18 July 2016
ESG factors directly contribute to value destruction, says Bernadette Barber
BP’s reputation was damaged following the 2010 Deepwater Horizon oil spill, in which 11 people died and extensive environmental damage was caused. BP has recently reported that the total cost of the incident was $55 billion, a large chunk of which related to record-breaking environmental fines.
The Deepwater Horizon example is extreme but it demonstrates how environmental, social and governance (ESG) factors can contribute to value destruction. Although quantifying the impact that organisational behaviours may have on value will never be an exact science, ESG issues are gaining prominence in the assessment of the long-term sustainability.
Governance factors have for many years been part of shareholder assessment of the risks and culture of a business. There appears to be reluctance by shareholders to ignore poor governance practice – as evidenced, for example, by the rise in votes against excessive pay. Yet although the AGM requires various resolutions that enable shareholders to express an opinion on governance and financial matters, there are no mandatory equivalents for social and environmental issues.
Where shareholders have been given an opportunity to vote on a specific social or environmental issue, this has generally been the result of campaigns by activists with a particular agenda.
Arguably these issues are a subset of the oversight and governance responsibilities that a board has and that, as such, it is sufficient for boards to be judged on their governance effectiveness as a whole. However, in competing for the resources the business needs – whether that is capital, suppliers, customers or staff – boards need to be aware that their social and environmental credentials will be taken into account more and more.
Boards are expected to facilitate assessment of their company’s social and environmental credentials through transparent reporting. An organisation that fails to live up to expected standards, or falls short of those on offer from its competitors, may well find its business disadvantaged.
In certain jurisdictions pension trustees are guided to take account of ESG matters in making their investment decisions. The investment management industry is responding to the logic that an organisation which is run sustainably is likely to be a better long-term bet than one where the board is unperturbed by such considerations.
Applying a standard methodology to valuations of such non-financial factors is a challenge that the fund management industry has been trying to address for some time. Progress is being made and ESG is no longer an issue reserved for specialist ‘ethical’ funds – it is now mainstream and here to stay.
Pressure to behave better has also come from the new British Prime Minister, Theresa May. She intends to ‘get tough on irresponsible behaviour in big business’, with suggested reforms to include binding votes on executive remuneration and additional pay and reward transparency initiatives, employee representation on boards and further action on tax evasion and avoidance. If changes are made to UK corporate governance to emphasise social responsibility, other jurisdictions that often follow the UK’s lead in such matters may modify their regimes similarly.
Boards should understand that it is no longer sufficient to adopt a narrow mindset of just minimising the negative environmental and social impacts their companies’ activities have. A more farsighted approach is needed to consider how actively supporting social and environmental initiatives might enhance and derisk their businesses in the longer term.
That might be investing in apprentices to provide a loyal workforce with the skills needed to drive the business forward, supporting the communities that produce their raw materials to secure a more efficient supply chain, or investing in projects that improve the population’s wellbeing to grow their customer base.
Such initiatives send a message into the business to support embedding of appropriate values. They signal to stakeholders that the board recognises that sustainability is best served by taking a long-term view. When that is supported by investors who recognise that strong ESG practices deliver long-term returns, the short-termism that adds conflicting pressures to many board decisions may be alleviated.