ESG 2.0 | The Roadmap to a Global Changeover
By Capt. Dimitrios Mattheou, Chief Executive Officer, Arcadia Shipmanagement Co Ltd.
“…our bodies are recycled earth, our emotions are recycled energy,
and our thoughts are recycled information…” Deepak Chopra
In the alphabet soup of financial acronyms, there are three letters that have risen from relative obscurity to prevailing importance in less than two decades: ESG
ESG stands for Environmental, Social, and Governance factors used to evaluate companies and countries on how far advanced they are with sustainability. With growing concern about the ethical status of quoted companies, these standards are the central factors that measure the ethical impact and sustainability of investment in a company.
What is the difference between CSR and ESG? CSR (Corporate Social Responsibility) is the ideal and gives context about sustainability agendas and corporate responsibility culture. ESG is the action and measurable outcome. To simplify, CSR can be thought of as the qualitative side and ESG as the quantitative side.
The ESG factors
Environmental factors include the contribution a company or government makes to climate change through greenhouse gas emissions, along with waste management and energy efficiency. Given renewed efforts to combat global warming, cutting emissions and decarbonizing is become more important.
Social include human rights, labor standards in the supply chain, any exposure to illegal child labor, and more routine issues such as adherence to workplace health and safety. A social score also rises if a company is well integrated with its local community and therefore has a ‘social license’ to operate with consent.
Governance refers to a set of rules or principles defining rights, responsibilities and expectations between different stakeholders in the governance of corporations. A well-defined corporate governance system can be used to balance or align interests between stakeholders and can work as a tool to support a company’s long-term strategy.
In less than 21 years, the ESG movement has grown from a corporate social responsibility initiative launched by the United Nations into a global phenomenon representing more than US$30 trillion in assets under management. Last year, a surge of capital totaling US$17.67 billion flowed into ESG-linked products, an almost 525 percent increase from 2015, according to Morningstar.
One of the key challenges for (ESG) investing, at least in its still-early stage, is that it has always been a movement in search of a philosophy. True. Since the “mainstreaming” of ESG began in the early 2000s, it has sought to bring important social and environmental issues into the “market mentality” around risk and return.
The current crisis, however, presents an opportunity for a much deeper assessment of the role of markets, governments and, for that matter, ESG. Clearly, some self-reflection is needed to recognize the limited capacities of ESG to effect meaningful change within the market dynamic, and also to address the balance between returns and social/environmental impact.
If it functions only as an add-on to the prevalent market philosophy, ESG cannot inform on the balance between shareholder rewards and societal resilience.
The COVID-19 pandemic, as the first truly global natural disaster of modern times, has shown that the current shareholder trend is extremely fragile and will likely require changes far beyond the recognition of the model by stakeholders in the World Business Council.
Public Intervention Precedence – “Whatever It Takes”
In response to the COVID-19 crisis, governments have proven that when sufficiently motivated, they are willing to deploy apparently unlimited resources to address issues of social risk. Ideas that were viewed as fringe only months ago are not only accepted now, but rolled out on a scale that was once-unimaginable even by their proponents.
It also now seems unfounded to argue that the extraordinary efforts made by governments to prevent COVID-related deaths should also not be taken to address other pressing socio-environmental threats, such as hunger, air pollution, poor hygiene etc.
Building on the Past, Improving for the Future
So far, according to statistical studies the relative performance of companies on ESG metrics has been meaningfully different. Companies with better ESG scores have outperformed. This reflects the reality that within any given sector, some companies are taking ESG risks and opportunities seriously and devising explicit strategies to improve or capitalize. Over time, however, the tendency in any industry is towards convergence on issues that are viewed as material.
For example, if diversity is a strategic advantage, all companies will tend to adopt diversity practices. So, imagine a future in which all boards are diverse – and then imagine trying to distinguish materiality among diversity strategies. Or consider climate change. The years of fighting a rearguard action for resources companies will likely morph into credible – and widely adopted – strategies for reducing their carbon footprint and assisting with the energy “transition” (lower emitting sources). Whether used for long-only strategies or those employing shorting, over time the efficacy of a simplistic interpretation of ESG data points is less and less likely to be meaningful.
