ESG Investing – The New Normal Of Finance

Globally, the concept of Environmental Social Governance (ESG) has gained immense importance in recent years with companies intensifying their efforts to report ESG matters to investors. Governments and companies alike are taking initiatives to support sustainable, resilient practices by incorporating ESG standards. Internationally, there has been an increase of 26 percent in ESG assets from 2019 to 2021 according to United Nations Principles for Responsible Investment (UNPRI). Nowadays, investors are more concerned than ever with the sustainability of a company's operations as well as its financial performance. They want to know how the companies assess their performance across three key areas of ESG: environmental, social and governance. It can be rightly said that ESG investing has emerged as the new normal of Finance.

What is ESG reporting and investing?

The ESG standards stand for the Environmental, Social, and Governance (ESG) standards. It is a comprehensive assessment of a company's environmental, social, and government impacts caused by its ordinary operations and activities. To begin, it is important to identify the issues that fall into the umbrella categories of environment, social, and governance. Environmental criteria describe how the operations of an organization affect the environment. Furthermore, it includes environmental risks that a company may face and how that company manages those risks. Concerns about the environment relate to topics such as climate change, carbon emissions reduction, pollution of water, and deforestation. Social criteria refer to how a company manages its relationships and creates value for its stakeholders. It represents a company's commitment to the whole community, which includes not only the community in which it operates but also the wider community. Key issues include data hygiene, security, gender equality, diversity inclusion, community relations and mental health. Lastly, the company's governance relates to its leadership, management philosophy, policies, practices, and executive compensation.

ESG reporting measures performance across these three areas in contrast with accounting driven KPIs that focus more on financial performance. Integrated business strategy based on ESG principles is no longer a should-do but is increasingly considered a must-do for companies. An ESG investment is not only based on traditional financial factors but also incorporates sustainable and ethical factors. An increasing number of investors prefer to invest in companies that demonstrate their commitment to responsible investing, and who integrate financial information with societal and non-financial values.

New Zealand Perspective

Several initiatives have been launched by the government in NZ to develop ESG practices. The NZX Limited published a guidance note on ESG reporting in 2017 as part of its updating of the Corporate Governance Code which includes the voluntary disclosure of ESG information. The Māori business community also operates with long time horizons and broad social and environmental aspirations, where managing the land, supporting their communities, and regenerating ecosystem services are integral parts of their workplace culture. The government should benefit from mātauranga Māori (Māori cultural intelligence) and must partner with Māori in developing corporate reporting standards. Several Māori businesses and iwi trusts voluntarily report their ESG performance (see, for example, Raukawa Settlement Trust, 2020; Ngāi Tahu, 2020; Te Runanga a Iwi o Ngāpuhi, 2019).

A KPMG report (2020) shows that 47% of New Zealand organisations report on sustainability performance in their annual reports. Moreover, 74% of New Zealand entities reported on ESG matters in 2020, up from 69% in 2017. Even though the percentage of New Zealand organisations with independently assured ESG information has risen from 7% to 28%, it is still below the global average (around 50%). Additionally, the number of organisations acknowledging climate risks in their financial or annual reports has increased by 13%. The number of ESG-focused investments options continues to increase in New Zealand, with ESG opportunities in index funds, Kiwi saver, mutual funds and ETFs Furthermore, according to the research, investors see corporate decarbonization as a major factor in their investment decision-making, with 86% claiming to invest in companies with aggressive carbon reduction strategies because of their strategic importance. There has been a noticeable increase in the number of organisations including climate risk in their annual report, from 10% to 39%. Shareholders have already put forward proposals to improve gender diversity on corporate boards in more companies than ever before, garnering support that was unimaginable just a decade ago.

Despite numerous initiatives taken internationally to integrate ESG reporting into corporate reporting, the goal remains unachievable for these main reasons:

1. Development of Framework- Even though IFRS (International Financial Reporting Standards) govern financial reporting and have been adopted by more than 144 countries, a framework has not yet been established for ESG reporting. Furthermore, ESG ratings published by leading publishers like MSCI, Bloomberg and S&P global still lack standardised methodologies which can lead to inconsistencies. There are few national requirements for companies to report ESG data, and companies are left to decide for themselves which of the ESG factors are material and which are immaterial. In 2019, 80 percent of the NZX top 100 companies reported some sustainability-related information. However, there was significant variation in the standard and type of information voluntarily reported (Proxima, 2019) as there are varying frameworks and standards for sustainability reporting. This practice causes inconsistency across reports and it can be difficult, or even impossible, to compare between reports.
2. Development of ESG metrics— Companies need to start measuring and reporting the results of their initiatives. Instead of simply communicating their policies on data privacy, water management, climate change mitigation, diversity, etc, they need to communicate outcomes, such as the number of customer accounts hacked, the amount of water consumed per unit of product produced, the amount of carbon dioxide saved, and the percentage of women on board. It would ensure that data collected is timely, reliable, transparent and measurable. Additionally, creating an impact-weighted accounting system would enable a firm to measure both its positive and negative environmental and social impacts, turn them into dollars, and then include them in its financial statements.
3. Data Solutions- In NZ where more than 90% of companies are small businesses, corporates need to improve their processes and data collection methods so that they can integrate ESG data into financial statements. Benchmarking with an independent sustainability firm offering advice and software solutions is a cost-effective and efficient approach. Utilizing their partners' expertise in sustainability will companies to better understand and record their ESG impact. Moreover, the software solutions will enable organizations to access the data to facilitate ongoing process improvement and tracking.
4. Building ESG culture: Efforts should be made by companies to update their ESG disclosures and notify all stakeholders of the financial and social outcomes of their activities. In the long run, they will be more able to deal with shocks and hardships if they are managed by following social trends, such as inclusion and climate change. Companies need to build ESG skills and culture within the organisation by talking about various sustainability issues. This would help in integrating sustainability issues into their investment model. By collaborating within and outside the organisations, organisations can drive engagement and have mission and objectives.

Future Outlook

An ESG focus can help management in reducing capital costs and improving the firm’s valuation. The reason lies in the fact that as more investors put money into companies with strong ESG performance, a larger pool of capital will be available to them. Furthermore, transparency on ESG matters can help them protect their valuations as more governments and regulators mandate ESG disclosures. Furthermore, efforts to ensure sustainable practices will help maintain shareholder satisfaction with board leadership. The bottom line is that companies operating with an ESG-focus can increase valuation, lower capital costs and contribute to shareholder satisfaction.

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