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Article 27.07.2022 15:53

Inflation, rising interest rates, recession, labor market uncertainty, energy crisis. The hottest buzzwords in financial media right now. What happened to last year's number one topic, ESG?

The German police raided the premises of Deutsche Bank's asset management company DWS in May. According to Bloomberg and WSJ, the reason was suspected greenwashing, which was allegedly practiced by DWS. It seemed that only a small part of DWS' ESG funds had actually been screened through the so-called ESG criteria. What´s more, DWS' former sustainability director had sued DWS earlier for wrongful employment termination, claiming the termination was because the director first brought up the issue of greenwashing internally. The charges of wrongful termination were dismissed, but the prosecutor said that the case led them to further evaluate DWS' ESG activities. Similar criticism against ESG has followed later globally for example in the USA and Canada.

The Wall Street Journal published a long article in which it stated that ESG has reached retirement age. ESG as a term was never properly standardized. Russia´s invasion of Ukraine and the subsequent discussion, e.g. about the responsibility of the arms industry, as well as the possible increase in the role of fossil energy sources, is muddling the ESG waters even further.

Faith in ESG is undeniably being tested, and the fact that the content of ESG reports in both the financial and business world quite often lack specifics does not diminish the distrust. In its current form, ESG, i.e. corporate responsibility, seems to stand at the edge of its credibility. So what next? Despite the accusations of greenwashing, I'm confident that the individual topics covered by the ESG term will increasingly impact the earnings potential of companies. Moreover, private investors need to comprehend a complex set of E, S and G topics to reduce volatility and avoid the effects of unexpected risks and previously unlikely development scenarios. Let's look at examples of E (environment) and S (social responsibility)

1) Emission reductions driven by the EU will affect the costs and growth opportunities of several industries. Energy production and prices are tightly linked to international politics, as we are currently witnessing, and a deeper understanding of this field is becoming more and more important for many industries. The expansion of the emissions trading system and carbon tariffs will develop over the next few years, and the effects on e.g. international supply chains need to be carefully assessed. In addition to this, in quite a few cases the voluntary climate goals set by the companies themselves cover both the reduction of emissions from supply chains and the reduction of emissions of products. Both often have a direct impact on costs, potentially on the structure of the supply chain, the availability of materials, and the need to renew the product portfolio.

2) At the end of last year, Joe Biden signed the so-called Uyghur forced labor act. Roughly summarized, the law that came into effect this year, would ban the import of all products to the US that can be connected in defined ways to, e.g. human rights issues in China's Xinjiang and the alleged use of forced labor. Although the law has only recently come into force and there is no visibility to the actual implementation level, this might bring a human rights related risk for companies if the supply chain is located in China and certain types of documented risk management and audit mechanisms have not been built in time.

Every year, the World Economic Forum publishes a global risk report about risks considered most significant in the coming years. The list has been compiled based on the views of business leaders, heads of state, social influencers, and researchers. At the top of the list are climate change and the failure to combat climate change. Biodiversity and social issues are also clearly at the top. From an economic and ethical point of view, it is clear that the importance of these topics is only increasing. Companies need to assess the related risks more carefully and investors need to understand when and how the risks or the measures to prevent them start to be reflected in the risks (i.e. return requirements) and/or earnings of the investment target.

So I'd say RIP ESG, and welcome the beginning of an era where new types of risks and opportunities are better recognized and (hopefully) communicated more clearly to investors as well. Hopefully, the new EU sustainability reporting directive, which will require companies to assess and report the financial and business effects of various ESG sub-areas in a couple of years, will help investors better grasp the issue. For private investors, the way to navigate through the transition period is to seek further information on key individual ESG topics. Inderes' mission is to democratize information and distribute it equally to all investors, so that investors can make investment decisions based on facts and their own investment plan. We continue to democratize information also for E, S and G.

The author of this article, Karoliina Loikkanen, is head of ESG solutions at Inderes. She has an extensive background on ESG issues and is passionated to develop the dialogue between investors and companies on ESG further.

Karoliina Loikkanen