Why you need to know about ESG in 2020

During 2019, investors were distracted with Brexit, US-China trade issues and UK elections. Somewhat under the radar has been the rise in ESG as a mainstream investor metric.

What is ESG?

“Environmental, Social and Governance” refers to three key areas which investors use to assess “good or bad” corporate policies and behaviour. Policies and behaviour by companies across these three categories is now becoming a real world metric used by investors, both professional and private, in determining whether to invest.

ESG is known as “responsible” or “ethical” investing and is wider than “impact investing” which has traditionally been defined as investments whose key objective has been to specifically make a positive impact on an environmental or social issue. Typically ESG may be made up of:

Environmental: Climate change related issues, waste, pollution, deforestation, water use.

Social: Working conditions, child labour, employee relations and diversity, local and indigenous community issues.

Governance: How an organisation is managed; checks and balances, issues such as executive pay, bribery and corruption policies, board diversity and corporate tax strategy.

Each of the sub-categories of ESG will have a different focus and priority for companies and investors depending on the sector and jurisdictions in which they operate or invest. Child labour and employee working conditions will have greater focus for manufacturing businesses, whereas for large multinational organisations, tax strategy may be a key focus.

For a long time the perception has been that investments which were ESG positive, or meet CRS (corporate social responsibility) requirements, were made largely to provide a public relations ‘feel good factor’. In the past, investments in companies which focused on these types of metrics could come at the expense of investor returns, however this is now less likely to be the case.

ESG is now being applied across the investment spectrum. Renewable energy businesses, such as solar energy developers (an enterprise with clear environmental benefits and objectives), must also consider whether their supply chain of materials and approach to local community issues is a positive one. Equally, mining, oil and gas companies need not be struck out of the ESG investment equation completely as bad actors in the ESG space, but can still compete in the market by preparing and implementing robust ESG policies within their sector (for example in relation to, waste, pollution, bribery and corruption and labour issues).

What are some of the developments in 2019?

Mark Carney speaks out

Mark Carney was appointed United Nations’ special envoy for climate change and finance and early in the New Year issued a warning to long term investors in fossil fuels, signalling his intention in the new role, to make climate change issues a key priority for investors in the financial decision making process.

Increased disclosure by pension funds

From 1 October 2019, through the Occupational Pension Schemes (Investment and Disclosure) (Amendment) Regulations 2019, pension funds now have a responsibility to integrate ESG issues into their investment approach. Pension funds will have to set out in their Statement of Investment Principles (“SIPs”) how they take account of financially material considerations such as ESG issues, as well as their approach to stewardship. They may also set out how they incorporate member preferences on issues such as sustainability impact. The SIP must be published on a publicly available free to access website.

London Stock Exchange turns green

In October 2019, the LSE launched its Green Economy Mark and Sustainable Bond Market to complement its Guidance for Issuers on ESG Reporting, published in January 2018.

The Green Economy Mark is offered to companies on a voluntary basis and recognises companies/investment funds on the Main Market and AIM that derive 50% or more of their total annual revenues from products and services that contribute to the global green economy. This status is available to green technology companies, as well as those across industries that make significant contributions to the transition.

The LSE’s Sustainable Bond Market (SBM) builds upon the Green Bond Segment, launched in 2015 and includes dedicated segments for social and sustainability bonds, in addition to the existing Green Bond Segment. These new segments enable investors to distinguish between different types of sustainable bonds, based on independently verified frameworks and use of proceeds.

There is also a new Issuer-Level Segment for bonds by companies whose core business activity is aligned with the “green economy”. This enables eligible green economy businesses with more than 90% green revenues to admit bonds to SBM. Included with this are mandatory annual post-issuance reporting requirements for issuers on SBM, to provide transparency to investors on the ongoing use of proceeds and demonstrate continued eligibility to SBM over the lifetime of the bonds.

2019 EU Taxonomy Regulation – establishing sustainable investments

In December 2019, EU Regulation 2019/2088 established an EU classification system intended to provide businesses and investors with a common language to determine to what extent economic activities are environmentally sustainable. It provides a list of environmental objectives which should be considered when evaluating how sustainable an economic activity is. Any economic activity which is carried out should contribute to one of the six objectives (climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control and restoration of biodiversity and ecosystems) and not significantly harm any of them.

It applies to any measures adopted by member states setting out requirements in respect of financial products or corporate bonds that are marketed as environmentally sustainable, as well as “financial market participants” offering financial products as environmentally sustainable investments or as investments which have similar characteristics.

The Regulation on sustainability-related disclosures in the financial services sector entered into force on 29 December 2019, further technical and disclosure standards are to be developed this year with the substantive provisions to apply from March 2021.

What are we thinking?

• ESG will continue to develop and refine its meaning for investors and organisations.
• ESG will remain challenging in the short to medium term; it captures a wide range of issues, which operate across multiple aspects of any organisation in different cultures and geo-political and economic climates.
• The cost of gathering, monitoring and reporting data will remain high and accuracy is likely to remain variable until more data is gathered and reporting frameworks are more widely adopted.
• ESG is only part of the investment decision; however in globally competitive investment environment, it will become an increasingly more relevant one.

As a firm, we have started to see ESG issues become a focus of investors and impact in a meaningful way on investor diligence and interest in transactions. We expect this to develop further during 2020.