Ethical Investing for Dummies

Ethical InvestingIn recent years there has been a growing need for accountability outside the realms of financial performance of ASX-listed entities. Individual and institutional investors have grown wise to a global focus on sustainability; they are looking for disclosure of, and action on environmental, social and governance (ESG) risk.

When looking at investing in a diverse portfolio, or even just one or two stocks, it is important to understand more than just a company’s financial and operational goals. An awareness of non-financial risk protects against problems down the track, which may impact your dividend return over the long term. Understanding ESG risk ensures that an investment portfolio is congruent with investors’ beliefs and values, enabling investors to further engage with their companies.

 

What are ESG risks?

The Environmental, Social & Governance categories cover a range of behaviours and situations that can prove to be risks or opportunities, depending on how they are treated. Climate change is one such environmental risk that should be factored into decision-making; there are financial costs associated with carbon regulation, and reputational issues can arise from contributing to pollution.

Labour and human rights factors are attributable as social risks; accidents and suicides due to poor OHS standards create legal and reputation issues, not to mention lost time and interrupted production due to industrial action. Consumer/employee satisfaction and stakeholder engagement are examples of other social risks, that can lead to similar repercussions. These events can affect human capital management, negatively disrupting operations and derailing employee engagement.

Governance factors are important outside of the boardroom; these are associated more with oversight of business operations rather than the traditional corporate strategy role a board plays. Companies (particularly with international operations) experience social & political instability and local community conflict, which can lead to crime and corruption. Those engaged in the resources sector internationally, for example, must take into account risks around security, bribery, misconduct of local employees and expat exposure to corruption. Information technology and social media traders must take into account the risks surrounding privacy & civil liberties, which can leave them vulnerable to legal, and reputation consequences.

 

What are a company’s legal obligations?

In Australia, ESG risks are measured against Recommendation 7.4 of the ASX Corporate Governance Council’s Corporate Governance Recommendations & Principles, which was only added to the list in late March this year. It states that ‘a listed entity should disclose whether it has any material exposure to economic, environmental and social sustainability risks and, if it does, how it manages or intends to manage those risks.’

Whilst this recommendation creates transparency around existing ESG risk, it will probably have a fairly minor impact due to its long-term focus, and also because it doesn’t require any immediate change to operations, merely reporting on foreseeable risk and/or what it is currently doing. Whilst the majority of the ASX 200 and certainly all of the Top 50 adhere to this, many smaller companies of the 2000-odd listed entities don’t report to this metric, so at least this change will raise awareness and discussion of ESG risk in the corporate community.

Additionally, Principle 4 of the ASX Principles and Guidelines moved from ‘financial’ to ‘corporate’ reporting, indirectly endorsing reporting across a wider spectrum than just the financial; this includes ESG disclosure and sustainability reporting. These standards only came into effect from 1st July 2014.

ASIC released similar reporting requirements in May, 2014. ASIC’s Regulatory Guide 247, Effective disclosure in an operating and financial review, calls for discussion of risks affecting financial and operating performance. It recommends environmental and sustainability risk disclosure – again merely asking for transparency in reporting rather than direct action.

 

What should investors look for?

When considering new options the best place to evaluate ESG risk is in a company’s official Annual Reports, or stand alone sustainability reports (which must be available from the company’s main website). These reports will detail measurement against GRI’s or other UNGC standards; Sustaining People’s recent Dial T for Telstra post discusses comprehensive stand-alone reports produced by Telstra for the last financial year.

The Australian Council of Superannuation Investors and Financial Services Council release an annual Guide to ESG reporting for Australian companies, that effectively assists institutional investors to understand reporting standards. It’s an easy to understand guide for individuals as well – perhaps more so than official principles and regulations from the ASX or ASIC. Additionally, Ethical Equities is a local site that catalogues the ethical standards of listed companies and why they might be worthwhile investing in.

 

Why is it important?

Knowledge of ESG risk gives investors added protection, enabling fully informed investment decisions about operations. This is not only useful for new investors, but for existing shareholders, who may need this knowledge to ratify decisions open to stakeholder vote.

Mitigation of this risk can actually lead to great opportunities for internationally focused companies operating in human capital-intensive industries. Understanding of, and adherence to environmental regulations and carbon reduction incentives schemes can create significant future financial uplift. Companies in volatile, price-sensitive industries like resources and manufacturing that prepare for these environmental costs are better equipped to retain a competitive advantage over those that have not factored it in.

Future-proofing against social factors means improving talent management, knowledge retention, succession planning and employee retention as well as creating transparent and robust industrial relations. These strategies enhance a company’s reputation as an employee of choice, improve its OHS standards, and promote efficiency through uninterrupted operations.

Maintaining robust governance standards ensures that operations are open and transparent, that stakeholder relations are effective and without conflict. This enables stakeholders to trust the executive team and support them in creating long-term strategy and goals for the future.

Knowledge of these risk factors/opportunites allow investors to better understand how a company might grow in the future and whether or not they have the capacity to manage change when it needs to. This sustainability focus allows companies to create greater stability in share price and return stronger dividends to stakeholders over the long term.

There are some areas, however, where ESG risks are less volatile and not as important for investment decisions. ANZ supports this in its review of ESG risk for Superannuation and Securities funds, stating: [they] are not really affected because their investment decisions are based on index pools managed relative to index benchmarks so ESG considerations are unlikely to be considered in such security selection. For other short-term stock transactions where the focus is on making a quick buck from up and coming share-hikes, ESG risks are less likely to be factored in.

 

How does the Australian market environment measure up?

The unresponsiveness of the Australian market and a less than robust regulatory environment means it has not built a culture of early adoption; it is affected by changes to international markets rather than leading change. The aforementioned ASX Principles & Recommendations were originally created in 2001, revised in 2004 and in 2010, and now, four years later they have finally revised them again to add in strong sustainability language.

Australia lags behind other countries in its treatment of ESG risk and sustainability action. Many other nations have incorporated action plans into their listing guidelines: In 2006 Belgium integrated ESG standards into management practice guidelines; in 2002 Austria instituted ethical procurement practices; in 2008 China announced influential directives encouraging PRC enterprises to follow sound CSR practices; and in 2013 the New York Stock Exchange rolled out resources for companies wishing to improve their CSR practices, and joined the United Nations Sustainable Stock Exchanges Initiative.

The next step for the ASX is to incorporate outcomes based regulation into its guidelines. A focus on improvement outcomes would require action on ESG risks by listed entities. The Australian Government has led the corporate sector on some of these risk issues, having made legislative changes over the last two years regarding ethical supply chain transformation. Along with numerous not-for-profits, it is encouraging the business community to do the same.

 

Will we see change any time soon?

Perhaps it is the market operator’s role to just recommend and encourage, and the Government’s role to force compliance and change but the ASX should look to incorporate more action-focused regulation into their rulebook. Unfortunately real transformation may prove difficult in that many (institutional) investors view ESG risk just as a barrier to higher profits and will mitigate them with minimal effort, rather than taking the opportunity to align values and develop sustainable practices for the future.

It would be fantastic if the ASX played catch up to other global exchanges in the next few years and took on a more substantial leadership role on sustainability, but let’s not hold our breath.