Pressure is building on firms to do more on their environmental, social, and governance issues. The literature on ESG point to a new field that is gaining increased importance, given that it is driven by the need and urgency to move to a greener environment, sustainable finance, and a socially aware corporate sector.
Recent years have witnessed an increased interest in ESG issues with the commitment at Davos by many of the world’s business leaders to move into a universally recognized ESG disclosure. Coronavirus hit and catapulted ESG into the forefront of debate. As the pandemic dragged on, popular movements started to emerge, asking firms to “walk the talk” on governance and sustainability.
It is important not to exaggerate the importance of ESG. To many firms, ESG could just be greenwashing. Recent dynamics, however, suggest that change is underway; if shareholders are unhappy, pressure on management arises. If workers are unhappy, labor unrest takes place. If safety and health conditions are poor, investors divest. Regulators, the media, and NGOs judge businesses for their social commitments and the values they boast of holding and preach about. Employees assess whether ESG align with their personal values before making career choices. Problems such as poor working conditions, pollution, the displacement of communities, land disruption, and inadequate health and safety records, all affect the reputation of a firm. These social forces are now in full display, and large firms around the world are already in the business of integrating ESG within their broader risk management frameworks.
Less Risk, more benefits
Risk arises out of uncertainty. It can be defined as the effect of uncertain future events on a firm or on the outcomes the firm achieves. Investors typically price certain types of controllable, financial risks and take investment decisions based on that pricing. Recently, however, there has been increased awareness on such non-financial risks as ESG’s. Investors, such as banks, sovereign wealth funds and portfolio managers, use ESG factors to build and manage their portfolios. Although accounting for these risks doesn’t necessarily make the capitalist system less prone to economic swings, firms could end up with less risk exposure and a higher ability to cope with uncertainty. We would still have Covid-19 (or say, Covid-20 several years later) but firms would be in a better position to effectively address its implications in such a way to reduce financial loss and ease economic distress. This also means that firms would build a higher capacity to plan, produce, and sell products with higher levels of certainty. On a macro level, the benefits are huge: less unemployment, a sustained demand, and an enhanced government capacity to support people’s lives with welfare programs.
Building such resilience requires that firms forgo short-term gains for the benefit of a more certain future in which profitability could be sustained. In other words, firms would be more confident about their long-term investments because these investments would eventually pay off with higher consumer demand and sustained confidence. In addition, the integration of ESG practices makes the risks associated with them less likely to occur, which would help in keeping firms’ reputation intact and their stock prices relatively stable.
Stakeholders Capitalism
Firms nowadays operate within the constraints of an eco-system of stakeholders. They face greater scrutiny from stakeholders, including consumers, investors, suppliers, the community, and governments over their ESG practices. They know that a poor management of their ESG risks might result in the price of their stocks and credit securities becoming more volatile or loosing value. A stakeholder-driven approach could pave way to a new kind of capitalism, that of a Stakeholder Capitalism. A Stakeholder Capitalism means a system in which firms are oriented to serve the interests of all their stakeholders, rather than just shareholders.
While Stakeholder Capitalism might be skeptically looked at, the question is whether the long-term success of any business rests on serving the interests of all stakeholders. Free-markets theorist Milton Freidman, for instance, thinks that “there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits.” Nowadays, though, market dynamics seem to suggest that prioritizing the maximization of financial value doesn’t align with the need and urgency to build resilience in times of uncertainty. A compromise is needed, and firms need to strike a balance between attaining profitability targets and remaining committed to sustainable finance.
The GCC
The GCC region plays a key role as a supplier of fossil fuels and its governments have been deeply involved in the fight against global warming. They continue to seek solutions that would reduce carbon emissions while moving closer to diversified economic systems. Some have even devised bold policies.
Consider, for instance, the UAE’s Net Zero By 2050 Strategic Initiative, which aims at achieving net zero emissions by 2050, or the issuance of Sharia-compliant green bonds or Dubai launching a UAE ESG Index in April 2020 and Saudi Arabia putting in place similar plans. These bold initiatives demonstrate a proactive approach that would help in meeting the Paris agreement to limit global warming to well below 2 degrees Celsius.
While investors in the region are using ESG to manage their portfolios, the question of “stranded assets” has recently been at the forefront of debates. Driven by growing concerns about fossil fuel assets losing value and becoming “stranded” over time, much government attention is being focused on how to transition into a more resilient and diversified economy in which the use of clean energy has primacy.
Although recent events have seen oil prices rallying 50%, forecasts point to demand slowing down and prices reaching peak levels even in the absence of climate change commitments. With this crucial development looming large, there is an obvious policy choice to make: working hard to reduce reliance on fossil fuel. The good news is that GCC countries are already aware that the world is changing and the need to be less dependent on carbon is more important than ever. Sustainability is at the top of their agenda, but government must also find new ways to raise enough revenues to balance their budgets.
