ESG is likely to be the most important three letter acronym that will influence corporate behaviour in the years to come. It stands for Environment, Social and Governance and the largest investors in the world are embracing ESG frameworks to promote better corporate behaviour. Globally, over $80 Trillion of funds being managed by over 2300 managers have already subscribed to the United Nations Principles for Responsible Investment, with a commitment to integrate ESG issues into their investment analysis and decision-making processes.
As the table below shows, this investment strategy is taking roots in India too.
The ESG Advantage
Research by one of the leading academics in the ESG investing space, Professor George Serafeim of the Harvard Business School, has demonstrated a clear correlation between material ESG actions and firm outcomes across markets. A focus on ESG typically yields over time lower cost of operations, reduced risk and therefore reduced insurance premia, lower cost of borrowing, increased analyst coverage and investor interest, and greater prospects for valuation rerating. The outperformance of the MSCI India ESG Leaders Index in the chart below demonstrates the value of an ESG focus.
Why should Corporate India take note?
In one word, Demand. This can be illustrated through the lens of different stakeholder groups:
Investors are increasingly demanding better ESG performance. Mandates given to Indian asset managers by foreign investors already require their portfolio investments to comply with ESG standards applicable in developed markets. Investors are also upset with the growing number of corporate flame-outs attributable to poor corporate governance, reflected in the rising number of cases before the National Company Law Tribunal and the over Rs 900,000 Crores of nonperforming assets (NPAs) in the banking system.
Shareholders are increasingly demanding that the compensation of promoters and senior executives correlate with financial performance. The rejection of shareholder resolutions for the re-appointment of directors and even compensation packages payable to senior executives at several Indian companies in recent years are evidence of growing shareholder activism and the important role that proxy advisory firms play.
Government and quasi-judicial bodies like the National Green Tribunal are pressing the regulatory accelerator on environmental issues. Be they tanneries that operate on the banks of the Ganges, or auto manufacturers who are yet to make the switch to electric vehicles, many businesses will face existential crises in the near future as a result of government action.
Customers (including many millennials) are increasingly demanding that companies demonstrate purpose beyond profit. If businesses are able to clarify the higher purpose they serve, as brands like The Body Shop have done, customers are willing to reward them with both mind-share and share of wallet.
Employees are demanding better, safer and fairer workplace practices. Research indicates that firms with high employee satisfaction outperform their peers by 2.3% to 3.8% per year in long-run equity returns, and in companies with strong sustainability programs, morale and employee loyalty are demonstrably higher.
The role of HR in improving company ESG performance
HR has a particularly important role to play in organizational design for ESG improvement. It has responsibility for identifying the right location for ESG oversight, and ensuring its functional integration across the organization. Vital tools available to HR in this endeavor include the organization’s Code of Conduct and the systems and processes put in place to cascade the organization’s values and ethics agenda across the organization. These include the whistle-blower and other grievance redressal mechanisms that have become so critical in the wake of multiple corporate governance failures in India and the rise of the #MeToo movement.
The Code of Conduct must speak to the need for diversity and inclusion in the workplace, and the treatment of all employees with dignity and respect. With women representing only 22% of the organized workforce in India and a significant pay gap reported between men and women, there is clearly much that HR has to do to ensure equal opportunities in the workplace.
HR also has a responsibility to address the growing inequality we are seeing in India, certainly insofar as it is manifested through rising income inequality within firms. Studies suggest that the median salary of top executives is already on average 243 times higher than the average salary for employees, and climbing; HR must develop a philosophy around what kind of pay differential between the highest and lowest paid employees within an organization is likely to receive stakeholder sanction. HR also has a duty to champion better health and the safety of employees and the members of the organization’s supply chain.
In improving the employer brand, HR can leverage an organization’s CSR spending. This can be oriented in favour of increasing the connect of the employees with the local community by supporting social causes that matter to the employees and linking these to corporate volunteering possibilities, thereby increasing employee pride and engagement levels. As organizations like Tatas have experienced, employees can feel extremely motivated when they view the corporate brand as one with a social conscience.
In the more evolved enterprises, HR is influencing the corporate culture in the direction of greater openness, transparency, and inclusion, and nurturing leadership that understands the importance of integrating ESG in corporate strategy. Ultimately, HR will play the pivotal role in preparing Indian companies to embrace the changes that the growing focus on ESG demands.
(Mukund Govind Rajan & Joslyn Chittilapally, ECube Investment Advisors)
A shorter version of this piece was published in the Times of India on October 16, 2019.