Introduction: What is ESG investing?
ESG is a term that is gaining popularity and momentum as investors take advantage of economic shifts such as the rise of electric cars and plant-based foods. But what exactly is ESG? ESG stands for Environment, Social, and Governance. ESG criteria are a set of common standards for companies to integrate in their operations, and in the long-run can help improve companies’ internal operations as well as provide benefits to stakeholders such as customers and the society.
In Thailand, there are two common terms mentioned when discussing about long term sustainability. One is ESG model as mentioned earlier, and other side is Bio-Circular-Green Economic or BCG model which is economy model to develop Thailand economy by adopting three dimensions including
- Bio economy aiming to make the most from bio resources
- Circular economy aiming to ensure resources recycling ability and reduce waste
- Green economy aiming to reduce pollution for overall global long-term sustainability
Key differences between the two are BCG model is the absolute economy goal for Thailand while, ESG model is the universal standard and methodology that allows companies to achieve better operational practices and long-term sustainability. For this article, we aim to explore more in the field of ESG model and especially deep dive further in ESG investing.
Taking ESG factors into consideration when evaluating investment opportunities is becoming more common and relevant at this present day as ESG investing does not only provide benefits toward the planet earth, but also to investors in the form of greater and more sustainable profit. According to CBInsights, the mentions of climate change, global warming, and ESG on earning calls surged significantly from Q2 2020 to 2021. This finding demonstrates that the consideration of ESG has a positive effect on the investment performance and is currently at the very top of institutional investors’ minds when they are making their investment decisions.
In this article, we will discuss the brief evolution of ESG investing, how investors view ESG investing, and the implications to the venture capital industry and financial institutions.
The Brief Evolution of ESG Investing: From Compulsory to Mandatory
In the past, the concept of social responsibility was simply a rule of faith separated entirely from investment activities. It was not recognized in business and investment operations until the 18th century, with the rising influence of Methodists and Quakers who believed that money gained should not come at the expense of life.
Integrating social responsibility in investment activities was not popular and not straightforward due the lack of technology to support ESG data assessment. This limited the ability of investors to access the ESG information of each company. Consequently, investors could not acquire sufficient information to make socially responsible or ethical investment decisions.
In the 1980s, the idea of integrating social responsibility in investment activities emerged as global warming became more threatening and disastrous incidents such as Bhopal and Exxon Valdez pushed people to recognize how much damage businesses could inflict on society, the environment, and the business’s profitability if they did not act responsibly. As a result of these two incidents, Union Carbide Corporation was charged 470 million dollars in damages by the Indian Supreme Court for the toxic gas leak at Bhopal, and Exxon had to spend more than 3.8 billion dollars on cleanup costs, fines, and compensation. These disasters served as wake-up calls and catalysts for investors to take greater interest in companies’ social impact. The demand for socially-responsible investments has increased, resulting in the establishment of the United States Sustainable Investment Forum (SIF) in 1984. The forum has assets under management of 5 trillion dollars for sustainable and responsible investment. It aims to develop sustainable and impact investing expertise by providing resources such as ESG investing knowledge sharing sessions and networking events for institutional members, including investment and advisory firms, mutual fund companies, and data firms.
Since then, the concept of ESG investing has gradually evolved and been incorporated into investment decision-making processes. It is expected to become more deeply integrated in the future due to technological advancement and increasing business stakeholders’ expectations.
|Stakeholders||Expectation with ESG|
|Investors||Many large institutional investors have explicitly agreed to apply ESG principles to guide their investment decisions and monitor key points in investing companies such as progress, disclosure & reporting on ESG issues, and ESG integration in business operations.|
|Customers||Customers are now focusing more on how much businesses care about ESG when they are making purchasing decisions and are willing to pay a premium for ESG-focused offerings.|
|Supply Chain Partners||Supply chain partners are expected to pay more attention to ESG matters as they are now regarded as parts of a company’s footprint and respective impact.|
|Employees||Millennial and Gen Z employees prefer to work at a company that has the vision to serve a higher purpose than profit generation.|
|Communities & Society||Communities and society expect companies to be responsible and take care of issues that impact the community in a more sustainable manner, not only for CSR purposes.|
What ESG Investing is in the Eyes of Investors: No Longer a Choice between Planet or Prosperity
Investors used to believe that they had to compromise performance to invest more responsibly. But today, they can also do well while doing good. Research from well-known organizations such as McKinsey & Company, CBInsights, and CFA Institute support that ESG investing is gaining attention and can produce more profit to investors than non-ESG investing.
According to MSCI, more than 80% of ESG and ethical fund indexes, which are designed to reflect the performance of investment strategies that seek to gain exposure in companies which demonstrate both a robust ESG profile and positive trend in improving that profile, have outperformed and proven to be as resilient as traditional funds over the last three years.
