Investor engagement with environmental, social and governance (ESG) factors has risen over the last two years. Business reaction to the Covid-19 pandemic has underscored the importance of these three areas to the long-term survival of businesses and societies ...likely to bring about lasting change.
Engagement by investors with companies on non-financial issues such as corporate governance, the environment or social responsibility is not in itself new. However, under the umbrella term of ESG, engagement in these areas has intensified over the last six months to a year.
There is growing emphasis on ensuring the long-term success of a company, encouraged by governments and regulators in response to a more mainstream awareness of the societal licence of companies to operate. ESG factors are recognised as having a significant impact on this success and as such, investors and companies are increasing their focus on them. Addressing these areas also responds to society’s desire to understand the impact of a business beyond its financial success.
A changing conversation
Deborah Gilshan has 20 years’ experience working in investment stewardship at three large institutional investors including the Co-operative Insurance Society, RPMI Railpen and Aberdeen Standard Investments. She now advises investors on stewardship, covering issues such as diversity, governance, remuneration and climate change. ‘It’s that longer-term time horizon that companies and investors automatically need to think about when they think about ESG considerations,’ she says. ‘I think [ESG engagement] instils a much longer-term perspective.’
‘I think more and more investors are beginning to realise… that these ESG factors are additional sources of risk and return,’ says Gilshan. ‘These are, very often, very long-term risks. Climate change is a very long-term risk; it’s manifesting itself now, but it will continue to do so over the longer term.’
Ensuring the long-term success of a company, therefore, is about understanding and managing these risks, as well as identifying the opportunities they offer to create long-term value.
Abigail Herron is Global Head of Responsible Investment at Aviva Investors. ‘There’s empirical evidence that shows that taking responsible investment factors into account does produce stronger performance over the long term,’ she says. It’s a natural evolution, therefore, to see ESG becoming more central to the dialogue between investors and companies as the emphasis on ensuring long-term success increases.
‘I think [ESG engagement] instils a much longer-term perspective’
Deborah Gilshan, adviser to investors on stewardship
‘The conversation has completely changed,’ says Marion Plouhinec, Senior Global ESG Analyst at Legal & General Investment Management (LGIM). ‘In the past just advising [clients] on our voting records, numbers for or against, would suffice,’ she says. ‘Whereas now, the conversation is more around: why did you vote against that company? What are you going to do about this coming meeting?’
Herron agrees, noting a completely different situation in respect of ESG compared to 15 years ago and ‘an enormous appetite for new products.’
A push for evidence of engagement outcomes
A greater focus on the outcomes of engagement has influenced the discussion between investors and companies. Regulators and governments have played a large part in this development. The UK Stewardship Code stands out as an initiative that, since its revision in 2019, places ‘a strong focus on the activities and outcomes of stewardship’, asking investors to ‘explain how they have exercised stewardship across asset classes.’
‘The UK Stewardship Code has certainly helped to up the game for everybody,’ says Maria Ortino, Global ESG Manager at LGIM.
According to Gilshan, ‘the new [UK] Stewardship Code is a real game-changer in terms of more transparency of the activities of engagement by signatories.’ She hopes that the move towards evidencing outcomes will also ‘drive more forceful stewardship… that is quite transparent to the marketplace about what’s being done on their behalf with their money.’
There are also international initiatives to encourage engagement and reporting on ESG issues. The Principles for Responsible Investment (PRI), for example, is a global umbrella organisation for the sector and the leading international proponent of its work. The Financial Stability Board (FSB)’s Task Force on Climate-related Financial Disclosures (TCFD), meanwhile, seeks to develop recommendations for voluntary climate-related financial disclosures that will provide information to investors, lenders and insurers that they can use in their decision-making processes. In 2017, it published recommendations for climate-related reporting, including specific disclosures organisations should include in financial filings or other reports to provide useful information to investors.
