The End of the Beginning
Beginning in the 1990s, a silent revolution began to transform how business dealt with environmental, social, and governance (ESG) issues. Only two decades ago, concerns about climate change, water scarcity, exposure to corruption, working conditions in the supply chain, and gender equality were barely on the agenda of company executives. They were considered externalities or were dealt with through philanthropic approaches with little or no impact on the bottom line.
Today, however, such issues are high on the agenda of CEOs and boards across the globe, as their material relevance for influencing costs and revenues are increasingly recognized. Thousands of companies from all continents are now integrating, at various different stages, ESG considerations into strategies and operations. What had started off as a moral imperative and as an ad hoc response to crisis situations has evolved into a truly global social movement. It is a movement known by many labels such as “corporate social responsibility” (CSR) or “corporate sustainability,” but is bound by a singular recognition that in an interdependent world, long-term financial success goes hand-in-hand with social responsibility, environmental stewardship, and sound ethics. And the cast of many thousands of actors who are helping to shape its growth are increasingly known as Generation S, those who understand the power of sustainability to create positive change.
In a recent landmark study, the international certification body and classification society DNV GL analyzed the history and impact of this movement, using the UN Global Compact – the world’s largest corporate sustainability network – as its core reference point. The study concluded that although notable impact has already been achieved, the corporate sustainability movement has so far produced only incremental change towards the goals of sustainable and inclusive markets.
To achieve transformation, four interconnected pathways will need to unfold.
First, the silent majority of companies that still operate on the maxim of short-term profits need to start embracing corporate sustainability, and even companies more advanced with their sustainability credentials need to more deeply integrate material ESG issues into the core of their corporate strategy. Second, a new narrative needs to be developed for the role of business in society. This narrative should redefine growth (how much is necessary?) and prosperity (should it only be measured in financial terms?) as a means of better protecting the planet while serving the needs of the people. Third, public policy failures which are holding back the corporate sustainability movement need to be addressed.
Finally, and what holds the most promise, is the need for greater alignment between companies and investors in the financial markets. This pathway is especially important because the first three alone will not lead to the pace of change necessary to ensure a sustainable society in the years to come. This is somewhat ironic. While the corporate sustainability movement can be fairly said to have a 20-year history, the investment community has only climbed on board in the last 10 years at best, and probably only in the last one or two to any degree of seriousness. Indeed, this marks the end of the beginning as we move to a significant and needed acceleration in this social movement.
Concerning the first pathway, it is fair to assume that the corporate sustainability movement will continue to grow over time due to the rise of transparency, stakeholder pressure, resource constraints, and regulatory developments. This will help broaden and deepen the movement so that it becomes the new standard. But the pace of growth based on these forces will be slow and it will take many more years before the movement has reached a critical mass that will be strong enough to change markets overall.
The same can be said about the second pathway of the emergence of a new narrative that has a strong enough appeal to change consumer behavior and lifestyles. While there are pockets of changing consumer behavior in areas such as food and transportation choice in some markets, the overall pace of change is slow and there isn’t a game-changing force within sight.
On the policy front, the third pathway, the Paris Climate Summit has set a new framework that aims to drive innovation and ESG integration over time, especially through policy changes such as pricing carbon. But at the same time, massive policy failures in other areas such as international peace, security, and good governance cast a dark shadow into the future. And if the past gives us any indication for the future, then enlightened policy making is unlikely to be the solution.
By far the most promising pathway ahead to accelerate actions toward more sustainable and inclusive markets is the alignment between the corporate sustainability movement and the world of finance. True, most capital today is invested in creating non-value added activities or in companies that are pursuing short-term profit maximization that have little or no concern for long-term impacts on the natural environment or societies’ well being. And despite the financial crisis of 2008, the landscape has changed little. But a number of developments have taken shape over recent years which suggest that financial markets have the potential to catch up with the corporate sustainability movement. This is manifest in a number of ways:
- Starting in 2005 with the creation of the Principles for Responsible Investment (PRI), institutional asset owners and asset managers have created awareness about the material relevance of ESG issues. PRI today has over 1,300 members representing over 60 trillion USD. Many of its members have initiated actions to better integrate ESG considerations into analysis and decision-making. These members are also committed to engaging with portfolio companies on their material ESG issues.
