Valuations
ESG is a non-financial element frequently appearing in financial reports traditionally excluded from financial analysis.
Harvard Business School’s George Serafeim advocates integrating ESG efforts into strategy and operations. He says that “an ESG focus can help management reduce capital costs and improve the firm’s valuation”. He adds that positive action and transparency on ESG matters protect companies' valuations as more global regulators and governments mandate ESG disclosures.
Research by Rachelle C. Sampson and Yuan Shi says, “Firms that make significant investments for longer-term payoffs have future cash flows that are discounted less by investors than the cash flows of firms that allocate a smaller portion of their cash for the long term”.
When looking at risks, Gray Maguire says “high-performing ESG companies are better at managing company-specific business and operational risks and, as a result, are less likely to suffer incidents that affect their share price. They also tend to have lower exposure to systematic risk factors, leading towards lower cost of capital, and demonstrate better operational performance and ultimately cashflows.”
Companies pursuing and publicising major sustainability initiatives among investors in integrated reports generally attract disproportionate numbers of longer-term shareholders.
Focusing on more sustainable and environmentally friendly business practices has led to companies spending more time on innovation. The results are improved costs, efficiencies and, ultimately, shareholders’ value.
Brand and Reputation
ESG similarly impacts brand value and equity. A renowned branding expert and Forbes Councils Member, Bo Bothe, says, “ESG reporting is quickly becoming the new annual report.” He adds, “[It is] an essential management tool that helps companies identify and mitigate risk, address operational inefficiencies, attract, and retain talent, and strengthen their brands.”
NGOs are focusing on justice matters like human rights, highlighting any perceived failings of corporates, lobbying and threatening litigation.
Unlike 20 years ago, stakeholders today actively investigate sustainability practices and environmental and social impact before engaging with a company. A myriad of literature discusses pressure from clients to consumers—from the Millennial, Gen Z cohorts in particular—communities and staff.
Millennials account for 23% of the global population and thus have the economic power to shape investment trends. They prioritise ESG investments, with interest in ESG rising from 84% to 95% between 2015 and 2019, according to MSCI’s
Swipe to Invest: The Story Behind Millennials and ESG Investing report.
Talent Attraction and Retention
As already stated, ESG is becoming a major consideration for the younger generation. This applies to their choice of employers, too.
In titled
ESG as a Workforce Strategy, Marsh McLennan Insights says, “ESG performance can help companies both improve employee satisfaction and attract prospective employees”. It states, “Satisfied employees work harder, stay longer with their employers, and seek to produce better results for the organisation,” and “Enthusiastic prospective employees strengthen a company’s talent pipeline and ensure the availability of crucial human capital.”
Impact on Finance
Green finance (also known as sustainable finance) considers ESG when making investments. The European Union has led the charge with initiatives that channel private investment into a “climate-neutral, climate-resilient, resource-efficient and fair economy”.
On the back of the EU’s example, South Africa’s first national Green Finance Taxonomy was launched on 1 April 2022. In a media statement, the Treasury said that the Taxonomy allows that “Investors, issuers, lenders and other financial sector participants can use the taxonomy to track, monitor, and demonstrate the credentials of their green activities” confidently and efficiently.
This illustrates the significance of ESG on finance on a national level as the Taxonomy ensures that national priorities are reflected and thus integrated into companies’ ESG activities.
Transparency and Disclosure
Let’s not forget the weight of King IV for institutional investors in principles 3 and 17 specifically. Both address responsible corporate citizenship, and the latter requires that the governing body of an organisation ensures responsible investing that promotes good governance and value creation by those investment benefactors.
The JSE recently launched its Sustainability and Climate Disclosure Guidance consultation papers to “promote transparency and good governance and guide listed companies on best practice” in ESG disclosure.
Investors and business leaders are increasingly applying ESG non-financial factors in their analysis to identify a company's material risks and growth opportunities. This is not a trend but a natural progression of reporting.
