How businesses can be ready for sustainable finance

By Raymond Greaves, Head of Research, finnCap 

For several years ESG has been thought of as the latest buzzword in business and investment criteria. No longer just a trend, and thought of as some sort of rogue wing of Greenpeace, people are now moving the conversation from, ‘What is ESG? to ‘How do I invest in ESG?’ and ‘How do I comply with ESG?’ or ‘How do I measure it?’.

It is, more or less, a given that companies should look after the environment they operate in, look after their employees and the communities they operate in, and be well run by a balanced group of people. These are three ideas that no longer seem controversial in our current climate and society and they make up the core elements of ESG.

We all want businesses to make money today, tomorrow and in 10 years’ time. It is this crucial point of sustainability, not just for the environment, but also the durability of the business model that is the key issue and why ultimately companies should take ESG seriously.

You could go as far as saying that ESG codifies, in a high-level sense, how a good business should be run.

Many of the world’s largest companies are incorporating ESG into their practices, recognising how these factors are integral to their future growth and development. Most importantly, there is fast becoming a global recognition of the impact that businesses have on the climate. At the heart of the UK climate plan alone is the understanding that companies generate more than two thirds of the world’s carbon emissions.

Now, an increasing number of businesses are looking at how best to integrate targets to reach net zero carbon in their strategic thinking, looking to go even beyond carbon negative. These include businesses such as Sky, which went carbon neutral in 2006 and has since reduced its carbon consumption by 55%, or even Microsoft, whose manufacturing sites use 100% renewable energy. In addition, Google has for a second year in a row powered its operations with 100% renewable electricity.

What is the global investment community is doing?

Moving beyond business strategy, and more towards an investment point of view, many people are now asking what exactly is the global investor community doing about ESG?

Incorporating ESG into business practices is now mainstream. A recent survey suggested that 90% of global fund managers use ESG to some extent to make decisions, primarily for risk management purposes.

Fund flows into ESG-driven funds have been impressive even before the pandemic. Globally, ESG-focused funds took in almost $70bn of assets in 2019, while traditional equity funds suffered almost $200bn in outflows. This bifurcation has only been exacerbated with the onset of the pandemic.

Evidence continues to mount that ESG investment styles deliver higher returns with lower risk. This outperformance has become particularly notable since the beginning of 2020, through the COVID-19 market crash and subsequent rebound. Morningstar research shows that European-based ESG funds have outperformed conventional funds across 1, 3, 5 and 10-year timeframes. That said, the outperformance hasn’t been as marked as some might imagine.

So why has ESG outperformed? There are many potential reasons but one stands out: ESG analysis tends to favour certain sectors over others since they are by nature more ESG-appropriate. For example, tech and life science companies tend to appear far more frequently in ESG portfolios than companies in Industrials and Basic Resources due to their substantially lower environmental footprints. Since tech and life science companies have outperformed many other sectors over the last 5-10 years, it is likely this bias can be used to explain at least some of ESG funds’ outperformance.

What are UK small company investors doing?

When it comes to small company investors though, just a small minority only really considered ESG a few years ago. Now, nearly all fund managers are using ESG factors for portfolio decisions. Prioritising ESG is an absolute must if you want to seek equity in business.

We recently conducted a survey of fund managers of UK smaller company funds to understand current attitudes towards the use of ESG factors in the investment process.

We found that only a small minority considered ESG factors three years ago. About two-thirds consider ESG factors in the investment process now but, significantly, nearly all envisage using these factors to make portfolio decisions in future. The direction of travel is clear.

Of those that use ESG factors today, the most prevalent considerations are centred around Governance. ‘E’ and ‘S’ factors are not studied in as much detail yet.

Interestingly, the reasons given for the adoption of ESG factors in decision making mainly relate to helping drive investment returns, with risk management being the next most important reason.

Finally, a significant majority of fund managers are actively pressuring their investee companies to be more ‘ESG compliant’ now.

