Can ESG help create a new economic future?

One of the major considerations that consumers take into account when supporting a company, particularly when it comes to investment on the JSE, is whether the company has an established environmental and social governance (ESG) programme or is at least increasing its focus in this area.

This is particularly important in the mining sector which is the pillar of investment on the JSE. Such is the importance of ESG that Schroders convinced two major South African coal mining companies to divest from coal and completely change their operating models.

Can ESG be used as an effective restructuring tool? I caught up with Premal Ranchod, Head of ESG research at Alexforbes Investments to find out more about this growing movement.

Question 1
When it comes to ESG, how important is it when establishing a company’s mission, vision and value statement? This is the DNA of a company that defines who it is, where it is going and the values that will get it there.

First off, it is vital that a company not only considers ESG, or broader than that sustainability, in positioning itself. We are long past debating whether it is important or not. Prospectively, we will be debating the level of application and rigour employed by the company in effecting its strategy.

Whether that comes in the form of the purpose statements, or the actual company strategy is what separates how important the company considers the topic. The purpose statements are useful in explaining to investors what the company stands for, but it provides little evidence of application. If there is little application, a company could be criticised for virtue signalling.

Question 2
How has this grown over the past three years? Please provide examples.

We evidence growth, or rather amplification of conversations on ESG, in all forms of the corporate sector. Global challenges amplified by the Covid-19 pandemic have made ESG issues even more pressing for policymakers, boards and executives. Examples are:

• listed entities in global stock exchanges;
• unlisted investments in the measurement of impact;
• the flow of money into indexation-based ESG products;
• rating agency frameworks incorporating ESG evaluation of debt;
• brokerage offerings of ESG services;
• ESG consultancies;
• the rise of civil society or shareholder activism;
• policy involvement from governments and banking regulators; and
• the quest for standardised corporate accounting reporting standards on ESG matters

At the World Economic Forum Annual Meeting 2020 in Davos, 120 of the world’s largest companies pledged to develop a core set of metrics to report on. In September 2020, 200 companies participated in a consultation for a set of common reporting metrics.

Whilst we cannot yet assess the rigour behind the metrics, the intent, and impact on those companies’ strategy or whether they are strong or poor in terms of ESG credentials, it is a start for large, listed businesses to be public about their stance.

Question 3
A recent report from EY points out that there are growing calls (globally) for companies to shift their focus from shareholder engagement to stakeholder engagement. Is this a trend that is driving the future of every company? Which sectors will feel the biggest impact?

Whilst we think that messaging statements such as the one from Business Roundtable can also be virtue signalling, it does suggest that a company’s value proposition is firmly under the microscope.

Examples are the world’s largest corporate failures such as Enron or the global financial crisis 2007/2008. Locally, consider Steinhoff and African Bank.

Add to this, the growing stakeholder voice on climate action from social justice and environmental rights organisations. It would appear that a focus to incorporate stakeholders into the primacy argument is under way.

It is difficult to define which sectors will be first movers. All sectors will have leaders and laggards. An insightful question is whether companies such as large-cap listed companies (the most liquid and well researched) are considering ESG on merit, and if they are using it as an opportunity to define themselves or if they are solely being compliant.

Question 4
Shareholder expectations and stakeholder expectations will always be opposed to each other. One focuses on profit while the other focuses on the impact that the company has within the greater ecosystem of the project. How hard is it to influence the board of mining companies to increase their focus on ESG?

Mining companies appear to be an easy target for being ESG laggards, but we think that nuance is necessary. In each sector, there are leaders and laggards.

Our discussions with asset managers and consumption of broker research suggest that given that mining companies are well researched, they tend to disclose ESG information more transparently than perhaps other sectors. Mining companies focus on ESG, issues are clear and most of the larger ones (by market capitalisation) are acutely aware of what externalities pertain to their business model.

Given that some South African listed companies have dual listings, they benefit from global shareholder engagement. Issues from the UK and EU where ESG is relatively more advanced have required improved disclosures and that boards of mining companies address vulnerabilities. Despite this, they do have exposure to environmental, social and governance risks, at times beyond other companies like financials or industrials solely based on the type of environment they operate in.

Question 5
What are some of the important aspects that drive the above discussion?

