Diversity and tax become key components of ESG

The diversity business case     |     Paying a ‘fair share’ of tax     |     Tax incentives

ESG agendas have shot to the fore in the last couple of years, with investors across the institutional base increasingly using them to drive positive change. This extends far beyond ensuring their own internal compliance, becoming an active mechanism to influence the governance and choices of their investees too. As discussed at KPMG’s 8^th annual Global Sovereign Wealth and Pension Funds Tax conference in September 2019, institutional investors are now driving positive ESG practices in their business decisions.

Why this is happening now is a complex question, a discussion of which could probably fill a whole publication in itself. There is growing conviction in boardrooms that these issues have become core to brand integrity and investability, at the same time as political and regulatory impetus for change has been strengthened. Simultaneously, there has been a shift in the attitudes of many consumers who are putting ever greater emphasis on issues of sustainability and ethical integrity. Meanwhile, a new young generation — spearheaded by figures such as Greta Thunberg — is becoming increasingly vocal over concerns about the climate change risks facing our planet.

Now, more urgent than ever, as the world comes to terms with COVID-19, corporate values and attributes that provide support to societies and communities will be of the utmost importance. COVID-19 could cast a new perspective on the fundamental significance of ESG activities.

Prior to COVID-19, it was the ‘E’ of ESG that has been on everybody’s lips. It was a dominant theme at this year’s World Economic Forum in Davos. While COVID-19 may currently be overshadowing the climate risk agenda, there is no doubt that it will come back, particularly as many countries have experienced the unintended climate benefits of cleaner air and water during the COVID-19 shutdowns. 

Many policymakers know they need to act. And there is growing momentum amongst investors, asset managers and insurers to encourage a shift to sustainable investment assets. So institutional investors and asset managers such as BlackRock are making sustainability their “new standard for investing”, some global banks have said they won’t lend to new assets in certain fossil fuel classes, and a growing number of insurers are moving away from underwriting new assets that are not ‘clean’.

Crucial as it is, ESG is about more than the ‘E’ element. Indeed, we have begun to see a broadening of the constituent issues that comprise ESG agendas — such that factors including tax transparency and diversity have become ever more embedded.

Taking diversity first, the debate has moved beyond whether it is the ‘right’ thing to do to foster diverse boards and workforces — to an acknowledgement that there is a direct commercial case for doing so. The body of empirical evidence that more diverse organizations perform better is considerable.

Investors are now upping the agenda by expecting the entities they invest in to embrace this too. In fact, some fund managers were unequivocal, stating that their research shows that companies with diverse boards “are more likely to achieve superior financial performance.” As a result, they are prepared to use their shareholder voting powers to encourage it.

The benefits of diversity can reach further than top-line performance — affecting issues such as health and safety, which is a key facet of the social pillar. A global mining giant, for example, discovered that the more diverse its workforces were in its sites across the Australia, the better the health and safety results. Those sites with a higher proportion of women tended to have fewer incidents and accidents, as well as better employee engagement generally. 

The Organization for Economic Co-operation and Development (OECD) drive to create greater tax transparency, with country-by-country reporting rules and a much tighter anti-avoidance agenda, along with local measures from national tax authorities, have put the spotlight on tax as one of the moral issues of our time. After all, revenue authorities collect taxes for governments to invest in hospitals, schools and roads, creating the social infrastructure that improves the lives of communities and nations. The effect of COVID-19 on economies around the world greatly heightens this issue: as economies rebuild, tax contributions from corporates are critically important. We can expect there to be zero tolerance of businesses seen to be avoiding paying their 'fair share'.

Tax has become a key component in the ‘S’ of ESG and it also plays a significant part in the ‘G’. For example, tax paying entities are becomingly increasingly focused on having the appropriate tax risk management and governance framework to ensure material tax risks are elevated to the board for consideration.

There is a careful balance to be struck, of course. Tax is one of many factors which an investment committee must consider when assessing the return on investment. In a competitive bid context, taking too conservative a tax position may lose you the bid, take too aggressive a tax position and you may end up in dispute with the tax revenues.

Institutional investors are also increasingly asserting their influence in portfolio companies to adopt tax risk management and governance frameworks similar to their own. It will be fascinating to see whether this spreads into the public company domain, where it is much harder to do given the challenges of obtaining sufficient shareholder backing.

Tax is certainly not confined to social and governance aspects, however: it is becoming steadily more embedded in environmental questions too. Discussion around carbon taxes as a way of driving decarbonization has been growing in recent times.

Clearly, tax concessions for green initiatives are a highly effective lever. In the US, one can virtually draw a straight line between tax credits for renewable energy projects and investor interest in them — often leading to partnerships between developers and non-energy investors who had sufficiently big tax bases to consume the credits.

We have also seen tax concessions in jurisdictions such as Australia for investments in 'clean building', while in Canada there are strong enticements to invest in solar power. Most developed economies have a growing array of sustainability incentives.

But the question arises, with the climate debate gathering urgency, whether the time will come to flip the equation — and mete out tax ‘punishments’ for those businesses who do not pursue or invest in more sustainable modes of business? Will we see stiffer carbon pricing, and a form of carbon tax? According to a recent report from the UN Principles of Responsible Investment this is one element of “the inevitable policy response”.

From that, we can surely expect to see investment institutions increasing the pressure through their ESG policies on portfolio assets to adopt lower carbon, more sustainable business models. This is at the early stages, however. It remains challenging at present for investors to understand where the chief climate risks in a portfolio lie and to evaluate those risks consistently and objectively across different investments. Today’s tools are relatively blunt. Carbon intensity is the most frequent yardstick, but it is only one measure. With so much value at risk, an acceleration in the development of investment ready tools which reflect climate risk and can be applied consistently is needed.

All of these factors point to one conclusion — tax and diversity have become integral part of any ESG approach. Just like their backing of diversity at the board level, including with respect to gender and the requirement for more transparency around key statistics and diversity metrics, investors are putting tax at the heart of their ESG approach.

As institutional investors and corporates are becoming increasingly transparent about their tax policies, making more information available in the public domain, investors need to ensure that tax governance is up to scratch in the companies they are invested in. Does a tax governance policy exist? Are the necessary controls in place to ensure it is set up correctly and functioning as intended? How are tax issues escalated to the board? Fundamentally, is the business paying the appropriate levels of tax and contributing to the public purse in the highly challenged post-COVID-19 environment?

Some may fear this could lead to an increase in ‘green washing’ — presenting investments and assets as greener than they are so as to be seen to be ticking the ethical box. But the likelihood is that discerning analysts and stakeholders will be able to see the difference.

Meanwhile, the focus of progressive institutional investors is on supporting fairer, more sustainable and more ethical businesses which, they believe, intrinsically offer the prospect of stronger long-term returns.

Given the economic challenges presented by COVID-19, this sustainable value creation will be needed more than ever before.