What is ESG (Environmental, Social and Governance)?
Environmental: How the company acts towards the environment, it helps measure how sustainably a company is operating and can include:
Energy use
Waste
Pollution
Greenhouse gas (GHG) emissions
Deforestation
Treatment of animals
Environmental can also be used to evaluate environmental risks the company may face and how the company would handle those risks.
Social: How the company acts with respect to its business relationships, including towards its employees, customers and communities. This can include:
Working conditions
Impact on the communities
Diversity of labour force and inclusion of minorities
Product safety
Governance: How the company manages itself. This involves the morals and ethics of the company. This can include:
Transparency
Diversity in the board
Stakeholder input
Cybersecurity
Illegal practices
Bribery and corruption
There is relatively low regulation for governance on private companies compared to public companies, but having good governance is still key for long-term success. A system of reporting within an organization can be a first step. The owner / manager may play most governance roles within the company but how the owner acts on both financial and other reporting is critical. How does the owner seek guidance? Perhaps a formal board would help the owner set out the business strategy and manage macro level concerns and opportunities.
““At its core, ESG investing is about influencing positive changes in society by being a better investor” ”
ESG vs Socially Responsible Investing (SRI)
While you may be thinking that ESG sounds like SRI, there are a few key differences between them. For starters, SRI is normally driven by a set of values usually guided by religious or certain societal principles, whereas ESG investments tend to be driven by more generalized moral values. SRI screens for things such as firearm production, alcohol, tobacco, gambling, terrorism affiliations, human rights and environmental damage whereas ESG is more focused on the moral values such as those listed above.
How Did ESG Become So Popular?
ESG issues were first mentioned in the 2006 United Nation’s Principles for Responsible Investment (PRI), and was required to be incorporated in the financial evaluations of companies as a result. At the time, 63 investment firms signed on to follow the principles, covering approximately $6.5 trillion in assets under managements (AUM). As of June 2019, there were 2,450 signatories representing over US$80 trillion in AUM.
Although ESG was first talked about in 2006, it did not start to really gain traction among investors until the last few years, mostly due to millennial investors. Millennials (born between 1981-1996) have had an increased interest in investing where their values and beliefs align closely with an organization. According to a Morgan Stanley survey, 84 per cent of millennials prefer to invest in companies with a focus on ESG as a central goal. Institutional investors also want to see an increase in ESG. They want an ROI on their money and want to see a sustainable future.
““Combined with a push from CEOs of major corporations to identify ESG risks within their own businesses, and with more regulations – in Europe, but soon elsewhere – around sustainable finance-related disclosure requirements, interest in ESG will likely continue well into the future” ”
How Do You Make Money Investing in ESG?
One might think that if a company is spending resources monitoring ESG impacts and making decisions to improve its ESG impacts, it means it is less profitable or operating at a competitive disadvantage. From an investment return perspective, this has not been the case, at least based on the history available. Since 2018, when ESG funds became mainstream, many ESG focused ETFs have shown returns similar to their non-ESG focused indexes.
Note: Historical data from May 6, 2019 to June 21, 2021 retrieved from Refinitiv Eikon.
Many investment managers believe, using an ESG screening criteria for their investments generally helps identify management teams with vision and management styles more instep today and going forward. If you are operating a business without ESG in mind, the theory holds you are going backwards and are less likely to adapt in the future.
How Much Capital is Flowing into the ESG / Sustainability Sector
According to Bloomberg, inflows into Canadian-based ESG funds topped $3.2 billion in 2020, while total net assets in ESG funds topped $22 billion, a 37 per cent increase over the year before. ESG assets may hit $53 trillion worldwide by 2025, a third of global AUM. Below looks at ESG projected AUM by select countries.
How Does ESG Impact My Private Business?
The ESG momentum is already impacting M&A in the private sector. Many large companies have adapted their acquisition criteria to at least maintain or improve their company’s ESG ratings. As well, most private equity firms are being proactive at addressing ESG criteria in their review of potential acquisition candidates. The bar is likely still relatively low for a private company but ensuring the business is at least “not a negative” from an ESG front is critical to attract as many buyers as possible. This could mean preparing the following:
Environmental – Ensuring all environmental guidelines as set out by governments or industry standards are exceeded. Do you monitor the soil at your business’s locations? Have there been any issues historically that could be managed better? Are you able to reduce air emissions by utilizing new technologies? Do you know your business’s carbon / methane footprint?
Social – How does your business interact with its local community or communities? Do you know your neighbours? Are there causes, charities, issues that are important to the community that are also important to the employees of your business? Is your labour force diverse relative to your community? Is there any subconscious bias in your hiring practices or policies?
Governance – Do you have a board? How are macro issues / opportunities reviewed and acted upon? There are no “one-size-fits-all” solution for private company governance. The lack of a formal board is not likely to reduce a buyer’s interest level significantly. However, having some support for management to access experienced, outside advice can be a huge benefit to growth, development and keeping the business as current as possible.
Conclusion
The ESG trend is here to stay, and it will be the “norm” of how businesses are reviewed and evaluated going forward by most stakeholders and especially lenders, investors and buyers. We would be happy to discuss your business’ ESG plans and share our experiences working with private equity investors and corporate buyers as they complete their ESG due diligence and reviews.
