Sustainability as a concept is gaining currency in the corporate world rapidly. With national governments setting net-zero targets for the next couple of decades, companies are actively looking for avenues to make their business practices more environmentally and socially responsible. This line of thought has led to the birth of Environmental, Social, and Governance concerns, more popularly known as ESG.
Understanding ESG
ESG refers to a set of assessment criteria that gauge a company’s performance based on three criteria. First of these is the ability of its governance structure. The second and third are its mechanisms to manage environmental and social risks. ESG essentially provides a framework for companies to report on the steps they have been taking and will be taking to make their operations more sustainable.
The ‘environmental’ part relates to the efforts taken by a company to reduce its impacts on nature. These efforts include initiatives such as sourcing electricity from renewables. The ‘social’ part refers to a company’s relationship with its employees, investors, and customers. Disclosing the diversity of its workforce is an example of the social aspect of ESG. Finally, the ‘governance’ component of ESG focuses on the administrative structure of an organisation and how the upper management perceives risks. Together, these factors allow companies to disclose their sustainability measures, bringing greater transparency and accountability to the corporate world.
How deeply do investors consider ESG?
Investors are increasingly viewing climate risks as financial risks. To them, these risks are two-fold, known as physical and transition risks.
- Physical risks refer to the potential damage to a company’s physical assets due to climate-driven extreme weather events, such as floods. For example, suppose a company has a manufacturing plant in a flood-prone region. In that case, investors will need to know how it plans to secure the plant from swamping or water damage.
- Transition risks are the costs companies will incur in retrofitting existing equipment and infrastructure with climate-resilient systems. They would be continually replacing old assets with new ones as needed or retiring environmentally unfriendly ones.
Investors are pushing companies to disclose their strategies to counter these risks. That way, they can ensure the robustness of their operations in light of growing climate insecurity. Investments in ESG are, therefore, expected to gather more significant momentum in the coming years. In a recent report by the accounting firm PricewaterhouseCoopers (PwC), it came to light that investments in ESG will surge to $33.9 trillion by 2026, indicating a whopping 84% spike from current levels.
Managing investor concerns over ESG
As a concept, ESG originated in 2004 through a combined effort of the International Finance Corporation (IFC), the UN, and the Swiss government. The idea was to aid the financial sector’s efforts toward making environmental issues a central consideration in mainstream investment decisions.
Today, several reporting standards exist, which provide a framework for companies to disclose their sustainability measures in the form of Annual Sustainability Reports. Some of the most common ones used are
- Task Force on Climate-related Financial Disclosures (TCFD),
- Global Reporting Initiative (GRI),
- Sustainability Accounting and Standards Board (SASB).
Companies use these standards to manage investor expectations and demands related to the financial risks posed by climate change. For example, an automotive company will have to disclose how it intends to respond to the growing demand for electric vehicles (EVs) in the market if it wishes to satisfy its investors. Moreover, climate-conscious investors and customers increasingly demand companies reveal their emissions data, pushing them to adopt more sustainable practices. This kind of transparency could also wipe out the chances of corporate greenwashing.
Several companies are using the framework provided by the TCFD to meet the abovementioned expectations. This framework segregates emissions into three types:
- Scope 1 includes emissions an organisation is directly responsible for, such as carbon released from manufacturing processes.
- Scope 2 includes emissions released during heating and cooling purposes.
- Scope 3 relates to emissions that an organisation cannot control. For example, electronic waste generated by discarded smartphones will come under the phone company’s Scope 3 emissions.
Companies and regulators working in tandem to establish ESG
With investor interest in climate-related financial risks growing, several large corporations are making ambitious commitments to reduce their carbon footprint through ESG measures. Here are some examples:
- In December 2022, Credit Suisse unveiled its Climate Action Plan directed toward its investment businesses. The publication outlines what strategies Credit Suisse Asset Management and Credit Suisse Wealth Management intend to implement to achieve the target of net zero across their portfolios by 2050.
- In the same month, Deloitte acquired the Dutch infrastructure consultancy firm PACER intending to capture climate opportunities in the energy transitions currently underway in the Netherlands. Deloitte has promised to enable PACER to carry out eco-responsible projects for its clients from the public and private sectors.
Further, multinational corporations (MNCs) are also recognising the role they can play in achieving carbon neutrality. For instance, logistics leader DHL Group and the auto sector behemoth Ford Motors recently collaborated to deploy electric vans for last-mile delivery of goods worldwide.
Complementing these ventures are regulating authorities legalising sustainability reporting standards and providing support to the private sector.
In November 2022, for example, the European Union (EU) Council adopted legislation approving the Corporate Sustainability Reporting Directive (CSRD). This directive will upgrade previous reporting standards by including more detailed requirements. One of these requirements is that companies digitally tag the reports to be accessible to all European capital markets.
In the US, the Federal Reserve Board announced a list of principles for banks having over US$ 100 billion in assets to manage climate-related risks. The proposed regulations back banks’ efforts to integrate climate-related financial risks into their broader risk management strategies.
These developments in the ESG domain are essential. The tacit understanding on both sides about mutual roles in aiding the sustainability-oriented transitions will prove crucial for economic progress in the forthcoming years.
Do ESG investments pay off?
Investing in ESG boils down to a single question—whether pumping money today to build a sustainable future is worth the opportunity cost of forgoing growth and profit in the short term. The answer is yes. Unfortunately, most top management does not see ESG as an investment opportunity. Instead, they see it as a cost the company has to bear to look good in the eyes of the investors. On the contrary, ESG has good pay-offs for companies investing in these measures. In a 2020 study, Just Capital prepared a list of 100 companies called Just 100, reporting on ESG. The study found that this particular group of companies had outperformed the market. Thus, ESG reporting adds value to a company.
The ‘business-as-usual’ scenario is obsolete in a world where pollution leads to countless premature deaths, unchecked resource exploitation causes irreparable biodiversity losses, and extreme weather anomalies destroy livelihoods. Instead, what’s needed is a complete overhaul of the traditional investment approach, in which investors consider only tangible benefits and ignore the intangibles. ESG offers a pathway out of this mess. It is, by no means, a perfect solution. Still, it is one that investors can collectively embrace for a better future.
