An ESG Investing Primer (Environment, Social, and Governance)
One of the things I enjoy doing most with my children is going to new beaches and snorkeling and enjoying clean waters and the marine and wild-life. With worries about global warming and environmental pollution escalating almost daily, many of us want to make sure that we are part of the solution, not the problem.
An increasingly popular path to being part of the solution is to make sure that you support companies whose values align with your own environmental concerns. Environmental, social, and governance (ESG) allows consumers, investors, and other constituents to have increased transparency in evaluating companies. This can involve which consumer products and services you buy or which companies you invest your money in as a shareholder, through the purchase of stocks and bonds for your personal investments. Consumers are able to evaluate the sustainability of their purchases and how much good or damage they are doing to society and the environment, and investors are able to see the long-term value of their investments.
ESG, or environmental, social, and governance scoring relies on independent ratings that help you assess a company’s behavior and policies when it comes to environmental performance, social impact and governance issues.
The “E” or environmental portion of ESG, which is the area this article will focus on, considers how a company performs as a steward of the physical environment. The “E” takes into account a company’s utilization of natural resources and the effect of their operations on the environment, both in their direct operations and across their supply chains. The environmental factor might focus on a company’s impact on the environment or the risks and opportunities associated with the impacts of climate change on the company, its business and its industry. ESG reports serve to outline how a firm deals with: climate change and carbon emissions; air and water pollution; biodiversity; deforestation; product innovation; green research and development; and related issues.
The “S” or social factor might focus on customer satisfaction; data protection and privacy; gender and diversity; human rights; and health and safety.
The “G” or governance factor includes everything from issues surrounding executive pay to diversity in leadership as well as how well that leadership responds to and interacts with shareholders. This component may reflect a rating of how well executive compensation is tied to performance in meeting the goals it sets forth, including environmental ones.
ESG reporting encompasses both qualitative disclosures of topics as well as quantitative metrics used to measure a company’s performance against ESG risks, opportunities, and related strategies. ESG reports are communication tools that play an important role in convincing observers that the company’s actions are sincere.
The majority of companies that are listed on major stock exchanges publish annual ESG reports. The reports are released to show their current levels of corporate sustainability. The information is provided voluntarily, but it’s recommended to reveal the company’s commitment to meeting ESG criteria. In addition, there are growing considerations to include mandatory ESG data reporting in corporate laws.
Independent third party rating agencies use ESG factors to assess companies on their environmental footprints by assessing factors including: greenhouse gas emissions, water use, waste and pollution, land use and biodiversity. Richard Mattison, CEO of Trucost, part of S&P Global Market Intelligence, suggests “Companies’ awareness and engagement with climate and environmental issues seems to be increasing rapidly”. It is estimated over eighty percent of the world’s largest companies are reporting exposure to physical or market transition risks associated with climate change and a similar share are engaging in reducing corporate emissions.
In April 2020, with the pandemic raging, a Deloitte and Touche study of citizens across 14 countries revealed that more than 70 percent of respondents agreed that in the long term, climate change is as serious a crisis as COVID-19.
The speed and scale of climate change over the next two decades are projected to go beyond anything that has been witnessed to date. The climate transformation that is already being seen around the world is taking place in the context of a 0.7 degrees Celsius increase in global warming relative to the pre-industrial age. According to the Intergovernmental Panel on Climate Change, the global economy must reduce its greenhouse gas emissions to net-zero by 2050 to keep the planet from warming more than 1.5 degrees Celsius and to avoid the most catastrophic impacts of global warming.
Environmental considerations were once seen as tangential pieces of the economy, but issues such as climate risk, water scarcity, extreme temperatures and carbon emissions are now threatening to dampen economic growth. Current financial disclosures no longer present a comprehensive picture of a company’s situation. Traditionally used audited financial statements can only provide assurance over a shrinking share of a company’s total value as intangibles, including environmental image and liabilities, account for a growing proportion of modern corporate balance sheets.
There are a number of faults in ESG reporting because every industry has different methods of reporting information. The lack of global consensus has been a barrier to creating a common framework to communicate the standards and practices of environmental stewardship. Sustainability, however, remains a strategic imperative for forward-looking firms. The assessment of corporations’ environmental footprints has moved from a simple measure of corporate responsibility to a high-level proposition.
The majority of ESG standards and disclosure frameworks currently focus predominantly on climate issues. Climate change has also remained the core focus of most national legislation. Over the last few years, various guidelines for ESG reporting have emerged, including voluntary standards, reporting frameworks, and national legislation. But these have all introduced slightly different requirements for businesses, leading to calls for a global ESG reporting standard. Such a standard could aid consistency and comparability of information, as well as increase the quality of disclosure.
According to Ernst & Young, a survey of global investors indicates that they are growing increasingly impatient with the quality of the nonfinancial disclosures that companies are providing. The proportion that are dissatisfied with environmental risk disclosures has increased by 14 percentage points since 2018. This does not, however, signify that corporate disclosures on environmental risks are getting worse, but simply that investors regard these risks as increasingly important and feel the quality of corporate reporting in this area is not improving quickly enough. In the same survey, three-quarters of investors said they value independent assurance on the rigor of an organization’s planning for climate risks.
While important progress has already been made, improving the quality and usefulness of nonfinancial disclosures related to environmental issues is an urgent challenge. There is much further to go to create a robust system for nonfinancial disclosures for ESG scoring and evaluation to help better address and solve more of the environmental problems we face today.
David Rosenstrock is the Director and Founder of Wharton Wealth Planning, LLC. He earned his MBA from the Wharton Business School and B.S. in economics from Cornell University. He is also a CERTIFIED FINANCIAL PLANNER™. David lives in New York with his wife and their two very active children.
For more information, contact David Rosenstrock, [email protected]
published by the North American Association for Environmental Education (NAAEE)