Environmental, social and governance (ESG) issues have become very important issues in the investment world. Sustainability has been one of the more significant recent trends in global financial markets. It has taken the form of investors' desire for sustainable responsible investing (SRI) and corporate management's focus on corporate social responsibility (CSR). An increasing proportion of global assets are being managed with a focus on sustainability. As global asset managers focus more and more on sustainability concerns, of which ESG issues form a major component, issuers will be increasingly pressured to show how they are addressing these issues.
What are ESG Factors?
ESG factors are environmental, social and governance risks and opportunities facing businesses. ESG factors include:
- Environmental issues. Pollution and contamination of land, air and water; legal compliance issues; eco‑efficiency; waste management, recycling and reuse; water use and efficiency; energy use and efficiency; natural resource scarcity; climate change and carbon emissions reduction strategies; and hazardous chemicals.
- Social issues. Treatment of employees; health and safety; labour conditions; child labour; human rights; supply chains; equality and diversity; and dealing with customers and communities.
- Governance issues. Governance, environmental and social issue management; anti‑bribery and corruption; business ethics and transparency; accounting standards; executive remuneration; and political contributions.
Why are ESG Factors Relevant?
A recent report that investigated over 200 academic studies and sources on sustainability1 demonstrated the economic relevance of sustainability parameters for corporate management and for investors. That study reported that:
- 90% of the cost of capital studies show that sound ESG standards lower the cost of capital.
- 88% of the studies show that solid ESG practices result in better operational performance.
- 80% of the studies show that stock price performance is positively influenced by good sustainability practices.
Given the foregoing, the study concluded that:
- It is in the best long‑term interest of corporate managers to include sustainability into strategic management decisions.
- It is in the best interest of institutional investors and trustees, in order to fulfill their fiduciary duties, to require the inclusion of sustainability parameters into the overall investment process.
- Investors should be active owners and exert their influence on the management of their invested companies to improve the management of sustainability parameters that are most relevant to operational and investment performance.
- It is in the best interest of asset management companies to integrate sustainability parameters into the investment process to deliver competitive risk‑adjusted performance over the medium to longer term and to fulfill their fiduciary duty towards their investors.
- The future of active ownership will most likely be one where multiple stakeholders (such as individual investors and consumers) are involved in setting the agenda for the active ownership strategy of institutional investors.
- There is need for ongoing research to identify which sustainability parameters are the most relevant for operational performance and investment returns.
How can an Issuer deal with ESG Factors?
Given the growing importance of ESG factors, an issuer would be well served to adopt policies and procedures which will assist potential investors in assessing whether that issuer adequately addresses the sustainability parameters which investors are reviewing in their investment management process.
The manner in which an issuer will demonstrate this will vary from issuer to issuer and will depend upon the industry that particular issuer is in. There are, however, common practices which can be adopted by many issuers:
- Good quality disclosure by the issuer which shows that the ESG factors have been considered by the issuer is a first step. A lack of disclosure may create doubt over the quality of the issuer's management of such factors. One of the simplest ways to show that the issuer has considered ESG issues is for the issuer to adopt policies in the relevant areas. Examples of environmental, social and governance policies are readily available but should be tailored to the specific circumstances facing the issuer. Other governance arrangements which are potentially relevant include Codes of Conduct, Bribery and Corruption Policies and Whistle Blower Policies. If you are a public company, your policies should be publicly disclosed.
- Having a policy in place is not enough, however, as the issuer must also implement the guidelines set out in the policy. The issuer should keep a record of the steps it takes to monitor the application of its various policies. By way of example, if an issuer has an environmental policy in place which mandates the monitoring of its properties, a detailed record of such monitoring should be kept showing the dates on which the properties were reviewed and the results of such review. It should also show the steps which were taken to remediate any problems.
- If the issuer has retained any external experts to prepare reports then the steps taken by the issuer to implement any recommendations by such experts should be documented in the records kept by that issuer.
- Any certificates, licenses, or consents should also be kept in easily accessible locations for immediate reference should the need arise. It is also important to keep a record of any breaches of such certificates, licenses, or consents as well as details of any health and safety accidents or incidents. Legislation may require that the foregoing records be disclosed.
Implementing the foregoing will serve an issuer well should an investor come knocking at the door as the issuer will be able to immediately respond to that investor with a well prepared and readily available due diligence package which will demonstrate that the issuer has considered, and takes seriously, the ESG factors relevant to that issuer.
Other Benefits – M&A Considerations
Should the issuer ever be put on the market the same policies and procedures which the issuer adopted will also serve it well in any potential merger or acquisition scenario. As ESG factors are becoming more and more important, potential purchasers are focusing more and more on them when they are trying to determine whether a potential target is worthwhile.
An issuer that has implemented the policies and procedures set out above will be well on the road to demonstrating to a potential purchaser that they have the policies and procedures in place to alleviate any concerns that a purchaser could have. This will impact not only the likelihood of the potential transaction occurring but it may also positively impact the price that the issuer will ultimately get. If the issuer can show that there are no outstanding ESG issues and any which did arise have been dealt with effectively than the purchaser will not be in a position to negotiate any price reductions (or at least not any significant ones) based on poor ESG performance.
The foregoing is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, please contact the author who would be pleased to discuss the issues above with you, in the context of your particular circumstances.
1. Gordon L. Clark, Michael Viehs and Andreas Feiner, "From the Stockholder to the Stakeholder – How Sustainability can Drive Financial Outperformance" (London, U.K.: Arabesque Partners in association with Smith School of Enterprise and the Environment (University of Oxford), March 2015).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.