by GK Strategy 19th November, 2018

Widespread ESG integration won’t be effective until it is better defined

The consequences of confusion about what ESG means – and how responsible/ethical/sustainable investment differ – were highlighted by the FT and a pensions think tank this month.

The FT’s Merryn Somerset Webb wrote: “It is time for the industry to come up with some proper definition of the words it increasingly bandies about”. The financial industry is “working very hard on diluting words such as ethical, green, socially responsible and sustainable down to a level of complete meaningless”.

Similarly, a report by the Pensions Policy Institute (PPI) concluded that a major barrier to ESG integration is that “there is a lack of consensus regarding how to define and implement ESG considerations.” They also found that there is “a conflation of ESG with ‘ethics’”.

So, while more investors use ESG principles than ever before – 72% vs 66%  last year, according to a recent RBC survey -, it is not clear how well these principles are being defined and applied.

Moreover, this constantly shifting landscape of terms is obscuring the need to improve our understanding and assessment of arguably the most important ESG factor of all – governance.

Investors and their advisors need to ensure that ESG and other concepts are properly understood and applied effectively.

The governance aspect of ESG is too narrow

A bigger problem lies with what is considered under the various ESG headings. While the scope of the environmental and social ‘buckets’ continues to expand as new issues come to the fore – such as modern slavery or land rights –, the scope of governance remains narrow and tick box oriented. It is typically limited to board composition, structure, executive pay and bribery & corruption.

This is how the PPI summarises the scope of governance, while the Invest Europe ESG Due Questionnaire (which we use as a helpful reference point) goes much further, extending it to risk registers, whistleblowing, responsibility for ESG strategy, etc.

But there are still problems.

First, the focus on boards does not work for a lot of SMEs as many don’t have formal boards. In practice, ESG issues are often considered separately by small, hands-on executive teams in weekly and monthly meetings. ESG Due Diligence needs to take account of this.

Secondly, governance is often treated as a separate but equal partner to the E and the S, whereas it should be seen as underpinning both, the foundation of the pyramid for environmental and social factors.

Dieselgate didn’t happen because Volkswagen had poor environmental policies; it was its governance that was at fault – with a board that failed to provide proper scrutiny and direction. Similarly, Carillion’s collapse – and the attendant negative social (and economic) impacts – was not because they had a poor sustainability strategy (it was good, on paper) but because its governance (and management) was inadequate.

Freeing governance from a tick box approach

Governance also needs to be freed from a tick box approach, which focuses on ‘hard governance factors’ rather than ‘soft’ ones, i.e. looking at the architecture of governance (mainly boards and processes) rather than how the boards function in practice and interact with the rest of the business.

But how governance is assessed under many ESG due diligence approaches does not take account of this. There needs a much more in-depth and qualitative approach, which is why we consider the interaction of senior management and site/operational teams and information flows when undertaking our ESG due diligence.

What next?

Competition for ‘ethical’ investors is incentivising investment firms to further differentiate their offer, highlighting what separates them from their competition. While this should be encouraged – to provide personal or institutional investors with a greater variety of options – it should not and need not be done at the expense of providing detailed definitions of the terms and how they differ from others.

Moreover, further refinement and expansion of the social and environmental goals of various funds should not result in governance being neglected. Good governance is the bedrock of any responsible company. Good environmental and social policies and processes can’t compensate when governance isn’t effective.

For more information on how GK approaches ESG in its due diligence and advisory services, please take a look at our ESG services page.

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