My interest in the area of ESG dates back to the year 2008 when I completed my Phd thesis on Corporate Governance and Valuations. The findings of my study suggested that stakeholder value creation is the key driving factor for the financial performance of firms in India. Profit driven from strategies focusing on social and environmental aspects were coined as “ Shared Value” a few years down the line.
Over the last decade, ESG has gained popularity. Ratings and metrics have been used by investment managers and asset management companies. Businesses that hold high rankings in ESG are considered to be better performers and value creators. There is much emerging evidence suggesting that companies that have successfully implemented strategies related to social responsibility and environmental, social and governance screening have delivered superior financial performance and shareholder returns. However, numerous other studies conducted using Dow Jones Sustainability Index have shown inconclusive evidence about correlation between high ESG rankings and financial performance. These criteria and metrics take into account environmental and societal considerations, board gender make up, salary differences, negative press, failures to comply etc. Some corporations focus on these metrics only in form and not in substance, to enhance their reputations and attract socially aware consumers, employees, and investors. That’s why over reliance on ESG rankings by investors have caused some hedge funds to short investment portfolios which are based on ESG ratings and rankings as they believe that high ratings achieved through “misrepresenting and adopting a checklist approach” can boost share prices artificially.
Investors consider these metrics as a tool to identify socially responsible companies or to abate the regulatory or reputation risks of their portfolio companies. Sustainable investments account for more than 25% of all the assets under management globally, according to the Global Sustainable Investment Alliance. Ratings and rankings not only give comfort to the investors but also save their time and effort. However, using only rankings can result in lower alphas in the short term.
There are two key issues in using ESG ratings for investments:
1. ESG ratings and measures are not government regulated and there are lack of disclosures on risks companies face.
2. These criteria do not focus on social innovation and economic value creation which are powerful value drivers.
3. ESG factors are not universal for all types of businesses. For example carbon footprint has nothing to do with the insurance industry.
4. ESG ratings encourage window dressing.
Some experts have stated when investors utilise ESG metrics and ratings for identifying and evaluating their investments they are missing out on superior alpha returns and opportunities to invest in companies that are “truly sustainable – having ability to sustain in long term” and companies that create economic value by investing in social innovation and environmental technologies. It is the social responsibility of investors to identify their investments carefully and to allocate their capital to generate better returns for the society and economy as a whole. It should be recognised that creating competencies, innovation, beating competition, risk management, social responsibility, creation of economic value are all integrated and should be weaved into one main purpose of corporate existence. Failure to recognise this integration can lead to erosion of capital and failure of companies.
Integration of ESG issues into strategy is critical but it should be done without losing the main goal of value creation. Achieving this integration is however, a complex process and will vary from company to company. It requires going way beyond a checklist of material factors.
Companies should focus on value creation socially and economically by focusing on their core competencies, combining social responsibility into their business models, value proposition and efficiencies. Integrating the ESG focus with economic value creation and financial performance focus can result in breakthrough strategies. Investing in such companies will result in higher returns for the shareholders. To identify such companies investors will have to conduct fundamental analysis and follow active investment strategies. Adopting active investment strategies is more time consuming, requires higher engagement with corporates and hiring a large number of ESG analysts by investment management firms. Independent ESG consultants can bridge this gap and make their impact on society by helping corporate and investors in creating “shared value”. They can play an important role in building a meaningful corporate world which is not window- dressed but real.