ESG & Sustainability

Time to rethink the ‘S’ in ESG

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COVID-19 prompts increased focus on a new ‘S’: the Stakeholder

Almost two years ago, a teenage girl, Greta Thunberg, started her climate protest outside the Swedish parliament, spawning a movement that captured the world’s attention. Over the same period, what was less apparent was the shift in capital markets to place greater emphasis on Environmental, Social & Governance or ‘ESG’ issues at companies around the world. In 2019, an incremental US$70bn is estimated to have been invested in ESG funds while traditional equity funds suffered almost US$200bn of outflows.

What was once a marginal consideration for investors is now front and centre. Since Enron’s collapse in 2001, and subsequent failings that led to the financial crisis in 2008, governance has been high on the corporate agenda. Recently, as regulators, investors and activists have pressurised companies, environmental issues have also come to the fore. ESG factors are also increasingly relevant in the cost of debt– both S&P Global and Moody’s acquired ESG ratings agencies in the past year and are now including those ratings within their overall credit rating criteria.

Despite all this, as a measure, the ‘S’ in ESG – the ’Social’ – has been somewhat left behind and remains the  hardest to define. ‘S’ factors impact businesses every day – customer or product quality issues, data security, industrial relations or supply-chain difficulties – often causing significant reputational damage. Think of the perceptions of how some retailers have treated workers; the damage to FMCG brands of links with child labour; and the loss of confidence in banks when IT systems fail and customer transactions can’t be honoured. These are all factors which fall within the ‘S’.

A 2017 study by the NYU Stern Centre for Business & Human Rights looked at over 1,750 ‘S’ measures from  different ESG rating frameworks – and found those measures were often “vague”.

COVID-19 has reaffirmed that factors relating to ‘S’ are now among the most pressing issues for companies globally. Many employees transitioned ‘overnight’ out of well-performing businesses to effective unemployment. Entire sectors of the economy, and not just the weakest players, are facing a stark and uncertain future. Now, more than ever, a company’s reputation – its ‘licence to operate’ – will be a function of how it engages and manages it stakeholders through this crisis.

Where there was a lack of focus and reporting on ‘S’ in the past, it will now clearly be an element of the corporate story and a prominent pillar of a company’s ESG credentials. It is incumbent on companies to grasp the meaning and implications of a strong ‘S’ and to communicate activity and progress to all stakeholders. The environment we now find ourselves in has also affirmed that we would be better served dropping the ‘Social’ from ESG and replacing with a more appropriate ‘S’: ‘Stakeholder’.

In the early part of the COVID-19 crisis, a number of companies were immediately in the spotlight for what were perceived as poor ‘S’ practices. In the UK, Frasers Group sought to keep its SportsDirect sports retail outlets open in the face of a Government lockdown of all but essential services. Pub group, JD Wetherspoon, was criticised for claiming staff should not be paid after its pubs closed and that workers should seek alternative employment at supermarkets.

Scrutiny of companies will rise further where they are in receipt of Government support; as EU Competition Commissioner Margrethe Vestager outlined: “Support comes with strings attached, including a ban on dividends, bonus payments as well as further measures to limit distortions of competition.” Andrew Cuomo, New York governor went a step further demanding that any corporate bailouts are repaid in full in the event that employees are not rehired after the crisis. A new form of social contract is being moulded between industry, employees, Government and society.

Investors have also clearly articulated the importance of ‘S’ in this new world. Legal & General encouraged companies: “not to focus solely on their shareholders but to focus on stakeholder primacy.” Schroders echoed this stating: “in the short term companies need to prioritise their key stakeholders, in particular employees but also customers and suppliers.” Investment in those stakeholders may be a short-term cost, but it will benefit companies in the long-term.

In seeking to protect and enhance corporate reputation – through good and bad times – a powerful guiding principle is to ‘do the right thing’. Simple as it sounds, it is reflected in the adage that ‘good PR starts with good behaviour’. This guiding principle also translates to building strong ‘S’ credentials. A company’s objective should be to take the steps they genuinely believe are in the best interest of the company and its wider stakeholders. Not every decision will meet the expectations of every stakeholder; but it’s a good place to start.

ESG will never replace financial performance as the primary driver of company valuations. Increasingly, however, it will influence the cost of capital, play an important role in risk management; and, critically, protect and enhance corporate reputation. Companies need to get a firm handle on how comprehensive their policies, procedures and data are in key areas through a candid ESG audit. Companies should then build a strategy around disclosure for communication with stakeholders. What has become clear over the past three months is that a host of stakeholders, including many investors, will expect a sea-change in their access to information. While there is no requirement to be the first mover, those that are laggards will face avoidable challenges and a rising threat to their ‘licence to operate’.

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