Upgrading to ESG 2.0

As investor, consumer, and regulatory demands for ESG (Environmental, Social, and Governance) principles started to pick up steam, four major global crises — COVID-19, climate change, racial and social inequality, and dysfunctional geopolitics — also hit. In the face of these challenges, it became evident that ESG principles and policies could provide firms with a clear path to address and complement the impacts of these crises.

The need for leadership in the advent of many factors related to ESG has seen a surge in the wake of recent global issues. In particular, the demand for a more holistic outlook on organizational management (and inadvertently investing) has ushered in another chapter of the ongoing ESG narrative.

What is ESG 2.0?

ESG 1.0 began as a multi-faceted framework to assess an organization's business practices and performance. Variables were categorized based on three overarching factors: environmental, social, and governance. It was a general structure to evaluate risks and opportunities based on sustainability and ethics.

This simple concept led to plenty of implications. Investors focused on capital markets, for instance, would be able to assess companies based on ESG criteria to inform their investment plans and construct strategies fundamentally predicated on profitability and the betterment of society and the world at large.

The term itself can be traced back to a 2004 report by the United Nations titled 'Who Cares Wins,' which included one of the first mainstreams mentions of ESG in the modern context. Since then, the concept's popularity as a valid approach to managing business and investing gradually took precedence.

New reporting requirements and growing expectations of business transparency from investors and consumers are ushering in a new wave of ESG activities that will redefine growth as companies create value for all stakeholders. 
A new wave of revolutionary business standards now deemed ESG 2.0, allows investors, consumers, and employees to demand practical and measurable company goals that embrace long-term thinking and produce value for all stakeholders beyond nebulous philanthropic pledges and environmental commitments.

In meeting these expectations, ESG frameworks guide businesses in adopting and adapting to this new mentality, especially during uncertainty. Research by Responsible Investor and UBS Asset Management in 2019 shows that 78% of asset owners worldwide have already embedded ESG considerations in their investment processes; these frameworks are poised to define the next ten years of growth.

As Japan aims to meet its Net Zero goal by 2050, the government and major investors like the Japanese GPIF (Government Pension Investment Fund) are actively promoting ESG investments. The projected global AUM (Assets Under Management) new wave in ESG could come from Asia, particularly Japan, due to its collaboration between policymakers, companies, and the financial sector in creating a robust ESG framework, along with increasing demand from both institutional and individual investors for socially responsible investments. Japan's remarkable success in responsible investing is evident from its fivefold increase in sustainable investment assets from 2016 to 2020, reaching $2,874 billion. With Japan accounting for 8 percent of the $35.3 trillion managed by significant markets, the country's growth in sustainable assets can be attributed to a clear investor appetite for ESG products and supportive regulatory measures.
 

The Significance and Changing Implications of ESG

Doubts have persisted regarding the reliability of ESG as a measure of financial performance. These thoughts, which can be categorized into two domains of thinking, now seem to be a reaction against the promise of ESG investing.

The first is that more conventional market fundamentals already account for any ESG data that is financially significant.

This extends the idea that prices accurately reflect all available information (the efficient-market hypothesis). According to this school of thought, the empirical research that suggests a connection between ESG and financial success is either ill-designed or uses proxy data to represent a market fundamental rather than an individual ESG impact. 
Another school of thought contends that ESG factors are, by definition, externalities to the firm and that taking responsibility for them entails costs and hurts financial performance.

This view, which originates in Milton Friedman's ideas, contends that corporations can only benefit financially by considering ESG factors when the government imposes fines or other incentives.

In other words, the link between ESG and financial performance only holds when regulations that distort the market are in place. As a result, markets will either seek out more efficient investments or find ways to get around the rules because capital flow to sustainable ventures is fundamentally less efficient.

While some might anticipate the rejection of ESG as an investment fad, it is possible that the present controversy over the validity of ESG heralds not the end of ESG investing but rather a turn for the better.

Senior Executives Pave the Way for ESG 2.0

The evolution of ESG practices into what can be termed 'ESG 2.0' is significantly influenced by senior executives' proficiency and business acumen in various industries. These next-generation ESG leaders are distinguished by their ability to navigate the complexities of ESG dimensions while aligning them with their industry-specific business strategies.

These leaders are tasked with the influential role of engaging and aligning a diverse array of stakeholders. This group includes not just the C-suite and the board of directors but also line-of-business leaders, institutional investors, legal and compliance professionals, regulators, and external partners such as portfolio companies, operating partners, and supply chain entities. Additionally, they must effectively communicate and collaborate with internal coworkers to ensure a cohesive approach to ESG implementation.