It’s also worth pointing out that on 10th March the EU’s Sustainable Finance Disclosure Regulation came into effect and, more recently, on 22nd June 2021, the Financial Conduct Authority (FCA) published new proposals on climate-related disclosure rules for listed companies and regulated firms. Clearly, ESG disclosure is right at the top of the agenda for regulators, shareholders and consumers – and will be top of mind for investors too.

How can companies get onto the first rung of the ESG ladder?

In any case, the most prevalent ESG decisions for business are centred around governance. At finnCap, we have developed a scorecard to provide an advisory framework for business. It focuses on how companies can get on the first rung of the ESG ladder.

As a scorecard based on 15 factors, it ranks a business against its peers and the wider market in terms of ESG priorities and focuses. It assesses our energy and water consumption, staff turnover, amount of tax being paid, ethics and community outreach policies, how the CEO and Chairman roles are split, how many independent directors a company has, what the CEO pay is like as well as what the gender diversity split is like at board level.

Our three key recommendations for companies looking to demonstrate their ESG credentials to potential investors are as follows:

• Obtain the key environmental datapoints

If starting afresh, the key thing is to obtain just the key environmental data points that you can work on first, before addressing every criterion. By picking two or three points to really hone in on when first starting out (such as energy, CO2, water and waste), you’re much more likely to make it in the long run. Small steps to achieve the bigger picture!

• Prepare and apply the most important policies

A company needs to have environmental, discrimination, ethics and community outreach policies as a minimum. They are not difficult to develop or apply, but too many companies are lacking environmental and community outreach policies in particular.

• Try to achieve greater diversity in the boardroom

Most companies we surveyed scored quite well on Governance, but companies still tend to be run overwhelmingly by white males. Armed as such, most smaller companies will be able to look forward to the forthcoming ESG scrutiny with confidence.

Ultimately, ESG is not just a fad and is certainly not going to go away. Investors will always want to invest in businesses with sustainable business models. The fact of the matter is that integrating ESG into your business will make you a much better business in the long-term.

By Raymond Greaves, Head of Research, finnCap 

For several years ESG has been thought of as the latest buzzword in business and investment criteria. No longer just a trend, and thought of as some sort of rogue wing of Greenpeace, people are now moving the conversation from, ‘What is ESG? to ‘How do I invest in ESG?’ and ‘How do I comply with ESG?’ or ‘How do I measure it?’.

It is, more or less, a given that companies should look after the environment they operate in, look after their employees and the communities they operate in, and be well run by a balanced group of people. These are three ideas that no longer seem controversial in our current climate and society and they make up the core elements of ESG.

We all want businesses to make money today, tomorrow and in 10 years’ time. It is this crucial point of sustainability, not just for the environment, but also the durability of the business model that is the key issue and why ultimately companies should take ESG seriously.

You could go as far as saying that ESG codifies, in a high-level sense, how a good business should be run.

Many of the world’s largest companies are incorporating ESG into their practices, recognising how these factors are integral to their future growth and development. Most importantly, there is fast becoming a global recognition of the impact that businesses have on the climate. At the heart of the UK climate plan alone is the understanding that companies generate more than two thirds of the world’s carbon emissions.

Now, an increasing number of businesses are looking at how best to integrate targets to reach net zero carbon in their strategic thinking, looking to go even beyond carbon negative. These include businesses such as Sky, which went carbon neutral in 2006 and has since reduced its carbon consumption by 55%, or even Microsoft, whose manufacturing sites use 100% renewable energy. In addition, Google has for a second year in a row powered its operations with 100% renewable electricity.

What is the global investment community is doing?

Moving beyond business strategy, and more towards an investment point of view, many people are now asking what exactly is the global investor community doing about ESG?

Incorporating ESG into business practices is now mainstream. A recent survey suggested that 90% of global fund managers use ESG to some extent to make decisions, primarily for risk management purposes.

