All You Need To Know About ESG
Broadly speaking, ESG is an evaluation of an organisation’s sustainable operations as well as its social and environmental conscientiousness.
In recent years, environmental turmoil and a growing political will to take action has seen ESG evolve from a corporate buzzword and into a critical aspect of a company’s operations. As well as playing a role in decisions around mergers, acquisitions and divestures, research has found a positive link between ESG and financial performance or value creation. ESG has also become an increasingly popular path for investors and corporate social responsibility scores have helped them avoid organisations with a high level of financial risk or questionable business practices. This article delves into ESG, exploring both its rise and its ramifications for organisations today.
The meaning of ESG
The anacronym refers to three core areas – Environmental, Social and Governance. Each pillar refers to a specific set of criteria such as environmental record, a firm holding true to its values and whether a business is acting with accuracy and transparency or not. ESG typically takes the form of a kind of social credit score where all three categories are leveraged to illustrate the amount of risk on offer to socially conscious investors. The score is usually calculated based on data surrounding metrics related to an organisation’s intangible assets. As a result, the decision to invest is not purely based on monetary return but also on values such as a clean environmental record and effective governance.
Socially responsible investing is nothing new and the practice of investing along ESG lines began in the 1960s. The modern ESG story can be traced back to the beginning of 2004 when then UN Secretary General Kofi Annan called on more than 50 CEOs at major financial institutions to participate in a joint initiative aimed at integrating the framework’s values into capital markets. The anacronym itself was coined around one year later at the 2005 “Who Cares Wins” conference.
That event brought together institutional investors, asset managers, buy-side and sell-side research analysts, global consultants and government bodies who explored the role of environmental, social and governance value drivers in asset management and financial research. In the years since, ESG has experienced a remarkable rise in line with responsible investing.
While it covers a broad range of issues that have not traditionally been part of an organisation’s financial analysis, many of the elements covered by ESG do have considerable financial relevance. According to Bloomberg, global ESG assets are on track to exceed $53 trillion by 2025, representing more than a third of the $140.5 trillion in projected total assets under management.
The importance of ESG for investors
Traditionally for investors, it was a case of “put your money where your mouth is” when it came to an attractive opportunity. Today, however, it is increasingly “put your money where your morals are” for a new generation of socially conscious investors. Given that climate change and the plethora of other problems facing the planet are not going away any time soon, neither is that new breed of investor and ESG investing is certainly here to stay.
There were concerns that the trend would lose steam in recent years as companies struggled to cope with the economic pressure of Covid-19. An EY analysis found that the opposite occurred and that companies actually accelerated their transition to a more inclusive and purposeful capitalism despite the impact of the global pandemic. There are numerous reasons for the trend remaining robust.
Pressure to pursue more sustainable strategies is coming from the public and governments alike. In the case of the latter, stimulus packages have been tied to green outcomes. For example, the EU Commission’s €750 billion Covid-19 recovery fund came with a requirement that a quarter is allocated for climate change mitigation.
There is also increasing awareness among both investors and businesses that ESG may become mandatory, meaning it is prudent to adopt sustainable strategies in order to keep ahead of any future green legislation. A myriad of other factors also have an influence on ESG such as a positive score proving pivotal to a company’s ability to attract the best talent.
It is also important to mention that ESG is different to Socially Responsible Investing (SRI). Whereas SRI typically relies on value judgements and excludes companies based on certain criteria, ESG is more focused on the organisation’s environmental, social and governance values, along with their impact on performance. Sustainable investment is certainly a hot topic but just how relevant is it today? A 2020 CFA Institute analysis found that 85% of investment professionals took ESG factors into account when making their investment, up from 73% in 2017. The bright future for ESG investment and ESG stock is summed up by a PwC report which states that “a growing body of evidence shows that companies with strong ESG credentials outperform. In particular, studies show that companies focusing on the ESG indicators most financially relevant to their industry tend to perform well”.
The report goes on to add that “companies are getting better at disclosing the ESG indicators that are most material to their long-term profitability”. The combination of soaring demand and investment rationale will therefore drive the ESG asset pool’s rapid growth. ESG outcomes and ESG funds are likely to become an integral part of investment solutions while ESG analysis is on track to become an essential investment tool.
ESG and compliance – a match made in heaven?
Unsurprisingly, ESG activities are intrinsically connected to an organisation’s values, closely tying them to compliance as a result. Likewise, they also tend to contribute to both trust and reputation, allowing a business to remain strong in the face of future challenges.
While some would argue that ESG and compliance are a match made in heaven, others have voiced concern that the ESG spectrum adds an extra layer of responsibility for compliance teams that are already overburdened or understaffed due to Covid-19 cuts. In certain quarters, compliance professionals and experts have even warned that ESG represents a form of “mission creep” for teams that already have their hands full tackling pressing issues such as data privacy and cyber security.
Despite those concerns, it cannot be disputed that ESG compliance has emerged as a critical priority for organisations and that it is not going away. Most public companies are now evaluated and rated on their ESG performances in addition to being required to disclose their own datapoints. As a result, it is imperative that businesses integrate an ESG strategy into their decision-making process.
While the concerns about staffing levels and workload are legitimate, compliance teams are already equipped to deal with many facets of ESG, especially the governance pillar that entails elements such as internal audits, legal affairs and matters for human resources. A Reuters overview stated that governance has become the perfect starting point for introducing an ESG framework for those very reasons.
