ESG: Building socially responsible portfolios

1.., 2.., 3.., 4.., 5

Wondering why there is a countdown here?

Well, these are the number of people who would have died by the time you read this sentence.

Reason: Environment-related factors

Who caused these problems?

Humans and their businesses.

Within just 2 million years of our existence on this 4.5 billion years old planet, we have created havoc. Our thirst for material growth has led to the indiscriminate exploitation of natural resources.

But our resources are scarce and our wants are unlimited. Studies like earth overshoot day and Malthusian theory have brought to us that our population grows by geometric progression while our resources hover in the arithmetic progression. How bizarre is that!

To understand how bad it really is, we’ll have to look into the flaws of the existing business world by understanding a basic concept of accounting. What is that?

The field of accountancy deals with something called the going concern concept. The concept talks about the eternal nature of a business. It says that all organizations are started with the assumption that they’ll remain in business in the foreseeable future, i.e., they are an endless entity. But what does this have to do with the environment?

Everything!

When companies don’t follow sustainable practices, they are in a way violating the core principle of accounting. As the word, unsustainable itself says ‘it won’t last long’. How can a business continue endlessly if it doesn’t follow sustainable business practices, and if it does then at what cost?

These were a few questions the economist Howard Rowen took by heart and in 1953 the concept of Corporate Social Responsibility. The concept specified the obligation of an organization towards society and the environment. It gave rise to a plethora of philanthropists who contributed large sums to the welfare of society.

But not everyone is a philanthropist, not everyone wishes to fulfill their CSR responsibilities, and not everyone truthfully files a CSR report. In fact, CSR led to many frauds!

Contribution towards CSR was exempted from tax, so the companies inflated the amount of their CSR contribution and exploited this noble initiative.

Now, this is where ESG comes in. The term ESG became popular in 2006 as a CSR initiative launched by the UN. Today it has become the umbrella term under which CSR falls. This was the result of a few inherent problems with CSR.

CSR as a standalone concept expected companies to be good doers and honor their obligations, whereas ESG presented a set of risks and opportunities. And note, people aren’t like the ones mentioned in fairy tales, they don’t do business to create the world a better place, they do it for opportunities to make money, big money!

ESG presents businesses with a profusion of opportunities. With time, several frameworks and organizations have been established for assessing the ESG performance of organizations and for providing ESG ratings. But before going into frameworks let us first understand what is ESG.

ESG classifies an organization’s activities into 3 layers:

Environment — Conservation of the natural world

- Biodiversity

- Climate Change

- Responsible Supply Chain

Social — Consideration for Stakeholders

- Anti — Competitive Behavior

- Community Relations

- Diversity & Inclusion

Governance — Standards for running a company

- Accounting Transparency

- Bribery & Corruption

- Director Independence

The above-mentioned points are just a pinch of salt from the pool of factors in ESG, but it is enough to give a picture of how wholesome the concept is. It doesn’t give any specific sector an unfair advantage. This is evident by the fact that Tesla an EV giant was not placed anywhere in ESG Funds despite it being an environment-friendly company producing a chunk of its income through Renewable Energy Certificates.

People who invest in good-grade ESG companies are called SRIs (Socially Responsible Investors). As their investment not only generates a good return but also creates a positive impact on society.

And if we look at the past trend, ESG funds have grown 5 times in 4 years, it is the buzzword today and why won’t it be? The benefits of good ESG performance are plenty:

- Companies following sustainable practices or helping the country in reducing its carbon footprints can avail of subsidies from the Government

- When companies treat their workforce well, it in turn attracts even better talent as the existing workforce spreads the good word of mouth

- Transparency in accounting and ethical governance practices help maintain a clean report of the company

The benefits of this concept are so many that it seems too good to be true at times. But all that glitters is not gold, even the mighty ESG has cons and while you’re on your way to constructing a sustainable portfolio you should definitely consider the following points:

There is no single common standard followed all across the world for ESG, which in turn leads to differences in its assessment

There is a problem of greenwashing, wherein there is a misrepresentation of facts

No perfect standard of what is right and what is wrong. For e.g. Majority of the people consider divesting from an unsustainable company a positive step as it discourages such businesses, but a few argue that by keeping themselves invested in those businesses companies can use their voting power to influence decisions of the board and implement more sustainable practices.

Of these risks, the most important is of greenwashing or misrepresentation of facts.

The concept of ESG Assurance is yet at a very nascent stage, but understand it as an audit of ESG reports published by an organization. ESG Assurance can act as a game changer in this ESG world, where misrepresentation of information can lead to a disaster.

There is an infamous case of the Volkswagen Scandal, wherein the company infused a defeat device that could test when the vehicle was being tested and change its performance for the time being. In Sep 2015, Environment Protection Agency detected this and termed it a ‘diesel dupe’. The company had to set aside $9.2 billion for this and this took a toll on its financial health, not just that it faired extremely low in the MSCI Index. Only recently, after a genuine move towards sustainable practices, it has moved a little up on ESG Scale as can be seen from the following graph.

As per MSCI Report 2021

Such cases are rare to detect, but they do happen. They occur right in front of our eyes yet are invisible. This is one reason why risk-averse investors invest just on the basis of the financials of a company because unlike the non-financial statements (ESG, TCFD, CDP, etc.), the financial ones are audited and a lot more credible. This is mainly because years of rigorous auditing and amendments in financial laws have made financial statements much more transparent than any other statement. ESG being a relatively new concept lacks credibility and enough know-how among the general public to judge companies on its basis. This is where ESG assurance kicks in.

ESG assurance is the best way to tackle all such nuances, as auditors are in a unique position to check the ESG reports through their ERM (Enterprise Risk Management).

But as of 2021, only a measly 6.2% of Fortune 500 got their ESG assurance from an auditor. This needs to change in order to change the fate of ESG and how it functions.

If true and fair ESG reports are presented in public, it will not only foster public confidence but will also enable ESG acceptance. ESG is soaring and by 2026 it is likely to account for 21.5% of assets under management given its significance it might become a SOX in the near future.

The prevalence is rising and hence needs to be assured by the pros — the auditors. This single step can go a long way in building “truly sustainable portfolios”.