ESG investing

Why and How Companies Must Prepare for ESG Investing

Historically, revenue, capital growth and safety of returns have been the key determinants used by investors when making any investment decision.

And, that still holds true – but there is a new factor that investment firms are increasingly taking note of when making their investments and that is known as ESG investing.

While ESG investing is relevant to businesses of all scales and sizes, startups and small businesses are the ones that need to make the necessary changes the fastest. This is because, large companies are more capable at warding off investor pressures as they do not need finance as much as startups and small businesses.

Further, their stock ownership by investors are more diversified and investors do not have that big of a leeway in making board decisions, as compared to startups. Further, small businesses and startups, which do not follow ESG principles and are in need of capital, will be forced to sell their stock at lower prices, which is not the case for large businesses, which are more credit worthy and can easily incur more debt.

What is ESG investing?

ESG investing is a new way of looking at investing. ESG stands for environmental, social and governance and it is a type of investing that uses these three different factors as the basis for investment decisions.

So, for example if a company makes a commitment to plant a certain number of trees every year by using a certain portion of its net profit, it could be said to be adhering to the environmental aspect of the ESG principles.

Similarly, businesses engaging in social upskilling by creating research institutes can be considered to be adhering to the social aspect of the ESG factors.

Companies that prioritize the well-being of their employees, and have proper grievance redressal mechanisms for its stakeholders, could also be considered to be improving the governance aspect of its business activities, which is another key part of the ESG framework.

ESG has many attributes that make it unique, including its focus on investing aspects other than financial ones. Investors evaluate companies based on how they perform in each of these three categories.

The idea behind this type of investing comes from the idea that if companies are measured in more ways than just by how much money they make, then they are more likely to be good long-term investments. This can be done by using a number of different methods to evaluate companies, including reading news coverage, but mainly from annual reports from companies.

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ESG investment trends

Many business leaders have been slow to adopt ESG criteria into their investment decisions, but this has started to change.

As of 2019, 93 percent of the 250 largest global corporations have incorporated ESG criteria into their decision-making process and are publicly reporting it. This is a huge increase, once you compare it with that of 20 years ago, when just a measly 35 percent used to follow the practice, according to research by the Boston College Center for Corporate Citizenship.

Why is ESG investing growing in popularity?

As more people gain awareness of the importance of environmental, social and governance issues, they want businesses to incorporate ESG practices into their operations and for investment managers to offer funds that reflect their values. Businesses can capitalize upon this trend by becoming more cognizant of their ESG investments.

Doing so will help them remain competitive and ensure that they are using their resources in the most beneficial way possible.

It isn’t just investment firms that are pushing forth ESG investing norms for companies to abide by. Asset owners are increasingly demanding asset managers incorporate ESG analysis into their decision-making process for allocating investments into private companies, according to research by Cerulli Associates.

Making your business ESG compliant helps ensure you have the best chances when you try to raise funds.

The law on ESG investments

So, how do you make your startup or business ESG compliant?

Well, the short answer is that there is no one correct way. In fact, if your business operations are spread out in more than one country, then it would be even more difficult for you to ensure your business follows ESG principles.

The core principles for a better ESG score can be found if we take the laws of several countries together as well as ensure that concerns from investor firms are taken into consideration.

How ESG investments are regulated in the U.S.

In the US, companies are not required to follow ESG initiatives or disclose the same in their annual reports. However, this may change when an investor in your company expressly seeks ESG disclosures. In fact, in a guidance note issued in January 2020, the Securities and Exchange Commission   that companies disclose such information, which may be material to its investors. This includes information that contains several ESG disclosures such as employee churn (a part of the social and governance aspect of the ESG framework) and energy consumption (a part of the environment aspect of the ESG framework).

Although this is a guidance note, it forms a part of persuasive precedents that courts may follow. And if an investor making an investment makes it known that he/she considers ESG disclosures to be material, then the company would be safer in disclosing such information if it wants to avoid unwanted litigation.

