ESG can also be a root cause of financial distress

In the past, both myself and The Mystery Practitioner have spoken extensively about ESG. The Mystery Practitioner even went as far as suggesting that ESG could be used as a useful building block for future profitability.

Much of the literature in the market regarding ESG has been about its role as a positive disruptive force. It forces companies to look at their actions and increase their accountability when it comes to certain aspects of their businesses. But what role does it play as a negative disrupter? Can ESG be a root cause of financial distress?

In The Mystery Practitioner’s latest thought leadership article, he highlighted the fact that Tesla was recently excluded from an S&P ESG Investment Index because the company failed to make certain ESG disclosures. This is the first sign that ESG can be a negative disrupter. Reading a LinkedIn post by the CIPC Commissioner – Rory Voller – on Sunday night, I was reminded about how companies can have one business model one day and be forced to change their operational model the next day.

Toe the line

A recent article by UK media giant The Guardian points out that a court in the Hague has ordered Royal Dutch Shell to cut its global carbon emissions by 45% by the end of 2030 compared with 2019 levels, in a landmark case brought by Friends of the Earth and over 17,000 co-plaintiffs.

The oil giant’s sustainability policy was found to be insufficiently “concrete” by the Dutch court in an unprecedented ruling that will have wide implications for the energy industry and other polluting multinationals.

The article adds that the Anglo-Dutch company was told it had a duty of care and that the level of emission reductions of Shell and its suppliers and buyers should be brought into line with the Paris climate agreement.

Judge Larisa Alwin said Shell must at once reduce its CO₂ output, adding that the ruling would have far-reaching consequences for the company and may curb the potential growth of the Shell group.

“The interest served with the reduction obligation outweighs the Shell group’s commercial interests,” she said.

Roger Cox, Lawyer for Friends of the Earth Netherlands, also known as Milieudefensie, called on organisations across the world to “pick up the gauntlet”, and take legal action to force multinationals to play their full part in tackling the climate emergency.

ESG is a turning point in history

The Guardian article points out that Cox said: “This is a turning point in history. This case is unique because it is the first time a judge has ordered a large polluting corporation to comply with the Paris climate agreement. This ruling may also have major consequences for other big polluters.”

Donald Pols, Director of Milieudefensie, described the decision as a monumental victory.

Alwin was not wrong when she warned that the ruling would have far reaching consequences for Shell. Stating that the ruling may curb the potential growth of the Shell group could be interpreted by turnaround professionals as a statement of intent and a significant red flag when it comes to financial distress. This may well turn out to be a root cause of distress if it is not managed appropriately.

There have been instances in the past where a challenge has been presented to a company and they have accepted it with enthusiasm. When I was a financial services journalist, I once wrote an article on how Schroders convinced Anglo Coal and South 32 to divest in all of their coal assets long before ESG was even on anyone’s radar. Jessica Ground, Global Head of Stewardship at Schroders, said that this alignment is not necessarily easy found.

Massive pressure

“There is massive pressure on asset managers to show that they are being good stewards by holding companies to account for their actions. Environmental, social and governance (ESG) investing is creating strong headwinds that companies need to take into account when going about their business,” said Ground.

The article points out that this could spell trouble for South African investors in years to come. The majority of the investment by South African retirement funds have to be made in companies that are domiciled in South Africa. A corner stone of the South African economy has been the mining industry which has come under fire in the past for its social responsibility programmes.

On the rise

Companies are aware that ESG concerns are on the rise and that there is pressure on them to improve their actions when it comes to social responsibility. Not only for the communities that they serve, but for the environment. According to Ground, while these companies have acknowledged that there is an increased focus on their actions, addressing these concerns is difficult and they face a long road ahead.

The article adds that this adjustment better come quickly. In some countries, stewardship codes are on the rise and government are putting pressure on asset management companies to hold companies to account for their actions.

And the numbers do not lie. According to the Schroders Global Investor Study done in 2019, 62% of the surveyed companies said that they will only invest in companies which are proactive in making sure their businesses are prepared for environmental and social changes which will affect them. ESG was gaining momentum.

The article points out that in addition, 41% of the surveyed companies said that they will only invest in companies that are best in class when it comes to environmental social or governance issues, even if they are not the most attractive investments.

Finally, 19% of the surveyed companies said that they will specifically avoids companies that are active in controversial areas when it comes to ESG investing.

Again, this is scary news for mining companies who depend on this type of investment in a market where is a decreased demand for commodities.

Key engagements

So, what does sustainability and stewardship look like?

The article points out that identifying issues poorly understood by the market, understanding the materiality and the impact on valuations, engaging with companies to encourage ongoing improvement, and providing transparency for investors.

There are a number of practical examples that we can analyse. Climate change is becoming a real challenge with water shortages becoming a major concern. ESG was a challenge even before it became a buzz word.

“SAB Miller is one of the companies that Schroders invests in. The drought in the Western Cape was close to becoming crippling and as Day Zero approached, SAB Miller offered key assurances that if Day Zero was reached that the company would stop producing beer and would exclusively produce bottled water. This is the kind of social responsibility concerns that investors are looking for,” said Ground.

The article adds that there is another important example to analyse from the mining industry.

“Anglo American is a company that Schroders invests heavily in. Between 2003 and 2013, Schroders engaged in a decade of climate change discussions with Anglo American which was initially focused on setting climate change targets. In 2014, Schroders questioned the continued expansion of thermal coal projects in South Africa and encouraged Anglo American to undertake carbon scenario planning. After a published report in 2015, Anglo American confirmed it would undertake scenario analysis within one year. In 2016, Anglo American announced restructuring which included a move away from thermal coal. In 2017, Anglo American announced a 2030 emissions reduction target and announced a move to science-based targets in the next two years,” said Ground who said that Anglo Coal should be commended for their commitment to ESG.

In addition, after engagement with Schroders, Mining company South 32 announced in 2018 that the company would be putting its South African thermal coal assets up for sale, which will remove thermal coal entirely from the company’s portfolio. Further, South 32 gave Schroders clarification on its 2050 carbon emission targets.

Where to from here

Balancing ESG concerns with profitability is tough for companies to achieve. However, it is necessary. How do companies achieve this balance?

Ground pointed out that there are several steps that companies can take in the future. “Companies need to engage in insightful implementation, this includes limiting unintended performance consequences. Secondly, companies need to be forward looking which means that they need to think about future risks in investment terms. Thirdly, companies need to have a comprehensive approach to their business where solutions are tailored to the different needs of asset owners. Finally, there needs to be a level of transparency which includes innovative reporting engagement and the sustainability profile of portfolios,” said Ground.

Positive change

It is becoming clear that ESG is mostly a force for good as it holds companies accountable for the decisions that they make. This will hopefully help them avoid future financial distress provided that the company acts ethically and takes ESG seriously.

But what happens to companies that are forced to change their operating models. This is no small change and once again highlights the need to be agile. The best example of this was when Muhammed Ali fought George Foreman in Kinshasa (the famous Rumble in the Jungle). Ali was at the end of his ban for draft dodging and was preparing for a fight with “Smoking” Joe Frazier. Foreman beat Frazier before Ali could and the whole world questioned how Foreman could be beaten. Ali showed his adaptability and effectively changed his fighting style, and the rest is history.

If a company takes up the agility and adaptability now, they can possibly avoid financial distress if there are sudden changes in the market in the future. Ignore it and you will be playing catch up in a market where change can happen at any moment.