The impact of ESG mandates

Widespread awareness of ESG (Environmental, Social, Governance) issues has resulted in a major shift toward socially responsible investing over the last decade. Investor demographics, climate change discussions, and social justice issues are all changing business value systems and increasing the adoption of ESG investment strategies. According to Morningstar, the number of sustainable funds available to U.S. investors grew to almost 400 in 2020, up 30% from 2019 and a nearly fourfold increase in just 10 years.

While there are still some doubters, an increasing number of public and private equity firms are recognizing that investing conditions have altered drastically. Global concerns such as pollution, loss of biodiversity, deforestation, social inequality, labor rights, and water shortages present tangible dangers to economies and livelihoods that affect companies, funds, investors, and consumers alike.

Many are coming to understand ESG investing isn’t just about doing good for good’s sake; there’s growing evidence that ESG programs can also improve returns and limit risk. And that’s good news, because ESG may soon no longer be a choice for public companies and investment funds, but a mandate.

The rise of ESG

ESG includes issues such as environmental protection, human capital, supply chain management, diversity and inclusion, cybersecurity, and corporate tax policy or political spending. These issues are broad enough to build a strong corporate brand and promote long-term growth for companies upon adoption.

A 2021 report published by S&P Global showed 19 of the 26 ESG exchange-traded funds and mutual funds with more than $250 million in assets under management grew between 27.3% and 55%, outpacing the S&P 500 index’s 27.1% rise. It’s the latest proof that suggests ESG considerations matter for investment performance.

The growth of ESG, however, is not self-generated but is responsive to investor and public demand. Many of today’s investors are conditioning large capital investments on the existence and quality of a company’s ESG program. These mandates are coming from governments as well.

In fact, ESG reporting is now required for the European Union's 50,000 largest corporations. The European Commission has approved a package of sustainable finance regulations, including reporting requirements, that are intended to encourage investors to refocus their efforts on more environmentally friendly technologies and enterprises, and align with Europe's commitment to the Paris Agreement to achieve net-zero carbon emissions by 2050.

ESG mandates increasing from all sides

Regardless of where companies and funds sit on the ESG adoption spectrum, stakeholders such as governments, investors, and consumers are driving ESG mandates that, sooner or later, may be required.

Government regulation & SEC review
On June 16, the House of Representatives approved the Corporate Governance Improvement and Investor Protection Act (H.R. 1187) as part of a package of bills on a near party-line vote of 215-214.

If fully passed, this bill would make it mandatory for publicly traded firms to publish certain ESG metrics to shareholders. Investors have been demanding an increase in the quantity and quality of ESG disclosures from public firms, according to proponents of the bill, with many investors viewing ESG factors as vital for evaluating operational risks, financial performance, and long-term sustainability.

The House’s passage of H.R. 1187 comes as the Securities and Exchange Commission (SEC) is undertaking a regulatory review on whether current ESG disclosures adequately inform investors. Upon the release of the SEC Risk Alert this year, the commission announced it would form a Climate and ESG Task Force in the Division of Enforcement, to ramp up reviews of corporate climate-related disclosures.

The SEC also released a spring regulatory agenda that confirmed plans to proceed with rulemaking regarding disclosures around ESG issues such as climate risk, human capital, workforce and corporate board diversity, and cybersecurity risk.

The investor push
Middle market private equity firms have been slower to adopt ESG strategies into their investment frameworks; however, evidence shows regulations and pressures from limited and general partners are pushing the private markets toward widespread ESG adoption.

And while many have been quick to write ESG off as “millennial issues”, the Schroders 2019 Global Investor Study, which surveyed 25,000 investors worldwide, found more than 60% of those under the age of 71 believe that all investment funds should consider sustainability factors when making investments.

With that said, ESG is being championed by millennials, a generation about to inherit $30 trillion over the next two decades. Millennials want to know not just how much return an investment will make, but what impact that investment will have on people, the planet, and communities.