Either ways, private investment firms are increasing their pressure on private companies to follow ESG best practices and disclose the same in accordance with Sustainability Accounting Standards Board guidelines as well as follow the Task Force on Climate-Related Financial Disclosure framework in their annual reports.

ESG investing regulation in the European Union

The European Union has already brought out laws to standardize and incentivize businesses to proactively do more good in society and disclose this information to the public.

The Taxonomy Regulation and the Sustainable Finance Disclosure Regulation ensures that investors and asset managers disclose in a uniform manner to the asset owners how much of the investments support environmental sustainability.

Investors who do not do so have to state to the public via a disclaimer that their investments “…do not take into account the EU criteria for environmentally sustainable investments.”

As such, companies are indirectly pressured to ensure that their business follows environmental, social and governance best practices otherwise risk missing out on lucrative stock purchase agreements at worst or be forced to raise funds at a discounted issue of shares, at best. In fact, basic commercial deals such as finance leases and commercial contracts can all become more expensive.

Apart from this, companies that have at least 500 employees and a revenue of 40 million Euros must disclose to what extent their activities are environmentally sustainable. As can be seen, businesses are under growing pressure to ensure that they conduct themselves in ways that are environmentally sustainable, socially beneficial and providers of good governance in the business operations.

Therefore, even if your business does not fall under the compulsory requirement, it is important that you start making changes to your operations to avoid increasing difficulty in raising money in your investment rounds.

In fact, not being ESG compliant can be a serious handicap for your startup because venture capitalists and investment firms will prioritize   compliant businesses considering the regulatory pressure that they face, as well as the disclosure requirements that they are bound to follow.

Best practices to follow to be compliant

While there is no commonly agreed-upon set of principles, there are certain best practices that businesses can follow to ensure they are considered to be engaged in activities that are beneficial to the society at large.

Since ESG has three components, let’s start with environment first.

Make your business environmentally friendly

Your business needs to have a plan in place to minimize its carbon footprint, including such things as cutting down on water usage or reducing plastic waste.

Your company should also be able to come up with a plan regarding how it will increase shareholder value while still being responsible toward the environment and society. A company must show that it has minimal environmental impact on its surroundings and has plans to mitigate any negative impacts that already exist through recycling efforts, plantings, reducing emissions, etc.

This could include investing in renewable energy sources such as solar or wind power generation, which requires less capital expenditure than traditional forms of energy production methods like power plants operating on coal.

Make your business socially beneficial

Companies must also show that they have positive social impacts on the community they operate in through charitable donations or volunteering opportunities.

A company should work with local communities and governments to ensure that their operations are sustainable in the long term without causing harm to any person, animal or ecosystem within its vicinity by developing policies for employee relations based on principles such as respect for human rights and fair working conditions, and promoting good corporate citizenship through community involvement programs.

Basically having a corporate social responsibility program can help the business out in this regard by a big margin.

Engaging in research and open-sourcing your discoveries, instead of patenting them comprehensively outright, can also be considered to be a socially beneficial activity. In fact, several multinational companies are opting to open-source their research discoveries instead of patenting them, important examples of them being Google and Microsoft.

Of course, you could do both, too – open source your patented inventions, as Tesla does!

Ensure your business has impeccable governance principles

Your company must show that it is governed well by implementing shareholder rights policies, having a diverse board of directors and executive team, having a high standard of ethics throughout the company and strong internal controls.

While keeping trade secrets instead of patenting might be a beneficial route for most startups, it can cause the business to pursue more secretive business policies, which might harm the governance principles in the long-run.

Having low employee churn and providing your employees with a greater voice in important business decisions are also keys for better governance of your business.

Wrapping it up

While there are no universally accepted ESG principles, there’s nothing you need to worry about if you are able to ensure that your business activities remain environmentally sustainable, socially beneficial and examples of good governance.

Apart from that, if you are in a bind, asking yourself “Are my activities ethical?” can also help point you in the right direction.

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