- More recently, the global dialogue on the fiduciary duty of trustees has evolved significantly. Today, it is widely recognized that the integration of ESG issues should be part of fiduciary duty. This realization constitutes a major game-changer and suggests that large asset owners in particular can now significantly accelerate ESG integration through their choices in how they allocate equity and debt capital.
- This enlightened view of the fiduciary duty of fund trustees complements and reinforces the growing recognition that the fiduciary duty of company board directors is to the corporation itself, not to shareholders which is commonly believed. This is not to say that shareholders are unimportant. To the contrary. What this means is that shareholders’ long-term interests are best served when company boards identify the company’s significant audiences and their expectations.
- The facilitation of better resource allocation decisions by both companies and investors and the quality and quantity of relevant information on ESG performance — something we take for granted with financial performance based on reporting requirements grounded in long established accounting and auditing standards — is improving. Investors increasingly require actionable information to account for ESG risks and opportunities. Despite progress made by the corporate sustainability reporting movement led by Global Reporting Initiative (GRI), the absence of relevant information has traditionally been a major barrier for investors. These gaps are now being filled thanks to the work of the International Integrated Reporting Council (IIRC), through “The International <IR> Framework,” and the Sustainability Accounting Standards Board (SASB), which has- created industry specific ESG performance metrics. While there are still many gaps and inconsistencies – the Global Initiative for Sustainability Ratings (GISR) offers a one-stop shop for over 400 sustainability rating schemes in use – data availability and quality is continuously improving.
- Evidence is now emerging that companies which focus on material sustainability issues also have superior financial returns, as demonstrated by the 2014 meta-study ‘From the Stockholder to the Stakeholder’ from the University of Oxford and Arabesque Partners. Leaders at the forefront of the corporate sustainability movement have long understood that good ESG and financial performance are intertwined. As the movement continues to grow and data availability improves, this evidence will in future be even stronger and it will be increasingly difficult for financial analysts to ignore the material relevance of ESG factors.
A fusion of the corporate sustainability movement with finance is now within reach. Thematic green bonds and impact investing are rapidly growing. Most recently, a new investment style has emerged: the “ESG Quant fund” which uses ESG performance as a core ingredient for quantitative models for buying and selling stocks. Indeed, the ESG Quant fund approach is breaking new ground. Whilst quantitative models in the past were exclusively based on financial information, ESG information has until recently been used primarily for screening purposes in “socially responsible investing.”
ESG Quant is breaking down the historical barriers that have existed between these two investment strategies. By systematically using state of the art ESG performance in combination with proven quantitative approaches across all industries, a powerful tool is now available to reinforce the corporate sustainability movement. As this approach gains momentum, more investment will flow into companies with superior ESG performance and thus stimulate better environmental stewardship, enhanced social responsibility and sound ethics.
Already, the ESG Quant approach has a strong performance track record, and therefore stands a fair chance of stimulating a major shift in the asset management industry. If significantly embraced by the investment mainstream, it will greatly accelerate changes and contribute to greater sustainability and market inclusion. Hundreds of billions or even trillions of dollars could move to this style, enhancing and increasing the integration of material ESG issues by both corporations and investors, and yielding superior performance for both.
For nearly two decades, thousands of individuals from all walks of life have been developing and improving the impact of the sustainability movement. A fusion with the world of finance now signals the end of the beginning, and marks an important new phase in the growth of Generation S.
About the Authors:
Dr. Robert Eccles is Chairman of Arabesque Partners, and Professor of Management Practice at Harvard Business School. He is a leading academic authority on integrated reporting and an award-winning author of twelve books. Dr. Eccles is also the founding Chairman of the Sustainability Accounting Standards Board (SASB) and is a steering member of the International Integrated Reporting Council (IIRC).
Georg Kell is Vice Chairman of Arabesque Partners and is the founder and former Executive Director of the United Nations Global Compact, the world’s largest voluntary corporate sustainability initiative with over 8,000 corporate participants in more than 160 countries. Kell also oversaw the conception and launch of the Global Compact’s sister iniatives on investment and business education, the Principles for Responsible Investment (PRI) and the Principles for Responsible Management Education (PRME), together with the Sustainable Stock Exchanges (SSE) initiative.
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