ESG progress defined as co-operation, not competition
As the COVID-19 pandemic has demonstrated, systemic risks such as natural disasters cannot be addressed competitively at the company level. Inter-company rivalry does not help improve health outcomes or reduce the burden of employee furloughs on societal balance sheets. Universal owners do not want human capital to be a competitive factor, but they do want standards to rise across society. Similarly, with 80% of oil-related emissions derived from the use of their product (i.e. Scope 3 emissions), oil companies must cooperate with one another and with governments to meaningfully introduce alternatives and reduce dependence. This co-operative activity will overwhelm the relative ESG analysis of company operations, since the differences in operational emissions pale in comparison to credit risks associated with systemic demand declines.
Sustainability themes will continue to provide a strong flashlight
In today’s crisis, government is prioritizing industries that it deems essential. Ironically, this trend is entirely congruent with the rise of “impact” investing. As today’s focus on data quality, disclosure and corporate structure standardizes by market cap and sector, emphasis will shift to the purpose of the company itself. After all, manufacturing ventilators or discovering vaccines is not the same as making products that increase respiratory risk, such as tobacco or combustion pollution; from an impact perspective, that the cost of capital for one should be lower than the other is aligned with societal objectives towards resiliency and health and well-being. Applying a thematic lens can capture these long-term trends while steering through shorter-term cycles and can provide a more predictable basis for outperformance.
Empowering Resilience &Wellness
It has perhaps never been in the spotlight the way it has in dealing with a pandemic, major economic disruption and significant social unrest related to inequity and discrimination.
Positive signs of continued momentum include investors demonstrating consistent ESG interest during the pandemic, and the launch of new climate commitments by companies like Shell and Microsoft even as the economy stumbles.
And there comes business resilience; an ability to anticipate and prepare for change, then adapt to circumstances in the manner that provides the greatest chance of thriving over the long-term. It is shaped by actions that companies choose to undertake, but it is also influenced by a range of external trends and developments. At its heart, resilience is about surviving and thriving in the face of challenges in the short, medium and especially the long-term.
Beyond ESG, climate and other signature sustainability issues, the crisis has particularly elevated issues ranging from physical safety to mental and emotional health related to worker well-being. While we regret the driver behind this, we are glad to see the human emphasis. A large number of companies — and other employers, like the UK’s National Health Service — have made meaningful sacrifices and changes in order to emphasize the economic, physical and mental well-being of their employees.
Healthy Workforce equals a Resilient Organization
Due to COVID-19 some of the biggest challenges have been employee-related, from restricted travel and re-designing essential workplaces to keep workers safe, to differently supporting whole workforces that shifted to working from home virtually overnight.
In the initial wave of the virus, ad hoc reactions of national and state governments in different regions left global companies to make many decisions on their own. While responses haven’t been perfect, many companies have made extra effort to put employee health and safety first.
Just as the pandemic has accelerated remote working, it has forced employers to reassess their approach to employee physical and mental well-being. Companies that demonstrate commitment to the well-being of their workers are more likely to be rewarded with increased employee loyalty, reduced levels of stress, and higher levels of productivity. However, above all they have managed to cultivate a strong and resilient culture while they have established a stronger market position.
ESG 2.0 is the next generation of Leadership
As anyone involved with ESG will attest, the current level of demand for ESG leadership talent is unsurpassed and unrelenting. Even firms with long-standing track records of successfully integrating ESG principles into their organizations are finding it more difficult than ever to stay ahead of dynamic and constantly evolving ESG expectations.
As ESG has gone from being a functional requirement to a commercial imperative, best-in-class organizations are embracing ESG in part because they firmly believe in the financial benefits of incorporating sustainability into their corporate and investment strategies.
It is clear that next-generation ESG leaders will look quite different from earlier archetypes, as the scope of the role grows and requires a far more senior and agile executive to be considered as a credible “ESG 2.0” leader.
ESG 2.0 leaders have four primary responsibilities:
1 Create a best-in-class enterprise-wide ESG policy and framework
2 Integrate ESG policy across the organization, ensuring a consistency of messaging and execution throughout each individual business line/investment strategy
3 Serve as the “face of the franchise” both internally and externally, articulating to investors how ESG permeates all levels of the organization and is embedded into each business line/investment strategy
4 Engage with external partners (portfolio companies, operating partners, supply chain) to help them create more sustainable business strategies for their own organizations
ESG Evolution (Source: Russell Reynolds Associates)
ESG 1.0 The initial wave of ESG hiring began in earnest three to four years ago, when C-suite leaders began to tire of being asked questions about ESG that they could not readily answer. This led many organizations to appoint a “head of ESG,” which usually tapped an internal employee coming out of legal, compliance, and marketing or investor relations. These ESG heads were generally mid-level functional executives reporting into compliance or marketing, and were tasked with creating a basic fundamental ESG framework designed to satisfy internal and external questions as they arose.
