Impact investment is growing rapidly. Why? What are the developments? And how is this sector driving the transition to a sustainable and inclusive society? In 6 articles we highlight the developments, opportunities and risks of Purpose & Impact investment. This is the first article.

By Martin de Jong & Anne Rademaker

“Doing good and getting good from it”: ESG investing is booming business

Environmental & social governance (ESG) information is considered relevant information by all stakeholders of an organization. It is mainly used for CSR/sustainability measurement for management and for external reporting purposes. Since investors understand that the highly rated ESG companies outperform their competitors and the market financially, there has been a rapid growth of ESG investments. Moreover, ESG investments boomed during the COVID-19 blowout. Reasons enough to examine the trends, positives and negatives of ESG investing and the ultimate question: how does a company improve its ESG performance?

Source: Visual Capitalist August 2020

ESG development

There is hardly a serious institutional investor who does not want companies to be active on ESG. Can you imagine that just a decade ago this was the reverse? The general perception was that ESG investments led to lower returns and higher risks. In recent years, this has changed dramatically: from a nice to have to a must have. If a company does not have ESG reporting, a growing number of potential investors are not interested. It is not a reward, but a mindset of punishment. Investing in ESG companies and funds (ETF) is developing rapidly because their financial performance generally outperforms non-ESG companies. It confirms: there is a causal relationship between ESG and financial performance.

The following question looms: Does an ESG company outperform the market because they are active in ESG? While many studies are available on the financial impact of investing in ESG companies, little academic research can be found on why. With a growing knowledge base on ESG investments and shared value creation by companies, it is expected that more models will emerge that will show the dependencies and interrelationships between ESG and other value drivers within a company. Article 6 of this series will address this more through Impact measurement.

What’s great about ESG investing?

Do you want to be remembered as a company that was great at making money? Or at creating value? ESG helps capture that value by qualifying a company’s efforts, processes and results in a social context. Consequently, the CEO and company are rewarded for their ESG progress. Rewarded for the social impact of more ESG-focused business operations, for financial outperformance and for attracting responsible ESG investors.

ESG investing also encourages companies to raise the bar on quality, transparency and reporting. As a first step, environmental and social metrics and targets must be reported. Internal processes should be created and a governance structure established. Based on externally available information, investors and other relevant stakeholders can ask questions and engage with the board on ESG. This mix of visibility and engagement can only lead to improvement. In practice, we see great examples of how companies are achieving this, such as carbon emissions reductions: A few years ago, a reduction in CO2 (in line with the Paris Agreement) was considered ambitious. Today, this ambition should be carbon neutral or even negative. The disclosure of ESG information on carbon emissions has helped with this.

What’s wrong with ESG investing?

ESG investing leads to better financial returns and a better world. How can this be wrong? The vast majority of institutional investors consider ESG in their decisions and have signed up to the Principles for Responsible Investment. This results in the fact that almost all listed companies publish ESG data and cooperate with well-known rating agencies (e.g. MSCI, Bloomberg, ISS, Morningstar, Vigeo Eiris, RobecoSAM, CDP, Thomas Reuters, and more…) to obtain an ESG rating. Consequently, the best-performing ESG companies by sector are popular with investors and thus the effect on our planet and life on it. In theory.

In practice, ESG information and intelligence does not have the level of maturity like financial data. This is the biggest concern of investors. And rightly so, as few companies have solid data of ESG performance over the years. And this is curious, as we have seen that a company’s ESG performance has become one of the key drivers of investment decisions.

Second, many companies treat relevant ESG information as a compliance checkbox. Once a year, during the preparation of the annual report, ESG information is gathered and the ESG table is created. So instead of using ESG on a daily basis, integrated into a company’s strategy and operations, as a way to build a sustainable, resilient business, it is mainly to satisfy investors and get a higher rating.

In addition, many companies paint a better picture of their performance. On purpose. External validation of ESG data often has “limited assurance,” meaning the auditor could not find evidence that the reported data is not true. While large teams of external verifiers are used for financial data, this is very limited for ESG data. So plenty of room for “ESG-washing. More on this in article 3 of this series:‘SDG-washing‘.

Fourth, investors rely on rating agencies, which have a rating function but do not show the true impact of real performance: An analyst creates a data file of a company, supplements the information and uses big data assumptions to fill in the gaps and identify the outliers. At a high level, this works fine, but zooming in shows two major problems:

• The ESG rating by rating agency can be very different, as a recent Harvard study showed
• Investment decisions are made based on high-level, possibly incorrect, big data assumptions.

We believe that solving the problems is related to improving qualitative ESG data and thus ESG performance as a first step, which we discuss below. And quantifying ESG data, which we refer to as Impact measurement, is the second step, which we will discuss in article 6 of this series.

How do we improve ESG performance?

The quality of financial and related commercial company data is also needed for ESG data. This means strong uptake of solid data over time, just as with financial and commercial data. It doesn’t just require an investment in data capture. It requires a culture change. People are used to thinking and acting with money, but need to think and act on qualitative ESG data. This is also where a huge opportunity lies. Getting not just management but the entire company on board requires a corporate change. ESG (or internal CSR sustainability or even impactful purpose) should be at the core of strategy and vision. Translated into product design and operations. Managed with internal teams and data systems leading to internal insights and progress, which is part of recurring board reporting and discussion. One company that has understood this well is SAP.

Since a company is “in business while it is under construction,” there are ways to improve ESG performance even in the short term. But there is no “one size fits all,” it is very company dependent. For example, the system legacy, what data is tracked, in what detail and by which business entity? What are the processes for capturing and validating data? If a company is just starting out, an outside-in look can be helpful: what kind of information are the rating agencies asking for? How does this fit with our ESG strategy? What ESG information is actually relevant? How do we combine ESG information with SDG reports? How does our information fit into ESG ratings? How do we include this information in our annual report? And how are our ESG risks managed, which requires strong collaboration on risk management (article 2 of this series, will explain the importance and difficulty of this).

ESG investment is here to stay. And companies should strive not only to be the ESG leader of their sector to be more attractive to investors, but also to outperform the market financially and create a company’s social value. Truly “doing well by doing good” (Benjamin Franklin).

This article was also published at: https://www.duurzaam-beleggen.nl/blog/doing-well-by-doing-good-esg-investing-is-booming-business/