Responding to demand for ESG: nonfinancial is financial

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By Kim Sung-woo

Environmental, social, governance (ESG) principle is one of the most popular buzz phrases in South Korea these days. Various topics including not only the environment, energy and social responsibility issues that represent the traditional “E” and “S” factors, but also any and all issues related to sustainable business, such as ethical management, impact investing, Creating Shared Value (CSV), human rights and safety issues appear to have been absorbed into the vast black hole of ESG.

Certain companies are even changing their organization and project names to include ESG in them. The wide popularity of ESG, however, raises a concern that its essence may get overlooked.

The essence of ESG is to secure sustainability in response to various stakeholders’ demands. Investors (or other stakeholders) evaluate target companies and demand improvement. The nonfinancial aspect of this evaluation-and-demand process is what constitutes the ESG principles.

The demand is made in various forms and shapes: from exercising voting rights as shareholders, to sending an annual letter to the company’s board to take more aggressive measures such as litigations, and to the withdrawal of investment.

As of last September, about 4,500 multinational corporations declared their efforts to achieve carbon neutrality along with the UN. One of the backgrounds of the companies undertaking such an initiative was the ESG demand from Climate Action 100+, an association formed by 617 global investors who operate $60 trillion worldwide. With respect to 167 companies, the association called for (i) setting a target related to climate change, (ii) transparent disclosure of how they incorporate climate change into their business, and (iii) the particular roles of their boards of directors.

On May 26, 2021, a major U.S. petroleum company elected at its shareholders’ meeting three outside directors who were recommended by Engine No. 1, an activist hedge fund in the U.S. The hedge fund recommended the outside directors to the company for the purpose of enhancing the company’s response to climate change.

This case demonstrates an example where a company responded to minor shareholders’ demand to implement a more rigorous target to reduce greenhouse gas and pursue a transition to a business model that suits a low-carbon emission society.

Why would an investor care about ESG principles? It’s because fulfilling ESG values brings profits that are sustainable in the long term. To illustrate, if companies are required to reduce their carbon emissions, pursuant to the 2015 Paris Agreement participated in by 195 countries, one-third of petroleum companies’ oil reserves must stay underground.

As oil companies’ value directly correlates to their oil reserves, this situation means that about one-fifth of their total market cap will disappear. Investing in a so-called “stranded asset” is detrimental to an investor’s bottom line. Having seen more than a 70-percent plunge in the valuation of coal companies over the past ten years, investors around the world are concerned about such phenomenon spreading to other industries.

Blackrock, one of the largest asset management companies in the world, began to make specific demands with respect to the companies in its portfolio to consider environmental issues. Last year, Blackrock announced that it would stop investing (directly and indirectly) in companies raising more than 25 percent of their revenue from power generation based on fossil fuels and the coal industry and called for the disclosure of this figure, aligned with the framework proposed by the Taskforce for Climate-related Financial Disclosure (TCFD).

Early this year, Blackrock made an even more ambitious demand to companies in its portfolio: to disclose a detailed plan on how they will make their business model compatible to a decarbonized economy by 2050.

Companies will increasingly receive ESG-related demands. First of all, they will be asked to make transparent disclosures of ESG-related information. If a company does not make the proper disclosure, stakeholders may stumble on information produced by a third party and make an investment decision in a way that is not intended by the company.

Next, companies will be asked to monitor whether the information they disclosed reflects how they are actually run and accounts for any discrepancies between the two. (Stakeholders are paying particular attention to so-called “greenwashing” problems.) Lastly, the final decision-makers of the company, such as the CEO or board of directors, will be asked to take the lead in integrating ESG standards into the company’s business model.

This is because ESG criteria cover a broad array of issues that cannot be handled by a single department, and it is natural that the top management, who are responsible for the internal management of the company, take control in deciding how to distribute resources within the company to ensure the fulfillment of ESG management practices and enhance the sustainability of the business.

About a year ago, I spoke about ESG at the Asian Leadership Conference. The conference, after sharing various insights with experts from around the world, reached the conclusion that the “nonfinancial is more financial.” While ESG is garnering so much popularity these days, it is equally crucial to think about what its essence is. Responding to the demand for ESG practices ― which are nonfinancial in nature ― could be in fact even more financially beneficial and enhance business sustainability.

Kim Sung-woo is head of the Environment & Energy Research Institute at law firm Kim & Chang.



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