ESG Factors in International Markets

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Introduction
• Why do shareholders buy shares?
• To gain financially from an increase in share value
• Therefore, decisions need to be made to help shareholders achieve this
objective.
• So, the goal of financial management is: maximise the market value for
the existing owners’ equity
• For a publicly listed firms, this could be stated as:
• maximise shareholder wealth
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ESG
• However, with increasing concern over company behaviour in terms of
social and environmental issues, it is becoming increasingly difficult for
companies to justify only considering maximising shareholder value
• There is increasing pressure – particularly from institutional
shareholders/investors – for companies to consider other issues as well
• In this lecture, we will look at environmental, social and governance (ESG)
issues that are relevant in today’s world of international finance
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ESG
• Note that sometimes the acronym SEE is used
• Social (S)
• Environmental (E)
• Economic (E)
• However, ESG is more usually used nowadays in finance
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ESG
• In the case of a international finance, ESG issues become more
relevant/pertinent because companies often outsource to developing
nations
• In these countries, social and environmental legislation and/or enforcement
may be weaker, allowing companies to conduct business in ways that would
not be legal/socially acceptable in their home country
• In this lecture, we will examine what some of these issues are, and how
they relate to international finance
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Environmental issues
• Planetary boundaries model:
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Environmental issues
• What are some environmental issues that corporations may face in the
international context?
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Environmental issues example: climate change
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Social issues
• What are some social issues that corporations may face in the international
context?
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Social issues example: modern slavery
• New legislation in Australia: Modern Slavery Act 2018
• Effective as at 1 January 2019 – first statements due 30 June 2020
• Businesses and other organisations with consolidated revenue of +$100
million must report annually:
• on the risks of modern slavery in their operations and supply chains
• action they have taken to assess and address those risks
• effectiveness of their response.
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Background: SDGs
• In September 2015 at an UN Summit, world leaders agreed to 17
Sustainable Development Goals (SDGs) to be reached globally by 2030
• Agree that countries will mobilize efforts to end all forms of poverty, fight
inequalities and tackle climate change, while ensuring that no one is left
behind.
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SDGs
https://www.un.org/sustainabledevelopment/
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UN Global Compact
• SDGs not only identify where the world needs to be in 2030 to create a
sustainable world
• Also outline new markets and opportunities for companies all over the
world.
• Companies have a role to play in meeting the SDGs
• UN Global Compact developed as a way to assist companies to do this
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UN Global Compact
• UNGC Mission:
• At the UN Global Compact, we aim to mobilize a global movement of
sustainable companies and stakeholders to create the world we want.
That’s our vision.
• To make this happen, the UN Global Compact supports companies to:
• Do business responsibly by aligning their strategies and operations with Ten
Principles on human rights, labour, environment and anti-corruption; and
• Take strategic actions to advance broader societal goals, such as the UN
Sustainable Development Goals, with an emphasis on collaboration and
innovation.
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UN Global Compact
• The ten principles:
• Human Rights
• Principle 1: Businesses should support and respect the protection of internationally
proclaimed human rights; and
• Principle 2: make sure that they are not complicit in human rights abuses.
• Labour
• Principle 3: Businesses should uphold the freedom of association and the effective
recognition of the right to collective bargaining;
• Principle 4: the elimination of all forms of forced and compulsory labour;
• Principle 5: the effective abolition of child labour; and
• Principle 6: the elimination of discrimination in respect of employment and occupation.
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UN Global Compact
• The ten principles:
• Environment
• Principle 7: Businesses should support a precautionary approach to environmental
challenges;
• Principle 8: undertake initiatives to promote greater environmental responsibility; and
• Principle 9: encourage the development and diffusion of environmentally friendly
technologies.
• Anti-Corruption
• Principle 10: Businesses should work against corruption in all its forms, including extortion
and bribery.
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UN Global Compact
• 14,349 organizations (4834 companies) are UNGC signatories as at May
2020
• From 160 countries
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UN-supported Principles for Responsible Investment
• An initiative for financial market participants
• Agree to include ESG into investment decision-making
• Over 3,000 signatories from across the globe as at May 2020
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https://www.unpri.org/pri/an-introduction-to-responsible-investment/what-are-the-principles-for-responsible-investment
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Global Reporting Initiative
• GRI produces a framework to help firms with disclosing their sustainability
performance.
• The most popular reporting framework for corporate responsibility reporting
• Over 13,000 organizations use the GRI reporting framework
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Carbon Disclosure Project
• Similar to the GRI, the Carbon Disclosure Project is also a not-for-profit
organisation that was formed to help firms disclose sustainability
information.
• In 2010, the GRI and Carbon Disclosure Project produced a linkage
document which aligned their reporting requirements.
• The Carbon Disclosure Project’s focus differs slightly from the GRI, as it
assists with reporting on greenhouse gas emissions, water usage and
climate change strategies.
• Organisations from 90 countries use the carbon disclosure project’s
reporting framework.
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Governance
• For publicly listed firms:
• Who owns the firm?
• Who manages (runs/controls what happens in the firm day to day) the firm?
