Navigating ESG in a Complicated World
Integrating environmental, social and governance (ESG) factors into business and investment decision making is necessary, but it can be very confusing. And questionable parties are trying to politicise the term for reasons that may not be in the common good, financially, or otherwise.
But what is ESG? Or perhaps
we should ask what is not ESG?
ESG is not impact investing or socially responsible investing. ESG is not philanthropy or stakeholder activism. And ESG is not – and must not be allowed to become – a proxy for the culture wars. ESG is a common-sense risk management process that creates real value for investors, companies, and the world they operate in, whichever way you swing politically.
Annycent’s Head of ESG and Impact, John-Paul Wale, explains.
A brief History of ESG
One of the earliest collective references to environmental, social, and corporate governance (“ESG”) factors as business risk and value drivers was in the 2004 United Nations (UN) led “Who Cares Wins” (WCW) white paper. The WCW initiative brought together 23 of the world’s leading financial institutions and asset managers with the aim of mainstreaming ESG integration within investment processes. One of the key outcomes of the WCW initiative was the launch of the Principles for Responsible Investment, which have become a significant contributor in the global shift towards sustainable development. By sustainable, we mean the triple bottom line of profit, people, and planet.
Managing ESG-related risks and opportunities has since become a generally accepted value-driving business process; however, it has also led to the development of necessary but increasingly complex and stringent regulatory frameworks, and to a proliferation of voluntary standards and certification schemes that can confuse even the most seasoned ESG practitioner. More recently, particularly in finance, ESG is becoming a highly politicised strawman, lost in a whirlwind of greenwashing, climate change, regulatory confusion and push-back.
But why do we “do” ESG? And why are we all talking about it?
To answer those questions, we need to agree on what ESG is exactly, and what it is not, which can be a challenge in itself. A useful Morningstar article considered a simple comparison to help clear up some of the mystery: “ESG as a Process versus ESG as a Product”.
ESG as a process
Every business has a set of policies, processes and associated physical and/or economic activities that must be executed to achieve its purpose and strategic objectives. Those processes, activities and associated operational and financial performance are governed by the decisions of a company’s leadership. The activities can interact with, impact upon, and/or can be impacted by, people and the environment in many ways – commonly referred to as ESG factors.
Impacts of business activities on external ESG factors can be positive, such as the creation of jobs at a company or the provision of products like clean water or energy, which contribute positively to wider society as well. That said, adverse impacts can also occur, for example through workplace discrimination and environmental pollution (direct impacts), or through forced labour in a supplier’s factory located on another continent (indirect impacts).
If a company doesn’t think about its ESG factors and associated potential impacts or opportunities (or “externalities”), it could also face related and unplanned threats to its business activities (known as “enterprise risks”). For example, a regulatory non-compliance due to a pollution event (an “E” factor) could result in a costly fine. Alternatively, an “S” factor such as a workforce protest about safety conditions could delay an expansion project and/or create a reputational risk that reduces the firm’s ability to raise capital.
To that effect, ESG has become the generally accepted term for a risk management process which aims to understand a company’s non-financial footprint, assess how this does or could interact with the world, and avoid or mitigate the potential associated adverse impacts and enterprise risks using commercially reasonable means. Aside from managing material risks, the process also seeks to identify and maximise potential ESG-related business opportunities, for example by investing in a more efficient plant to reduce emissions and selling associated carbon allowances.
ESG as a product
In contrast, much of the recent confusion and negative press around ESG is associated with sustainability-related financial products often referred to as “ESG funds” or “Sustainability Funds”. These products typically aim to channel investments into sustainable activities, for example the carbon transition and renewable energy or energy efficiency projects. Questionable sustainability-related claims by some market participants and the efficacy of disclosure regulations aiming to combat this greenwashing have added to an underlying confusion around ESG terminology. This confusion is further exacerbated by the proliferation of voluntary standards.
Adding to these challenges are concerted efforts by various lobby groups to advance a pejorative, anti-ESG narrative – predominantly around the climate change debate and the role of financial institutions, companies, and shareholders in advocating for sustainable outcomes. The increasing resources, lobbying and media coverage committed to the anti-ESG messaging are such that it is more important than ever to remind ourselves not just what ESG is and why we do it, but also what ESG is not.
What ESG is not
ESG is not impact investing or socially responsible investing.
ESG is not philanthropy or stakeholder activism.
Perhaps more importantly, ESG is not a proxy for the culture wars.
Campaigns around contentious issues such as climate change or human rights (and associated shareholder action) can of course be viewed through the ESG lens, as they relate to “E” and “S” factors, respectively. But the underlying causes and political divisions associated with these societal challenges are nothing to do with the application of value-generating ESG risk management processes or the market for sustainability-related financial products.
We must therefore carefully navigate the dubious voices aiming to politicise ESG as a proxy for divisive issues in the culture wars. Their motives are at best questionable. Unchecked, anti-ESG messaging could further muddy the waters and stymie the use of non-financial factors in decision making which – contrary to their narrative – may well compromise fiduciary duty.
This is because material ESG risks are real:
if you do not do ESG due diligence, you are not doing financial due diligence.
The way forward?
So far at least, we continue to move in the right direction despite the noise. This is mainly because at its core, ESG is not and nor should it be, altruistic. The primary objective of ESG, as a process or a product, is sustainable value creation for companies and their investors, and thus for wider stakeholders and the planet we inhabit.
Annycent believes this fundamental value proposition will ensure that we always “do” ESG, long after the current growing pains have subsided. ESG processes and sustainability-related products will increasingly become core strategic considerations for financial market participants. This trend will likely continue as ESG factors become more complex and material, new solutions are required from the market and regulatory regimes adapt to keep pace.
At Annycent, best-industry practice ESG and impact management principles are central to the company’s philosophy and are integrated throughout its investment processes. Material ESG risks and opportunities are identified and managed prior to investment, and Annycent aims to work collaboratively to support investees to meet these standards, build ESG capacity and enable investors to enhance positive non-financial outcomes along financial returns during ownership.
Annycent’s vision and mission are captured in Annycent Clean Energy’s Sustainable Investment Objective:
“Offer Investors attractive risk adjusted returns achieved through making investments ("Investments") in a carefully diversified group of clean energy projects and companies in emerging markets substantially contributing to climate change mitigation in alignment with the Paris Agreement. These investments are expected to include solar PV, onshore wind, energy storage and energy efficiency, primarily in operating renewable energy projects but also certain greenfield investments and investments in local asset developers (as well as their platforms). In addition, through these investments, the Fund aims to catalyse market sector growth (notably by using private capital to achieve such goals) and achieve measured, positive, environmental impact and social outcomes in asset host countries and communities in alignment with the UN 2030 Agenda for Sustainable Development.”
Alongside investor returns, Annycent’s investment strategy aims to achieve three core objectives:
Create lasting climate outcomes: The addition of renewable energy to the grid mitigates climate change by adding zero emissions capacity to displace or avoid inefficient and polluting thermal plants and point source emissions.
Catalyse market sector development: Annycent’s strategy aims to align with ESG and Impact investor requirements whilst attracting new institutional investors to the emerging market renewables sector. This aims to provide sellers with new sources of liquidity, which is typically redeployed on new greenfield projects, thus magnifying development outcomes at a scale well beyond Annycent’s footprint.
Deliver measurable positive social outcomes: Achieve measured, positive environmental and social outcomes in host-communities which contribute towards the UN Sustainable Development Goals.