Beyond governance, it can be argued that the other elements of ESG are still evolving with the associated considerations and procedures remaining nebulous to a certain extent. While this can prove both a blessing and a curse for overstretched compliance teams, the impact of technology can also prove hugely beneficial in meeting the ESG challenge head on.
Even outside the ESG spectrum, compliance teams with limited manpower are now leveraging technologies such as digital compliance automation and machine-learning to keep budgets low and re-allocate resources where necessary. As the ESG trend continues to gain traction in the years ahead, technological solutions specifically catered to the challenges it represents are going to become far more widespread.
The reality of the situation is that the potential for wrongdoing across environmental, social and governance pillars is huge. Compliance teams will be expected to integrate ESG-based concerns into their regulatory frameworks and aside from hiring more staff, technology is going to prove key in doing so. It should not be forgotten that compliance officers also have a major ace up their sleeve given that they generally have contact and influence over the board, facilitating the shift to ESG.
What companies need to do to follow the law
As mentioned earlier, both investors and businesses are becoming increasingly aware that ESG may become mandatory in some parts of the world in the not-so-distant future. This is already becoming the case in the European Union where a new legal framework for a sustainable economy is being established with a view to combatting climate change and achieving climate neutrality by 2050.
Under EU law, certain large companies are already required to disclose non-financial and diversity information under the Non-Financial Reporting Directive (NFRD). On 21 April 2021, the EU Commission adopted a proposal for a Corporate Sustainability Reporting Directive (CSRD), which would amend the NFRD’s existing reporting requirements. It would:
- Be extended to all large companies and firms listed on regulated markets (excluding micro-enterprises)
- Require the audit of reported information
- Introduce more detailed reporting requirements and EU sustainability reporting standards
- Require companies to digitally “tag” the reported information to make it machine readable and establish a single access point
The European Financial Reporting Advisory Group are developing a set of draft standards tailored to EU policies and the CSRD is slated to apply as early as January 2024 for the 2023 financial year. Around 50,000 companies with at least 250 employees are expected to be affected by the new legislation.
What will that mean in practice? Under the new reporting obligation, companies will be engaged in collecting and reporting data for the very first time on areas such as their carbon footprint, sustainable business practices and levels of diversity. The report would then be disclosed in a standardized format to a national business register which enables the key figures to be automatically accessed.
While the European Union is ploughing ahead with the CSRD, laws are not as stringent on the other side of the Atlantic. Despite the growing relevance of ESG in the United States, responses have been voluntary and market-led rather than taking the form of new regulations. That is very likely to change, however, as efforts to tackle climate change and environmental pollution continue to gather pace.
For example, the Biden administration issued an executive order in February 2021 requiring the federal government to “drive assessment, disclosure, and mitigation of climate pollution and climate-related risks in every sector of our economy, marshaling the creativity, courage, and capital necessary”. The US Securities and Exchange Committee (SEC) also announced efforts to fight climate change through the creation of a Climate and ESG Task Force while the Financial Stability Oversight Council issued a report on climate-related financial risk that calls for new disclosures.
Currently, there are no ESG disclosures in the US at federal level but the SEC does have a requirement for public companies to disclose information that could be important to investors and this takes ESG risks into account (ESG bonds or green bonds are an increasingly relevant aspect of risk assessment)
At global level, ESG reporting is on the way towards embracing more harmonized disclosure standards. In June 2021, G7 finance ministers and central bank governors committed to addressing ESG challenges and enhancing cooperation before endorsing an effort to adopt global standards for sustainability information. This is expected to make corporate ESG disclosures more uniform in the years ahead.
Why companies should go the extra mile
From reinforcing corporate values to enhancing reputations and attracting responsible investment, the list of reasons for companies to go the extra mile with ESG criteria is getting longer and longer. Undoubtedly, new rules and regulations are coming so businesses need to prepare now. In Europe at least, compulsory ESG company disclosures are on the horizon, audits of reported information will occur, and companies will have to take measures to adapt sooner rather than later.
Perhaps most importantly, the long-term gains of early, effective and far-reaching ESG implementation need to be emphasised. Alongside the nearly inevitable legal steps that have to be taken, an early move to integrate ESG into compliance and disclosures can enable an organisation to rethink its business model, take advantage of new opportunities and respond better to challenges.
Businesses opting for this route can also act as a role model for other companies seeking a more sustainable path, especially if those ESG values are loudly echoed by an enthusiastic tone from the top.
Another obvious reason to go beyond the minimum ESG standards is that new breed of investor. That could make all the difference to a socially-conscious investor who opts for the organisation which is making strides in reducing its carbon footprint and raising its levels of diversity as opposed to the other organisation that struggles with a poor pollution record.
Going the extra mile will make that ESG rating even higher while companies failing to adopt the appropriate measures will be seen as a riskier investment prospect while being exposed to risks. Some of the pitfalls of not taking action can include low employee morale, a bad reputation or even lawsuits, ultimately eroding trust with both customers and business partners. While the discussion about making ESG mandatory continues, companies ultimately have a responsibility to work towards climate neutrality regardless in order to make a positive contribution towards a more sustainable world.
Learn more about the Environmental aspect of ESG
Learn more about the Social aspect of ESG
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