- … building sustainability, corporate resilience and financial performance through ESG compliance framework.
The COVID-19 pandemic offers an opportunity to align business models with ESG principles to better prepare for the future crises. Environment, social and governance issues and the risk and opportunities they create are becoming increasingly relevant for organizations of all sizes to pay attention to. Managing risk that ESG create is a challenging proposition but doing nothing is not an option either. Therefore, the significant momentum to address environmental challenges and its impacts on business performance should see issues of sustainability and social responsibility firmly put in the spotlight.
It is believed that the economy is in transition to a sustainable economic model where economic growth is coupled with improved social and environmental outcomes. To maximize re-adjusted financial returns is to address the world’s sustainable challenges particularly climate change, environmental pollution, natural resource constraints, demographic and human capital issues such as diversity, inclusion and gender equity.
And as many businesses continue to search and champion the agenda for how they could remain financially profitable, sustainable and socially responsible as these traits are positive points for investors, governments and customers, the deepening expectation to build support systems that care about the impact of the society is arguably imperative. The interesting concern is that, the value of an investment is no longer just about returns but the impacts those investments have on societies and the world at large. In fact, socially responsible investing or impact investment as it is termed calls for the growing demand of the proliferation of funds and strategies that integrate ethical considerations into the investment process and outcome, the expectation of investors. Hence, this series intends to look at the balance of ESG compliance and the relative impacts on corporate resilience, sustainability and profits. Let’s talk ESG compliance, a tool for building corporate resilience and financial stability.
ESG and the future of Business:
The consideration of shifting attitudes towards social responsibility both from consumers and businesses as well as the rise of ESG investing in general, have clearly necessitated why this framework is gaining traction. In fact, investors claim that, sound investing are as a results of the integration of ESG factors into the business and that, driving sustainable and socially responsible investing business, ethics and corporate governance are now moving to the forefront as metrics to identify how well a company is performing. With this initiative backed by the increasingly demand of investors to see that environmental issues are factored into the financial portfolios, aiming at responding to the differentiating services of the environment, social and governance as criteria for screening workflow define the future of businesses.
Consequently, ESG information is considered beneficial for investors and society due to its significant role in the financial markets. A key concern with mandating ESG reporting is whether it can have effects on firm’s financial policies and performance. There is a current evidence connecting environmental, social and governance credentials with the bottom line results of business. It is advised and shown that, financial reporting affects firm’s investment behaviors by reducing information asymmetries and agency costs, improving external monitoring and reducing inefficiency in managerial decisions. Besides, key potential benefit for ESG reporting is the improvement it offers in investment efficiency.
In addition, ESG performance is acknowledged from investors, firm managers and other stakeholders as significant variable to increase the firm’s value. This is made possible by the production and the incorporation of ESG into managerial strategies of the firm to reduce risk. Much more, the identification of concrete links between ESG and financial performance is said to accelerate the uptake of ESG criteria as a prime driver in investment strategies and their influence on corporate decision making. Industry and geography are also determining factors when it comes to corporate concern with specific elements of ESG. A palm oil producer in the rainforest for instance will have a very different ESG profile to a financial services provider in the city. For the palm producer, environmental considerations will be paramount while the financial institution, governance issues such as executive remuneration will play key.
Also, academic studies into the link between ESG and financial performance show on the whole a positive correlation. This is justified by a 2015 research report of Smith School of Enterprise and the Environment at the University of Oxford and Arabesque Asset Management that looked into the relationship between ESG and financial performance. The report cited among other things the correlation between better operational performances with robust sustainability practices coupled with strategic ESG management translating into positive cash flows as evidential among companies. The review also revealed that, prudent sustainability practices had a positive impact on investment performance.
Global Trends and Regulatory Agenda:
The global trends point to COVID-19 crisis having to bring ESG factors to the forefront of every aspect of our lives. Its impact has seen financial institutions more likely than ever to increasingly consider climate-related, biodiversity and other nature-based risk and opportunities into investment decisions. It has equally put the spotlight on long-term resilience in portfolios and highlighted the importance of robust risk management processes.
These trends on sustainability reporting practices suggest that non-financial reporting plays a key role in improving investment efficiency which can in turn have significant consequences on the real economy, an added benefit to providing more transparency on firm’s corporate and social responsibility. The rising significance to adhere to international climate change targets through UN Sustainable Development Goals (SDG’S) and the Paris Climate Protection Agreement championing the realignment of capital flows towards sustainable investment, the inclusion of sustainability in risk management as well as the promotion of transparency and longevity bring to bear the core essence of what the regulators are looking for.
Besides, the creation of specific sustainability strategies and the respective revision of business strategies in relation to target customers, new products, new performance metrics, the inclusion of sustainability risks in the risk strategy and the overall risk management framework are some responds measures to curtail or manage ESG opportunities and risks across the organization.
ESG and Corporate Sustainability impacts:
Meanwhile, while most studies have been aimed at ESG investing with financial motives, ESG materially can affect financial performance in myriad ways. Better management of environmental and social factors can generate new opportunities, minimize ESG risk and decrease costs. The real case scenario is that, the growth in sustainable investing has made the appeal of ethical funds to shareholder groups with different priorities, have significant or less direct, impacts on corporate finances.
