ESG (environmental, social, and governance) has become one of the most discussed topics in the investment world. Investors, increasingly, are demanding corporate transparency and action on various ESG issues. The panel discussion, hosted by CFA Society Toronto’s Industry Relations & Corporate Governance Committee and the Institute of Corporate Directors, was on Oct. 21, 2019, at the National Club. The event covered how ESG-related issues present themselves as both a risk and an opportunity, issues around ESG disclosure and reporting, and how companies are tackling these complex issues. The panelists included Chris Guthrie (CEO and CIO, Hillsdale Investment Management Inc.), Andrew Chisholm (director, Royal Bank of Canada), and Nancy H.O. Lockhart (director, Atrium Mortgage Investment Corp., George Weston Ltd., and Choice Properties REIT).

The panelists agreed that interest in the impact that companies have on society has increased from shareholders, employees, customers, and suppliers. Companies need to get support from these stakeholders to have the freedom to pursue sustainable profit and maintain competitive edge. For example:

• A company’s ability to address questions from employees may impact its ability to attract and retain talent, particularly among senior management.
• Its relationship with its suppliers depends on the ability to provide information to suppliers, who in turn must report the impact to their stakeholders.
• As investors, it is important for shareholders to identify companies who recognize and care about their impact, and are able to measure the impact accurately.  

Challenges

High volume of data requests

As ESG is a relatively new area, many companies receive a high volume of questions from multiple stakeholders, ESG research providers, and rating agencies, putting a strain on their resources. Chisholm observed that, in most cases, only a small portion of those questions are relevant to a company’s business. He said he expected that the growing coalitions among investors who create a common template will create the opportunity to reduce the number of questions, and help companies manage their resources to respond. He also suggested that companies should focus reporting on issues that are critical to their business, and discussed why those issues drive outcomes significantly.

ESG ratings

The additional complexity in ESG assessment comes from inconsistent and conflicting ratings from ESG research and rating providers, as each provider has its own methodology and metrics. Furthermore, the ratings sometimes provide little to no value to investors and the companies being rated, since the ratings do not reflect the reality of the business. Guthrie suggested that investors should try to filter down the metrics to a smaller number that may move a company’s valuation, and maintain dialogue about these metrics with the companies they invest in. The conversation between shareholders and companies provides an opportunity for both parties to find the relevant metrics and to focus on improving those metrics.

Chisholm added that the maturity process, including harmonization across different providers over time, is very important. With greater harmonization, he said, he expected the ratings will provide a better reflection of the reality of the business, including the factors relevant to the company’s business that the company should focus on. The ratings may be different across different aspects of the business, but that would be reasonable if they reflect the company’s business.

Reporting standards

Another challenge that companies face is selecting the ESG reporting standard. Guthrie noted that the field is still evolving. The large number of organizations collecting and advocating for different ESG metrics make it difficult to come up with a single standard that will fit all companies. However, he said, he expects the industry will end up with two or three standards that most companies will agree upon. As an investor, he said that he focuses more on the integration between what the companies are supposed to do and what they report on, instead of which reporting standard that the companies use. For example, he looks for an alignment between the company’s financial metrics and compensation, particularly among the senior management, and whether the company address one or two critical issues in their business, (i.e., environmental impact for a mining company).

Defining climate issues

Specific to climate issues, Lockhart and Chisholm noted that companies are aware of stakeholder concerns and take them seriously. However, Lockhart cautioned that companies haven’t moved as quickly as investors expected because climate issues are hard to define, in terms of both timing and magnitude of the impact. Chisholm said that another challenge is investors lacking clarity on materiality thresholds (i.e., missing or incorrect information in financial statements) that the companies set. With so many companies claiming immateriality, it is not clear to investors whether a company genuinely believes the issues are immaterial or won’t act because the impact and timing are highly uncertain.

“Best in class” approach in ESG

All the panelists agreed that a “best in class” approach in ESG exists, but that the approach may be different across industries, and between large and small companies. Lockhart stated that “best in class” is not about reporting, but the sustainability of the business in a world where stakeholders pay more attention about carbon, resources, and environment. Chisholm added on the importance of providing clarity as to how these issues are connected to the business. The first step is identifying the most relevant issues that drive the businesses’ success and competitive advantage. The second step is clarifying oversight and accountability (including who is responsible), who they report to, and their thoughts about these issues. The last step is determining the external reporting process, the audience, and whether the reporting fits within the risk process and is built into strategic thinking.

The role of boards of directors

As a company’s board of directors is responsible for overseeing the company’s strategy, the board must understand how ESG issues affect the business and stay informed so they can fully appreciate the risks. A board’s role is also to ensure that the values that drive the company are set with clear accountability, oversight, and reporting. Guthrie added that investors look for an alignment between boards and management in the ESG value adoption and execution: whether the CEO embraces the values and incorporates them into their own thinking and leadership style, for example. Investors also look for quantifiable metrics to measure success, such as staff turnover and the tenures of senior management (CEO and CFO).

ESG in passive investment

The panel wrapped up with a discussion of the implications for ESG coming from the rise of passive investment. The moderator, Judy Cotte, noted that concerns over passive investment are colliding with the focus on ESG. As such, the only real way to ensure ESG concerns are being addressed in a passive fund is to apply screens to decide whether a company is included in an ESG index. However, if this trend continues, it may impact a company’s cost of capital. Guthrie and Chisholm agreed the large asset inflows into index funds help channeling capital towards companies who run their business responsibly. The asset flows also encourage companies to think about ESG in managing their businesses if they want to retain their access to capital.

The second challenge with passive investing is that the existing benchmarks that the index funds replicate reflect the status quo. Chisholm noted that some companies understand the escalating impact of climate change on their business, such as insurance companies who must provide insurance payouts for one disaster after another. As large investors, insurance companies have pushed their investment advisors to work with them and create a benchmark that will protect them against climate issues. That process needs to be thoughtful, and create a benchmark with better risk-reward profile than the traditional benchmark given the change in realities. Guthrie acknowledged that the fiduciary responsibility may limit the ability of asset managers or asset owners to impose their views on ESG, since it may impede their ability to meet their investment objectives if the views don’t materialize. Chisholm suggested an alternative approach to mitigate the uncertainty by estimating the impact and risks of different ESG scenarios on a company’s business, and incorporating them into potential return and risks analysis.

Overall, the panelists agreed that companies and investors view ESG as an important agenda. They recognized that ESG is a relatively new area and that shaping ESG standards, implementation and measurement is an evolving process. Another key theme from the panel discussion is the importance of defining relevant ESG issues for a company or industry. This means measuring the impact from those issues, from the perspectives of both the company’s management and stakeholders, since those issues ultimately drive the company’s ability to maintain its competitive edge, and to produce sustainable profit in the new market environment where market participants demand transparency and action on ESG.