For many low- and middle-income countries, foreign direct investment (FDI) is vital for making their economies eco-friendly and sustainable. It brings “capital, employment, export opportunities, greater consumer choice, advanced technologies, managerial know-how and overall economic growth” to countries with the most profitable opportunities but lack finance or know-how noted the World Economic Forum’s Davos Agenda published this year.
Nowadays, foreign investors want to see more than just high profits and healthy balance sheets; many are requiring reports on environmental, social and governance (ESG) plans. “The ESG factor assessments are more of an inherent aspect of a sound investment process than a separate investment discipline,” Satyabarta Aich, a researcher at Inje University in South Korea, wrote in a September article on MDPI, an open-access research platform.
According to PricewaterhouseCoopers’ 2021 Global Investor ESG survey, 79% said: “a company’s performance in managing ESG risks and opportunities is pivotal to investment decisions.” Meanwhile, 59% of investors would vote against compensation increases for top executives if the organization is non-compliant. Half said they “would be willing to divest from a company that wasn’t taking action on ESG issues.”
In Egypt, only a handful of large companies, including Elsewedy Electric (since 2017), Cleopatra Hospital (before going public in 2016), and Edita (since 2018), voluntarily report on their ESG activities. That should change next year after the Financial Regulatory Authority (FRA) announced in October that all listed companies must “publicly disclose their performance on key [ESG] metrics each year when they submit their annual financial statements.” That would also apply to non-bank financial services companies.
However, compliance could prove expensive, complex and tricky. “It’s new, it’s evolving, and it’s all over the place,” wrote Fabrizio Tocchini, head of innovation at Wolters Kluwer CCH Tagetik, a management consultancy, in a blog. “As it stands, comparability between ESG reports is low, and investors’ demand for consistency is high.”
Such confusion will create risks for organizations operating across various jurisdictions. “ESG risks are especially challenging to monitor because many aren’t quantifiable,” said Tocchini. “They can’t be defined in terms of dollars and cents.”
What is ESG?
The idea that a company’s board of directors follows specific self-imposed standards for managing companies in a socially responsible manner to attract outside capital isn’t new. “It was in the 1950s and ’60s that the vast pension funds … recognized the opportunity to affect the wider social environment using their capital assets,” said a research paper titled “Trade Union Government and Administration in Great Britain,” published by Harvard University Press.
Over the decades, research tackled the importance of having such standards to ensure a company operates responsibly, attracting more capital. In 2004, the ESG concept came into the limelight after the IFC published a paper titled “Who Cares Wins, 2004-08.” It “aimed to increase the industry’s understanding of ESG risks and opportunities, and … improve integration of ESG into the investment decision making,” the IFC paper noted.
After the UN launched its 17 sustainable development goals (SDGs) and targets until 2030, ESG became the framework for companies to achieve at least part of the SDGs. “In less than 20 years, the ESG movement has grown from a corporate social responsibility initiative launched by the United Nations into a global phenomenon representing more than $30 trillion in assets under management,” noted research from Convenient Capital. “In … 2019 alone, a surge of capital totaling $17.67 billion flowed into ESG-linked products, an almost 525% increase from 2015.”
Sofia Karadima, a senior editor and researcher at Investment Monitor who focuses on ESG, said in September 2020, “The term takes in a wider group of risks and opportunities that are significant indicators of the performance and competitiveness of an organization. It also takes into consideration material factors and incorporates them into the decision-making process.”
The environmental aspect of ESG “screens investments for environmental risks, with key topics including climate change, greenhouse gas emission management, waste management and water depletion,” explained Karadima. Its scope also covers companies supplying ESG-compliant firms.
ESG’s social aspect looks at the “risks and opportunities related to occupational health and safety,” said Karadima, including “product safety, employee relations, management of human capital, human rights, as well as access to products and services.”
Lastly, governance focuses on a “board’s structure, diversity, succession planning for senior roles and the board, compensation policy, anti-corruption measures and tax responsibility,” wrote Karadima.
The ESG framework influences several types of investments said Karadima. The first is “responsible investment,” which uses ESG reporting standards to “mitigate risk, as well as enhance risk-adjusted financial returns.”
The framework also affects “impact investing … investments that generate measurable social or environmental impact along with financial returns,” wrote Karadima. “Impact investments are [present] in several sectors, with some of the more prominent being renewable energy, affordable housing and healthcare.”
