Environment, society, governance: new business imperatives

May 2020  |  SPECIAL REPORT: BUSINESS STRATEGY AND OPERATIONAL PERFORMANCE

Financier Worldwide Magazine

May 2020 Issue

Key stakeholders are increasingly concerned with the environmental, social and governance (ESG) policies, practices and results of organisations. Shareholders are looking to invest in companies that give them a sound financial return, of course, but are also increasingly keen to choose stocks based on ESG criteria. BlackRock recently announced a significant change in its investment policies in this direction, as have many other professional investment firms and retail investors.

Equally, employees are increasingly looking to work in organisations that not only ‘do the right thing’ environmentally and socially, but that perform well and proactively, for example in contributing to society and minimising their environmental footprint. They are also looking for high-quality governance, to ensure that the returns and risks associated with where they invest their personal human capital are sound.

Customers too have shown a preference for purchasing from businesses that ‘take the high road’ on ESG matters, which can significantly impact a company’s reputation. Businesses that have got their ESG policies wrong have paid high prices. Notable examples have included an automotive company that cheated on its emission controls and standards, a move that cost it many billions, and a restaurant chain that cheated by underpaying its employees and went into liquidation when its revenues halved. It is no longer acceptable to be selling premium brands in developed economies, where manufacturing was done in substandard factories in developing countries.

Doing nothing or taking a minimalist approach to ESG is an outdated idea, one which stems from 50 years ago, when the economist, the late Professor Milton Friedman, wrote an article in the New York Times titled: ‘The social responsibility of business is to increase its profits’. In that article he asserted that any business that “takes seriously its responsibilities for providing employment, eliminating discrimination, avoiding pollution... are... preaching pure and unadulterated socialism”. Although he won a Nobel prize for things other than his views about social responsibility and sustainability, on this issue, five decades later and with a lot more compelling evidence than he had, we can conclude that he was wrong, or at least highly incomplete in his views about shareholder primacy and taking a minimalist approach to ESG.

Evidence in recent decades has shown that the three key stakeholders that businesses must succeed in creating value for, prioritise the ESG practices and results of these organisations. These ESG elements are encompassed in the organisation’s reputation, measured and reported in its publications, and the outcomes for those stakeholders are not in conflict with each other when practices are well led and sensibly chosen and implemented.

Trillions of dollars are invested in businesses that are socially and environmentally doing much more than minimum requirements, and the evidence is mixed about whether socially responsible investing leads to higher returns, with many studies pointing in both directions about whether environmental and social proactivity leads to higher financial returns. Part of the measurement problem here is that many sustainable investment funds choose only a low level of compliance or conform to quite minimal standards of environmental and social strategies, and they often do not consider governance.

In 2020, we are seeing three major shifts that are rightly reshaping these issues. First, an integrated approach is now in play that combines governance with the environmental and social contexts, hence ESG, exacerbated by climate challenges and increased attention to labour market issues in modern supply chains, such as modern slavery. Second is a major change in how ESG will be measured, reported and managed, which is from fragmented to holistic and from conformance and compliance-related to performance focused and proactive. Third, stakeholders have ramped up their interest in ESG activities and results. They want to closely examine what is going on inside organisations regarding these matters.

A holistic quantitative scoring system can have an impact. A scoring system should cover the key ingredients of ESG and can inform key stakeholders succinctly and accurately. The six core elements of this are: (i) leadership of ESG, including ESG as a component of overall business strategy, and its congruence and strength of alignment with stakeholder outcomes; (ii) planning and implementing ESG strategies and initiatives; (iii) environmental practices and initiatives, including reduced carbon emissions, water management, preservation of the natural environment and contribution to reduction, reuse and recycling of resources, right across products, services, processes and business models; (iv) social practices and initiatives, such as respectful treatment of all stakeholders, safety and contribution to community wellbeing and diversity, and human rights; (v) governance practices and initiatives, including board effectiveness, ethical standards, accountability and transparency, throughout the organisation; and (vi) ESG results, being concrete outcomes across all five areas.