• That’s why the managers are hired in the first place.
• Many shareholders are not qualified to make complex business decisions.
• A shareholder with a diversified portfolio would not have the time to devote
to making the numerous decisions at each of his many companies anyway.
• This is what we call the “separation of ownership and control”
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Governance
• Managers are agents for the company’s owners (shareholders) – this means that they
are supposed to run the firm in the best interests of the shareholders, not their own
best interests.
• Can you think of a goal that that managers might have that differs from the owners?
• This problem is called the agency problem
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Governance
• A number of market mechanisms are used to minimize agency problems
• Board of directors
• Compensation
• Concentrated ownership
• Debt
• Overseas listing
• The market for corporate control
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The board of directors
• The structure and legal charge of corporate boards vary greatly across
counties.
• In Australia and the U.S., shareholders have the right to elect the board of
directors.
• If the board remains independent of management, it can serve as an effective mechanism
for curbing the agency problem.
• In Germany the board is not legally charged with representing the interests
of shareholders, but is instead charged with representing the interests of
stakeholders (e.g. workers, creditors, etc.).
• In Japan, most corporate boards are insider-dominated and primarily
concerned with the welfare of the keiretsu to which the company belongs
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Compensation
• It is difficult to design a compensation scheme that gives executives an
incentive to work hard at increasing shareholder wealth.
• Accounting-based schemes are subject to manipulation.
• Executive stock options are an increasingly popular form of incentive
compatible compensation.
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Concentrated ownership
• Another way to alleviate the agency problem is to concentrate
shareholdings.
• In the United States and the United Kingdom, concentrated ownership is
relatively rare.
• In Australia, large institutional investors (particularly super funds) hold a lot
of the available equity
• Elsewhere in the world, however, concentrated ownership is the norm.
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EXHIBIT 4.4 Consequences of Law: Ownership and
Capital Markets: English Common Law
Country
Ownership
Concentration External Cap/GNP
Domestic
Firms/Population
Australia 0.28 0.49 63.55
Canada 0.4 0.39 40.86
Hong Kong 0.54 1.18 88.16
India 0.4 0.31 7.79
Ireland 0.39 0.27 20
Israel 0.51 0.25 127.6
Kenya na na 2.24
Malaysia 0.54 1.48 25.15
New Zealand 0.48 0.28 69
Nigeria 0.4 0.27 1.68
Pakistan 0.37 0.18 5.88
Singapore 0.49 1.18 80
South Africa 0.52 1.45 16
Sri Lanka 0.6 0.11 11.94
Thailand 0.47 0.56 6.7
United Kingdom 0.19 1 35.68
United States 0.2 0.58 30.11
Zimbabwe 0.55 0.18 5.81
English-origin average 0.43 0.6 35.45
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EXHIBIT 4.4 Consequences of Law: Ownership and
Capital Markets: French Civil Law
Country Ownership Concentration External Cap/GNP Domestic Firms/Population
Argentina 0.53 0.07 4.58
Belgium 0.54 0.17 15.5
Brazil 0.57 0.18 3.48
Chile 0.45 0.8 19.92
Colombia 0.63 0.14 3.13
Ecuador na na 13.18
Egypt 0.62 0.08 3.48
France 0.34 0.23 8.05
Greece 0.67 0.07 21.6
Indonesia 0.58 0.15 1.15
Italy 0.58 0.08 3.91
Jordan na na 23.75
Mexico 0.64 0.22 2.28
Netherlands 0.39 0.52 21.13
Peru 0.56 0.4 9.47
Philippines 0.57 0.1 2.9
Portugal 0.52 0.08 19.5
Spain 0.51 0.17 9.71
Turkey 0.59 0.18 2.93
Uruguay na na 7
Venezuela 0.51 0.08 4.28
French-origin average 0.54 0.21 10
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Concentrated ownership
• Companies domiciled in countries with weak investor protection many need
to have concentrated ownership as a substitute for legal protection.
• This is not without costs. In companies with concentrated ownership, large
shareholders can abuse smaller shareholders.
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Debt
• Debt can be used as a way to manage agency costs
• If managers fail to pay interest and principal to creditors, the company can
be forced into bankruptcy and managers may lose their jobs.
• Borrowing can have a major disciplinary effect on managers, motivating
them to curb private benefits and wasteful investments and trim bloated
organizations.
• However, excessive debt creates its own agency problems.
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Overseas listing
• Companies domiciled in countries with weak investor protection can bond
themselves credibly to better investor protection by listing their stocks in
countries with strong investor protection.
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Law and corporate governance
• Commercial legal systems of most countries derive from a relatively few
legal origins.
• English common law
• French civil law
• German civil law
• Scandinavian civil law
• Thus how the law protects investors’ rights varies a great deal across
countries.
• It should also be noted that the quality of law enforcement varies a great
deal across countries.
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Differences in investor legal protections
• There is a marked difference in the legal protection of investors between the
two most influential legal systems: English common law and French civil
law.
• The English common law system more protective of investors than the
French civil law system:
• The state historically has played a more active role in regulating economic activities and
has been less protective of property rights in civil law countries than in common law
countries.