Other types of investing influenced by ESG concerns are “socially responsible investment,” which determines whether investors want to invest in a company or not based on social and environmental indicators. Ethical investment is a subset of socially responsible investment based on ethical or moral values, explained Karadima.
Investors also rely on ESG reporting when considering sustainable and thematic investments. The latter includes “selected [sectors] with links to ESG such as healthcare, board diversity, equality, water distribution, climate change and cleantech,” said Karadima.
ESG coming to Egypt
In October, the FRA issued a decree requiring all EGX-listed companies and non-bank financial institutions (listed or not) to comply with a predetermined subset of international ESG reporting standards starting in 2023. The affected companies will be required to make those reports public.
It applies to companies whose issued capital starts at EGP 100 million ($5.4 million). Annual reports will comprise 21 ESG-related key performance indicators. “The document features 50 questions on everything from the operational environment footprint of firms to metrics on diversity, anti-discrimination, and health and safety,” reported Enterprise, which saw a copy of the FRA’s ESG document.
Companies with an issued capital above EGP 500 million will have to report on more metrics, including “whether [companies] have guidelines to track climate risk and whether firms integrate and address the risks in their short and long-term strategy,” Enterprise reported. Those companies also must publicly disclose their carbon footprint or mention if they don’t measure it.
In October, Sina Hbous, the executive director of the Regional Center for Sustainable Finance created by the FRA in 2021, told Enterprise that companies should provide quarterly updates on how they intend to comply with the ESG reporting requirements. “They also can voluntarily submit the document ahead of time to get one-on-one feedback from the FRA,” reported Enterprise. “These reports will not be made public.”
According to Hbous, most ESG reporting standards are based on the Task Force on Climate Financial Disclosure, founded by the Financial Stability Board, an international body. It will also adopt standards from the United Nation’s International Labor Organization and the U.N. SDGs.
The FRA decree also notes that Egypt’s ESG reporting standards shouldn’t conflict with stipulations in the Global Reporting Initiative, an independent organization that sets sustainable reporting standards. It also needs to align with standards mentioned in the Carbon Disclosure Project, a global not-for-profit charity; Sustainability Accounting Standards Board, a non-profit organization, and the U.N. Global Compact.
Hbous said the FRA decree would be limited to reporting on ESG and won’t require companies to have a compliance strategy. “The FRA cannot force firms to undertake an ESG strategy, but just push them to report on what they’re currently doing,” she told Enterprise.
The reporting requirement aims to keep companies “aware of the long-term threat climate change has on their operations and motivates them to undertake sustainability initiatives,” Enterprise reported.
Despite the global spotlight on ESG reporting and standards, Longitude Research, a think tank, found 56% of ESG adopters are worried about a “lack of clarity over its terminology.”
That impacts smaller firms, particularly those supplying large organizations whose “sophisticated larger investors tend to be more familiar with ESG investing,” said Karadima of Investment Monitor.
Some hurdles include “struggling to understand the related terminology or identify the differences between responsible investing and sustainable investing or impact investing and ethical investing,” explained Karadima. “Some of these terms are used interchangeably, but as more investors are looking to embrace ESG, there is focus on achieving standardization with regards to what these terms mean.”
Tocchini of Wolters Kluwer CCH Tagetik noted the problem with ESGs is that “no single, global standard for ESG reporting exists. [Instead, there] are a lot of regional and industry-specific standards to choose from.” While they have common points, each also has unique standards that might not align with the requirements of other regulatory bodies in other countries.
To cope with such rapid, extensive changes, companies complying with ESG reporting standards in different jurisdictions must be flexible and on their toes. “If this is any indication of the future of ESG reporting, two things are certain: Standards are quickly changing, and organizations will have their work cut out for them when it comes to data management,” Tocchini said.
Technological advances and changing regulations make “data management … one of the biggest, if not the biggest, challenges companies will face when creating ESG disclosures,” said Tocchini. He added multinationals would be affected the most because they might have to comply with multiple ESG reporting standards.
That would ultimately complicate understanding, managing and quantifying the risks of not complying with ESG reporting standards. “All elements of ESG reporting are really based on proper risk management,” wrote Barbara Porco, director for the Center of Professional Accounting Practices at Fordham Business School, in Forbes in November. “It’s the risks that you don’t know about [which ESG reporting reveals] that will be the problem.”
Case by case
Companies will struggle to various degrees when implementing ESG reporting standards within their existing structures. “Environmental initiatives are the hardest as they need a long-term plan while being in line with climate, water, and energy requirements and policies used globally,” Tarek Yehia, senior IR manager at Elsewedy Electric, told Enterprise in October.
