What is 'ESG' and how can companies profit from it?

 

We interview Ketan Patel, Socially Responsible Investment Analyst at Ecclesiastical, who tells us why Environmental Social Governance is important and why companies that employ it well make money for their shareholders.

 

1.    What is ESG?

The positive criteria Ecclesiastical Investment Management search for in companies is very much built on ESG (Environmental Social Governance). Sustainable long-term investment drives the investment process.

We have an integrated investment process, which incorporates both financial and non-financial (ESG) factors. We don’t have a SRI or ESG team, or a separate financial analyst team. We are very much integrated and believe that only by looking at both the financial and non-financial criteria at the same time can you get the full picture of a company.  

For us ESG incorporates:

• Risk management -  how a company looks after the environment;
• Communities in which it operates and this involves all stakeholders - employees and customers; and
• The governance of that company and whether it is run for the benefit of its shareholders.
  
  

2.    Why is ESG important and how does it help fund managers?

In the past it has been asked whether ESG actually adds anything to an investment or in other words can you have a company with a really good financials and bad ESG and still do well?  Actually this is not how we look at issue. Fundamentally incorporating ESG into the investment process is important for the following reasons.

Risk management

Firstly it helps to identify and assess risk factors.  How a company manages their risk profile is important and if they are not acting in a responsible and sustainable manner, they will put themselves at financial and reputational risk.  A good example of a company which has suffered recently because of being lax in this area is BP. There are plenty of examples of companies that have not managed their risk and it is the shareholders who have had to bear the brunt of management failure.

Profiting from good environmental practice

Secondly and on the positive side, there has been a paradigm shift whereby ESG is no longer categorised as a cost base, but it’s seen as a profit centre.

Good examples here are companies that are embracing the environmental agenda. A firm like *Tesco is an excellent example of a company with a strong environmental programme, part of which is to build 'green' stores.  Previously a store was seen as a capital expense but if you make that building a ‘green building’ you can actually give back to the grid and earn money from it. That has changed the business model for a lot of companies especially the ones that are invested in the long term, so it’s gone from a cost centre to a profit centre and that’s a big shift for a lot of CEO’s.

Most fund managers will only look at a company in terms of its financials which in some cases is fine but to get a complete picture of a company, and assess where it sits within its peer group, ESG is an important factor in giving that extra bit of insight and a good measure of corporate culture.

If a company’s committed to the environment, has good social roots, and decent governance it shows that it’s been run correctly for the long term and not just for the current management.  A firm run well financially should also have strong ESG credentials. The combination should help identify companies that are dedicated to long-term sustainability.

Social side

On the social side, a well-run company can benefit from lower employee turnover. People tend to forget an organisation is a collection of individuals and talent comes in and talent walks out the door every day. How an organisation trains, develops, and retains staff is a key indicator of how well the company will do in the long-term. Similarly, how an organisation interacts with the communities in which it operates should help to identify companies that are committed to a long-term strategy.

Cadbury is an old but good example of this.  If you’d go to the Birmingham or to Bourneville factory, there was a real culture of where the firm was placed, it had good links to town and the surrounding area and it had a massive social impact around the environment as well.  Things have changed now because organisations have become mobile, but in emerging markets how firms operate are really important, whether you are a multi-national or a local company.

3.    What do you look for in a company pertaining to have good ESG and do you have set criteria that you use to assess them with?

We use a combination of positive criteria and negative screens.

The negative screens include alcohol, tobacco, pornography, gambling and armaments and we don’t invest in companies that have material businesses in these areas.

We have nine positive criteria that we use to assess the ESG credentials of companies:

• Business Practices – following ethical practices towards customers, including maintaining product quality, ethical sources of supply, opposin g corruption and respecting indigenous peoples
• Community Relations – making charitable donations, employing local people, and offering work placement schemes
• Corporate Governance Practices – transparency, anti-bribery and corruption codes, adhering to International Labour Organisation regulations on labour and child labour
• Education – providing training and development along with access to education
• Environmental Management – supporting biodiversity, managing their climate change impact and carbon footprint, water conservation, air pollution and managing waste and recycling and supporting renewable energy
• Healthcare – providing affordable healthcare and access to medicine
• Human Rights – supporting basic human rights by adopting the United Nations Universal Declaration of Human Rights
• Labour Relations – promoting equal opportunity and diversity, health and safety, transparent pay structure, union participation, professional development, employee participation, whistleblower protection
• Urban Regeneration – supporting affordable/ social housing

We don’t expect all companies to score highly on every pillar, but we would look to see a progressive trend in most areas. For companies, with higher impact on the environment, we would look for organisations that are taking the lead on issues such as biodiversity and carbon footprint management.

4.    Can you give me an example of a company with outstanding ESG?

A company with strong ESG credentials is GlaxoSmithKline (GSK). Not only is it a firm that gives away free medicines worth several hundred million pounds annually, it also has a phenomenal ESG track record in its global operations.

It’s a good employer, has excellent customer relations and operates in the right way throughout its global operations.  Drug companies often come under attack for reputedly over pricing drugs and making a huge amount of profit.  However, the positive impact on people’s lives made by GSK’s products cannot be underestimated.

GSK have taken the lead in anti-viral drugs for HIV and have even given away their patents in South Africa and give the drugs away at cost which is enormously generous when you consider all the years of research and development it takes to produce a drug, around $1 billion in some cases.  They are now working on a new vaccine for malaria which is one of the biggest killers of children in the developing world. Not a lucrative area, but one that will make a huge difference to sufferers.

The firm runs really well from a governance point of view too and has an independent board.  We’ve had problems with boards in the past that aren’t independent, which has led to management running the business for their personal gain and not for the benefit for the shareholder, who ultimately own the business.

We’ve seen people being grossly overpaid and if you look at the banking sector there’s been a huge turnover of CEO’s who have taken too much risk and put the company in jeopardy and in some cases corporates have gone under because of a combination of short termism and very poor risk management.  



*Tesco told Worldwise Investor that they aim to reduce their carbon footprint by 50% by 2020 and to be a zero-carbon business by 2050.  They currently have a few zero-carbon stores (pictured above the world's first zero carbon store in Ramsey) which are part of their environmental and energy management programmes.  They also employ energy-saving technologies in stores to reduce energy consumption and therefore make financial savings.