ESG Factors (1): What's in It for You If You Are in Emerging Markets?
Anyone in the know on financial news has heard about environmental, social, and corporate governance (ESG) factors, and how they are promoted at the highest level. But, from emerging markets and in the midst of a pandemic, there is a question to answer: what good are they?
In January this year, the 50th edition of the World Economic Forum (WEF, the so-called “Davos Forum”) renewed its manifesto, advocating a new role for business in the fourth industrial revolution. Klaus Schwab, founder and CEO of the WEF, stated that "capitalism has neglected the fact that a company is a social organism as well as a for-profit entity ... Capitalism is increasingly disconnected from the real economy" .
With these words, Schwab defined the guidelines of a new capitalism in which the purpose of companies is not only to respond to their shareholders, but to society as a whole, particularly to the communities where companies operate and their stakeholders.
Under the premise that companies act as guardians of natural resources for future generations, the need for a transition towards a circular and regenerative economy model is undeniable, a new model that will make it possible to achieve the goals of the 17 Sustainable Development Goals of the UN in the next 10 years.
These are certainly well-intentioned initiatives. However, we must examine what's in it for us in Latin America and the Caribbean, the world's region that has been hardest hit by the coronavirus and the ensuing economic crisis. In this article we will focus on the nature of ESG principles, which remain largely unknown even among many investors, while in a future article we will explore how they can be integrated and implemented in all types of companies and institutions.
A key point of the ESG principles is that, by being integrated into your strategy and core business, they can not only increase your rates of return but also be sustainable over time. Similarly, reporting on how these factors are managed must be transparent and periodic, as an essential condition for the satisfaction of all stakeholders: the shareholders of the companies and the communities they serve.
Historically, the way the activities carried out by a company and the events that affect it were recorded and quantified evolved coinciding with the appearance of corporations, towards what we now know as financial accounting.
Financial statements became evidence of a company's ability to generate profits, under independent external review by qualified auditors. Investors' access to verified financial information became an essential condition for the proper functioning of capital markets, and to strengthen investor confidence in issuers.
Over time, the information requirements of investors became more sophisticated, resulting in the need to standardize the financial reporting of corporations globally with accepted accounting principles. A good example was the wave of corporate bond issuance in the US in the late 19th century – triggered by the boom in rail companies – that created a pressing need to meet the demands of European investors. These required access to key credit information on companies, information that could no longer be obtained through communications with business families and banks.
Investors needed independent third parties to provide them with the information on which to base their investment decisions. In this context, the first rating agencies such as Moody’s, S&P, and Fitch emerged, recognized then for the integrity, independence and reliability of their information. Today, regulators in many countries – also in Latin America and the Caribbean – require that fixed income issues be accompanied by a credit rating by a legally recognized credit agency. We are currently observing the same trend and investor requirement to have non-financial information.
At the end of the 20th century, companies began to become aware of their environmental and social responsibility, beyond financials, with the promotion of new financial instruments, guidelines and principles aimed at banks, corporations, issuers and investors, and a multiplicity of initiatives led by multilateral development banks and international organizations. Thus, including ESG factors or risks in decision making and reporting on the process of identification and mitigation of these factors becomes the accepted way of doing business.
In this scenario, environmental risks, related to pollution, biodiversity and climate change; social ones, related to human and labor rights, gender equality, etc; and corporate ones, focused on transparency, internal controls, composition of boards of directors, among others, emerge as a new way of doing business at the corporate level. A way to assess non-financial risks that create opportunities for companies in emerging markets, in the same way that financial risks are assessed.