In 1976 Milton Friedman said that businesses’ primary responsibility was to look after their shareholders and maximise profits. This is the primary thesis that our economic system and business models were designed around. What may however have been overlooked is that Friedman also said this was with the assumption it is the role of government to look after society and the planet, and thus the parameters in which businesses were to maximise profits would be set accordingly. It has been just shy of five decades since this thesis shaped the world and minds of business leaders and investors across the globe.

In 2018 the first prominent voice of change came through a shareholder letter written by Blackrock CEO Larry Fink, who declared that businesses should have a social purpose. Fink said companies should benefit all of their stakeholders including shareholders, employees, customers and the communities in which they operate. The world has changed, and the business models, leadership mindsets and investor expectations are changing too.

The world has changed, and the business models, leadership mindsets and investor expectations are changing too.

With our natural world being exploited to the brink of severe imbalance and an increasingly unequal society, businesses are increasingly being called into question via shareholder activism, the voice of millennials, changing regulation and demands of heightened risks. Likewise, investors are seeking this change through the integration of environmental, social and governance (ESG) considerations into business reporting and decision making.

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The evolution of ESG

The adoption of ESG was initially driven by exclusionary policies that excluded any company or industry deemed to be causing harm. Over time this has evolved into responsible investing policies that look at how ESG factors are being factored into decision-making. Global challenges including climate change, Covid-19 and the invasion of Ukraine are testing the depth and robustness of ESG integration, including its application by fund managers.

Pre the Ukraine invasion, world headlines were largely dominated by the climate crisis and its related impact on sustainable investing. The Covid-19 pandemic was the first global challenge that heightened the prevalence of the ‘S’ and ‘G’ aspects of ESG. The ‘S’ of ESG is now dominating global headlines because of the global food crisis that has been unleashed by the war, along with a renewed focus on a country’s right to defend itself and its citizens.

The Covid-19 pandemic was the first global challenge that heightened the prevalence of the ‘S’ and ‘G’ aspects of ESG.

The defence and weapons industry has long been on the grey list for many investment houses, citing ESG concerns specifically around who the related weaponry was being supplied to and how it was used. In addition, the flow of money for the purchase of weapons has been scrutinised, meaning that firms also had to consider their risks according to money laundering legislation. However, post the Ukraine invasion we have seen increased investment in the defence industry, with the prevailing narrative that “it is a social right to defend our borders”. We have witnessed governments sending additional help and weaponry to Ukraine in support of this right. This has rapidly shifted the exclusionary approach of defence stocks to increased investments in these sectors being justified.

With Ukraine unable to export its grains and suppliers unable to procure from Russia as a result of the economic sanctions, the world is now facing dramatic cost increases in basic food products including wheat, barley and maize. Governments are being urged to move fast to offer either financial aid or social protection to avert a humanitarian disaster. Banks and other international institutions need to assess this when providing finance and financial assistance to ensure that all stakeholders are being considered in their processes and decision-making.

ESG should not be seen as a one-size-fits-all, exclusionary process but rather as a framework that overlays risk analysis, with a key focus on quantifying stakeholder impact. We believe the most efficient and effective approach is one that enables investors to assess the environmental and social impact of their investments. However, the measurement of that impact is not as easy to define in practice; simply put, you can’t manage what you can’t measure.

Quantifying impact

Impact measurement starts with companies tracking the environmental and social metrics relevant to their operations. Companies that are unaware of the impact their business may have on the environment and all stakeholders are at a distinct disadvantage. As investment managers, it is our role to ensure companies are measuring and disclosing beyond traditional financial metrics to include all relevant data.

Until recently, companies assumed that our natural resources are infinite and that any negative externalities were a cost to be borne by society and not by shareholders. As cited by Friedman, there was an assumption that governments would provide oversight and regulation to ensure that companies behaved responsibly. This has unfortunately not been the case. Lobby groups funded by the private sector have furthered corporate interests at the cost of society. Politicians funded by corporates are often compromised in their decision-making. Management has been incentivised with a focus on short-term growth and profitability rather than long-term, sustainable profitability.

Operating sustainably requires capital expenditure to ensure that businesses operations have the lowest possible impact on the environment and that employees are safe, motivated and adequately compensated. This translates into companies, products and services that are not only relevant today but also for future generations with a greater emphasis on sustainability. In the paper ‘Corporate Sustainability: First Evidence on Materiality’ by Harvard’s Kahn, Serafeim and Yoon, it was observed that companies with good performance on material sustainability issues significantly outperform firms with poor performance on these issues.

As an active investment manager, we believe it is a vital part of our fiduciary responsibility to assess corporate sustainability as part of our research and investment decision-making. We believe the United Nations’ 17 Sustainable Development Goals (SDGs) provide an ideal framework to assess sustainability. The SDGs address the global challenges we face, including poverty, inequality, climate change, environmental degradation, peace and justice, and provide a blueprint to achieve a better, more sustainable future for all.

Using the Institutional Shareholder Service (ISS) methodology for quantifying net impact across each of the 17 SDGs, we can aggregate that data to quantify whether a company has a positive or negative net impact and then base our investment decision-making and engagement activity on that output. This enables us to root our thinking in an evolving global economic system where the hearts and minds of investors and companies are being challenged, where impact measurement is rapidly being enhanced and where all stakeholders are placed at the centre of a shared value equation.

The Investec Global Sustainable Equity Fund invests in world-class companies that are aligned with the UN's Sustainable Development Goals (SDGs). Find out more here.

This article originally appeared in a Citywire SA feature ESG – The good and the bad.

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