Why does good ESG performance attract investment?
The Wall Street Journal reported earlier this year that USD 8.7 trillion is now invested in U.S. equities that demonstrate environmental, social and governance (ESG) principles.
But why are investors increasingly backing high ESG performers?
The rationale is quite simple. If management teams and corporate leaders are integrating ESG issues into their decision-making processes, we can assume that they will have a more holistic view of their business, potential risks and opportunities, and therefore are more likely to flourish.
On the other hand, companies that ignore ESG issues may be taking risky short-cuts that fail to explore innovation opportunities in the long run, while increasing potential legal and reputational costs.
Do not rest on the score alone
A number of data providers provide ESG scores of companies to help investors choose suitable investment opportunities. But what is the actual meaning of an ESG performance score? Does it constitute a performance indicator to attract investors and to ensure the formulation of a sustainable company? Theoretically - yes.
But as Yogi Berra once said, “In theory there is no difference between theory and practice. In practice, there is.”
Even if two companies achieve the same score, which would appear to indicate an equal investment opportunity, their performance trajectory could be considerably different. And that difference depends on the ability of their human capital.
What about People?
Besides reviewing a company’s technologies and processes, investors should adopt stronger consideration of People in their investment strategies and decisions. This means assessing investment opportunities based on the ability of a company’s team to solve complex problems, such as innovating towards sustainability, maintaining robust growth and creating long-term value, while at the same time minimizing negative externalities. However, to what extent do investors consider these capabilities?
The answer is, not very much. For example, questions may be asked regarding the board members’ ‘understanding of sustainability issues’ or ‘oversight of ESG issues’, but these are not covered in depth. Our research on rating providers shows that there is no mandatory request for additional information on the educational or professional ESG background of the members of the Board of Directors, or the executives who are responsible for shaping the sustainable corporate path of their company.
What can companies do?
Invest in their People! Instead of seeking to invest only in the adaptation of best practices, or developing infrastructure to improve operational efficiency, companies could improve their ESG performance by investing in People with a strong Environmental, Social and Governance background.
An effective approach for this is based on three steps:
1. Ensure to use the skills of People within the company who have a strong educational and/or professional ESG-related background.
2. Invest in educational enhancement, by providing adequate and frequent training to employees at all levels.
3. Create an effective working environment, by aligning the recruitment strategy with a maximization of the cognitive diversity of the group.
Address the ‘How to’
Fortunately, there is light at the end of the tunnel. And it is not difficult to see it.
· A growing number of universities now offer sustainability-relevant degree programs and courses, and as a result many new graduates are already educated on addressing sustainability issues. Our Senior Partner, George Serafeim who is also the Jakurski Family Professor of Business Administration at Harvard Business School is teaching a relevant course in the MBA curriculum ‘Reimagining Capitalism: Business and Big Problems’. Additional research and articles from HBS on the topic can be found here.
· There are plenty of custom-made training programs from advisory firms and NGOs, for both corporate executives and investors, on ESG integration and governance. Our team at KKS has worked extensively with investors, helping them with ESG integration as well as with corporations in developing sustainable strategies.
· There is demonstrated added value in efficiency, where the work environment is characterized by cognitive diversity. One of our experts, Alison Reynolds has shown that cognitive diversity is what corporations need to succeed in dealing with new, uncertain and complex situations.
Face the ‘What if’
A previous article from KKS and the UNEP FI describes a more effective governance model called ‘Integrated Governance’. This brings sustainability to the board level, and is “the system by which companies are directed and controlled, in which sustainability issues are integrated in a way that ensures value creation for the company and beneficial results for all stakeholders in the long term”. But how many existing corporations have a governance structure constituted by sustainability experts with an adequate background on ESG topics?
I am afraid not many. Most corporations are sticking to their existing governance models, while trying to adapt to the requirements of a new era. But as we already know: “We cannot solve our problems with the same thinking we used when we created them”.