The term ESG refers to the integration of environmental, social and governance criteria in investment analysis and in the evaluation of future company performance. Material ESG factors are those which could have a significant impact on company performance. A company’s success in this regard is determined by its ability to address risk and opportunities in these areas.
ESG has also become somewhat of a buzzword, used indiscriminately at times. A company reducing energy or paper use is not necessarily addressing ESG issues appropriately. Both measures will clearly reduce operational costs, but costs alone do not determine ESG materiality. A growing body of evidence has found that when ESG matters are recognised as material to a business, and incorporated into a company’s strategic direction, they have a positive impact on corporate financial performance.
The risks that are material to a company vary and need to be identified on a case by case basis. Take a consumer staples company like PepsiCo and a bank such as HSBC as examples. What seems obviously relevant to the snacks company in terms of environmental issues (e.g. agricultural practices, water use, etc.) may not be so obvious for a bank. HSBC may have recycling and water use policies as well as energy reduction targets (all of which reduce operational costs). However, the possibility that its lending practices lead to environmental damage could have a much more devastating effect on the planet than the bank’s ability to recycle. Reputational risk therefore comes into play as the bank’s involvement in such projects can lead to a loss in confidence in the bank and subsequent loss in market share and shareholder’s value.
Current practice is for a company to identify its own ESG materiality and decide how to disclose it, which can become a very subjective exercise. In consequence, ESG rating agencies and data providers have set out to achieve a very specific goal: to assess ESG materiality in all sectors and determine how well or otherwise companies are doing in this regard. The criteria used to assess ESG performance is part of the intellectual property of each rating agency, and is based on their own scoring systems for how companies are addressing ESG risks and opportunities. Companies are therefor likely to receive different ESG scores in different ESG methodologies. This lack of standardisation in ESG data can create ambiguity, particularly when comparing companies against their peers. Managers of ESG funds have been left with no other option than to increase their in-house ESG capacity in order to dissect ESG data from companies and avoid relying on a single ESG rating agency.
Along with a thorough understanding of materiality comes a system-thinking approach that allows an ESG analyst to see cascading effects, feedback loops and impacts that can emerge when addressing issues of sustainability. This is the essence of ESG: an approach to address social and environmental sustainability challenges through good corporate governance. It allows for the correct formulation, implementation and oversight of the company’s strategic direction, including the sustainability strategy, which can ultimately improve the bottom line.
The Road to Standardisation
In June of this year the European Commission Technical Expert Group (TEG) on Sustainable Finance published a number of important reports to help increase standardisation of sustainability data. Most significant were its final recommendations for the EU taxonomy (classification) of environmentally sustainable activities. On the same day, the European Commission also released guidelines that promote best practice for companies on how to report on ESG information.
The EU Taxonomy is a more detailed set of criteria which has identified 67 economic activities that are split into low carbon activities (e.g. zero-emissions transport), transition activities (e.g. electricity generation) and those that enable these two subsets of activity (e.g. manufacturing of wind turbines).
It also introduces minimum social standards such as labour rights, for all eligible activities. The taxonomy has not yet been officially adopted, as it will be refined over the next six months.
Apart from the obvious benefit of increasing standardisation of sustainability data, the taxonomy will allow for the better identification of sustainable assets and consequently the integration of sustainability factors in investment decisions. It will increase transparency and reduce the risk of “greenwashing” (a company’s unsubstantiated claims about its environmental performance), a practice that has unfortunately become common as companies try to appeal to the growing number of socially responsible investors.
In 2018, sustainable investment assets reached $31tn with almost half of this in Europe ($14tn) alone. These assets all include strategies such as impact investing, ESG integration, negative screening and norms-based screening.
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