The right balance between ESG and profitability

Richard Plaistowe, Principal, Financial Services wonders whether some companies may be sacrificing profitability for the sake of ESG.   

Environmental, social and governance (ESG) is rightly a major issue for businesses today. Companies should consider how what they do impacts their people, local communities and the health of our planet amid growing regulatory and societal pressures to act as responsible corporate citizens.

But – and this may be a poorly received example of playing devil’s advocate given the severity of the climate crisis – has the pendulum swung too far within certain organisations? Is there a risk of ESG being prioritised over profits to the detriment of the business? Companies exist to make money after all.

The most high-profile instance of shareholder unhappiness about the prioritisation of ESG saw the ousting in March 2021 of Emmanuel Faber as CEO and chairman of French food giant Danone. Faber steered Danone into becoming the first big listed French company designated an enterprise à mission, or purpose-driven company, ploughing investment into reducing plastic packaging and pioneering the adoption of a new ‘carbon adjusted’ earnings per share metric.

Activist shareholders were unimpressed, believing the major focus on ESG caused a negative impact on the company’s financial performance, which lagged behind that of its main rivals, and they forced Faber out. Incidentally, Faber now chairs the International Sustainability Standards Board (ISSB) formed to develop “standards that will result in a high-quality, comprehensive global baseline of sustainability disclosures focused on the needs of investors and the financial markets”.

Achieving greater consistency in global standards is important because of concerns that companies with a strong focus on ESG may be at a disadvantage when competing against businesses from countries with less stringent sustainability standards, such as China. Although China has made moves to standardise its fragmented ESG reporting landscape, for a variety of reasons, including the government’s stance on sharing data, Chinese companies score poorly on ESG metrics or fail to report such data altogether.

The big question at the heart of all of this is, if a company devotes too much energy to pursuing ESG objectives, does it risk losing its focus on growth and market share? Is the drive for sustainability potentially disadvantageous when assessed by cold, hard metrics such as profitability and share price performance? The answer must be ‘yes’. ESG is important but it cannot undermine profits.

This is a sensitive area for many reasons, not least because it carries political connotations too. We are seeing the UK Government pulling back on some of their climate commitments on the grounds that they feel the need to balance environmental issues with ensuring they do not impoverish the country.

Meanwhile, it is interesting to note that Joe Biden’s first presidential veto, issued more than two years into his White House tenure, centred on legislation that touched on ESG.  In March this year the US Senate voted 50-46 in favour of blocking plans allowing certain retirement plans to weigh ESG factors when selecting investments, rather than making decisions based only on the likely best rate of return. Biden used his veto to overturn the Senate block, allowing the original plans to go ahead. These permit, but not require, pension investment decision-makers to consider ESG factors when selecting investment options.

However, within UK financial services, ESG regulation is tightening. The Financial Conduct Authority publishes rules and guidance on the disclosure of climate-related financial information in its ESG sourcebook and is working on finalising Sustainable Disclosure Requirements.

For business leaders, it may feel as if they are caught between a rock and a hard place. They are under pressure both to deliver on ESG and financial objectives.

A PwC survey found that global investors place ESG-related outcomes such as effective corporate governance and greenhouse gas emissions reduction among their top five priorities for business to deliver. However, 81% went on to say they would accept only a one percentage point or smaller reduction in returns to advance ESG objectives, both those that are relevant to the business and those that have a beneficial impact on society. And roughly half of that group were especially unyielding and would not accept any decline in returns at all.

There you have it: striking the right balance is essential. Investors want ESG, but not if it significantly erodes returns.