ESG: The butterfly effect

Companies need to be aware of a complex web of issues that surround environmental, social and governance factors – or ESG – for their own sakes as much as for that of the world. Mark Evans reports

Two words are hard to avoid these days: Brexit and environment. The former we can safely leave to one side on this page, and the less said about that, the better; but where the environment is concerned, we are a lot clearer on what’s happening and the impact it may have.

It is therefore not surprising that from shareholder meetings to public protests, people are vocal and active in holding companies to account for their actions, a development that is only likely to escalate – from august bodies such as the Association of Member Nominated Trustees (AMNT) demanding the Financial Conduct Authority make companies publish their environmental, governance and social data to rag tag groups like Extinction Rebellion gluing themselves to BP’s corporate headquarters.

And it’s not just environmental records being scrutinised: executive pay, diversity, probity and governance are all under inspection. (One recent report from PwC even suggests that more CEOs are being dismissed for ethical lapses than for financial performance or board struggles.)

The levers that work on any corporate – however good or bad, whether direct or indirect – are the same. The direct effect that an ESG (or RI, or RB or take your pick of acronym) has are on the shareholders/investors; consumers/clients; regulators and employees. There may well be indirect pressure that moves one of these levers (such as general public opinion) but the actual pressure will be from one of the above.

Shareholders clearly hold a lot of the power, and of late many institutional investors and groups have been exercising their power, from the AMNT – an organisation that represents one third of the total UK occupational pensions sector – asking the FCA to investigate fund managers for providing limited choice on ESG matters to activist managers such as Aberdeen Standard Life calling for curbs to executive pay. Whatever combination of financial prudence in avoiding stocks that might dive as certain areas become untenable to genuine interest can never be fully clear, but results are there for all to see.

Consumers or clients have power in a similar way, but are more likely to be concerned about an organisation’s reputation. This, of course, in an inexact science and many companies have appeared to shrug off appalling behaviour whilst others have struggled to overcome even prosaic mistakes.

In some examples this could be because of excellent management and planning, and there is certainly evidence that those companies deemed to have ‘behaved’ in the past will recover better than those that have not. (VW, given the enormity of the Dieselgate scandal have suffered less reputational damage than BP did for the Gulf of Mexico – in 2016 VW Group sales only fell by less than one per cent.)

The bad news is, however, ‘sticky’ as research did show that VW Group suffered every time its lack of ethics and transparency were highlighted by new legal moves. Likewise, for BP, the Deepwater Horizon disaster received more exposure from a feature film starring Mark Wahlberg, so whilst reputational damage might be ‘oversold’ it clearly does exist, and can be on a long fuse.

If reputation can be a slow affair, then regulations tend to move at a glacial pace. But they do progress, and regulators are increasingly expanding their horizons. Last year Ofwat released its conclusions that high levels of executive pay and large dividends were, and are, losing UK water companies the trust of the public.

It was not so much the announcement that was a surprise – there has long been a move against the perceived ‘fat cats’, but that a regulator would take the chance to make a public comment of what only a few years ago would have been a matter only for the companies concerned.

Ofwat actually went further and issued a set of rules to make companies explain how their executive pay is linked to performance – outlined in Ofwat’s 2019 price review (PR19) methodology.

At the time, Ofwat chief executive, Rachel Fletcher said: “Through the measures we’ve announced today, we are strengthening the incentive on companies to improve their performance for customers and cutting the rewards that come from financial engineering.”
Then, of course, there are the employees. The need to acquire and retain people is fundamental, particularly in this period of high employment and a new generation which feels acutely the pressure on the environment and will arguably feel the effects of climate change most. Growing up in the expectation of a fairer society; being an attractive employer is a business necessity.

Randstad, the human resource consulting firm, reported in 2016 the important role of ESG, with 84 per cent of respondents to a survey it conducted saying they would leave their current job to work for a company with a better corporate reputation.

As an aside, it was interesting that in this international survey the UK country-specific research identified a stark mismatch between what workers want and what UK employers are perceived to offer the workforce.

Pick and mix

The complexity of these issues is compounded by the way they intersect and overlap. Perceived bad performance on, say, reducing the company carbon footprint, can lead to adverse public reaction and a decline in reputation that causes a loss of clients, creating a toxic environment at the AGM, where the major shareholders revolt, creating a worse public image, that means recruiting becomes harder.

As an example, earlier this year the Department for Digital, Culture, Media & Sport issued a proclamation that businesses seeking to secure government contracts would need to show that they can also ‘improve society’, such as helping address modern slavery or climate change.

Launched at the Social Value Summit, David Lidington MP said: “Every year, the government spends £49 billion with external organisations and it is morally right that we make sure none of that money goes to any organisations which profit from the evil practices of modern slavery. Similarly, it is right that we demand that the organisations we work with meet the high standards we need to protect our environment and employ workforces which represent our diverse society, including people with disabilities and those from ethnic minorities.”

Blurred lines

An already difficult issue is exacerbated because there are no current universally agreed standards for ESG – one of the central points made by AMNT, which even thinks this ambiguity might sometimes be deliberate. Whilst there may not exist expressly ‘good’ practices, there are at least some clear ideas of what is not good, and most trade bodies have their own relevant guidelines.

This helps, but even here there are issues. Words such as ‘diversity’ can actually be very vague. Should the workforce represent the local or national community? Is this by gender, or race? (And that alone has a potentially controversial set of definitions). Background? Education? Class? Disability? Even the Equality and Human Rights Commission recently pondered over whether such ‘boxes’ might be counterproductive – a point since echoed by Cranfield University.

More operationally, where does the responsibility end? In what your organisation does? What your supply chain does? (Remember Apple and Foxconn?) Or, does it go even further? Very recently this became a matter of debate as the two oil majors, BP and Shell, took two diverging philosophies to the issue. Shell pledges to consider what its clients were doing with its products, including responsibility for the carbon footprint of the fossil fuels used: BP takes the view that once the product is ‘out of the door’ it is out of its control and it is pointless to attempt to regulate use. Whether Shell is brave or BP too dated in its view only time will tell.

Failure to consider ESG, not just as it is currently understood but as a changing and developing process, is tempting the fates, and the fates of risk management are fickle gods. On top of that, there might not be a lot of a business left if the underlying ideas are not incorporated in to the business model. As Unilever under Paul Polman demonstrated, the idea that there is business and a world as two separate things is not just denying reality, it is bad business, and a good business is an ESG business.

This article was published in the July-August 2019 issue of CIR Magazine.

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