What is ESG?
ESG is centered around considering and analyzing environmental, social and governance factors. ESG investing considers these factors alongside financial factors in the investment decision-making process to assess risk. ESG has become an increasingly important metric for capital markets. Companies with high ESG performance have proven to have lower risks, higher returns, and are more resilient in times of crisis.
Environmental risks refer to the impact on air, land, water, ecosystems, and human health. An assessment of these risks will often identify and measure how pollution, emissions and climate impact can be reduced and/or managed. Examples of environmental positive outcomes are: i) lowering costs and increasing profitability through renewable energy and other efficiencies; ii) avoiding or minimizing environmental liabilities; iii) reducing regulatory, litigation and reputational risk.
Social risks refer to the impact on society. They are addressed by activities such as promoting health and safety, encouraging labor-management relations, protecting human rights and focusing on product integrity. Examples of social positive outcomes are: i) active community involvement; ii) reducing employee turnover; iii) effective diversity, equity and inclusion initiatives.
Governance risks may address areas such as board and C-suite composition with respect to increasing gender and racial diversity, corporate risk management, executive compensation, and disclosure of information. Governance positive outcomes may include: i) aligning interests of shareowners and management; ii) transparency and regularity of Corporate Social Responsibility and/or sustainability reporting practices; among others.
Integrating ESG Data with Financial Data in the Investment Process
ESG data are often used by investors who seek to integrate non-financial factors when identifying and analyzing material risks as part of their investment process. While disclosure of ESG metrics is not required as a part of mandatory financial reporting, there is growing momentum and companies are increasingly doing this in their annual reports or in standalone sustainability reports. Institutions such as the Sustainability Accounting Standards Board (SASB), the Global Reporting Initiative (GRI), and the Task Force on Climate-related Financial Disclosures (TCFD) have been working to establish standards and define materiality to facilitate incorporation of ESG data in the investment process. It is anticipated that recent EU Taxonomy legislation published in the Official Journal of the European Union and enforced in 2020 will make disclosure of climate-related and environmentally sustainable data more of a formal requirement not just in Europe, but in many other parts of the world.
As ESG continues to become mainstream and integrated in investment philosophy, issuer engagement is often an important way for asset owners and asset managers to identify material risks and opportunities and influence better corporate behavior. Central to this is a belief that ESG material issues can affect long term performance of a security, and that a corporation or issuing entity can benefit from listening to feedback on these material issues from investors and active owners in their role as “stewards”.
ESG Engagement and Stewardship