The PRI is supportive of the TCFD recommendations and has included TCFD-aligned indicators into its own reporting framework. From 2020, it intends to make some of these climate indicators mandatory for its signatories to report but voluntary to disclose. Herron says this is ‘going to push people to [make] this voluntary TCFD disclosure.’ She sees this trajectory as leading to ‘some form of black letter law underpinning [the TCFD] in the next few years.’
There is already some regulation in this area on the horizon in the form of the European Union regulation on sustainability-related disclosures in the financial services sector, which will apply from March 2021. As part of the regulation, financial markets participants will be required to integrate sustainability risks into their decision-making processes. The EU is also working on a taxonomy regulation, which would introduce common criteria for defining what constitutes environmentally sustainable economic activities.
The importance of purpose and profit
On a micro level, there is also a very human element behind the rise in ESG engagement. This has come about as individuals outside the world of professional investment begin to make the link between their own values and their financial products, especially their pensions, and in some cases identify a disconnect between the two. ‘They might personally take great offence at a topic such as modern slavery,’ says Herron, ‘but then their pension invests in companies that aren’t really doing much on this topic.’
Herron says NGOs and the media are doing significant work to help individuals understand the relationship between their finances and their values. ‘When people realise that it’s pretty straightforward to make sure your pension fund aligns with your values: that’s when we see the magic happening,’ she says. Sallie Pilot, Chief Insight and Engagement Officer at Black Sun, an organisation specialising in stakeholder communications, agrees, and says ‘there is a lot more acknowledgement by society as a whole of… the importance of purpose and profit.’
Embedding ESG
As a result of all these developments, investors are now looking for ESG factors to be embedded throughout a company’s corporate strategy, rather than being treated as an afterthought.
Many of them are using ESG scores as a way of understanding how a company is performing in these areas, often as a starting point for more nuanced, one-to-one engagement. There is caution about relying solely on third-party data, as it often isn’t reliable on its own and doesn’t paint a true picture of a company’s ESG activity. Instead, investors can develop their own proprietary ESG scores, which take into account a range of third-party data as well as their own insights.
This information is often used to rank companies, allowing them to identify the laggards in particular areas and take those findings to the individual company as the starting point for a more detailed conversation. Plouhinec describes how LGIM has used ESG scores to launch social and governance campaigns. ‘We engaged with a total of 98 companies on their scores and the idea was to raise awareness around the increasing use by investors such as LGIM of ESG scores to make investment decisions,’ she explains.
‘There is a lot more acknowledgement by society as a whole of… the importance of purpose and profit’
Sallie Pilot, Chief Insight and Engagement Officer at Black Sun
Plouhinec says that LGIM also encourages companies to check their ESG data to ensure it paints an accurate picture of their activities, because investors are increasingly utilising that data.
Businesses are starting to take note. ‘Companies used to have a corporate or financial strategy and then they had a sustainability strategy,’ says Pilot. ‘But you should have one corporate strategy.’
‘When we look at [the] strategic priorities of an organisation, about 75 per cent of them have some beyond growth and profit and revenue… and they’re also measuring it through [a] performance metric,’ she adds. ‘Because of this we’re seeing more of an integration of the sustainability story into the annual report, because those issues are material, or business critical.’
Significantly, Pilot has begun to see ESG factors linked to executive remuneration, which is ‘quite telling in terms of [these issues] being on the boardroom agenda.’ Companies are also beginning to discuss ESG factors in their investor presentations, and hiring to ensure they have the right expertise in place to respond to the rise in ESG engagement. ‘We’re seeing investor relations teams hire people just to deal with ESG communications,’ says Pilot.
This is reflected on the investor side too, as ‘it’s an absolutely red-hot market for hiring talent in responsible investment,’ says Herron. ‘Investment consultants are staffing up so that they’re able to offer a much more sophisticated service to their asset-owner clients around responsible investment.’
