Discounting ESG – A risky strategy for small cap investor relations

Small to mid cap companies should consider ESG factors in their investor relations programs as investors assess the risks of not investing responsibly.

ESG has become an important area of risk management for publicly listed companies, and companies who choose not to disclose environmental, social and governance (ESG) factors will struggle to compete for capital and are more likely to underperform peers with strong ESG credentials.

The consideration of ESG factors in investment decisions is a key theme in capital markets as super fund trustees are increasingly focused on having their capital invested responsibly.

Responsible Investment is an approach that incorporates ESG factors to identify risk and generate sustainable, long term returns. In 2017, superannuation assets accounted for approximately 78% of total Australian funds under management (FUM) and $622 billion of these assets were invested through responsible investment filters.

At the institutional investor level, there are a number of factors driving the inclusion of ESG factors in investment decisions.

  • Asset owners are awarding mandates to fund managers with investment frameworks that consider ESG factors.
  • Active managers are using ESG as a lead indicator of management quality, sound risk management and sustainable financial performance.
  • Active fund managers with investment processes that include ESG are outperforming the S&P ASX 300 over one, three, five and ten-year periods.
  • Passive investors are using ESG to drive change and engage with companies and proxy advisors, particularly at Board level.

With ESG embedded in the flow of capital, various stakeholder groups are demanding more reliable ESG disclosure from listed companies. As a result, Boards are increasingly focused on ESG risk management and overseeing greater consideration of ESG factors at the executive level. This was highlighted in a recent report by BNY Mellon on global trends in investor relations. It showed that Australian and New Zealand companies targeting ESG-focused investors have increased from 22% in 2015 to 58% in 2017.

It is more important than ever for small to mid caps to address ESG within their overall business strategy and broader IR program. ESG reporting guidelines can seem onerous as smaller companies often lack the resources to meet cumbersome disclosure requirements. Instead companies should take a building blocks approach, developing their ESG credentials around areas that are most material to their core business.

Investors prefer to see a company identify and address the most relevant ESG factors and work to expand these over time rather than do nothing at all. Ideally, these ESG factors would be integral to a company’s strategy and measurable so that progress can be benchmarked over time. Perhaps most importantly, the ESG factors chosen should be authentic to avoid a charge of ‘green washing’ or tokenism.

For many companies, it may simply be a case of identifying disclosure gaps, better communicating what they’re doing well and explaining why this is relevant to their business.

Either way, the identification of the value at risk, and the development of an ESG framework is no longer something that only ASX100 companies do – not if small to mid caps want to figure in the capital allocation decisions of the asset owners and managers who will be investing the estimated $9.5 trillion in Australian superannuation funds by 2035.