ESG and its meaning

The environmental impact and social responsibility of a businesses is currently front and centre, increasingly becoming a key factor in the decisions of customers, employees, shareholders, governments and investors alike, brought into focus even more so by the impact of Covid19.

The environmental impact and social responsibility of a businesses is currently front and centre, increasingly becoming a key factor in the decisions of customers, employees, shareholders, governments and investors alike, brought into focus even more so by the impact of Covid19.

The 1983 United Nations Brundtland Commission defined sustainable development as “meeting the needs of the present without compromising the ability of future generations to meet their own needs.”1

‘Sustainability’ however has become a very broad concept meaning almost anything under the ‘doing well by doing good’ phrase, as is similar with the terms ‘corporate responsibility’, ‘socially responsible investing’ and ‘green’.

Despite the growth in sustainable investing in the early 2000s, a realisation within capital markets and international organizations such as the United Nations began to emerge, this realisation being that such investments needed to make financial sense and not just be tied to a moralistic stance against unethical businesses.

In 2006 the United Nation’s Principles for Responsible Investment (PRI) report (consisting of the Freshfield Report and “Who Cares Wins”) provided for the first-time recommendations on how to incorporate environmental, social, and corporate governance into financial evaluations, asset management and securities brokerage. At the time of the report, 63 investment companies composed of asset owners, asset managers and service providers signed with $6.5 trillion in assets under management (AUM) incorporating ESG issues. As of June 2019, there are 2450 signatories representing over $80 trillion in AUM.2

So, what does Environmental, Social and Corporate Governance (ESG) mean and why is this so important?

ESG stands for Environmental, Social and Governance – three categories that enable businesses to measure the real sustainable and societal impact of their outputs. These target areas need to see genuine, persistent improvement for us to experience real positive change in the workplace and the world around us.

While sounding similar to corporate social responsibility (CSR), the difference is that ESG is measured, quantifiable and criteria-led, allowing businesses to fully integrate better ESG strategies into their DNA and brand whilst reporting improvements to shareholders.

As outlined in the AICPA & CIMA paper, Sustainability and Business: The call to action: build back better3, the three areas can be defined in further detail as:

Environmental – Considers how a company performs as a steward of nature. This factor includes the nature and extent of non-renewable resources used in production, as well as the release of harmful elements to the air, land or water.

Social – Examines how an organisation manages relationships with employees, suppliers, customers, and the communities where it operates. Social issues range from human rights and health and safety to other responsible business practices such as product marketing and privacy. Expectations around these issues, as well as environmental issues, define what is often referred to as the social licence to operate.

Governance – Deals with an organisation’s leadership and effective management of the business. In addition to overseeing strategy execution, performance and management of risks, effective governance ensures maintenance of the social licence to operate.

Covid19 and its impact on ESG’s

So, what impact has Covid19 had on ESG’s, if any? According to a survey conducted by BNP Paribas Asset Management on European Institutional investors and intermediary distributors4, a greater focus of ESG in their investment decisions was reported by 23% of the respondents. Additionally, in a report published by EY in June 20205, they outline that ‘strong ESG programs may help buffer the impacts of the current crisis, hasten recovery, spur innovation needed to navigate a “new normal” and reduce risks to additional crises in the future.’

But it isn’t just investors who are seeing the benefits of ESG’s, it is impacting the way in which we use our human resources too, our employees. As EY go on to highlight ‘The crisis has revealed for many companies the benefits of investing in their social and human capital, which is enabling them to mobilize talent and resources in new ways and continue to function in uncertain circumstances through a culture of trust, commitment and innovation’. Similarly, research has shown that a loyal and motivated workforce creates enterprise value over the long term through increased productivity, lower voluntary turnover and improved labor costs.

ESG and the Middle East

As KPMG highlight;

“In the Middle East, we are seeing a growing maturity and understanding of CSR as encompassing economic aspects of an organisation, as well as environmental and social.

Moreover, with national initiatives like the ‘Year of Giving’ and the ‘Year of Tolerance’ in the UAE, organisations are starting to think about the wider context and implications of social responsibility. More than a potential ‘nice-to-have marketing stunt’, it is recognised as a responsibility monitored by regulatory authority.”6

In fact, Middle East companies may in general have a head start with regard to ESG, relating to their focus on Islamic Finance where capital raised and invested is in accordance with Shariah Law. Whilst ESG may be secondary to Shariah law, the two are complementary in their capital-raising and investment approaches with many shared principles (CFA Institute and Principles for Responsible Investment Report – Nov 19)7. For example, ESG investing and Islamic finance both prohibit investments in tobacco, alcohol, weapons, gambling and human trafficking (human rights), to name a few.

ESG scores from Refinitiv’s EIKON database of over 5,000 non-financial companies suggest a direct correlation between Shariah compliance and higher ESG scores. Shariah-compliant companies – to which Islamic financial institutions will direct capital – have ESG scores that are on average 6% higher than for those excluded by the Shariah screening process. For non-financial companies, the difference rises to 10%. ESG scores for Shariah-compliant companies ranged from 3.0% higher for governance to 7.3% and 7.0%, respectively, for environmental and social issues. (Islamic Finance ESG Outlook 2019 – Shared Values)8.

Although they will remain separate investment approaches, Islamic finance and ESG investing are converging. This is not surprising given the origins of each investment approach and their common underlying principles. A deeper understanding of Islamic finance and ESG investing by all investors and the increasing materiality of social and environmental issues will likely continue this trend toward the use of common techniques and analyses.

As was outlined at the start, the environmental impact and social responsibility of a businesses is currently front and centre, companies who ignore ESG and its importance, do so at their peril.

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