. The organizations that focus on these “ESG” principles and measures are earning the trust and loyalty of those stakeholders, and are proving to be more sustainable, driving long-term, profitable growth. For a concept with a fluid definition and, as yet, no universally applied metrics, ESG draws increasing global attention from investors, corporate leaders, trade press and think tanks.
A Common Misunderstanding
“ESG (environmental, social and governance) is a generic term used in capital markets and used by investors to evaluate corporate behaviour and to determine the future financial performance of companies. ESG factors are a subset of non-financial performance indicators which include sustainable, ethical and corporate governance issues such as managing the company’s carbon footprint and ensuring there are systems in place to ensure accountability.” – Ft.com/lexicon, Financial Times
So are ESG principles an emerging priority for investors, or an operational guideline for sustainability-minded companies? “Both, and that’s the beauty.” Kurt Harrison is co-leader of the ESG, Sustainability and Impact Investing team at Russell Reynolds Associates. He says, “ESG has become increasingly relevant in both an investment and corporate strategy context.”
For example, Harrison says, “If you ask a fixed-income investment manager, they will say ESG is one of their core investment metrics.They look at companies from a cashflow perspective, a revenue perspective, and also how thoroughly they are incorporating sustainable investment principles into their business model. It's just another part of their investment process.” He adds, “From a corporate strategy perspective, if you ask an oil and gas company how they think about ESG, they're working on how to move toward carbon neutrality in a world that is pivoting aggressively toward a sharp reduction in carbon footprints and fossil fuels. For them, it is more of an existential question – ‘If we keep doing what we're doing, we're going to be out of business in 20 years.’ So let's think about ESG from a corporate governance perspective and a long-term corporate strategy perspective; how we can actually change our business model to be more sustainable in the long run?”
To counter the notion that ESG is about putting public good ahead of financial returns, Harrison makes clear that is not the case. “The major private equity and investment firms are not going to accept below market returns and change their investment processes, which have been successful for 20, 30, 50 years, just to make the world a better place. Instead, the people who run these organizations have to embrace and understand the fact that employing a more sustainable and ESG-compliant investment process is going to improve financial returns in the long run.”
For example, he says, “If you are a private equity manager and you're raising a new fund with a 20 year time horizon, you know that 20 years from now the world’s going to be a very different place. You have to incorporate forward-looking sustainable metrics into your investment process if you’re going to generate above-market, long-term returns. So we can’t sit here and say you should accept lower returns just to make the world a better place, because that’s just not going to work. No one’s going to embrace that.”