To make a justification for this assertion, consumers who want to make sustainable choices now decide to purchase goods and services from companies they believe are environmentally and socially responsible and are making an immediate contribution at the bottom line. In the value chain for instance, good governance could mean stronger relationship with suppliers, leading to reliable goods provision, increased efficiency and attractive credit terms. Digging deeper, environmental policies could protect natural resources, safeguarding raw materials feeding into the supply chain. On the hindsight, relocating production facilities is considered a strategy that could reduce both pollution and transport costs with guaranteed resource supply cutting exposure to volatility in those markets. All of these factors promote corporate profitability.
Again, as was captured in our previous series on ESG and the human capital impacts, we noticed that, staffing is another area where ESG can have a financial impact. Fair pay, employee perks, receptive management and clear corporate purpose would all ensure a satisfied workforce. This means greater productivity and the attraction and retention of talent, reducing the costs associated with staff turnover. Aon Hewitt research study concluded that, a 5% increase in employee’s commitment to their employee led to a 3% increase in revenue the following year, an assertion that goes to compliment ESG position for performance impact.
Relationship between ESG and Firm Performance:
ESG is the integration of firm performance regarding its economic, environmental, social and corporate governance performance. With this, individuals and institutional investors pursue attractive financial returns that associate with a positive impact on communities and the environment. Godfrey (2009) argued that investment in ESG is insurance for reputational risks. Therefore, an ESG rating reduces the residual risk of the firm through its non-accounting parameters.
Several studies have also provided evidence to the correlative impact ESG has on a firm’s performance. One such viewpoint is the Stakeholder theory which suggests that CSR and ESG activities can improve the relationship between firms and their stakeholder. The resource-based view also assumes that a firm’s resources are invaluable, unique, imitable and non-substitutable. Such resources allow them to conduct CSR activities to develop their brand image and public reputation thereby boosting their appeal to employees, enhance customer trust and subsequently strengthen their competitive advantage and improve the firm’s financial performance.
It is equally argued that, high ESG ratings lower the residual risk of companies compared to the market. Many studies have explored the relationship between ESG and corporate financial performance as admitted by Sasen (2006) showing that, ESG has a negative and significant impact on all types of risk related to the firm. With this Barnett argued that, financial gain is achieved through an improvement in the trustworthiness of the relationship with stakeholders and reduction of transaction costs. King and Lenox (2000) explain that low environmental performance leads to operational inefficiency due to a competitive disadvantage. Hence, the ESG performance of the firm is related to its operating performance through a reduction in costs and risk.
Therefore, firms that adopt corporate social responsibility or ESG framework is said to do so as a tool for value creation. That being said, corporate sector businesses in this perception can achieve social responsibility through profitability as the firms with profitability can deliver the returns to investors, fulfill employee need and commitment and supply quality goods and services to customers.
This trend will drive growth for well-positioned companies and create risks for those unable or unwilling to adapt. Fundamental analysis which incorporates long-term risks, including ESG factors enhance investment decisions. ESG can provide a window into this intangible value and can serve as a canary for the early detection and identification of problems in companies especially in combination with financial or strategic changes. With regards to the connection between financial resilience and ESG is that, ESG make companies more sustainable and tend to also make them resilient and companies that are more resilient are better positioned to weather the inevitable future crises and downturns and ensure they bounce back quickly from them.
Managing ESG Risk and Key learnings:
Financial institutions are operating in highly challenging and unpredictable times as we all know. They are still managing and responding to the impacts of the COVID-19 pandemic. They have proven their resilience and adaptability through this time and need to do so again over a longer time frame with ESG risk. Organizations’ ability to cope with COVID-19 as well as with ESG risks largely depends on their level of maturity in terms of operational resilience. Moreover, frameworks for operational resilience are designed not only to preserve business continuity, but also to enable organizations to permanently adjust to changing conditions.
In view of this and whatever the structure, risk management of ESG must run right across the business. Whether it is in relation to credit and lending decisions, the underwriting of insurance cover or the investment strategy across an asset portfolio, client relationship owners must factor ESG in and actively discuss it with their clients. They have a role to play not only in following the ESG approach of the institution itself, but in helping clients consider and build up ESG strategies of their own.
The holistic approach starts with sound risk governance and a sensible risk strategy before being implemented into the risk management cycle. While the establishment of a central coordination unit for ESG risk can be beneficial, enhancing the roles and responsibilities of existing units across the three lines of defense-in business units themselves, in risk and compliance functions and in internal audit is key.
In summary, it is instructive to mention that, having a formalized ESG analysis framework in place helps build resilience in the long-term and promote positive financial health for businesses. Therefore, the identification of concrete links between ESG and financial performance and the commitment for accelerating the uptake of ESG criteria as a prime driver in investment strategies and influence on corporate decisions is critical.
Discovery….Thinking solutions, shaping visions.
ABOUT THE AUTHORS
Frank is the CEO and Strategic Partner of AQUABEV Investment and Discovery Consulting Group.
Dr. Genevieve Pearl Duncan Obuobi (Banker/SME Consultant and Leadership Strategist
