As the likes of J Sainsbury PLC (LON:SBRY) make their environmental pledges, small caps need to act too if they do not want miss out on backing from the investment community, experts say.

The market is waking up to the issues of ethical investing and, most importantly, environmental, social and governance issues (ESG), with regulations tightening as early as this year.

READ: BlackRock announces full ESG compliance, FTSE 100 constituents still have work to do

Companies such as BlackRock Inc (NYSE:BLK), the world’s largest asset manager, and Wall Street giant Goldman Sachs are adopting ESG benchmarks to provide investors with a framework for risk analysis, so that they can determine the long-term financial performance of a firm.

“The evidence on climate risk is compelling investors to reassess core assumptions about modern finance,” Larry Fink, chairman and chief executive of BlackRock, said earlier this month.

“Our investment conviction is that sustainability- and climate-integrated portfolios can provide better risk-adjusted returns to investors,” he added.

In a letter to clients illustrating the new strategy, Fink said companies need to embrace sustainability principles to fuel long-term profitability, or else they will meet scepticism in the market.

For example, pharmaceutical companies hiking prices ruthlessly and miners coming short on safety will eventually be challenged by stakeholders.

“We believe ESG is truly financially material,” Abby Glennie, investment director and fund manager at Aberdeen Standard Investments, part of Standard Life Aberdeen PLC (LON:SLA), told Proactive.

However, the one problem with ESG is the quality of data, “particularly among smaller cap companies”, she added.

Cost and time pressure may be an issue for the thousands of growth businesses that either cannot, or just will not disclose ESG information.

“Smaller companies often lack internal resource, and there can be a lack of understanding… of what they should be doing and what is important for shareholders to know,” Glennie said.

The greenwashing risk

Another challenge is posed by companies that subvert the ESG rules in a process called ‘greenwashing’.

“Greenwashing is a deliberate intention to mislead,” Julia Dreblow, founder at SRI Services & Fund EcoMarket, told Proactive.

However, she added it can also happen accidentally, if driven by ignorance or lack of tools.

It does not concern only big companies, Dreblow said, although it is what we usually hear in the news.

Only last month, non-profit legal group ClientEarth submitted an official complaint against BP PLC (LON:BP), claiming its advertisements focused on renewables distract consumers from its hydrocarbon activities.

But other multinationals are making strides to comply with ESG requirements.

Unilever PLC’s (LON:ULVR) efforts in terms of gender balance, recycling and energy consumption made it the ‘most sustainable’ FTSE 100 constituent according to a ranking published by Tortoise Media earlier this month.

The British-Dutch company owns global brands such as Knorr, Magnum and Dove and distributes in 190 countries. 

All need to act

A fallacy around the issue of ESG is believing that ‘green’ investing only relates to activities within the sustainability space, such as renewables.

All companies need to integrate sustainability practices to their core offering and increase their transparency to stakeholders, experts say.

“You do not need to only invest in green funds to avoid greenwashing: what we have got to do is to build a greener structure, address all companies in the supply chain,” Dreblow added.

Sainsbury’s seems on board with this, as it vowed to ask suppliers for their own carbon reduction commitments.

“There is no doubt that ‘going green’ is becoming an increasingly powerful investment theme as the climate emergency intensifies,” Moira O’Neill, head of personal finance at interactive investor.

“The big issue is transparency and making sure that firms that ‘talk the talk’ on the environment can also ‘walk the walk’,” she concluded.