• materiality and leadership response to ESG issues;
• linkage to business strategy;
• size of the business or market cap;
• transparency of reporting; and
• progress year on year in addressing ESG factors.

Question 6
ESG has obviously progressed since then. How has ESG developed over the years and what are some of the most important aspects of ESG that are currently driving this debate?

In addition to the points levelled in question 5, we believe that the following are important going forward:

• identification of a company’s ESG risk profile;
• its link to corporate strategy;
• its communication to stakeholders and shareholders; and
• follow-through in disclosure practice.

The role a company plays in adopting ESG reporting through IFRS or a form of sustainability reporting framework is going to be defining in years to come.

Question 7
In terms of companies that are facing financial distress, how can focusing on ESG help these companies address their distress?

When in distress:

• corporate governance plans and adherence are needed;
• adjusted business plan that addresses risks become necessary;
• BRPS need to elevate the  transparency of management plans to address the distress;
• material ESG risks that are impacted by the distress need to be addressed (unemployment and the communities impacted by this in areas where a company employs most of the community);
• the impact on the company’s performance and balance sheet (assets and liabilities) needs to be addressed;
• credible metrics and keeping to improvement could reduce the discount rate (rate that debt or equity financing is priced at), which allows the company’s valuation to rise; and
• communication allows markets to price information readily rather than in a surprise or shock fashion

Question 8
When re-launching a company exiting financial distress or business rescue, how can ESG drive a company forward?

Credible metrics and keeping to improvement could reduce the discount rate (rate that debt or equity financing is priced at). This allows the company’s valuation to rise.

There have been examples of companies being rewarded after addressing their ESG concerns or distress situation. It is not as simple for all companies. Our experience is that the liquid, well-researched companies tend to be those that are most susceptible or prosperous based on ESG credentials.

In general, if we consider that ESG or sustainability is a long-term fundamental pillar of a business, then irrespective of its status, survival should be the measure of success. A company that has addressed its ESG vulnerabilities linked to a viable strategic value proposition for existing clients (fulfilling a demand in society) should ultimately be sustainable.

Question 9
Finally, what is the future when it comes to ESG and the role it plays in good governance?

At present, ESG can be optional. Integrated reporting frameworks are not governed or audited but a recommended practice for companies that are listed. Governance codes are generally part of a listing requirement on an apply or explain basis. Unlisted companies could decide to ignore it.

A simple example is that if you are negligent in your allocation of investor (shareholder or debt) capital, you will in time lose the right to a financing mechanism and ultimately find your business model without a growth path or at worst, a corporate failure.

When it comes to sustainability, there are several reporting frameworks to choose from. However, we do not believe that there is a substitute for good governance. It would be an immediate red flag for investment purposes; despite not being a legal requirement, markets tend to price for good governance.

Short of governance being a regulatory or legal requirement, we believe that ESG frameworks or in time corporate accounting reporting standards will become mandatory and auditable.

The role in business rescue and the future economy of South Africa
What does the above mean for BRPs and companies in the future economy of South Africa?

Let’s focus on the relevance to the future economy of South Africa. There is a significant need for economic reform and a well-structured plan that will create jobs and transform South Africa into the economic powerhouse that it once was. In the past, this was mostly driven by State Owned Entities; however, President Cyril Ramaphosa has pointed out that there needs to be increased involvement from private companies in driving the future economic aspirations of the country.

What does this mean for BRPs? We are seeing many companies that are financially distressed that are in desperate need for restructuring. Focusing on ESG concerns may give BRPs the necessary leverage to turn the companies into the well structured and financially sound companies that the WEF has said is needed to create a new economic future.

“In 1970, the New York Times published an article by Milton Friedman, a professor of economics. He said that the social responsibility of a company is to make profits, in other words a return for shareholders. From then onward, US companies adopted a philosophy known as shareholder primacy. In August of 2019, the Business Roundtable, a group made up of the most influential US CEOs, published a letter shifting their stance on the purpose of a corporation. These corporations will no longer prioritise maximising profits for shareholders, but instead turn their focus to benefiting all stakeholders. This includes citizens, customers, suppliers and employees,” says Ranchod.

If we focus on this as BRPs, it can only benefit the profession.

The Mystery Practitioner is an industry commentator that focuses on the shifting dynamics and innovative thinking that BRPS and turnaround professionals will need to embrace in order to achieve success in their businesses.