This minimalist approach worked initially, but investors continued to raise the bar on the level of ESG sophistication, measurement and reporting they required, most notably reflected in BlackRock’s annual letter to CEOs heralding the importance of corporate purpose. By 2019, the “ESG 1.0” model had proven to be insufficient.
Just as ESG demands from investors, consumers and regulators began to reach a fever pitch in 2020, the world was hit with simultaneous global crises: COVID-19, climate change, racial and social injustice, and dysfunctional geopolitics. When it became clear that ESG policies and frameworks could provide a roadmap for organizations to emerge more effectively from these concurrent global crises, the demand for ESG leadership talent exploded. Organizations now require more credible and more senior leaders who combine ESG domain expertise with business/ P&L backgrounds, and diversity of thought and experience.
ESG 1.0 leaders were:
· Repurposed internal employee
· Functional background, no prior ESG expertise
· Mid-level, reporting into a functional head
(Source: Russell Reynolds Associates)
ESG 2.0 leaders are:
· Senior executive who combines ESG expertise with industry experience
· Business background, focused on value creation
· MD/executive level, reporting to CEO/president/ executive committee/board
· Global citizen with a global perspective
· World-class influencing skills
ESG 2.0 Leaders bring multi-functional business experience and a diversity of perspective
Best-in-class ESG leaders are business people first, with hands-on industry experience that will enable them to be credible with internal line of business leaders. They are senior executives who are fluent across the suite of ESG dimensions with an industry- specific commercial acumen. These individuals must also possess the ability to successfully influence across an incredibly diverse set of stakeholders, including the C-suite and board of directors, line of business leaders, institutional investors, legal & compliance, regulators, external partners (portfolio companies, operating partners, supply chain) and internal colleagues.
Strong female representation at the top
The ESG function has also managed to avoid the cultural and structural barriers that have limited the number of female executives ascending to senior roles – 70% of recently appointed senior ESG leaders are female. This may result from the fact that, as a relatively new role, the paths to ESG leadership remain varied and multi-faceted, allowing companies to expand the aperture of their search for the best talent.
As companies seek greater gender diversity in the C-suite, it would appear that the ESG function will be an important pipeline of talent, particularly given their cross-functional expertise and visibility into both the operational and strategic aspects of the business.
ESG 2.0 in Shipping: from periodic to systemic change
In the last decade, there has been a strong interest in sustainability in the shipping industry. Issues such as environmental, social and corporate governance (ESG) significantly influence funding decisions, fleet renewal and industry-wide regulatory changes.
In 2018, the UN’s International Maritime Organization (IMO) set a high bar for the industry: to lower shipping’s CO2 intensity by 40% by 2030 and its greenhouse gas emissions by 50% by 2050, as compared with a 2008 baseline.
Decarbonisation is viewed as the main challenge for shipping, well ahead of non-ESG factors, though this varies somewhat regionally. Within the ESG matrix, there is broad agreement among financiers and ship operators worldwide that emissions are the main priority. Beyond that, concerns differ, though regulatory issues around health & safety and governance rank equally in our survey.
There is not yet consensus on how to meet environmental targets and the technological challenge is immense. Zero-carbon fuels already exist but the networks to deploy them at scale and the right cost have yet to be developed. At the heart of shipping’s decarbonisation challenge is the question of who assumes the first-mover financial risk of researching, developing and installing new technology.
One way to bridge the problem is through collaboration and risk sharing; two conditions that will lead to a systemic change and eventually fill in the gap between how the shipowners view ESG and how banks and other sources of capital are adjusting their portfolios according to sustainability and governance criteria.
Compliance with governance and social standards is also becoming important as pressure from regulators and law makers increases. However, shipowners view the social element of ESG as more important than governance criteria, being significantly more concerned about crew welfare than financial reporting, understandably so given the Covid pandemic.
Interestingly, many in Shipping believe that the orientation to sustainability will lead to changes in the shape, capital structure and financing of the sector, which means that shipping will not be able to bring about significant environmental changes without addressing social and governance issues.
Despite its reputation as old-fashioned and cumbersome to change, shipping has proven to be a very durable and adaptable industry over the years. There is a clear global recognition that shipping (ESG oriented) leaders are able to bring significant changes in the coming years that will reshape and thrive in the world of tomorrow …for us, for our people, for the world!