He noted that environmental compliance would require investments to “adjust, purchase and upgrade facilities in factories,” but in the long term, “the move translates into higher quality products and growth.” Gender and governance aspects are the most straightforward to implement. “These parameters require adopting new policies as opposed to big investments and changes in operations,” Yehia explained.
On the other hand, Hassan Fikry, Cleopatra Hospital’s corporate strategy and IR director, said the company has had ESG standards and reporting for years. He explained to Enterprise in October that they implemented them at the behest of the “main shareholders and core investors.”
Snack-food maker Edita has reported on its ESG efforts since 2018 to retain its foreign investors, Menatallah Shams El-Din, the company’s senior director for investor relations and business development, told Enterprise in October.
Some companies have internal policies that prevent reporting ESG standards. A case in point is investment firm Berkshire Hathaway, whose CEO is Warren Buffet, listed on the Bloomberg Billionaires Index as the world’s fifth-richest man.
At the firm’s last annual shareholders’ meeting in May 2021, Buffet and his top directors, who control 35% of Berkshire Hathaway’s voting power, voted against ESG reporting. They opposed the company’s other investors supporting ESG reporting, including BlackRock, the world’s largest asset manager; the California Public Employees’ Retirement System, the largest U.S. public pension fund; and the $62 billion asset manager Federated Hermes.
Other companies resisting ESG reporting include Citigroup and Amazon, reported Reuters in May.
Ric Marshall, executive director for ESG research at MSCI, believes firms and investors that resist ESG reporting are losing ground. “Even an investor of Buffet’s renown may not be immune to such larger market trends,” he told Reuters in May after Berkshire Hathaway announced the results of its vote.
According to the PricewaterhouseCoopers survey, companies must be careful when implementing ESG standards to avoid hurting their bottom lines. “While most investors said they were likely to take action if companies fail to address ESG issues, most also didn’t want a company’s actions on ESG to significantly impact their investment returns,” said the survey’s press release.
The survey showed 81% would not accept “more than one percentage point less in investment returns for ESG goals,” the PwC press release said, with half “unwilling to accept any reduction in returns.”
Karadima of Investment Monitor believes many investors see ESG as a way to “safeguard their businesses without having to compromise on returns” rather than improving the business’s environmental, social, and governance standards for the benefit of society.
Government leading the way
Increasing awareness of ESG standards by younger investors and the pandemic’s acceleration of environmental considerations mean government regulations are vital. According to the U.N. Principles for Responsible Investment (UNPRI), governments will have a significant role in “creating an enabling environment [by] developing sustainable finance policy frameworks.” Those funding options must align with the climate and SDG agendas to help create an “environment that attracts and enables responsible investment.”
Another vital role for the government is to raise awareness among businesses, particularly SMEs, of the benefits and challenges of implementing ESG standards. The state also must promote and quantify the opportunities and risks for potential investors who lack expertise in emerging markets, said the UNPRI.
The next step for the government is to offer “investable opportunities,” accompanied by suitable financing options, such as green bonds or blended finance, said the UNPRI. That said, emerging market governments need to realize they would be competing for a limited pool of ESG-allocated private capital from multilateral development banks and institutional investors.
The other challenge facing emerging markets when incorporating ESG standards is that those principles were developed in, and for, developed markets, noted the UNPRI. Therefore, emerging market governments must overcome “cultural and structural differences in the understanding and application” of those standards.
Keys to ESG
Overcoming ESG’s obstacles would require the government to create a match-making environment between local and international investors to collaborate, share information and develop best practices. “It is unreasonable to have one-size-fits-all standards … on climate change and diversity,” noted the Berkshire Hathaway investors who opposed ESG reporting.
Tocchini of Wolters Kluwer CCH Tagetik stressed companies must be “agile in the face of new and changing regulations.” Meanwhile, the government should “automate disclosure requirements [to] control, validate and report accurate ESG data.”
That allows easy monitoring and measuring of ESG’s key performance indicators, enabling governments and companies to “see the impact of ESG activities on … financial and operational plans, and use those insights to improve ESG planning,” wrote Tocchini.
At their core, ESGs are “no different than … sales and marketing data,” Tocchini noted. “How can you quantify the impact of word of mouth? Both marketing and ESG impacts can be elusive, yet they have an incredible influence on the bottom line.”