With some of the biggest share price falls of 2016 being related to scandals at seemingly strong companies, it is becoming increasingly clear that financial data alone are no longer sufficient to measure the health and strength of a company.
An example is the German car manufacturer, Volkswagen, which admitted to installing defective devices on its vehicles to cheat on emissions tests. This resulted in the potential recall costs related to 482,000 vehicles, with up to 11 million vehicles possibly affected. Beyond its attempt to deceive customers and regulators, the scandal highlighted the failure of traditional valuation models in capturing cost implications of a wider range of risks that can shape a company’s outlook. These include environmental (E) issues such as pollution, global warming and energy conservation; social (S) issues such as work practice considerations; and governance (G) issues such as corporate management, culture and conduct.
An increasing awareness of these risks by investors at both retail and institutional levels has seen a rise in demand for the incorporation of ESG reporting by companies. According to a survey conducted by the Australian Council of Superannuation Investors (ACSI), 90% of ASX200 companies now provide some level of reporting on sustainability factors. The most improved of these companies being in the utilities, gas, and energy distribution sectors, which may be correlated with increasing pressure from investors in these sectors to be transparent about economic and environmental risks.
We appreciate that financial markets are skewed to the short-term, however, reporting on ESG issues provides both internal and external stakeholders with the transparency and insight needed to make better investment decisions. Although tremendous progress has been made in raising the profile of ESG considerations in the decision-making process, its integration remains sparse and inconsistent. Some of the challenges preventing a more widespread integration of ESG reporting include the quantification of risks, along with the lack of a standardised framework, given different companies can face different risks.
Global fund managers like the Stewart Investors Worldwide Sustainability Fund and the Generation Global Share Fund highlight the importance of ESG when selecting companies for inclusion in portfolios on the premise of sustainable growth and earnings. At the same time, it’s important to note that while larger companies are increasingly adapting ESG in their reporting, smaller companies can often remain left behind due to a lack of resources. We take the view that the incorporation of ESG reflects a company’s ability to consider the long-term risks and opportunities relevant to a business, linking those material risks to the sustainability of financial performance.