Material issues and the impact of Covid-19
One of the best ways to ensure ESG engagement is constructive is to focus on issues that are material to the company. Pilot describes these as ‘the most important issues to a company’s business model and strategy.’ Gilshan agrees, and believes ‘the key issue has to be materiality.’ Not every issue under the ESG heading will be material to every single company, she highlights.
When an investor recognises this, it can lead to a much better relationship with the company and better outcomes. Marco Bollini is Chair of the IBA Corporate Counsel Forum. In his experience, from the company perspective, it is much easier to engage with investors who have a thorough understanding of the context in which the company operates and the nuances of the business it carries out, particularly when it comes to ESG engagement. ‘If the stakeholder arrives prepared then also the company is prepared and the dialogue or the [constructive] confrontation is much more useful,’ he says.
The Covid-19 pandemic has left us in no doubt as to the materiality of ESG issues. For Herron, ‘Covid-19 is the biggest medium-term ESG issue that we’re facing.’ The way that companies have responded to coronavirus has laid bare their culture and values. The weaknesses it has exposed generally fall under the non-financial areas of engagement that investors would undertake with companies. Some of these risks had been raised by investors in previous engagement and have been underscored by the virus, while others have been pushed up the agenda by the current crisis and are unlikely to drop back down in the future. ‘When we find ourselves in a crisis situation like now with Covid-19, this is where ESG really matters,’ says Ortino. ‘In a sense it confirms what we have done [on ESG] during all these years.’
‘When we find ourselves in a crisis situation like now with Covid-19, this is where ESG really matters. In a sense it confirms what we have done [on ESG] during all these years’
Maria Ortino, Global ESG Manager at Legal & General Investment Management
In terms of corporate governance, for example, Covid-19 has exposed the risks associated with ‘overboarding’, a term referring to a board member who holds too many board positions to be able to execute their duties successfully. In 2019, major investors LGIM, BlackRock and Vanguard all strengthened their positions on this issue, outlining policies that capped the number of external positions directors should take on depending on their board role at the company in question. Overall, there was a lack of tolerance for directors taking on more than four external positions and, in some cases, the investors suggested directors limit themselves to just one additional board position.
Because Covid-19 has left no company untouched, it has exposed the risk of overboarding to its full extent. Following lockdown across major jurisdictions, all companies are in crisis mode and making difficult decisions very quickly. This presents a real challenge for a board member who holds too many positions: how will they prioritise their time? Ortino says that, when you hold multiple board positions, ‘in a time of crisis there is no way that you can be up to date with all the companies that you are sitting on the boards of.’
The need for boardroom diversity is also highlighted by Covid-19. ‘If you have tough decisions to make, you absolutely need teams of people who are diverse and who are able to challenge each other to get to the best outcome,’ says Gilshan. A lack of diversity can lead to groupthink, a term that refers to a board composed of similar people who are likely to make decisions based on a limited set of experiences. ‘You most certainly don’t want to have groupthink at this time,’ says Ortino.
For Plouhinec, ‘this crisis has demonstrated that we, more than ever, need good ESG, we need a competent and functioning board, we need a board to deal with unprecedented circumstances.’
Social to the fore
To date, the most overlooked ‘bucket’ within the umbrella term of ESG, has been the ‘S’ for social. ‘Coronavirus has really brought the “S” in ESG into the spotlight,’ says Herron. It’s hoped this new and intense focus on the social impact of business in light of the Covid-19 pandemic will build momentum to bring about lasting change.
In the broadest sense, there is an awareness that some companies have behaved much better than others in response to the crisis. Herron mentions a website, didtheyhelp.com, which is beginning to aggregate corporate responses so that organisations like hers, as well as the public as a whole, can gain an understanding of the best and the worst examples of corporate behaviour during this time. Poor corporate behaviour has reputational implications that will be long lasting. As Herron says, ‘there’s always been an intrinsic link between reputational risk and ESG and I think the response to coronavirus has brought that into even more sharp relief.’
