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It’s one thing to talk about sustainable finance, it’s another thing to put it into practice. Studies show that adopting environmental, social and governance (ESG) principles is good for business, but doing it right requires companies to develop a proper framework that communicates their purpose with sustainability as a prominent driver. If investors and businesses aren’t thinking about integrating ESG, they will need to start soon as sustainability is here to stay. This is the third in a three-part series on sustainable finance.
In August 2019, the 200 CEOs that make up the Business Roundtable released an updated Statement of Purpose. Since its formation in 1972, the roundtable was mostly focused on developing initiatives and promoting policies that support company shareholders, but it amended its purpose to say it’s committed to all stakeholders and “moving away from shareholder primacy.” Essentially, the CEOs explained customers, employees, suppliers and communities should be on the same footing as the shareholder.
More companies around the world are following the roundtable’s lead, seeking a connection between purpose and long-term profit and ESG becomes an accelerator for that path.
"Boldly Grow the Good in Business and Life"
In June of this year, BMO CEO Darryl White unveiled the bank’s commitments to support a thriving economy, sustainable future and inclusive society. "BMO is driven by a single Purpose to Boldly Grow the Good in Business and Life,” he said. “At our core, we are focused on driving positive change for our customers, employees and the communities where we do business. Our bank is mobilized and accelerating. And in every new opportunity we take on, we're driven by a clear purpose and a bold ambition – one that mirrors the aspirations of our customers."
A UNGC – Accenture Strategy CEO Study on Sustainability1 shared that a majority of CEOs think that businesses should be making a far greater contribution to achieving a sustainable global economy and society by 2030. To make this a reality, CEOs will need to shape their companies into becoming highly purpose-driven entities with the firm support of their Boards of Directors. This may redefine value creation, while creating new incentives and pricing structures.
A Statement of Purpose campaign has begun, taking the stand that the Board of Directors is the ultimate authority for representing the interests of the corporation. The goal is that by 2025, the board of every listed company, and others, will publish a Statement of Purpose aimed for providing sustainable returns to shareholders. Initial guidance from collaborators such as Hermes EOS, Said Business School, Berkeley Law School and others is that the board would publish a page articulating the company’s purpose and achieve a sustainable solution for society2.
People have come to expect that companies and investors link purpose and profit through careful application of material ESG factors. The idea that companies can benefit their communities or environment and, in turn, the planet, has been touted by socially responsible investment (SRI) experts for years. Research shows that by following various ESG tenets, company profits increase. Harvard Business School’s George Serafeim, Robert G. Eccles and Ioannis Ioannou found that companies able to measure, manage and communicate ESG performance outperformed a control group over the next 18 years3.
Further, strong ESG proposition links to value creation and cash flow by facilitating top-line growth, reducing costs, minimizing regulatory and legal interventions, increasing employee productivity and optimizing investment and capital expenditures.4
Creating and communicating purpose
Factors such as reputation and other intangible assets are responsible for over 80% of the perceived market value of the S&P 500 companies5. Therefore, it is increasingly important for corporations to fully understand the impact their ESG profile has among stakeholders and shareholders. Interviews of 70 executives at global investment firms revealed that “ESG was almost universally top of the mind”6.
As part of developing a Statement of Purpose, businesses will need to conduct a materiality analysis, identifying a few critical ESG-related actionable strategies that could significantly impact business performance. By identifying these, companies would gain more insight into what they’re doing right and what can be improved upon. Ultimately, it would allow businesses to define their purpose, which would then drive their environmental and socially beneficial products and services – and profit.
Sharing purpose is also important. Businesses and investment firms must make it clear to stakeholders how they plan to integrate ESG into their decision-making process and other corporate activities. In addition, they need to show how their ESG initiatives are aligned to their bottom line. Communicating these plans is critical – by owning the narrative and sharing social and environmental impact activities with the public, businesses can better manage risk and showcase the good work they’re doing.
Organizing a systematic, annualized approach to investor relations and communication is an influential step where active involvement from the Board of Directors benefits the company long-term. (see figure 1)
A systematic, annualized approach to shareholder relations and communication
Figure 1: Harvard Law School
While work still needs to be done, ESG is here to stay, which means executives should examine ESG considerations in all their key business decisions.
Onto New Dimensions
The 2019 Global Risks Report, published by the World Economic Forum identifies, for the first time, the top three global risks are related to climate change: extreme weather events, failure of climate change mitigation and adaptation, and natural disasters. (see figure 2) Climate change is a key ‘E’ issue for most companies and investors today. Applying systems thinking would allow companies to build impactful strategies for both mitigating this risk while embracing opportunities for a just transition to a low carbon future.
The Global Risks Interconnections Map 2019
Figure 2: WEF
Another significant trend is assessing ESG issues in the arena of mergers and acquisitions, which is already happening. A recent Responsible Investor article put it this way: “It is hard to think of any financial decision where managing ESG risks – and indeed identifying sustainable growth opportunities – would be more important than when acquiring an entire company, or a sizeable stake in a business.” Ninety percent of the corporate executives interviewed conducted ESG due diligence before making an acquisition7.
