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ESG Explained

ByMelany Cummings
[speaker]

As stakeholders increasingly expect companies to make their operations more sustainable, ESG is changing the business world.

There are compelling reasons to meet those expectations, but before you get started, it’s critical to understand what ESG is and what it means for your business.

ESG, in broad terms, refers to an examination of a company’s environmental, social, and governance practices, their impacts, and the company’s performance against benchmarks. ESG programs are a sort of risk management. Investors, lenders, and government agencies, as well as communities, customers, employees, and others, are all interested in corporate ESG performance. Investors and lenders, for example, may rely on ESG data, such as ESG scores or ratings, to assess a firm’s risk exposure as well as its potential future financial performance. Communities and customers may be interested in learning about a company’s environmental and social practices in order to make informed advocacy and purchasing decisions.

Environmental

Natural Resource Conservation

  • Climate Change
  • Greenhouse gas emissions
  • Air and water pollution
  • Deforestation
  • Biodiversity
  • Pollution
  • Water scarcity
  • Waste Management
  • Energy Efficiency

Social

People and relationships

  • Customer Relations
  • Employee Relations
  • Labour Relations
  • Human Rights, Occupational Health and Safety
  • Community Relations
  • Supply Chain

Governance

Standards for running a company

  • Board management practices
  • Succession planning
  • Executive Compensation
  • Diversity & Inclusion
  • Regulatory compliance
  • Bribery & Corruption
  • Fraud
  • Data Hygiene & Security

ESG’s rise as a Framework for Sustainable Business

Following the 2005 UN-sponsored report, Who Cares Wins: Connecting Financial Markets to a Changing World, ESG gained global attention. According to the report, incorporating ESG considerations into capital markets would result in better societal outcomes. Following that, the UN created the (PRI) as the standard for a sustainable global financial system. Since 2006, the number of PRI signatories has increased from 63 with US$6.5 trillion in assets under management (AUM) to over 3,800 with US$121 trillion in AUM.

Why is ESG growth picking up?

Global sustainability challenges such as flood risk and rising sea levels, privacy and data security, demographic shifts, and regulatory pressures are introducing novel risk factors for investors.

As companies face increasing global complexity, investors may reconsider traditional investment strategies.

The world is evolving.

Climate risk, increased regulatory pressures, social and demographic shifts, and privacy and data security concerns all pose new or increasing risks to investors. The economic stress caused by the COVID-19 pandemic has impacted companies’ exposure to ESG risks and their ability to manage them. Companies that do not adequately manage their ESG or climate risk face increasing complexities and scrutiny.

A new investor generation

Interest from millennial investors all over the world has already contributed to the rapid growth of ESG investment. Bank of America Merrill Lynch stated in a 2018 survey that they could “conservatively estimate” USD 20 trillion in asset growth in US-domiciled ESG funds alone over the next two decades.

Better data and technology for deeper insights

Artificial intelligence (AI) and alternative data extraction techniques, for example, help to reduce our reliance on voluntary disclosure from companies. Machine learning and natural language processing enable us to improve the accuracy and timeliness of data collection, analysis, and validation in order to deliver dynamic content and financially relevant ESG insights.

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CSR and ESG are compatible, but they are not the same.

Many businesses already have corporate social responsibility (CSR) programs, which are distinct from ESG programs in several ways. CSR initiatives are usually voluntary and aim to improve a company’s relationships with external stakeholders. CSR managers, for example, may be in charge of corporate philanthropy or partnerships with community organizations. ESG programs are typically implemented as part of a larger corporate strategy to respond to investor or regulatory demands. To understand the risks and impacts, ESG practice entails fairly rigorous measuring and reporting on environmental, social, and corporate governance activities.

ESG Scores – The Topic on Every CEO’s Mind

With the increased emphasis on ESG practice and reporting, decision-makers must analyze massive amounts of specialized data. To make matters worse, ESG reporting is not yet standardized. This is where ESG and risk ratings come in handy. An ESG rating and the data used to calculate it give investors and executives tools to assess a company’s ESG performance and risk management.

ESG rating providers generate a company’s ESG score or risk rating using publicly available data. Because each provider rates companies differently, what constitutes a good score varies. ESG Risk Rating aims to demonstrate how exposed a company is to a set of material ESG risks and how well those risks are managed. A low risk rating indicates that risk is effectively managed. A high risk rating indicates significant gaps in the management of ESG risks.

ESG Risk Management is the same as regular risk management.

Regardless of your company’s size, industry, or ESG score, incorporating ESG factors into corporate decision-making is good risk management. Every company faces a variety of ESG-related issues, some of which can be material and cause financial or reputational harm. Furthermore, any company that ignores environmental, social, and governance issues increases the likelihood of an ESG-related incident or controversy. In other words, ESG risk is a type of business risk, and managing it should be part of a company’s standard risk-reduction practices. Indeed, even in the absence of a formally defined ESG program, most companies manage some of these risks.

The Price of Inaction

Because negative ESG incidents are becoming more damaging and costly, it is critical to build on existing risk management practices. According to research, companies that experienced moderate to severe ESG incidents lost 6% of their market capitalization on average. Consumer staples and utilities are most vulnerable to ESG-related market value declines. This average conceals the potentially disastrous effects of ESG debates. For example, Valeant Pharmaceuticals, once the most valuable company on the Toronto Stock Exchange, lost 90% of its market value in 2015 due to accounting and pricing scandals. Companies that implement effective ESG practices, on the other hand, are less likely to face harmful controversies and are better able to respond when such incidents do occur. While smaller and medium-sized businesses may not face the same stakeholder scrutiny or regulatory requirements, the risk of ESG incidents applies to them as well — and can be far more damaging. Smaller businesses may not be able to recover from negative events without the support of major investors. In short, ESG risk is a material risk, and failing to address it promptly and appropriately can result in a variety of negative outcomes.

Managing ESG Risk Benefits Everyone

While environmental, social, and corporate governance (ESG) may appear to be a trendy new buzzword, your company has most likely been managing some environmental, social, and corporate governance risks for years. The difference today is the urgency with which these issues are being addressed — as well as the approach. Companies are under more pressure than ever to set clear goals for risk reduction, effectively measure progress, and report in a transparent manner.

The good news is that managing ESG risk does not have to be difficult, and there are numerous services available to assist. The benefits of action far outweigh the costs of inaction, especially for medium-sized businesses that cannot afford to be embroiled in a major ESG controversy. Many businesses have discovered that implementing an ESG program provides a unique opportunity to be good corporate citizens while also doing what is good for business. Companies can confidently begin addressing ESG risks with this knowledge.