ESG: Speaking the Same Language (Part 1)

Whether you are in the U.S. or Japan, when it comes to the Environmental, Social, and Corporate Governance (ESG) framework, we need to speak the same language. ESG rapidly gained mindshare with LPs, VC investors, and founders alike and it is critical that we understand both its origin and purpose to have meaningful conversations about investing for long-term sustainable growth. In this two-part series we will provide:

• History and relevance of ESG as a framework (Part One)
• Clear distinctions between ESG and other “Responsible Investing” strategies (Part Two)

What is ESG?

Simply put, ESG is about risk. The Environmental, Social, and Corporate Governance framework evaluates risks that are not captured on financial statements but are nonetheless material to achieving long-term financial sustainability. While there are no universally accepted standards for what constitutes ESG risks, the examples listed below thematically capture what agencies and data vendors seek to measure.

Why Should You Care?

ESG awareness means taking a holistic, long-term approach to risk and investing, which is especially relevant to asset classes held for periods greater than five years. Because there is a lot that can go wrong during those years, the ESG framework bolsters investors’ abilities to measure and manage risks as they guide companies to exit. The risks presented by these companies are myriad, but most often fall under some combination of team, product, market, and demonstrated traction. As far as predicting future company performance goes, financial analysis is necessary but not sufficient.

While evaluating the financial performance of an investment is critical, extrapolating future revenue expectations from a few quarters of track record is difficult. Rather, strong financial returns come as a result of executing on other core business components; invariably, companies fail without foundations of strong culture, responsible governance, or regard for the environments in which they operate.

Although you cannot find ESG risks on a balance sheet, failing to account for poor ESG risks has substantial monetary consequences. Those skeptical of the importance of ESG risks’ impact on returns should look no further than Volkswagen’s 2015 emission scandal, after which the company lost 46% of its share price, equaling $42.5B in the first two months alone.

How big is ESG Globally and in Japan?

Commitment to ESG principles is more than just talk; investors have thrown the real weight of their assets behind the movement. There are an estimated $37.8 trillion of ESG assets under management, with continued expected growth. In 2020, Morgan Stanley tracked major investors’ ESG adoption and found that 80% of surveyed asset owners incorporate ESG factors into their investment process.

ESG adoption has been a global phenomenon and Japan has led the charge. From 2016 to 2018, Japan quadrupled sustainable assets under management, which now total over $2 trillion. In 2020, Japan’s largest pension fund, Government Pension Investment Fund (GPIF), collaborated with Keidanren (the Japan Business Federation) and the University of Tokyo to craft a report signaling their intent to invest in “human-centric solutions” to realize the government’s “Society 5.0 Initiative.”

Japan has long-fostered economic and environmental sustainability: as large Japanese public and private sector organizations supported ESG initiatives through their investments, the country has made enormous strides towards decarbonization. By investing in efficiency gains for the electricity, steel, and chemical sectors, Japan was able to reduce the energy intensity of its GDP by 40% from the 1970s to 2010s and is planning to reach net-zero carbon emissions by 2050.

The History of ESG: 2005 to Present

The concept of “Environmental, Social, and Corporate Governance” is not new. The term “ESG” was coined in a 2005 report titled, “Who Cares Wins,” following UN Secretary General Kofi Annan’s 2004 call to CEOs of major financial institutions to collaborate on incorporating these components into their investment processes. However, it took over a decade for ESG to become mainstream. Public market leaders like BlackRock CEO, Larry Fink, were critical to reintroducing ESG into investors’ lexicon.

Fink took steps to replant ESG’s seeds in 2015, when he urged CEOs to reshape their operations towards a “long-term approach to creating value” and eschew short-term fixations on meeting quarterly analyst estimates. In 2016, he offered ESG as a framework to model and manage long-term risks that are not currently captured on a balance sheet or reported on a 10-Q, stating “Over the long-term, environmental, social and governance (ESG) issues — ranging from climate change to diversity to board effectiveness — have real and quantifiable financial impacts.” With the power of BlackRock’s trillions of dollars of assets under management, capable of externally implementing Board-level change through proxy voting, Fink’s message of promoting long-termism rang loud and clear to both investors and corporate leaders alike.