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Differences in investor legal protections
• Protection of investors’ rights has major economic consequences.
• These consequences include:
• The pattern of corporate ownership and valuation.
• Development of capital markets.
• Economic growth.
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Example: Italy vs UK
• Italy has a French civil law tradition with weak shareholder protection, whereas the
United Kingdom, with its English common law tradition, provides strong investor
protection.
• In Italy the three largest shareholders own 58 percent of the company, on average.
In the U.K. the three largest shareholders own 19 percent of the company, on
average.
• Company ownership is thus highly concentrated in Italy and more diffuse in the United
Kingdom.
• In addition, as of 2019, only 230 companies are listed on the stock exchange in
Italy, whereas approx. 2,100 companies are listed in the United Kingdom.
• The stark contrast between the two countries suggests that protection of investors
has significant economic consequences
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Capital markets and valuation
• Investor protection promotes the development of external capital markets.
• When investors are assured of receiving fair returns on their funds, they will
be willing to pay more for securities.
• Thus, strong investor protection will be conducive to large capital markets.
• Weak investor protection can be a factor in sharp market declines during a
financial crisis.
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The market for corporate control
• If a management team is really out-of-control, over time the share price will
decline.
• At some point, it will be realized that the firm is badly managed, and there
are opportunities to turn it around – someone will buy up enough shares to
gain control of the board.
• Then the new owner either fires the incompetent managers and turns the
firm around or he sells everything in sight for the break-up value.
• Either way, the old managers are out of a job.
• The threat of this unemployment may keep them in line.
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Corporate governance and legislation
• In the wake of major corporate and accounting scandals (Enron,
Worldcom), there have been a number of major reforms in terms of
corporate governance globally
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The Cadbury Code of Best Practice
• UK – Financial Aspects of Corporate Governance (Cadbury report, 1993)
• Requires the board of directors of firms to:
• Meet regularly.
• Retain full and effective control over the company.
• Monitor executive management.
• The code says that there should be a clearly accepted division of responsibilities at
the head of a company, such that no one person has unfettered power.
• The board should include non-executive directors in sufficient number for their
views to carry weight.
• An ethical standard, without the force of law.
• However, the London Stock Exchange requires listed firms to either comply or
explain why they cannot.
• About 90 percent of LSE-listed firms comply with the code.
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Sarbanes Oxley Act
• USA legislation – enacted in 2002
• Major components of the Sarbanes-Oxley Act include:
• Accounting regulation.
• Audit committee.
• Internal control assessment.
• Executive responsibility.
• Many companies find compliance burdensome, costing millions of dollars.
• Some foreign firms have chosen to list their shares on the London Stock
Exchange instead of U.S. exchanges to avoid costly compliance.
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Australian Corporate Governance Principles & Recommendations
Lay solid foundations for management and oversight: A listed entity should clearly delineate the respective roles and
responsibilities of its board and management and regularly review their performance.
Structure the board to be effective and add value: The board of a listed entity should be of an appropriate size and
collectively have the skills, commitment and knowledge of the entity and the industry in which it operates, to enable it to
discharge its duties effectively and to add value.
Instil a culture of acting lawfully, ethically and responsibly: A listed entity should instil and continually reinforce a
culture across the organisation of acting lawfully, ethically and responsibly.
Safeguard the integrity of corporate reports: A listed entity should have appropriate processes to verify the integrity of
its corporate reports.
Make timely and balanced disclosure: A listed entity should make timely and balanced disclosure of all matters
concerning it that a reasonable person would expect to have a material effect on the price or value of its securities.
Respect the rights of security holders: A listed entity should provide its security holders with appropriate information
and facilities to allow them to exercise their rights as security holders effectively.
Recognise and manage risk: A listed entity should establish a sound risk management framework and periodically
review the effectiveness of that framework.
Remunerate fairly and responsibly: A listed entity should pay director remuneration sufficient to attract and retain high
quality directors and design its executive remuneration to attract, retain and motivate high quality senior executives and
to align their interests with the creation of value for security holders and with the entity’s values and risk appetite.
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Governance issues
• What are some governance issues that corporations may face in the
international context?
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Why should we care about ESG issues?
• Institutional shareholder demand – many large institutional investors’
mandates now require that they must consider ESG issues.
• Examples:
• Largest pension plan in the US, the California Public Employees’ Retirement System (CalPERS),
has committed to integrating ESG factors into all of its investments.
• Most the world’s institutional investors have signed the United Nations-supported Principles for
Responsible Investment where signatories commit to including ESG factors into decision-making
• This means that companies are likely to face pressure from influential
shareholders to consider more than just financial returns
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Why should we care?
• Legislation and listing rules
• The ASX now requires companies to disclose what they are doing across a number of
ESG issues
• Many other stock exchanges have introduced similar requirements
• Risk minimisation
• The primary reason practitioners give for ESG
• Argument is ESG can reduce unsystematic risk e.g. prevents employee strikes; consumer
boycotts; environmental disasters
• Company reputation
• Remaining competitive
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