Social Responsibility

James Dunn considers the growing importance of ESG reporting, the changing governance landscape and what it all means for directors.

Those companies that think their reporting requirements are confined to the financial categories of sales, profits, margins, costs of inputs, assets, liabilities, salaries and the like are in for a rude awakening – if they have not had one already. The push to include environmental, social and governance (ESG) data and information is a powerful trend, driven by institutional shareholders.

Not so long ago, most companies subscribed to the position associated with the great economist Milton Friedman, that by creating employment and producing goods and services in a competitive market, employers fully met their moral obligations and that no more should be required of them.

But the concept of ethical investment – investing so as to consider both financial return and social good – has always been bubbling away, since the days of the Quakers. Also known as socially responsible investment (SRI), this method of investing subscribes to the “triple bottom line” concept, which holds that an organisation must assess its operations and activities through not only a financial lens, but also consider the social and environmental aspects of what it does, and its impact on the world.

The global financial crisis (GFC) brought this idea – now described as the investment framework known as ESG – to the fore. According to US-based non-profit organisation, Business for Social Responsibility, the value of investments guided by ESG principles rose from about US$5 trillion in 2007 to US$32 trillion in 2012.

The United Nations-supported Principles for Responsible Investment (PRI), a “voluntary and aspirational” group of investment principles that offer a menu of possible actions for incorporating ESG issues into investment practice, has almost 1,500 signatories from more than 50 countries, representing US$62 trillion of invested funds.

In short, ESG is a major force in investment – and companies have had to adapt.

However, reporting on ESG issues is not mandatory. Since the financial year 2015-16, Australian listed companies have been required to report on their handling of ESG issues, on an ‘if not, why not’ basis. Under Recommendation 7.4 of the ASX Corporate Governance Principles, ASX listed companies must report on sustainability issues in their business. The recommendation states: “A listed entity should disclose whether it has any material exposure to economic, environmental and social sustainability risks and, if it does, how it manages or intends to manage those risks.”

In its report Sustainability Reporting Practices of S&P/ASX200 Companies: 2016, the Australian Council of Superannuation Investors (ACSI) found that of the 174 ASX200 companies surveyed in both 2015 and 2016, 48 upgraded their ESG reporting level while only eight companies downgraded their reporting level. Overall, 90 per cent of ASX200 companies provided some level of ESG reporting in their 2015 disclosures.

The ACSI report found the number of “no reporting” category companies in its research dropped from 26 in 2015 to nine in 2016 – and, for the first time, there were not any “no reporting companies” in the ASX100.

“I think sustainability disclosure is what’s expected of a modern company,” says Elaine Prior, senior ESG investment analyst at stockbroking firm Citi. “Investors are more closely scrutinising companies for their sustainability performance and approach – and they want sustainability to be incorporated into the company’s strategy and the way it conducts its mainstream business, rather than being seen as an add-on.

“Investors are increasingly looking at how companies are being managed for the longer term, rather than necessarily the next period’s results, and some of the ESG issues would be very relevant to that lens. In a sense, it can be consistent with the company setting strategy and assessing and managing risks, as well as opportunities, over the longer term,” says Prior.

Emerging significance

ESG is not just touchy-feely: a definite link has emerged between effective management of ESG risks and opportunities, and company and investment performance. While academic evidence linking investment returns and ESG capabilities has been mixed over the years – partly because of inconsistencies in ESG data across companies and sectors, and partly due to a lack of a universally accepted framework for ESG reporting – the link is now “pretty well-established, and quite compelling” says Pablo Berrutti, head of responsible investment, Asia-Pacific, at Colonial First State Global Asset Management.

Berrutti says ESG and financial performance: aggregated evidence from more than 2000 empirical studies, a 2015 study conducted by Deutsche Asset Management and the University of Hamburg was seminal: the study found a positive ESG impact on corporate financial performance over time, and “clear evidence for the business case for ESG investing.”

Says Berrutti: “This study found that there is a really strong relationship between managing ESG issues well, and both corporate performance and investment performance when building portfolios. Everything that we see generally supports that idea. If you’re really focusing on the issues that matter – that are going to be most material to companies depending on where they operate and the business they’re in – then the relationship is very strongly established.”

In June last year, Macquarie Wealth Management analysed the impact of employee trends that were disclosed through corporate reporting of ASX listed companies. It created a dynamic portfolio of companies with leading scores on employee indicators and a second portfolio with companies that had weaker returns on employee indicators.

Macquarie’s Employee Engagement Survey considered issues such as industrial relations, staff turnover, employee absenteeism, remuneration and productivity, workplace diversity, and occupational health and safety – data that high-performing boards understood well.

The survey found the portfolio of companies with engaged workforces had consistently outperformed the second portfolio over nine years: the relative outperformance was 6.6 per cent annually over the past three years and Macquarie said the gap was growing as more ESG data was reported.

Importantly, a change in a company’s employee engagement was found to be a predictor and signal for future share price performance. Macquarie’s research highlighted that this kind of data directly influenced company valuations and future share price performance.

Dr Ian Woods GAICD, head of ESG investment research at AMP Capital, says ESG issues go to the heart of companies’ value. “The majority – typically 75 per cent – of a company’s value (as measured by market capitalisation) is not represented on the company balance sheets. Intangible assets, such as relationships with internal and external stakeholders and issues such as ethics and culture, are key to intangible value. As investors recognise this, they are looking at ways to systematically assess the material ESG issues.”