It’s not hard to understand why M&A leaders care about ESG: it encompasses climate change, cyber security, labour standards, board diversity, executive pay, supply chain sustainability and more. Ignoring these fundamental tenets of good corporate citizenship puts companies at risk.
Investors are also constructing portfolios that integrate ESG, including in fixed income as illustrated in figure 3. Companies need to see that ESG is both a risk and an opportunity – businesses that don’t adapt subject themselves to a host of problems, including reputational and operational, while the ones that do will be much more prepared for the future.
Diagram of ESG integration by investors in credit risk analysis.
Figure 3: PRI
Imagining a new normal
While ESG is becoming more mainstream, there’s still a long way to go before we see a large emergence of purpose-driven companies. We have ushered in a new start, but it will not drive the transformation over the long-term quickly. For that to happen, we need more innovation. As I discussed in my last article the world needs a more diverse set of sustainable investment offerings to help foster the development of new technologies, ground-breaking ideas and products that address at least some of the 17 United Nations SDGs that sustainable investors are seeking.
One such innovation is transition financing, which will provide funding to energy, transportation and other industrial companies that want to reduce their environmental footprint and demonstrate their commitment to move to a low carbon economy in the face of climate change. It can also help fill a gap in green financing, where certain investments may not meet a green standard, but can still help reduce emissions and mitigate climate change in the near-term.
Companies adopting ESG to drive their sustainability commitments will only grow from here. Meanwhile, investors examining a company’s commitments to sustainability through ESG analysis is a growing market trend.
Investors are also seeing the benefits of ESG investing. In one meta study, 88% of reviewed sources, companies with robust sustainability practices demonstrated better operational performance while 80% of the reviewed studies exhibit that prudent sustainability practices have a positive influence on investment performance.8 Sixty five percent of hedge fund managers are now planning to have ESG policy in place by end of 2019, according to Preqin9. Meanwhile, short-selling laggards in the sustainable investment universe or those exposed to climate risk has emerged as a new trend in the asset management landscape.
Due to the voluntary nature of reporting annually and the lack of standardization, much of the ESG data and disclosures of companies are incomplete today, and often lack insights that investors can directly use. One factor that would accelerate ESG adoption is artificial intelligence. As data collection becomes more advanced and as AI’s analytical capabilities become even more sophisticated, we can imagine a day when, along with the stock or bond prices, quantifiable ESG metrics and other insights will roll across our TV screens on a real-time basis. It will not only be easier for companies to report their own sustainability data monthly, but third-party research firms and sell and buy-side analysts will do more comprehensive analysis themselves.
A company’s purpose, material ESG factors, financial and ESG performance, together with its impact metrics, will be shared as a normal way of doing business. Performance attribution will no longer be limited to financial return; monthly statements from retail to institutional investors could include ESG insights. As well, we’ll hopefully see more companies measure their social and environmental impact in real time, with their ESG profile clearly linked to their purpose. The businesses that do this will be the new winners. It demonstrates transparency and will help their business by giving them access to lower cost of capital or easier access for funding their capex linked to sustainability. Their ability to move forward and transform with a triple bottom line approach will allow them to stay competitive against their peers.
As the sustainable finance industry develops, definitions around ESG and implementation of ESG-influenced business practices and metrics will evolve. If an energy company issues transition bonds, then their ESG impact will need to be re-examined. If oil and gas producers can create a net zero model, funds that exclude these companies will have to rethink labeling them as incompatible with a low-carbon future.
New innovations could make us rethink the way we invest or fund businesses. New entrepreneurs will make us re-imagine what’s possible. More people will see just how all-encompassing ESG can be.
Purpose, as many people are finding out, is becoming paramount. The rise of new corporate forms such as a Benefit LLC, Low Profit Liability Company, Public Benefit Corp and Sustainable Benefit Corp allow different ways for a business to demonstrate its purpose, which means we’ll only see more ESG-driven companies in the future. As Virgin’s Richard Branson says: "If the people who work for a business are proud of the business they work for, they'll work that much harder, and therefore, I think turning your business into a real force for good is good business sense as well."
Manju Seal is Head of Sustainable Finance Advisory, BMO Capital Markets. She is co-host of the BMO Sustainability Leaders podcast, spearheads thought leadership and leads efforts for sustainable finance within Capital Markets. Manju heads efforts at BMO for identifying impactful solutions around green/social bond underwriting, product development and other sustainable financing activities. She has over 20 years of diverse professional experience, including, investment banking, institutional asset management and nonprofit & board leadership.
The views and opinions expressed do not necessarily reflect the views or positions of BMO Financial Group and or its affiliates.
Head of Sustainable Finance, Advisory at BMO Capital Markets. Leading efforts with corporate and institutional clients to incorporate environmental, social and governance (ESG) criteria into their investment considerations. She also spearheads broader Enterprise wide strategy and thought leadership around sustainable finance and ESG investment considerations.
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