As ESG officially goes “mainstream”, ethics and governance adviser Clare Payne believes directors must understand the nuances of an area that has moved far from its inception.
The term “environmental, social and governance” (ESG) was first reported in 2004 by the UN Global Compact. With its origins in finance, ESG saw global financial institutions committing to better integrating ESG issues into analysis, asset management and securities brokerage.
ESG has come a long way since these early initiatives. There’s now a growing acknowledgement that ESG is mainstream, and not just for financial markets, but also businesses and consumers.
The evidence is in the numbers. In February 2021, Bloomberg Intelligence announced that Global ESG assets may exceed US$53 trillion by 2025, representing a third of global assets under management (AuM).
Despite the continuing COVID-19 pandemic, 2021 saw record inflows to financial products labelled ESG and “sustainable”. Now, many CEOs and boards find themselves under pressure to increase disclosures around ESG issues, with ESG-specific reporting becoming commonplace. These businesses are also competing to hire ESG and sustainability professionals to build out their internal capabilities.
However, at the same time, we’re also seeing a range of commentary and activity that may lead some to question whether ESG already needs fixing. For example, in 2020, the United Nations Principles for Responsible Investment (PRI) began de-listing signatories for not meeting requirements. Then in 2021, the US Securities and Exchange Commission (SEC) began investigating whether ESG claims were misleading.
Accusations of “greenwashing” (misleading claims about environmental credentials) are frequent, with litigation growing.
The 2021 investigation by the SEC and German authorities into Deutsche Bank AG’s asset management is considered a “landmark probe” and is being watched closely by those in finance.
In Australia last year, the Australian Securities and Investments Commission announced a review of the threat of greenwashing, and law firms are warning of the risk of climate-related litigation.
False claims and rising scepticism about the authenticity of some ESG claims threatens to undermine an otherwise positive movement. Relabelling products and even the credentials of individuals to meet demand, without the appropriate experience and practices, is being called out, particularly by those who have decades of experience in the field.
Understanding the origins of ESG is key to understanding the criticisms and opportunities. While some claim that ESG has “gone wrong” and is flawed and failing, others see it as a process of refinement — one that is evolving with expectations so that it can be relied upon by investors and others, including the public.
ESG is shifting from its original purpose, and many of the criticisms aimed at it — such as ESG awards for high polluters — relate to misunderstandings about what it was designed to achieve. At the outset, ESG was created as an additional tool to assess non-financial risks and assist in making more informed financial decisions in the selection of companies to invest in or lend money. ESG was a tool to maintain share value and financial performance of a portfolio.
Many outside the world of finance have been under the impression ESG holds a more noble purpose. Specifically, that ESG considerations are used to improve environmental, social and governance outcomes. Of course, both are possible and there is evidence of positive societal impacts beyond financial returns.
ESG professionals welcome the focus on an area in which many have long been advocating, and are also constructively working to make ESG better and more reliable; lifting it to a more noble purpose.
With combined experience of over 70 years in ESG-related fields, these professionals share a range of views on the current state of ESG.
“As a journalist friend often reminds me, two is a coincidence, three is a trend. Three recent events show this is a fascinating inflection point and trend in history for ESG. Firstly, the recent AGL bid demonstrating that environmental considerations can lead the largest takeover offer in the Australian energy market, of Australia’s largest emitter. Secondly, the devastating events in Ukraine, with energy security and social impact at its core.
Thirdly, the ‘one-in-a-1000-year’ storms battering the Australian coast — evidence of the changing climate resulting in more severe and frequent storms. These events are showing ESG is not just about reporting, it is the central part of the political economies we live in. This moment will be recorded in textbooks as [a time] when large-scale shifts took place to put ESG truly on par with capital returns in the Australian financial markets.”
Katerina Kimmorley, board member NSW Net Zero Emissions & Clean Economy, independent investment committee member Investible, director Allume Energy
“It is increasingly clear that, on its own, ESG integration is not enough to align the financial system with sustainable development because it isn’t anchored on sustainable development boundaries and objectives. That is changing with the focus on sustainable development goals, Paris alignment and the influence of impact and activist investors. However, the investment industry still has a long way to go.”
Pablo Berrutti GAICD, senior investment specialist Stewart Investors Sustainable Funds Group
“The seismic shift towards ESG consideration in capital markets is a fundamentally positive move. While we are moving through a phase of professionalising the approach to ESG — with regulators and standard-setters globally playing catch-up — the ultimate outcome is shifting us closer to having better-informed capital markets that better respond to the full suite of risks across financial and non-financial issues, and deploying capital in a manner that better aligns with a future that meets the expectations of our beneficiaries.”
Simon O’Connor, CEO Responsible Investment Association Australasia
“ESG has come a long way from a few years ago. There is greater understanding and quantification of ESG-related issues and greenwashing is getting called out more often. I’m concerned about ESG being confused with sustainability, as ESG needs a purpose. And that purpose is not to make more money or waste company resources providing disclosure on immaterial company information. The weight of interest in ESG should lead to better outcomes for society and the environment.”
Mark Andrich, founder/CEO Sustainable Platform
“The ESG movement holds much promise, however, we must continue to work to ensure that its potential is reached. I’m still optimistic ESG will evolve more strategically and that loopholes will be closed.”
Dr Bronwyn King AO MAICD, founder and CEO Tobacco Free Portfolios
Five director tips
Directors must understand changing expectations and ensure they are confident in ESG and the sustainability policies and practices of the organisations in which they have influence. Areas of ESG development for directors to keep abreast of include:
- Move to clear definitions of sustainable practices and labelling of products. A 2017 European Commission report into the term “green” — in the context of green bonds, lending and listed equity — found definitions are often developed individually and vary in regard to scope, level of detail, transparency and other dimensions. However, a likely outcome of greenwashing and climate-related litigation will be the formalisation of definitions.
- Standardised ESG reporting. With more than 600 ESG reporting standards used across business and financial markets, there are calls for consolidation. At the 2021 UN Climate Change Conference, the International Financial Reporting Standards established the International Sustainability Standards Board to bring consistency/comparability to ESG reporting standards. In August 2021, the World Economic Forum reported that business leaders welcomed the G7 and G20 finance ministers’ support for mandatory sustainability reporting.
- Regulations and disclosures to ensure trust in ESG and prevent greenwashing. In July 2020, the EU Taxonomy came into force, designed to create security for investors, protect private investors from greenwashing, help companies become more climate-friendly, mitigate market fragmentation and shift investment to where it is most needed. In December 2021, New Zealand passed legislation making climate-related disclosures mandatory for large publicly listed companies, insurers, banks, non- bank deposit takers and investment managers.
- Holding businesses to account for progress on ESG commitments. Engagement has long been a method by which investors and ESG professionals try to understand risks and improve impact. The 2018 PRI report, How ESG Engagement Creates Value for Investors and Companies critiqued the pros and cons of different forms of engagement. There are also calls for more progress reporting, including when policies are implemented rather than announced.
- Proactively identifying blind spots. Despite COVID-19 highlighting the interrelation of people and health with the economy, the “social” of ESG remains less of a focus in comparison to “environment”. The formalisation of the Modern Slavery Act 2018 and continued focus on human rights in supply chains is a positive development. However, measurement of human health is almost invariably underdeveloped, with a limited focus on occupational health and safety of staff and supply chains — or it is entirely absent. Efforts appear to be weighted to the “E” of ESG, leading one to predict the “S” will soon make its way up the agenda.
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