Environmental, Social, Governance or ‘ESG’ is a set of criteria or standards in a business’ operations. Interestingly, investors are using this criterion to help evaluate the merit of potential investments. The three pillars of ESG cover different company values:
Environmental: How businesses accommodate the planet throughout their activities.
Social: How businesses manage their relationships with their employees and the wider community.
Governance: This addresses a business’ leadership reputation, executive pay, audits, internal controls and share holder’s rights.
In essence, ESG helps investors evaluate the morals of a company, that has a demonstrated history in aiding the safeguarding of risk in a business.
“ESG is a collection of a very diverse array of environmental, social, and governance factors, concerns, and disciplines that companies are exposed to or have challenges around.
These factors have historically been internalised by business in terms or risk management and reporting.
Understanding these factors is now being viewed as essential to assist in business decisions and valuations. As such these factors are now becoming core to the business strategies of companies, and key factors external investors and lenders want to understand.
ESG is becoming a financial and credit risk which in turn could lead to a significant financial impact on their business.”
- Simon White
When did ESG begin?
Responsible investing began in the 1960s as an alternative view to investing in companies that had a greater focus on social and environmental responsibility. Investors subscribed to the ideal exclude stocks or entire industries from their investment portfolios to better support what they believe is progressive for the planet.
Momentum grew steadily over the next decades, and it wasn’t until 2006 that ESG was mentioned for the first time in the United Nation’s Principles for Responsible Investment (PRI). This was the first time that ESG became established as a framework to assist in the financial evaluations of companies. A huge win for champions of sustainable investments.
When did ESG become relevant for investing?
ESG issues were first mentioned in the 2006 United Nations Principles for Responsible Investment (PRI) report consisting of the Freshfield Report and “Who Cares Wins”. The ESG criteria was, for the first time, required to be included in the financial evaluations of companies. This effort was focused on further developing sustainable investments.
At the time, 63 investment companies composed of asset owners, asset managers, and service providers signed with $6.5 trillion in Assets Under Management (AUM) incorporating ESG assessments into their investment decisions. As of June 2019, there are 2450 signatories representing over $80 trillion in AUM.
Fast-forward to today; corresponding values between company and investor continue to be common motivations of many investors. The area, however, has expanded to consider financial materiality, with investors looking to include ESG factors into their investment process just as much as they utilise financial analysis. Today, many asset managers, investors, and lenders see ESG as a key part of the overall decision-making process.
In part this is due to growing evidence that companies which have a strong focus on ESG topics outperform companies which do not. According to research undertaken by McKinsey & Company, this focus allows better performance due to customer loyalty / reduced cost / reduced regulatory risk / attracting and retaining talent and investment optimization. This gives an estimated 10% advantage in the cost of capital against those companies which do not have a strong focus or strategy on ESG issues.
In 2021, investors concerned about climate change, sustainability and social justice invested a record $649 bn USD into ESG-focused funds, up from $285bn in 2019. These ESG focused investors are also having far more of a say in how companies’ operate. Support for social and environmental proposals at shareholder meetings in US companies hit 32%, up from only 21% in 2017.1
ESG Ratings
This has materialised further, with ‘ESG Ratings’ now being attributed to measure the long-term resilience of companies.
For example, the ‘MSCI ESG Ratings’ model is used to identify ESG risk and opportunity. Key issues will be measured against this model which is based on over 13 years of data. Throughout time, you would expect the model to become more accurate, with more data to draw upon. The framework is as follows:
Laggard
CCC / B
Describes a company that generally fails the manage significant ESG risks.
Average
BB / BBB / A
This rating is the broadest and depicts a company as improving their ESG commitments, with the mixed success of the management of these risks.
Leader
AA / AAA
A rating that describes a company with best practice standards for managing ESG risk and opportunities.
ESG Legislation
ESG is now moving beyond the voluntary frameworks set up by NGO’s and the financial community. In order to protect consumers and allow a much better understanding of the products they are investing in, regulators are introducing comprehensive legislative frameworks.
This is now turning ESG reporting into a mandatory and legal requirement. One of the best examples of this is the EU Green Deal which is implementing a multifaceted approach to setting standards and reporting obligations.
At its core is legislation such as the Sustainable Finance Disclosure Regulation and the Non-Financial Reporting Directive, which work alongside the Taxonomy. The Taxonomy being a classification system identifying activities and objectives for what should fall within an ESG product.
[1] Source: https://www.reuters.com/markets/us/how-2021-became-year-esg-investing-2021-12-23/