Consumer consciousness
It’s not only investors and governments that care about ESG issues; consumers do too. According to a Sustainable Brands survey, millennial investors are more likely to integrate sustainability into their consumer behavior. As millennials become employees and buyers, they’re taking note of positive corporate action and rewarding them with loyalty.

Millennials also make up 50% of the workforce and there’s no question that ESG initiatives like diversity and inclusion are good for business. A Cone Communications survey found 64% of Millennials consider a company’s social and environmental commitments when deciding where to work and 64% won’t take a job if a company doesn’t have strong corporate social responsibility values.

The need for (and problem with) ESG adoption

Members of the ESG movement are diverse, in both identity and motivation. With this diversity comes the task of making ESG issues relevant to a wide swath of investors. At one end of the spectrum sit traditional investors who are focused mainly on financial returns and hesitant to jump on board. At the other end, are philanthropists who are usually hyperfocused on issues where social or environmental needs may require a material financial tradeoff, sometimes as much as 100%.

Between these two pendulums, there is a wide range of investors embracing ESG principles across the investment value chain. But, in order to speak the same language, this diverse audience needs clear definitions of ESG and standardized, comprehensive reporting that provides accurate, measurable, and transparent information. But therein lies a problem. Socially responsible investing (SRI), sustainable investing, and ESG investing; these terms are widely used in today’s investment world. But what’s the difference between them, and which investment methodology is best? This lack of standardized terminology has created confusion over how to differentiate ESG investing. While it may seem like a small matter of semantics, this lack of definition is one of the issues surrounding ESG adoption.

There are multiple leaders in the ESG space seeking to provide comprehensive definitions to For example, in their G4 Sustainability Reporting Guidelines, the Global Reporting Initiative (GRI) provided some foundational definitions surrounding ESG as follows:

• Environmental: effluents and waste, emissions, water, land use, biodiversity, energy, materials
• Social: labor practices, occupational health and safety, human rights, diversity and equal opportunity, health and wellness, product safety, and corruption
• Governance: competitive behavior, responsible employment, indirect economic impact, procurement practices, fair trade, governance and transparency, tax compliance

These leaders are also working toward providing reporting frameworks that can be used to gain insights into the success and value of a company’s performance as well as provide reliable disclosures, whether mandated or voluntary.

While many public companies are inclined to brag about their ESG accomplishments, the U.S. currently has no standardized ESG reporting frameworks that can ensure accountability. However, investor demand for transparency surrounding ESG issues is transforming fiduciary responsibility and the larger landscape of corporate governance while creating a demand for clear standards and ESG assessment tools.

To nurture stronger communications with shareholders, companies are turning to initiatives such as the GRI, Principles for Responsible Investment (PRI), and SASB to define relevant sustainability issues and understand their impact on a company’s future performance.

Preparing for ESG regulations

Many public companies and fund managers are proactively driving change, but those who are taking a wait-and-see approach will eventually be moved to act through pressure from investors and regulators.

It would be wise for companies and funds should not treat ESG as a passing fad. Activist consumers, investors, governments, legislators, regulators, and civil society will no longer accept profit-only driven approaches. Companies and funds can prepare for impending mandates by implementing ESG strategies and frameworks from the top down. Those ESG efforts should begin by mapping out cross-functional ESG strategies and risks while working to capture data on relevant, material ESG metrics.

ESG materiality assessments

With investors inquiring more and more frequently about what your company is doing in regard to responsible investment, how you treat employees and vendors, your dedication to sustainability initiatives, and other activities that fall under the ESG umbrella, it’s important to have answers to these questions.

An ESG materiality assessment empowers you to easily report on your current state and outline future initiatives while taking into consideration your business goals and risks. Download our guide to creating and extracting the maximum strategic value from an ESG materiality assessment.

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Helee Lev

Helee joined our team in 2012, overseeing strategic account management, new business, and industry alliances. In 2015, she participated in raising $5M of venture capital funding. She leads sales, business development, and Conservice ESG's strategic consulting group.

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