Local environmentalist and International Trade and Industry Minister Datuk Seri Tengku Zafrul Abdul Aziz recently made an urgent call to action: “We can and must try to change potentially catastrophic climate-change effects on Malaysia. But the window for us to do so is getting smaller by the month.” His solution? ESG.

Promoting investment based on Environmental, Social and Governance (ESG) criteria is increasingly popular among policymakers who want to show that they are working on solving complex problems such as climate change and social inequality. It sounds fantastic! But what does it really mean?

Tengku Zafrul specifically promoted his not-yet-announced national industry ESG policy (“i-ESG”), which will assist Small- and Medium-sized Enterprises (SMEs) in four main ways: developing ESG standards, financial support and incentives, capacity building, and market mechanisms.

Research carried out at the Asia School of Business (ASB) on the adoption of ESG practices by SMEs shows that the last part, market mechanisms, are the most significant factor in driving ESG adoption.

Currently, there are very few commercial incentives to drive the adoption of ESG practices among SMEs, even if management is keen to develop them. While financing, standards, and firm capabilities matter, without a compelling business case, ESG practices will not be adopted.

Most SMEs have thin operating margins, and unless there is demand for a “green” product and customers are willing to pay a premium, there is no incentive to supply it. We spoke to several firms who had introduced a “sustainable” product at a premium price, but had not succeeded in the local market.

Interest rates for sustainable projects are also very similar to conventional or Islamic loans: there are no ESG discounts. Therefore, investing in “green” technologies like rooftop photovoltaics or low-energy lighting is popular mainly due to cost-effectiveness, not because of more affordable financing.

With regard to ESG standards, manufacturers already follow a range of standards, such as ISO (quality) or HACCP (food safety), which means that they do not view new ESG standards as a major barrier.

Some market mechanisms that can drive the adoption of ESG practices by Malaysian SMEs include:

ESG public procurement

The government can require its suppliers (including SMEs) to follow ESG standards. Federal government procurement alone accounts for around 12 per cent of GDP, — a substantial influence on the national economy. Extending the measures to state and local governments and government-linked companies will yield an even greater impact.

New ESG standards should accompany a vendor development programme to help SMEs build the necessary capacity. National petroleum company Petronas has 30 years of experience in this area, having operated a successful programme since 1993, which scholars see as a vital factor in developing the Malaysian oil & gas industry. Malaysia’s ESG sector should be developed in a similar way.

Energy pricing

Increasing energy prices may incentivise investments in renewable energy and energy conservation. Concurrently, SMEs should be offered attractive terms to finance these investments, thus ensuring a minimal net impact on their business cost.

As an upper-middle-income economy, Malaysia’s economic competitiveness should not depend on low energy prices, which are already among the lowest in the region. Raising energy and carbon prices to reflect the environmental cost of greenhouse gas emissions is critically important to making ESG practices commercially viable.

Social dialogue

Although not always seen as a market mechanism, the social (“S”) component of ESG also concerns the fair treatment of workers. For SMEs, offering certain benefits, such as maternity leave, can be difficult due to their small scale, and therefore more benefits should be borne by social insurance (Socso) and not just individual firms.

However, firms also have an obligation to ensure their workers receive fair compensation under ESG principles. In April the Malaysian Commercial Banks’ Association took responsibility in this regard and agreed to raise the salaries of the lowest-paid clerical employees by 18 per cent.

A push to raise workers’ income should also include incentives for training and investment, all of which align with broader ESG goals.

Understandably these policies not only cost money, but will also raise the cost of doing business for some SMEs, potentially leading to job losses and business closures. However, these losses can be offset by the creation of new ESG-focused businesses.

When it comes to the more complex issues involved in creating market mechanisms for ESG adoption, the optimistic ESG rhetoric faces a reality check.

When asked about carbon taxes, Tengku Zafrul noted that this requires “looking into” and that it “would need to be done in stages”, and then deflected to his colleague and former ministry: “I’m sure the Ministry of Finance will be ready to get into that.”

Being both politically complex and crucial for ESG adoption by SMEs, the government’s ability to implement new ESG market mechanisms will be the true test of its commitment to ESG.

Pieter E. Stek is a Postdoctoral Researcher at the Asia School of Business’ Asean Research Center and Center of Technology, Strategy & Sustainability. The opinions expressed in this piece are those of the author.