Will ESG prevent the next Enron? Will ESG prevent the next Enron? http://www.federatedinvestors.com/static/images/fhi/fed-hermes-logo-amp.png http://www.federatedinvestors.com/daf\images\insights\article\volcano-eruption-night-small.jpg September 13 2021 September 14 2021

Will ESG prevent the next Enron?

Non-financial evaluation can play a pivotal role in averting business disasters.

Published September 14 2021
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This year marks the twentieth anniversary of the demise of Enron. Once valued as America’s seventh-largest corporation, Enron completed a spectacular fall from being atop the energy industry to a bankruptcy that sent many executives to prison, put Arthur Andersen out of business and wiped out billions of enterprise value. The collateral damage was immense. Employees lost their jobs, health care and much of their retirement savings, which were largely invested in the company.

Enron had plenty of abhorrent practices, including playing with people’s well-being when it capitalized on the massive California energy crisis of 2000-01, driving prices sky high and fabricating brownouts. But the scheme that enabled it all was much subtler: accounting fraud.

At the center was the deliberate manipulation of mark-to-market valuation and the accrual method at the heart of the Generally Accepted Accounting Principles (GAAP). This is considered more accurate than the cash method as it books expenses when they happen, not when payments are made. Enron accountants turned the method on its head. They would recognize revenue from the energy contracts they expected to receive rather than reporting what they actually got. Clearly, this shows the importance of assessing governance—one of the three legs of Environmental, Social and Governance (ESG) investing. Had more investors and stakeholders demanded transparency in financial reporting, the crimes might have been caught earlier and limited the damage.

As the push for assessing companies’ sustainability and contribution to the greater good continues to accelerate across sectors and countries, managers should consider modeling their approach to ESG on their accounting practices. Call it “ESG accruals.” A business must weigh strategic actions that can help it grow and strengthen its position for the future versus short-lived and transitory benefits. Leaders can take the same approach to extra-financial concerns. If they don’t acknowledge their industry is structurally changing and don’t invest in new practices, products and training, they face falling behind peers. A company that begins setting a long-term strategy to move to greener pastures might experience uneven profitability in the short term, but investors may reward it with a premium valuation. 

Social issues are no less important, and thinking myopically about profits at the expense of people’s welfare can come back to hurt you. Take the pharmaceutical industry. Quadrupling the price of a drug will boost today's revenue, but it not only will reduce access for people in need, it likely will lead to a customer revolt that plays out in the press and social media. Another case of flirting with disaster comes with our new virtual reality. For instance, failing to invest in strong cybersecurity is an obvious mistake these days. Weak data governance can damage reputations and lead to customer exodus if personal information is compromised.

The emergence of ESG evaluations, lessons from Enron and other poorly governed entities are clearer than ever. Transparency, prudence and the vision to navigate structural risk can accrue positives and avoid devastating problems down the line.

 

Tags Responsible Investing . Markets/Economy .
DISCLOSURES

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Terminology such as “ESG integrated,” “sustainable” or “impact,” among other terms, is not uniformly defined across the industry. Investment managers may understand and apply ESG factors in different ways, and that the role those factors play in investment decisions also varies. Therefore, we recommend investors understand the role of ESG factors in a strategy to ensure that approach is consistent with their investment objectives. Like any aspect of investment analysis, there is no guarantee that an investment strategy that considers ESG factors will result in performance better than or equal to products that do not consider such factors. Investing and making buy-and-sell decisions that emphasize ESG factors carries the risk that, under certain market conditions, the fund or strategy may underperform those that do not incorporate such factors explicitly into the decision-making process. The application of ESG criteria may affect exposure to certain sectors or securities and may impact relative investment performance depending on whether such sectors or securities are generally in or out of favor in the market.

 

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