The idea that businesses should approach their operations with an environmental, social and governance (ESG) focus has become the most prevalent watchword all over the world. In fact, it is one of the fastest-growing trends in the investment world, but there is an unintended consequence, writes Brondwyn Douglas, ESG officer at Spear Capital.
An unintended consequence of the ESG focus is the potential negative impact it has in some parts of the world. This ESG focus has the potential to take investment away from emerging markets.
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Yet, sadly, these are the places that should most benefit from the positive impact that investment brings, such as the elimination of poverty and the creation of opportunities for skills development and education.
The reasons for this are probably related to some of the factors that those in the field use to assess a country to invest in. If one rates the location on the basis of its standing on a corruption index, for instance, it may immediately appear unsuitable for investment.
But, what this misses is that, within the country, there may be any number of quality investment opportunities, especially among solid businesses that operate ethically and that are making the right sort of impact – such as, providing employment opportunities, promoting women in meaningful business roles, and improving their operations so that the environment is protected.
This concern highlights a number of issues for emerging market economies.
One that we need to acknowledge is that investors employ a process that involves using ratings agencies which typically apply an analysis of data about a business. What a ratings agency may conclude is then used to guide investors to make decisions about where to apply the funds they have available.
How is ESG performance measured?
For various reasons, many African businesses are unable to provide sophisticated data of the sort one would find in an advanced economy in Europe. And so we have to play catch-up to get to where many companies in Europe or the United States may be in terms of their ability to collect and analyse data.
Similarly, access to the services of ratings agencies is more limited in Africa – not least because of the high costs involved in engaging these service-providers, which are mostly not domestic businesses.
Another concern that affects the decision-making relating to investments is the way in which ESG performance is measured. Globally, there is a lack of agreement on how to measure a company on ESG issues as there are differences in rating methodologies and a limited amount of directly comparable ESG data.
The recognition of this gap has led to a greater focus on the issue by the International Sustainability Standards Board (ISSB), which aims to establish a global baseline for ESG disclosures, and to thus aid in establishing uniformity across the key ratings providers so that stakeholders may be better able to evaluate and compare companies to their peers.
This move toward consolidation is further supported by the recent alignment between the Global Reporting Initiatives and the International Financial Reporting Standards (IFRS), creators of the ISSB. But, while these debates are raging, many potential investments are not reaching businesses in Africa.
A potential solution that we at Spear Capital believe could make sense is to apply a lens of material risk management. Should we not promote the basics of managing and mitigating ESG risk? If we did this, would we then be providing a way for emerging markets to demonstrate ESG management and related performance which allows them to access investment?
To expand on this, focusing on an approach to manage ESG which centres around identifying the issues that are most material to the success and sustainability of companies is critical to real value-added mitigation on the ground. It speaks of specific impact.
So, if this is the case, and if investors are looking to identify assets to participate in, analysts should focus on assessing an organisation’s ability to identify, assess, manage and mitigate ESG-related risks, rather than using the outputs of ESG ratings agencies alone.
By identifying material risks, a company can determine effective metrics associated with each to measure and track performance. If these were disclosed accurately, investors and potential investors would be able to assess a company based on actual risk and mitigation.
Against this background, it is clear that we need to reconsider what is important from an ESG perspective. Doing so will allow us to look closely at how an investment can positively impact the economy, society and the environment. These considerations pass the baton to the investor and what their ESG strategy and investment mandate are, as well as their risk appetite.
Yes, it’s about what companies are currently managing with respect to ESG, but it is also about their future potential and the willingness of investment companies to add value to a business through supporting it along its ESG journey.
Clearly, the current complexities in the assessment of companies on the basis of their ESG performance is not suitable for all regions, especially emerging markets. And Africa consequently suffers from a lack of investment, but it looks like this may be for the wrong reasons.
- Spear Capital has adopted an integrated approach to identifying and assessing potential investments. It screens for ESG risk as well as potential, and supports investments to adopt and implement ESG practices which add value.
