Moving away from the checkbox ESG approach

• Ratings should have context, writes Denene Erasmus

A plethora of environmental, social and governance (ESG) ratings and methodologies exist to evaluate companies’ sustainability and societal impacts.

These ratings, some of which are provided by trusted names in international finance and business such as Bloomberg, S&P Global, Morgan Stanley Capital International, FTSE Russel ESG Ratings and the Dow Jones Sustainability Index, give investors and companies insight into a company’s performance in environmental responsibility, social and labour practices, and corporate governance.

However, existing ratings and methodologies have been criticised for focusing on historical achievement rather than future potential, thus creating a risk for developing markets.

Over-reliance on compliance with such ratings and methodologies also creates the risk that ESG will become a “tick box” exercise for companies, where their strategies are devised to get the highest rating, rather than on focusing on projects that would have the most meaningful impact in their environment.

But, said Shameela Ebrahim, chief sustainability officer at the JSE, there was a fundamental shift happening as people start to see and understand how issues such as inequality and environmental degradation threatened their own existence.

Ebrahim was a speaker on a panel discussing SA’s success in meeting the ESG expectations of investors at the recent launch of the Sanlam ESG Barometer.

“There is a growing realisation of the need to think differently and outside the usual ESG tick box, to consider the broader context of sustainability, which implies an explicit consideration of things like ecological boundaries, which are not necessarily part and parcel of our current data sources,” she said.

The easiest example, said Ebrahim, is climate change. “When we talk about boundaries, climate change boundaries are clearly quantified. We know that if we go above a certain level of global warming, because we have exceeded a certain carbon emission threshold, there will be measurable consequences.”

Compliance is one thing, she said, but companies also had to deal with what is actually happening from an environmental and a social perspective.

“We need to see a closer coming together of the contextual element, which is the ecological boundaries linked to social foundations, and the compliance elements which is manifested in different laws, regulations, ESG standards and frameworks.”

They have been seeing “a shift in intent”, but the responsibility stretches beyond companies and fund managers.

“Every person needs to own this and make sure that whatever retirement fund they have is actually supportive of ensuring an environment that they want to retire in,” Ebrahim said.

“This is the context in which laws and regulations around compliance should be developed — it needs to be driven by a fundamentally different set of motives rather than being a tickbox exercise.”

Teboho Makhabane, head of ESG and Impact at Sanlam Investments, who also participated in the panel discussion, said Sanlam was building its own ESG rating methodology because many of the existing ratings do not offer sufficient transparency.

This offers them the opportunity to bring the methodology closer to specific funds which makes it possible to contextualise their ratings better.

Some issues are more important in SA than they might be in other jurisdictions — water, for example, is a major issue for companies in SA and probably even more so than climate change, Makhabane said.

In a survey of 21 of the top 40 companies on the JSE conducted by Intellidex for the Sanlam ESG Barometer, 10% of respondents rated responsible water use as their most relevant ESG risk. This was on par with those that rated climate change and its potential negative effects on company resources as the most relevant risk.

Makhabane said existing, international ESG ratings can be used to aid the local industry to refine their methodology and criteria scoring, “but you need to apply your own thinking”.

Louise Gardiner, of the International Finance Corporation’s (IFC) Sustainable Banking and Finance Network, said investors can use the “ESG lens” in a strategic way to look at the context

and understand the risks and the appropriate responses.

“Remember, investors are not a homogeneous group. The IFC, for instance, is a good example of a development finance institution that has a financial mandate as well as development mandate.

According to Gardiner the concept of additionality in sustainable and ESG investing, for example, has always been part of its investment mandate. “We are looking for companies and investing in emerging markets that are able to provide that contribution to environmental, social and economic goals.”

Importantly, she said, the ESG lens within IFC’s investment strategy is about “doing no

harm.

“You will hear this in the EU’s approach to sustainable finance as well. The reason why this approach is important is because if there is harm, it can turn into business risk.

“The investor needs to know that these risks are being managed. For development finance institutions that are designed for investing in emerging markets, we have to assess the commitment, the competence and the capacity of companies to manage those risks.”

Gardiner said SA companies stand out for their knowledge and capacity to manage ESG risk and there was a good, long history in SA going back almost 20 years of ESG disclosures.