In each of these categories, evaluation and scoring should be done on the basis of layers of capability. At the lowest level should be the ‘ad hoc’ or inconsistent approach of nothing or not much in the way of strategy, practices and outcomes. A better approach is where plans are made and executed in these domains that bring advantages to the enterprise and its stakeholders, and even better is when those practices are systematic and gain synergies between what is good for multiple stakeholders. An example is an employee health and fitness plan that adds to employee health and motivation, leading to a discretionary work effort and thus better customer service. Another is actioning an energy efficiency audit, whereby energy use reduction improves emissions, lowers costs and benefits the green environment. A third is moving from extensive use of paper to electronic or reducing packaging, lowering costs and improving environment outcomes. In governance terms, one can hardly go beyond Toyota’s sincere approach of its central ‘Respect for People’ principle, that pervades what it does from boardroom, to team member on the shop floor, to customers and suppliers, and definitely the communities from where it works and draws its workforce.

When a mature and systematic approach is taken and proactive practices and initiatives are implemented, ESG scores are high, reputation is strong and all stakeholders can take some pride in the organisation, that allows it to win or at least gain an advantage in all the marketplaces in which it competes, being the obvious one for its products or services, the labour market where it wishes to get the best people, and the investment market.

At the most advanced stage, businesses are invested in learning, innovation and proactively engaging with stakeholders to create mutual value at high levels.

This is all going to work, stick and deliver if an enlightened set of leaders in the organisation recognise that the ‘scorched earth’ approach of minimalism or compliance only is inferior to proactively searching for and seizing opportunities to transform how the organisation works, from top to bottom, and including everything it does.

We have seen how the world’s biggest resource company, BHP, took its ESG forward to great effect. Similarly, Toyota has a very broad stakeholder-focused approach and is highly proactive. Conversely, Australia’s banks and many other financial services businesses elsewhere have recently been found to be poor in their consideration of customers’ requirements and governance practices. Australia’s financial services sector was so focused on profits for shareholders, that a Royal Commission of inquiry was recently held, finding that a multitude of illegal and highly unethical practices were systematically in play, crushing the reputation of most of these businesses, and costing them billions of dollars in fines and even more in goodwill.

It is for these reasons that Larry Fink, chairman and chief executive of BlackRock, recently published a letter to CEOs in which he foreshadowed a change to how investing is done. “Companies must be deliberate and committed to embracing purpose and serving all stakeholders – your shareholders, customers, employees, and the communities where you operate. In doing so, your company will enjoy greater long-term prosperity, as will investors, workers, and society as a whole,” said Mr Fink. He also signalled a “more sustainable and inclusive capitalism”, which is a significant and powerful step forward since Professor Friedman proposed a scorched earth approach to sustainability.

What is the catch to all of this? Arguably, there is no catch, except that like anything worth doing, moving forward on ESG involves significant work, of identifying and doing what works, and that starts, of course, with ESG leadership.

The experiences of BHP, Toyota and a number of banks are testimony to what advances are possible, what benefits arise and also what trouble hits those who bury their head in the sand or either deliberately or through incompetence do the wrong thing by stakeholders. Toyota and BHP have made major advances in ESG, while many financial sector companies have shown that they have a long way to go.

BlackRock, with some US$7 trillion under management, has recently succinctly written to clients: “As your fiduciary, BlackRock is committed to helping you navigate this transition and build more resilient portfolios, including striving for more stable and higher long-term returns. Because sustainable investment options have the potential to offer clients better outcomes, we are making sustainability integral to the way BlackRock manages risk, constructs portfolios, designs products, and engages with companies. We believe that sustainability should be our new standard for investing.”

While studies of C-suite executives show that all major elements of ESG are associated with short- and long-term improvements in value, like most things, it is a case of actions first and outcomes later.

Businesses can move incrementally, choosing to achieve quick wins while simultaneously building a systematic and comprehensive approach. Our advice is to conduct a thorough diagnosis of a business’ current position, on the measures outlined above, then implement initiatives, then re-measure, benchmark the industry and renew the cycle.

Danny Samson is professor of management at the University of Melbourne. He can be contacted on +61 3 8344 5344 or by email: d.samson@unimelb.edu.au.

© Financier Worldwide

BY

Danny Samson

University of Melbourne

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