The multifaceted nature of these responsibilities often necessitates that these leaders possess expertise across three or more functional areas. Such a diverse skill set enables them to have a holistic view of the organization, ensuring that ESG principles are understood and effectively integrated across various departments and levels. This broad perspective is crucial for driving the organization towards sustainable and responsible business practices in line with the emerging trends and expectations of ESG 2.0.

ESG 2.0 Can Help Companies Achieve Their Sustainability Goals

ESG is a tool to measure a company's performance and impact in areas such as environmental responsibility, social inclusivity, and governance practices. This involves using various metrics, such as carbon footprint calculations, initiatives promoting eco-friendly practices, diversity, equity, and inclusion (DEI), and other relevant factors.

On the other hand, sustainability represents a broader principle that guides a company's policies and actions to minimize its overall impact, particularly on the environment and society. It encompasses long-term strategies and commitments for sustainable practices and responsible resource management.

ESG can be a potential tool to measure company performance and impact based on variables such as carbon footprint calculations or Go Green initiatives, tying into sustainability as a broader principle guiding company policy towards improved environmental and social aspects. This can progressively lead to various sustainability initiatives that are important to businesses and simple to implement, including parts of strategy, reporting, and management about sustainability life cycles.

ESG 2.0 Can Also Help Improve Financial Performance

An ESG can enhance a company's overall financial performance and make it more appealing to lenders. Examples include adopting advanced energy-efficient technologies, which reduce energy costs and demonstrate a commitment to environmental stewardship. Investing in sustainable supply chain practices can lead to long-term cost efficiencies and risk reduction while fostering a positive corporate reputation. Implementing robust social and governance procedures, such as promoting a diverse and inclusive workforce or enhancing transparency in corporate governance, can attract top talent, improve employee engagement, and build investor and consumer trust.

These measures can improve operational efficiencies, create stronger customer loyalty, and potentially increase market valuation. 
To justify the impact, companies must monitor critical metrics, such as energy consumption, raw material use, and waste treatment, to stay on top of ESG programs. These measures eventually result in lower energy bills and cost savings. Companies' bottom lines benefit when they maintain ESG compliance because they are less susceptible to fines, hazards, and penalties.

Challenges in Growth, Scalability, and Integration

Aspects of ESG are intimately linked to organizational transformation and the adoption of digital technology for data-driven evaluations, affecting all societal groups and market participants during this transition. Therefore, it is not surprising that several challenges emerge in the growth, scalability, and integration of ESG into investing processes.

These challenges include a lack of standardization across ESG metrics, limited availability of comprehensive data, and the subjective nature of ESG assessments that can vary significantly between evaluators. Additionally, the time and resources required to collect, refine, and disclose ESG data complicate these processes. There is also the added cost and complexity of the work involved in integrating ESG factors, which can be significant, especially for smaller organizations or those in the early stages of ESG adoption. Addressing these challenges is crucial for the effective integration of ESG principles into investment strategies and for the broader goal of achieving sustainable and responsible investing practices.

Challenges to Maintaining ESG Performance

Over more extended time frames, the correlation between robust ESG practices and financial performance becomes increasingly apparent. Most analysts agree that this link is well-proven, supported by a growing body of research. Studies have shown that companies with strong ESG credentials tend to outperform their counterparts in the long run. This outperformance is attributed to better risk management, innovation, and a greater likelihood of business continuity during market and environmental stress. Companies with firm ESG profiles are often better equipped to adapt to changing regulatory landscapes and consumer preferences, increasingly favouring sustainability, and social responsibility.

Moreover, investors are progressively using ESG criteria as a guide to identify companies well-positioned for future challenges and opportunities, leading to a higher demand and potentially higher valuations for such companies. The growing emphasis on ESG factors reflects a broader shift in the investment community, recognizing that sustainable business practices are ethically desirable and financially beneficial in the long run.

With ESG, we confront a fresh set of ramifications for markets and society. Delay or failure to decarbonize will cause significant, irreparable harm. Managing consistent performance simultaneously versus many timescales will be necessary for success.

Increasing Regulatory Demands

Different authorities increasingly impose more stringent ESG requirements when conducting business with them. For instance, introducing initiatives like the Carbon Border Adjustment Mechanism (CBAM) has made it imperative for companies to incorporate ESG into their strategies to meet compliance standards.

However, merely complying with ESG regulations is not sufficient. Companies need to go beyond mere compliance - ESG 2.0 should take hold of incorporates and their strategies if they want to capitalize on the ESG wave. This will require senior leaders in sustainability to push this agenda forward internally and ensure that ESG becomes an integral part of their long-term business strategies.

ESG is gradually becoming divided into two categories: first, financial products that incorporate ESG policies, data, and practices to uncover new financial risks and maximize value creation; second, funds that purposefully have a positive social or environmental impact and align with moral principles. In part, the key to a successful transition into ESG 2.0 will comprise combining both categories of value creation and positive impact for all areas concerning the significant criteria.