What is ESG?
Environmental, social, and governance (ESG) criteria have become increasingly important to socially conscious investors in recent years. These potential stakeholders want to assess a company's ethics and the impact their operations have on the environment, their employees, and the societies where they operate and source their products or materials.
ESG provides insights for investors so that they can evaluate whether or not a company shares its values. These standards can also indirectly impact company decision-making. ESG performance may not make or break a company, but higher scores often correspond with lower share price volatility. Low ESG scores can harm a company's reputation among investors, especially when it comes to issues like consumer safety and privacy, pollution, and poor labor practices. Poor performance can also harm employee relations because workers won’t want to be associated with a company that doesn’t share their values.
Because of this interest, brokerage firms and financial advisors often include ESG data when offering clients research materials or summaries of the stocks and funds available for investment. Also, ESG can affect investments so it is essential to understand the broad set of metrics that make up the ratings and to include them in risk assessment and risk management strategies.
How Environmental, Social, and Governance (ESG) Works
ESG metrics involve measuring the ethical performance of a company and whether its operations have a positive or negative impact on the communities where it operates and the wider world. However, the overall scope of ESG is quite broad and not all criteria impact stock prices, reputation, and employee relations in the same way.
Here is a closer look at the three components of ESG.
Environmental Factors
The environmental factors that make up ESG calculations can vary. However, they commonly get categorized into four different areas:
- Climate change, which includes greenhouse gas (GHG) and carbon emissions and vulnerability to the effects of climate change;
- Natural resource stewardship and conservation, which includes water use, sustainable sources for raw materials, and avoiding damage to ecosystems and habitats;
- Pollution and waste management, which includes safe waste disposal, low emissions, and the adoption of biodegradable packaging and products;
- Environmental policies and use of technology, which includes the use of renewable energy and tech that increases efficiency and reduces pollution.
These categories measure a company’s policies, practices, and safeguards. While pollution, adoption of clean energy tech, and waste management are important, less-obvious factors, such as testing on animals or financing projects that have a positive environmental impact can also play a role in ESG performance.
Today’s companies are constantly assessing their environment-related activities. Aspects like energy use can affect the bottom line in terms of operations costs. While reduced energy consumption can increase ESG score and potentially lower expenses, investing in the necessary upgrades could be a waste if it does not produce the expected savings or does not perform up to expectations.
For reasons like this, environmental factors are often an important variable in risk mitigation strategies. In addition to cost-related factors, companies need to have strategies in place to deal with the reputational risk that could arise from negative environmental reports such as poor waste management, increasing GHG emissions, or environmental damage caused by a supplier.
Risk management software can be an integral part of this effort. These digital systems can collect information on potential risks and current issues and facilitate analysis that could lead to risk reduction plans or illustrate the need for additional insurance or policy changes.
Social Factors
The social factors in ESG can vary depending on the location, industry, and size of the enterprise. As with the environmental component of ESG, this one has a broad scope.
Social factors include in-house criteria, such as labor relations, workplace safety, policy on diversity, inclusiveness, office culture, and employee support and benefits.
This portion of ESG can also include external components. For example, the company’s activity in and relationship with the local community is a consideration. These efforts can include engagement and investment in the local community, employment or training programs for unprivileged or disenfranchised populations, and contributions to local development efforts.
Social factors can have a global reach. For example, companies may have exemplary labor policies themselves, but they may get materials or assemble products from suppliers that use forced or child labor or engage in corruption. Tech companies are often accused of relying on mining companies using child labor to source necessary materials, such as cobalt, for their devices. Such findings could have a negative impact on overall ESG ratings.
Governance Factors
Governance factors are somewhat misunderstood. To many people, it does not seem to have the same ethics-related focus as the other two ESG categories. However, the decision-making methods and power structure can significantly impact a company’s impact on environmental and social factors.
High-profile examples include Facebook’s decisions related to data use and privacy, which had a profound impact on national elections in multiple countries. Not only did these incidents do reputational damage, but they also resulted in fines that affected the company’s overall finances and lowered stock prices.
Governance factors also include the board structure, which defines who is making the decisions for the company and who is assessing the quality of those decisions.
In recent times, another governance factor has earned headlines: executive compensation. Recent controversies have highlighted the rising economic inequalities between executives and the workers who they employ. In addition to a general sense of unfairness, this factor could offer insights into the company’s overall performance. Many top executives’ earnings are not tied to company performance, meaning they have little personal stake in the outcome of their decisions. Investors can see such arrangements as significant risk factors.
The Impact of ESG on Investment Decisions
ESG can often serve as a reliable indicator of company performance. NYU’s Stern School of Business found a 58% positive correlation between ESG ratings and the financial performance of corporations.
Other research has found that many changes that positively affected the environment also provided long-term financial benefits. For example, companies sourcing materials closer to home limited carbon emissions from shipping and also reduced shipping costs. Likewise, efficiency improvements can lower operating costs while simultaneously reducing GHG emissions.
Finally, regulators are increasingly focused on environmental and social concerns. Companies actively seeking to improve ESG performance can avoid sanctions from regulatory agencies. Recent examples from Facebook and Volkswagen, whose diesel scandal led to record fines, show the risks associated with non-compliance to ESG-related rules.
Because of the increased impact of ESG factors on investment and financial performance, it is essential for companies to use risk management systems to find and define potential ESG-related risks so that they can act early to mitigate them and avoid damaging problems like Facebook and VW recently experienced.
For investors, companies with ESG issues like the above examples pose significant risks.
Risk Management Strategies for ESG Investing
The key to mitigating risks related to ESG factors is to collect information about how risk affects operations across the entire enterprise. Risk management information system software can provide insights into different ESG factors so that decision-makers can see how they could impact overall performance and the type of risks they pose to the company’s bottom line, reputation, and current operations.
Companies can use insurance to protect against risks they cannot mitigate. Other strategies could include outsourcing processes to transfer the risk to a third party or developing contingency plans to deal with ESG risks that are possible but not imminent.
Investors can lower ESG-related risks by diversifying their assets to include companies with high ESG scores and hedging by purchasing assets that could increase when certain events negatively impact their primary holdings.