Fund flows into ESG-driven funds have been impressive even before the pandemic. Globally, ESG-focused funds took in almost $70bn of assets in 2019, while traditional equity funds suffered almost $200bn in outflows. This bifurcation has only been exacerbated with the onset of the pandemic.

Evidence continues to mount that ESG investment styles deliver higher returns with lower risk. This outperformance has become particularly notable since the beginning of 2020, through the COVID-19 market crash and subsequent rebound. Morningstar research shows that European-based ESG funds have outperformed conventional funds across 1, 3, 5 and 10-year timeframes. That said, the outperformance hasn’t been as marked as some might imagine.

So why has ESG outperformed? There are many potential reasons but one stands out: ESG analysis tends to favour certain sectors over others since they are by nature more ESG-appropriate. For example, tech and life science companies tend to appear far more frequently in ESG portfolios than companies in Industrials and Basic Resources due to their substantially lower environmental footprints. Since tech and life science companies have outperformed many other sectors over the last 5-10 years, it is likely this bias can be used to explain at least some of ESG funds’ outperformance.

What are UK small company investors doing?

When it comes to small company investors though, just a small minority only really considered ESG a few years ago. Now, nearly all fund managers are using ESG factors for portfolio decisions. Prioritising ESG is an absolute must if you want to seek equity in business.

We recently conducted a survey of fund managers of UK smaller company funds to understand current attitudes towards the use of ESG factors in the investment process.

We found that only a small minority considered ESG factors three years ago. About two-thirds consider ESG factors in the investment process now but, significantly, nearly all envisage using these factors to make portfolio decisions in future. The direction of travel is clear.

Of those that use ESG factors today, the most prevalent considerations are centred around Governance. ‘E’ and ‘S’ factors are not studied in as much detail yet.

Interestingly, the reasons given for the adoption of ESG factors in decision making mainly relate to helping drive investment returns, with risk management being the next most important reason.

Finally, a significant majority of fund managers are actively pressuring their investee companies to be more ‘ESG compliant’ now.

It’s also worth pointing out that on 10th March the EU’s Sustainable Finance Disclosure Regulation came into effect and, more recently, on 22nd June 2021, the Financial Conduct Authority (FCA) published new proposals on climate-related disclosure rules for listed companies and regulated firms. Clearly, ESG disclosure is right at the top of the agenda for regulators, shareholders and consumers – and will be top of mind for investors too.

How can companies get onto the first rung of the ESG ladder?

In any case, the most prevalent ESG decisions for business are centred around governance. At finnCap, we have developed a scorecard to provide an advisory framework for business. It focuses on how companies can get on the first rung of the ESG ladder.

As a scorecard based on 15 factors, it ranks a business against its peers and the wider market in terms of ESG priorities and focuses. It assesses our energy and water consumption, staff turnover, amount of tax being paid, ethics and community outreach policies, how the CEO and Chairman roles are split, how many independent directors a company has, what the CEO pay is like as well as what the gender diversity split is like at board level.

Our three key recommendations for companies looking to demonstrate their ESG credentials to potential investors are as follows:

• Obtain the key environmental datapoints

If starting afresh, the key thing is to obtain just the key environmental data points that you can work on first, before addressing every criterion. By picking two or three points to really hone in on when first starting out (such as energy, CO2, water and waste), you’re much more likely to make it in the long run. Small steps to achieve the bigger picture!

• Prepare and apply the most important policies

A company needs to have environmental, discrimination, ethics and community outreach policies as a minimum. They are not difficult to develop or apply, but too many companies are lacking environmental and community outreach policies in particular.

• Try to achieve greater diversity in the boardroom

Most companies we surveyed scored quite well on Governance, but companies still tend to be run overwhelmingly by white males. Armed as such, most smaller companies will be able to look forward to the forthcoming ESG scrutiny with confidence.

Ultimately, ESG is not just a fad and is certainly not going to go away. Investors will always want to invest in businesses with sustainable business models. The fact of the matter is that integrating ESG into your business will make you a much better business in the long-term.