In the years that followed, investors, limited partners, and corporate leaders rallied around the concept of creating a financially sustainable future. Investment firms rushed to define their ESG policies as Limited Partners wanted to manage their aggregate exposures to off-balance sheet risk. Index providers and ratings agencies rapidly developed quantitative metrics for investors to measure that risk.

Simultaneously, regulatory agencies like the Sustainability Accounting Standards Board (SASB) established criteria for what ESG components are most strongly correlated with financial performance for a company and its sector. For example, while a bank should not ignore its carbon emissions, its corporate governance and social responsibility practices are more likely to have stronger impacts on its long-term financial sustainability.

In 2019, nearly 200 CEOs from America’s largest companies came together to create the Business Roundtable, an association dedicated to public policy that promotes sustainable business practices. Together they drafted a statement that shifted the purpose of a corporation away from Milton Friedman’s 1970 assertion that a business’ prime imperative is to deliver “shareholder value,” to the broader lens of delivering “stakeholder value.”

This approach focuses not only on a company’s investors but also signals a company’s commitment to deliver value to its customers, employees, partners, and the communities in which they live and work. While not explicitly related to an ESG investing framework, the Business Roundtable’s focus on stakeholder value shares an all-encompassing view to business operations and the need to look beyond pure financial metrics to evaluate a company’s long-term viability.

Why Now and Not Sooner?

As the saying goes, we are what we measure. As with all data-driven investment frameworks, effectively measuring ESG components requires robust information sets to quantify risk. Forbes estimated that 90% of the world’s data was created in the last two years, and for better or for worse, for ESG data, the same largely holds true. Numerous institutional third-party data vendors like MSCI, Sustainalytics, Refinitiv, and Bloomberg have all developed their own ESG datasets. Without years of relevant metrics, creating benchmarks that hold up to statistical backtests is tenuous. As both data infrastructure improves companies’ ability to track key operational metrics, such as employee retention or supply chain lineage, and third-party data vendors are able to transform that raw data into ESG signals, the predictive value between ESG and financial performance becomes clearer.

While public market data sets are maturing, the measurement problem becomes more complex for private markets. Many private companies do not operate at a large enough scale to take ESG-driven actions, like influencing their supply chain or distribution channel partners. They also lack the scale needed to compile extensive ESG data about their operations. For private markets, there is less standardization around how companies run, so ESG-aligned decisions will be highly contextual to their sector and stage.

Key Takeaways

1. ESG is about risk, specifically those that live outside a company’s financial statements. Despite not having a line item on a balance sheet, environmental, social, and corporate governance are core tenets of business operations, and executing or failing to execute on them materially affects a company’s long-term financial performance.
2. ESG is massive. Over $37.8 trillion assets under management are allocated to ESG investment strategies and it continues to grow rapidly worldwide. Countries outside of the U.S. like Japan are rallying both public and private institutions around the idea of long-term economic and environmental sustainability.
3. ESG is not new, but ESG data is. ESG has been around since 2004 but did not gain momentum until the mid-2010s. It gained momentum not only because corporate leaders and asset managers championed the movement, but also because modern data infrastructure and data vendors were able to sufficiently capture metrics necessary to evaluate a company’s ESG exposure.

What’s Next?

In part two, we will continue our series by clearly defining what ESG is and is not with respect to other Responsible Investing strategies. Specifically, we will outline the difference between Socially Responsible Investing (SRI), Impact Investing, and ESG investing. By creating clear distinctions between what each of these strategies aims to achieve, we can better allocate our capital to meet our own specific goals for building a sustainable future.

I’m Nick, one of the investors at Geodesic Capital. If you’re working on your international expansion strategy, an investor interested in the ESG framework, or if you simply want to discuss any of the above, I’d love to hear from you.

@nickgiomettiv | LinkedIn