The rationale behind this superior performance is that ESG can enhance overall company performance in key areas:
- Revenue boost;
- Cost reduction;
- Overall risk minimization; and
- Employee productivity enhancement.
1) Revenue Boost
With a solid ESG proposition, companies can increase revenue from both existing and new markets.
For existing markets, ESG consideration allows companies to gain more revenue as consumer preferences have shifted and customers are now willing to pay a premium for ESG-focused products or services. According to PwC research, nearly 80% of Thai consumers said that they have become more eco-friendly when purchasing products and services. This trend is more applicable with younger populations as they are generally more well-educated and are the generations that will have to bear the costs of ESG-related misconduct.
For new markets, integrating ESG consideration in business operations will allow companies to expand to the new market more easily due to regulatory support. Businesses with strong sustainable consideration are likely to get support and access from the government relations and communities as the positive impact that the businesses will create is in line with the government’s long-term policies.
2) Cost Reduction
Considering ESG can also help reduce cost of production and expenses for companies in both short and long term.
In the short term, applying ESG ideas in business operations will allow companies to reduce costs such as raw materials, energy, water, waste/hazard, or carbon footprint by adopting production methods that generate less waste to the environment and lower the threat of getting fined as a result of participating in risky activities. According to a study by McKinsey & Company, as financial performance and resource efficiency are significantly correlated, 60% of operational expenses can be offset by implementing ESG in a proper way. 3M is an excellent case study for ESG cost reduction. In 1975, the company saved 2.2 billion dollars as a result of the Pollution Prevention Pays (3Ps) initiative, focusing on preventing pollution by reformulating products, optimizing manufacturing processes, redesigning equipment, recycling, and reusing industrial waste. Another great example is FedEx. The company plans to convert its whole 35,000-vehicle fleet to electric or hybrid engines. With 20 percent of the fleet converted so far, FedEx has saved more than 50 million gallons of fuel consumption.
In the long term, having a strong ESG position can prevent companies from costs that might occur in the future such as non-compliance costs. ESG has become a mandatory measure and criteria in many countries, and it is essential for companies with plans to expand their businesses abroad. For example, Nestlé announced they would invest up to 2.1 billion dollars by 2025 with the aim to shift from virgin plastic packaging to food-grade recycled plastics, and to develop other sustainable packaging solutions. Its goal is to reduce carbon emissions as well as to protect itself from non-compliance charges in the several countries where it is operating.
3) Overall Risk Minimization
Organizations that focus on integrating ESG have lower risk levels because ESG practices allow companies to be less vulnerable to regulatory and legal interventions. The reduced exposure to these interventions can then help reduce overall cost of capital.
The ESG-focused companies will be able to avoid the risk of incurring costs from the government such as fines, penalties, and enforcement actions. According to McKinsey & Company, more than 30% of corporate profits are at risk from state or government intervention and can be even higher depending on the industries.
Source: McKinsey & Company
The correlation between the cost of capital and the company’s risk are well established. Therefore, the ESG-focused firms with lower volatilities and risk levels tend to have lower cost of capital for both debt and equity. With support from MSCI research, organizations with high ESG scores, on average, experienced lower costs of capital compared to those with low ESG scores in both developed and emerging markets during a four-year study period.
4) Employee Productivity Enhancement
According to research by Mckinsey & Company, favorable social actions of organizations have a positive correlation with increased job satisfaction. The positive impact of their work on society helps motivate employees to act in a more prosocial manner and encourages them to work more productively. This finding is supported by a study from Alex Edmans, professor of Finance at London Business School that companies on the “100 Best Companies to Work For” list which have strong employee governance earned 2.3 – 3.8 percent higher profit than typical players over the 25-year period.
ESG investing and Venture Capital Industry: Venture Capital Investment and ESG integration
Venture Capital (VC) firms, like other traditional investment entities, are giving more focus towards more responsible and impact-driven practices for greater social and economic return. According to a PRI survey, most VC respondents indicated that they mostly consider ESG factors in their investment processes during the due diligence and decision-making processes.
However, ESG incorporation in the investment processes for VCs has not yet been standardized throughout the industry and is often less comprehensive than public firms. These are how VCs incorporate ESG in their investment activities from screening, due diligence to investment decision making.
ESG Incorporation and Investment Policies
Currently, there are various practices for ESG incorporation in investment policies. Some VC partners have clear and concrete investment policies on ESG in place that define the scope and nature of their ESG strategies. Some VCs have policies covering only particular ESG aspects such as diversity, equity, inclusion and anti-harassment. Other VCs may have incorporated ESG issues in a less formalized way and do not have any policy to govern their practices.
