Environmental, Social and Governance or ESG, are a set of data and principles used to evaluate how an organization’s behavior is impacting society and the environment, and the standards to which it is governed. Unfortunately, the lack of alignment as to the specific data and principles causes confusion and less than 15% of global consumers know what ESG means. Let’s clear things up:
The Basics
- Environmental
Factors such as corporate climate policies, energy use, waste, pollution, contribution to greenhouse gasses and climate change, natural resource conservation and treatment of animals.
- Social
A company’s relationship with the people, institutions and communities in which it operates. Specifically tolerance of discrimination, working conditions, health and safety, employee relations and its charitable contribution to society.
- Governance
The standards to which a company is run. For example: board diversity, executive remuneration, corporate transparency, political lobbying and distribution of decision-making responsibilities. Governance is particularly hard to standardize because companies are obliged to act according to the standards set by the countries in which they operate.
ESG Rating Agencies
ESG rating agencies examine a company's environmental, social and governance policies to determine its ESG rating. These are independent organizations that choose the criteria they use to make their assessments. Rating agencies work closely alongside data providers, some of whom have also started incorporating machine learning (AI) into the process to gain a more comprehensive insight. A “good” ESG rating service will cover an extensive number of topics in its assessment. The top players are MSCI, ISS ESG, Sustainanalytics, Refinitiv and FTSE Russell.
Popular ESG criteria for investors
Evaluation criteria vary between boards that offer an ESG rating service. Further, each industry has a different set of criteria, depending on what is applicable, though they all follow a similar theme: Environmental, Social and Governance. An organization’s final ESG rating is the sum of how they have performed against all of the criteria. The Sustainability Accounting Standards Board (SASB) is paving the way with ESG standards available for 77 industries, developed using an evidence based and market informed process. They focus on surfacing sustainability information which is financially material i.e. “reasonably likely to affect the financial performance of the typical company in an industry”. SASB’s approach is widely accepted and investors tend to respect and trust their opinion.
Another innovative approach can be found at Trillium, a leading investment firm who set their own criteria. The company has been praised for having a “strict exclusionary screen”. They will not invest in companies that operate in high-risk areas, are exposed to activities such as coal mining, tobacco, firearms or have been involved in major or recent human rights, animal welfare and governance issues.
ESG disclosure requirements: the new normal?
ESG reporting is mandatory for UK companies with over 500 employees or £500 million annual turnover, and EU companies with over 500 employees or €500 million annual turnover. Companies operating outside Europe and the UK do not have any formal reporting obligations.
Problems with ESG reporting
Data management is considered the biggest challenge in creating ESG disclosures. There are more than 600 ESG reporting frameworks globally, leaving 85% of companies using multiple schemes. Companies aren’t given clear guidelines on which metrics to measure and even if they were, those factors are hard to quantify.
Novisto believe the 3 features of sophisticated ESG data management are:
1. Automated and centralized data management
2. An efficient reporting process that enables compelling narratives
3. AI-driven insights and guidance for ESG improvement
ESG reporting becomes haphazard as companies manipulate the defining factors to produce impressive ESG ratings. “The data we’re looking at is largely unorganized and expressed in different ‘languages’ or frameworks with different indicators,” says Daniel Klier from Fortune.
Many are calling for a universal ESG scoring system to eliminate subjectivity and achieve consistency.
So why do we need to adopt ESG practices?
Investor fears of being “green-washed”, can be mitigated by strong ESG frameworks. Enabling the $90 trillion of investment which is needed by 2030 to meet the goal of limiting the global temperature increase to 1.5°C.
The environmental elements of ESG support initiatives like the UK’s target of net zero greenhouse gas emissions by 2050. Our “path to net zero” requires tougher governance. Only this year was the UK’s Companies Act of 2006 expanded to include sustainability matters, including these mandatory disclosures:
- Governance arrangements in relation to assessing and managing climate related risks and opportunities
- Actual and potential impacts of climate-related risks and opportunities of the company
- Analysis of the resilience of the company with consideration of different climate-related scenarios
The ESG framework is also a driving force within the EU as a mechanism that will support the green deal and ensure the implementation of a more sustainable economy. “ESG is likely to play a bigger role in how companies are assessed, not only by investors but by consumers and stakeholders” explains Nathan Bonnisseau, Co-Founder & CMO at Plan A.
Aside from environmental benefits, ESG practices benefit everyone in the workforce ecosystem; from investors and managers, to employees and consumers.
- Investors need to be assured that they are not being “green-washed” and avoid investments that contribute to destructive long-term issues that are hard to uncover without being presented with appropriate and accurate data
- Those in managerial roles benefit from cost reductions (lower energy consumption, reduced water intake etc.) and will attract B2B and B2C customers if they offer more sustainable products. 3 out of 4 Gen Z prioritize sustainable purchases (First Insight)
- Positive social impact as a result of an employee’s work boosts productivity, inspires them to perform better because they are contributing to an ethical cause and ignites greater enthusiasm, which is a catalyst for healthy wellbeing
Summary
If those in corporate roles are serious about a sustainable future, we need to bring the ESG ecosystem to life. A reliable ESG rating system will encourage consistent calculations and referencing, vital for improving a company's long-term performance and positive contributions to ESG related topics. Even though many fund managers believe the regulations are too extreme and will stunt growth, it’s inevitable that ESG reporting will be compulsory; how and when is the question.
Is an independent non-profit like the SASB a fair governor, or should this be in the hands of states across the globe to determine? Whatever evolves, it's clear that we need world leaders on board with enforcing companies to disclose accurate and relevant data.
Key Takeaways
- ESG is a set of standards used by companies to measure their performance and impact surrounding the environment, its impact on society and the way in which it is governed
- There are multiple frameworks, comprising different criteria, to which a company can determine their ESG rating
- ESG reporting is only mandatory for large-scale organizations in the UK and EU
- ESG investing is the consideration of ESG factors in the investment decision making process. Nataxis say 49% of investors are interested in ESG, though 41% are reluctant to invest in ESG funds because they don’t know enough
- Data management is the biggest challenge in scaling ESG reporting and practices
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