There are also implications for the societal licence of companies to operate when poor behaviour is witnessed, especially when it affects employees or a company’s supply chain. Covid-19 has affected both these areas and in doing so it has reignited the debate over how companies treat all of their stakeholders, not just their shareholders. ‘Once we ever return to some sort of new normal, there will be reflection on the hierarchy of the stakeholder model,’ says Gilshan. ‘I think it’s extremely relevant to think about the fact that the success of a company is based on not one individual, the CEO, but actually… on a team of people, the employees as a body, and that corporate culture is absolutely key to long-term success,’ she adds. Pilot agrees, and believes ‘there probably will be more of an expectation to understand how business responded. Not just to make sure they kept making money, but what beyond that did they do? I hope that will be the hallmark of good companies moving forward.’
At the end of March, LGIM wrote privately to its companies globally to indicate its support for them in this time of crisis. Ortino says the letter also aimed to ‘underscore to them the importance to us that all stakeholders are taken into account when they are making decisions [at] board level that will have an immediate or longer-term impact on all stakeholders: employees obviously and also their supply chains and the contracts that they hold with them.’
Importantly, Ortino says that in the letter, LGIM also said it ‘would be understanding of cutting dividend payouts,’ demonstrating that as a shareholder it is willing to take the appropriate hit to ensure that the stakeholders with the greatest need are prioritised during the corporate response to Covid-19.
‘Climate change is the most significant long-term market failure. It does eclipse everything else [and] there’s no clear-cut remedy on the horizon’
Abigail Herron, Global Head of Responsible Investment at Aviva Investors
The International Corporate Governance Network (ICGN) is an investor-led organisation that aims to promote effective standards of corporate governance and investor stewardship. On 23 April it wrote to corporate leaders outlining its perspective on governance priorities for investors and companies alike when facing the challenge that Covid-19 presents. Significantly, the letter states that ‘Covid-19 presents a new era of engagement, one which… elevates the importance of social factors as a key determinant to a company’s long-term financial health and sustainability.’
The letter outlines the ICGN’s Statement of Shared Governance Responsibilities, which urges companies to, among other things, ‘prioritise employee safety and welfare… pursue a long-term view on social responsibility and publicly define a social purpose… take a holistic and equitable approach to capital allocation, considering the workforce, stakeholders and providers of capital and communicate comprehensively with all stakeholders to instil confidence and trust.’
Kerrie Waring is CEO of ICGN. She says that, in reacting to the crisis that Covid-19 has created, ‘companies must be cognisant of their social contract to operate and heed the need to treat stakeholders equitably. For example, pay policies for executive management should reflect the experience of the overall workforce, particularly in relation to pay level reductions, bonus awards, pension contributions and other benefits.’
Waring stresses that redundancies should be made only as a last resort, especially if the company is in receipt of government grants. She also says that there is increased scrutiny over how sympathetically companies treat their supply chain at a time when many are facing financial challenges and suggests ‘extending payment terms’ as an option for companies to help their supply chain through difficulty.
Build back better
Despite all this, the ‘E’ of ESG can’t be forgotten or overlooked. Climate change remains, as Herron describes it, ‘the most significant long-term market failure. It does eclipse everything else [and] there’s no clear-cut remedy on the horizon.’ Perhaps one of the more positive outcomes of Covid-19 is that we have been forced to travel less, with a significant effect on carbon emissions across the world.
There is growing support to ‘build back better’, which encourages a recovery from the pandemic that takes environmental and sustainability concerns into account. ‘If governments are going to bail out energy-intensive sectors,’ says Herron, ‘we would definitely want to see conditional assurances of a commitment [to] a transition towards a low-carbon future wrapped into any bailout.’
Perhaps the determination to recover from Covid-19 in a green and sustainable way can be attributed, at least in part, to the growing understanding of how ESG factors affect long-term survival, both of businesses and of the planet as a whole.
International Bar Association