World leaders met in Glasgow for COP26 to address the critical and urgent issue of climate change. There, the IFRS Foundation Trustees announced three significant developments, namely:
Together, these developments create the necessary institutional arrangements set out in the
Foundation’s revised Constitution.
The ISSB will sit alongside, and work in close cooperation with the IASB, ensuring connectivity and compatibility between IFRS Accounting Standards and the ISSB’s standards. The ISSB and the IASB will be independent, and their standards will complement each other to provide comprehensive information to investors and other capital providers.
Investment Strategies
ESG is shaping investment strategies. It has become one of the primary considerations for investors before making a purchase. As Deon Gouws puts it, “In the past few years, ESG funds have become mainstream; if you even begin to question the strategy, you will be seen not only as a contrarian but probably also as a heretic.”
Evidence of this is seen in the JSE and B Corp ratings on ESG and the Nasdaq ESG Reporting described as a “voluntary support program for companies” launched in May 2019.
Regarding sustainability benchmarks and indices, the MSCI South Africa ESG Leaders Index is a “capitalisation-weighted index that offers exposure to companies with high ESG performance relative to other South African entities.
“In 2015, the JSE partnered with FTSE Russell to produce the FTSE/JSE Responsible Investment index series, which comprises all eligible companies who achieve the required minimum FTSE Russell ESG rating”.
Pension Funds and insurers’ investment policies are required to consider any factor that may materially affect the sustainable long-term performance of the asset in which they are (or intend to be) invested, including ESG factors.
The Code for Responsible Investing in South Africa (CRISA) requires institutional investors to disclose to stakeholders at least once a year, fully and publicly, to what extent the Code has been applied. Principle 5 states, “Institutional investors should be transparent about the content of their policies, how the policies are implemented and how CRISA is applied to enable stakeholders to make informed assessments.”
The Gallup survey in the USA shows that roughly one-quarter of US investors (aged 18 and older) confirm looking into corporate governance policies or the social values that company leadership advocates before buying. Slightly fewer (35%) research the environmental record or impact of a company.
Corporate Governance
For years, B-BBEE has sought to address racial inequalities in corporate governance and increase empowerment among the disadvantaged. In a way, the framework propels South Africa forward regarding socio-economic growth and development. However, the country still lags behind its international peers in integrating ESG holistically into its corporate and investment activities.
There is enormous potential for organisations to flourish in their social impact ESG endeavours by embracing the principles of B-BBEE. Namely, employment equity, skills transfer, supplier development, investment, enterprise ownership and management.
ESG has become a burning issue for boards. Failure to consider ESG factors could constitute a breach of duty of care and ethical responsibility (resulting in legal action) since they are ultimately responsible for oversight and protection of their companies.
See, for example, this short, non-exhaustive list of ESG compliance regulations:
- Regulation 28 of the Pension Funds Act requires boards to consider factors that may materially affect an asset's sustainable long-term performance, including ESG factors. Note that regulation 28 has a subsequent marked effect on the ESG practices of other institutional investors and asset managers.
- The Prudential Standard GOI 3 requires insurers’ (inc. life-, non-life-, and re-insurers) investment policies to (among others) also consider factors that can materially affect sustainable performance, including ESG factors.
- Promulgations to law concerning carbon tax, energy efficiency, and a national minimum wage.
There are numerous elements in multiple laws and regulations to consider regarding ESG. It is essential that compliance with ESG requirements is part of any organisation's risk management due to compliance requirements and social pressure.
For this reason, companies are pressured to incorporate ESG metrics into their incentive and remuneration structures for executives.
M&A and Succession Planning
It is evident that ESG affects every facet of business and should therefore be considered in your succession planning strategy. ESG should be woven into the fabric of an organisation and not treated as something tacked on at the end of reports.
I encourage organisations seeking to embrace ESG to contact your
local Moore firm here.