3 reasons investors will care about ESG in 2015

3 reasons investors will care about ESG in 2015

If the bottom-line business case for sustainability is so compelling, why aren’t more companies aggressively taking environmental, social and governance (ESG) action? I get that question a lot.

Some companies are waiting for stronger signals from investors that ESG efforts matter to them. Investors and lenders -- the capital markets -- have been skeptical that ESG matters to company performance and generally have not required companies to disclose their ESG efforts.

Investor disinterest dampens company action. In turn, lack of company action on ESG fuels investor skepticism. It’s a vicious circle that needs to be molded into a virtuous circle, where capital markets reward corporate sustainability performance with the capital and credit it deserves.

But that lack of interest from capital markets is changing. Until recently, investors made decisions based largely on a company’s track record, believing that past performance was a proxy for future success. But now, all bets are off.

The future will be different. Coming changes are highlighted in KPMG’s recent “Expect the Unexpected” report, which shows how 10 “global sustainability megaforces” will affect firms.

Once these megaforces were seen as irrelevant externalities, or someone else’s problem. Now their disruptive impacts on business are becoming unavoidable and increasingly significant. These impacts are big enough to intensify risk and volatility, the two nemeses of successful long-term investing. Together, they’re a disruption that can’t be ignored.

Capital markets now want to know if a company can handle the related risks and opportunities. Lenders ask: Can a company pay back its loans? How should we adjust our lending rates? Investors ask: Will a company continue to deliver a healthy return on our financial capital? Is it being a good steward of the natural and social capital on which it depends?

New guidance for ESG in capital markets

By 2015, three new initiatives will provide capital markets with insights about how future-proof a company is. Individually, these efforts address firm ratings, voluntary reporting and regulatory disclosure. Together, they will cause a sweeping change in how capital markets treat ESG.

Top image of a pen showing a diagram on a screen by fotohunter via Shutterstock.

1. A new ratings standard

Rating organizations such as Sustainalytics and Sustainable Asset Management evaluate firms on a host of criteria, including elements of ESG. Their ratings guide investors’ decisions. But the ratings landscape has become chaotic. Ratings have proliferated -- there are now more than 100 rating organizations -- and it’s often difficult to know whether they adequately capture firms’ ESG actions and vulnerabilities. Indeed, NBS’s Leadership Council identified the proliferation of ratings as one of its 2013 Challenges.

The Global Initiative for Sustainability Ratings (GISR) aims to create a single, world-class corporate-sustainability ratings standard. Just as the Global Reporting Initiative (GRI) is a reporting standard and ISO 14000 is an environmental-management-systems standard, GISR will provide a unified ratings standard. GISR will not rate companies. Instead, it will certify ratings organizations based on whether they follow GISR standard’s principles, issues and indicators. This standardization will make all ratings more clear, systematic and relevant.

GISR is a joint project of CERES and the Tellus Institute, founders of the GRI. GISR is developing the standard with a global group of investment managers, pension funds, companies, NGOs, accountancies, academics, governments, raters and the public. The first version will be available by the first quarter of 2015.

The impact will be huge. Firms want high marks from raters; now, ratings will be driving improved firm actions on ESG. To meet raters’ informational needs, firms also will step up their reporting, both voluntary and regulatory. Enter the second initiative: the International Integrated Reporting Council.

2. A new voluntary reporting framework

Past ESG reporting often has been siloed, kept separate from the production of financial statements and, therefore, marginalized. The International Integrated Reporting Council (IIRC) aims to change this by integrating sustainability reports with financial reports. By the end of 2014, the IIRC will release the first version of its framework for integrating financial and intangible/ESG reporting.

It’s growing increasingly critical for company valuations to capture the intangibles. Today, more than 80 percent of a typical company’s market valuation is intangible, up from only 18 percent in 1975. That means that most of a company’s worth comes not just from its assets or products, but from its reputation and other considerations closely related to ESG. Companies can reduce risks and capitalize on opportunities related to intangibles via ESG initiatives.

The impact of integrated reporting would be magnified if accountants agreed that the ESG information in the company’s integrated report was important for stakeholders to know and auditable. The final initiative I describe, the Sustainability Accounting Standards Board (SASB), aims to bring precisely that change.

3. New regulatory reporting guidance

Accountants at the nonprofit SASB are defining auditable, industry-specific ESG indicators to guide large U.S. companies’ disclosures on their annual reports. These 10-K reports summarize a company's performance, as well as future risks and opportunities. The SASB plans to complete its ESG disclosure standards for 10 industry sectors early in 2015.

By definition, items are disclosed in 10-Ks only if they are considered material to investors. If ESG factors are included, they will matter to investors and -- as a result -- to U.S. executives. The ripple effect of actions by large U.S. companies will ensure that the same factors will matter to executives in Canada and globally.

The Golden Rule

In business, the Golden Rule is: “He who has the gold makes the rules.” Capital markets have the gold; capital is the lifeblood of business. So if company ESG performance interests capital markets, it will fascinate corporate executives.

Today, we’re experiencing the early stages of a global movement to embed ESG considerations into capital-market activity. This action is fueled not by values, as in the past, but by recognition that sustainability performance reflects a company’s management strength and long-term prospects. ESG considerations are becoming must-have value drivers, rather than nice-to-have values-based screens.

Together, the three initiatives discussed above form an aligned ecosystem. The developers of the GISR ESG ratings standard, IIRC voluntary reporting guidance and SASB ESG regulatory disclosure guidance are working to ensure that they will all ask companies for the same information.

We know that what gets measured gets managed, and what gets managed gets embedded into company culture. By 2015, with the combined influence of GISR, IIRC and SASB efforts, capital markets could be transformed from laggard skeptics to leading advocates for truly sustainable business models.