A long list of events highlights how ESG issues can have a material impact on individual company’s returns and on markets as a whole. Events include BHP’s Samarco tailings dam collapse in Brazil, James Hardie’s asbestos liability, revelations of unethical sales practices by major banks, governance breaches and corporate collapses such as ABC Learning, executives’ misuse of company credit cards, and even revelations of embarrassing behaviour of senior executives.

Such events can badly damage a company’s share price and its reputation – and investors do not like to see them. “From an investor perspective the questions raised are: ‘what value could have been saved with foresight (rather than hindsight) in considering these things?’ and ‘how can you systematically consider these in investment decisions?’” says Woods.

Companies have to understand that investors – who are their owners – will increasingly seek to proactively head off these issues. “As a long-term investor, AustralianSuper recognises that ESG issues may affect the value of investments, and our key priority is achieving superior long-term investment returns for our members,” says Andrew Gray, AustralianSuper’s investment manager for governance. “Therefore we incorporate ESG considerations into our investment decisions and processes to maximise long-term returns to members.

“We also see voting and engagement as inextricably linked. Engagement gives us long-term relationships and dialogue with company boards. Ultimately this leads to voting outcomes where we can have our say on members’ behalf. AustralianSuper’s objective is to vote on items in a manner that will create or enhance company value and ensure the value is fairly distributed to shareholders,” says Gray.

High priority

Big shareholders expressing these kinds of views should put any company on notice that ESG issues must be elevated to high priority – if they are not already. This imperative will be felt as keenly around the board table as it is at all other levels of the company.

“Directors should be aware of ESG factors that confront their operations as a matter of course – it should not be an afterthought or an add-on to their duties,” says Lisa Domagala, ESG analyst at Solaris Investment Management Limited. “The key challenges involve correctly identifying the material ESG factors that their companies face, however I do not see this as an additional challenge. If an ESG factor is material it should be being considered at board level, along with everything else that’s material, for example, interest rates and commodity prices.”

Domagala argues that the increased focus on ESG issues does not bring added demands on directors: the demands are issues of which directors should already be well aware. “They should be well across the major drivers of their companies’ businesses, and this will include ESG factors to varying degrees.”

In general, listed companies today are much more willing to consider a wider range of issues than has historically been the case. Domagala believes they have been influenced by the willingness of investors to vote as long-term owners. “Certainly we are seeing more engagement instigated by chairs and boards around proxy voting season. Safety, bribery and corruption, cybersecurity, supply chain scrutiny, climate change adaptation, pollution reduction, community impacts – all are areas that are now regularly reviewed and openly discussed by directors. In years past many of these issues were not discussed,” she says.

Inevitably, this widening of the board’s remit calls for greater focus on its composition, and the combination of skills and experience that is brought to the table, she says.

“Ideally the board would have some style of risk matrix which incorporates ESG factors. The non-executive directors need to have sufficient understanding of the issues or available resources at their disposal, which allow them to be fully informed, so that rational decisions can be made. Scenario planning is a must; adaptability is a bonus. We like to see what we consider to be dynamic boards that are not afraid to discuss issues that are new to them,” says Domagala.

Boards not thinking this way already may find themselves forced to do so as institutional investors further flex their muscles. “From a shareholder point of view, we believe that having the right board in place at a company is vital to promote the interests of our members, and that getting the right directors on the board is a fundamental right and responsibility that we have,” says Gray.

AustralianSuper has a policy on director voting, and is also developing a board evaluation framework to assess the way a board operates in practice. “We want to move away from a ‘tick the box’ governance approach to a more practical approach, which looks at how the board is operating and whether it is representing long-term shareholders and focusing on long-term value creation,” says Gray.

Similar skill set

ESG is a vital part of this, but Gray does not believe that the skill set for considering ESG issues is greatly different from that which directors need to make long-term strategic decisions for the benefit of the company and its shareholders. “Directors need the ability to take into consideration a wide range of issues, including those relating to ESG, when determining a company’s strategic direction. ESG issues should not necessarily require additional skills, but they should require directors to be more aware and informed of the wide range of issues that can impact long-term value creation and therefore concerns that shareholders now have,” he says.

Woods says the increasing focus on ESG highlights the need for diversity of skill and background on boards. “Each director on a board will bring their own particular expertise and complementary skills. In the same way that all directors need a minimum understanding of accounting, finance and risk management, directors will increasingly require a broader set of skills, perhaps requiring specific training on the material ESG issues facing the company,” he says.

Clearly, this may vary between industries. “For example, those in the oil and gas industry may require skills development in process safety, bribery and corruption risk or the implications of climate change on the potential future demand of fossil fuels, whereas privacy and effectively assessing customer service or employee engagement may be more appropriate for a director of a service company,” says Woods.

Experienced non-executive director Simon Bolles GAICD believes the answer lies with a well-diversified board with diverse backgrounds and experiences, such that the directors are able to approach most questions with skill and diligence, working through the most difficult issues, while requesting expert opinion where required.

“The largest companies may have a requirement for an ESG expert on their board but for most of us, having an experienced and diverse board will be enough to answer and work through most challenges, bringing in expert advice from time to time where required,” says Bolles.

He cautions, however, that boards will face challenges when establishing processes by which ESG risks and opportunities are reported to the board, risk committees and management. Clearly identifying who is accountable for ESG issues may be another difficulty, and Bolles adds that “for smaller companies this can be particularly challenging.”