Environmental, social and governance (‘ESG’) issues have gained a lot of attention in recent years. The United Nations’ Principles of Responsible Investments framework has been counting a rapidly growing number of signatories since its creation in 2006. Until recently, the focus has been on the ‘G’ – a dimension which has been largely codified by now and allows for stakeholders to point to any deviation from what is defined as ‘right’. It is the turn of the ‘E’ and ‘S’ as conscious capitalism is finally catching on and the pool of investors looking for both purpose and profit is growing.
Robert Eccles, a renowned academic in this field, discusses the latest trends in HBR’s ‘The Investor Revolution’ (2019) and makes the topic an inevitable one for executives, investors and corporate advisors. Here are the burning questions asked to firms: What material ESG risks are they faced with; how could such risk factors impact their financial performance; and what are they doing about it?
ESG is evidently critical to the Industrial Technologies sector. When it comes to environmental risk, there are two dimensions. First, companies in any given sector intensively use resources (including energy, materials and labor) and generate waste, essentially as part of their manufacturing process. Second, they may supply industries deemed to have a material impact on the environment. As a sector, capital goods (to use a traditional appellation) ranks towards the bottom from an ESG risk perspective, below consumer goods (higher social risk), building materials (energy intensity), power generation or resources extraction industries which top the risk rankings (based on S&P Global).
At the individual company level, various rating agencies provide some guidance. For example, Yahoo Finance offers an ESG rating for free based on Morningstar’s Sustainalytics. MSCI offers the same here. There is, however, an important caveat: In a recent M.I.T. Sloan report entitled ‘Aggregate Confusion: The Divergence of ESG Ratings’ (2019), the authors demonstrate that there is little correlation amongst ESG raters. Their analysis attributes this to differences in scope and in the way each ESG category is measured. The latter issue arises from a lack of standardization in reporting despite the efforts made by the Global Reporting Initiative, currently the leading framework collaborating with the International Integrated Reporting Council (see ‘Integrated Reporting’, July ’18), the SASB or the Task Force on Climate-related Financial Disclosures. Fundamentally, ratings do not fairly capture the reality as it tends to be too complex for them: if electrical vehicles are environmentally friendly from an emissions perspective, how does one account for their extensive use of inherently toxic batteries? ESG ratings are bound to be perfectly subjective, i.e. imperfect.
From ‘nice-to-have’, ESG reporting has fast become a ‘must-have’ as it has been recognized by leading Industrial Technologies companies for a few years already. Whilst this note puts emphasis on environmental risks, social aspects are no less relevant nor less difficult to measure. Experts suggest that there is no point in being overly influenced by ratings and rankings given their inherent flaws. Corporates do know what is important to them from an ESG risk perspective and are encouraged to communicate transparently about it, with a strict focus on materiality. It is the only way for leadership teams to remain in control of the ESG agenda.
Or else, they may be subject to shareholder activism. Whilst attention has been publicly focused on Industrial Technologies companies’ end customers, including miners, utilities or oil & gas companies, the entire value chain is being scrutinized across end-markets. Given their positioning in the upper parts of the value chain, Industrial Technologies companies are expected not only to run their operations but also to drive product and services innovation in a way which supports a transition to a sustainable future.
There is plenty of research demonstrating that a corporate focus on ESG and superior returns for shareholders are not incompatible. One of the explanations relies upon the intuitive fact that such focus speaks to a Management team’s quality. As ESG investing matures, it can be expected to become one of the main drivers behind High Quality Industrial Technologies companies – whether public or private. To paraphrase an old saying, ‘ESG pays dividends to those who pay interest.’