ESG Incorporation and Screening
For the screening phase, several VCs have adopted customized screening policies that incorporate ESG factors. For example, Amadeus Capital Partners avoids investing in a variety of industries and business models, including gambling, predatory credit and debt traps and Truffle Capital avoids investing in companies whose scientific procedure led to a way of modifying human beings.
ESG Incorporation and Due Diligence
There are many distinct ways VCs can apply ESG incorporation to the due diligence process. Some VCs use pre-investment ESG questionnaires to discover and understand the ESG risks and opportunities of potential target companies. VCs might also apply standard measures as a criterion for due diligence, such as Sustainability Accounting Standards Board (SASB) standards. VCs might also apply informal methods to examine ESG, such as assessing the founders’ principles and ethics by observing how they interact with others.
ESG Incorporation and Investment Decision Making
For the decision-making process, some VCs consider ESG data when deciding whether to pursue an investment. Startups with high ESG risks that severely impact the society and other stakeholders and are difficult to mitigate, such as unethical business operation process or improper waste management, may be rejected.
Some VCs might insert additional sustainability clauses requiring startup founders to consider and be aware of ESG in business operations. These terms may include warranting the company’s due diligence results, enforcing the company’s compliance, and monitoring and addressing the company’s non-compliance with ESG requirements. This practice could help ensure the appropriate overall ESG risk during the investment period.
Next Step for VCs and ESG investments
There are several areas that can be enhanced to enable VCs to effectively move forward with the ESG integration. Examples include:
- Broadening the understanding of ESG incorporation in the VC industry by forming and joining communities of practitioners such as Venture ESG community who work together 12to improve practices; and
- Enhancing sharing of best practices of practitioners and investors on experiences, observations, and insights as well as ongoing challenges through channels such as case studies reports, podcasts and roundtables.
ESG Investing and Financial Institutions: Current and Potential Initiatives
Financial institutions (FIs), like other businesses, are conscious of the movement toward ESG practices. They are aware of the advantages of incorporating ESG into their business operations, as well as the pressure of increasing customer expectations. According to Forbes, more than 40 percent of banks holding global assets have agreed to join the net-zero banking alliance, which would synchronize lending and investment strategies while utilizing technology and policies to achieve net-zero emissions by 2030. This agreement does not only target the industry’s own carbon emissions, but also allocates lending and investment funds to organizations involved in the reduction of carbon emissions.
In Thailand, there are numerous internal and external initiatives from Thai FIs striving for ESG incorporation and sustainability. For internal operations, FIs aim to improve their core operations by proposing policies to achieve net zero carbon including setting up zero waste policies to reduce greenhouse gas emission activities in the working environment by 2030 and digitizing internal operations processes. For external initiatives, FIs have been developing and providing loan portfolios to accommodate sustainable projects such as green bonds, green project financing, and EV car loans to support customers with ESG vision.
Looking forward, there are several opportunities for FIs to support ESG incorporation and sustainability, including:
- Considering carbon credits as a criterion for loan offering
- Treating carbon credits as loan collateral; and
- Investing in sustainable fintech startups which provide innovative solutions for long-term sustainable finance development.
ESG investing is not only a way to support businesses that are doing good for the society, but it is also a new key consideration for better investment returns. However, there are challenges lying ahead in ESG investing in the VC industry which are the lack of knowledge and deep understanding of ESG incorporation in the current investment process. Joining ESG investing communities for VC and encouraging sharing of best practices of ESG incorporation will drive ESG incorporation in VC to another step. For financial institutions, there are many opportunities to explore more in the area of ESG incorporation and sustainability for better operational efficiency and meeting customer expectations. The immediate initiatives for FIs to incorporate ESG investing in their operation is through their core business such as adopting ESG as a loan criteria and considering carbon credit as a collateral. As ESG investing is expected to remain dynamic in years to come, it is also important for investors to pay close attention to the ESG disclosures by the target companies and carefully interpret the actual meaning behind those statements to achieve the appropriate and desirable ESG exposure and make the most optimal investment decision.
Author: Chaloemlak Tantiviwatkhul (Gam)
 The Bhopal tragedy was a gas leak accident that happened on December 2-3, 1984, at the Union Carbide India Limited pesticide plant in Bhopal, India.
 The Exxon Valdez oil spill was a man-made disaster that happened on March 24, 1989, when the Exxon Valdez, an Exxon Shipping Company oil tanker, dumped 11 million gallons of crude oil into Alaska’s Prince William Sound.
 Sustainable Investment Forum (SIF) is a Washington, DC-based membership organization that promotes sustainable investment across all asset classes.