Understanding ESG and ESG-related risks:
Environmental, social, and governance (ESG) investing is a fast-evolving trend in the financial industries. ESG investors track factors related to climate change and carbon emissions, human rights and worker conditions, corporate board diversity, and a number of other social and environment-related issues.
While ESG analysis will continue to play an important role in investing, consumers and other stakeholders are also paying more attention to these measures of a company’s performance. As consumers demand greater transparency into everything from labor standards to executive compensation and deforestation policies, companies — including both financial and nonfinancial institutions — need to keep a close eye on the ESG-related concerns of stakeholders.
Long-term corporate success in a rapidly changing world depends on avoiding reputational risks and protecting the integrity of the company brand. Failing to manage for these factors increasingly carries a financial and even regulatory risk.
ESG performance measures
Although the term ESG has been applied broadly, it is generally understood to encompass three main factors for evaluating a company or investment. Environmental measures reflect the company’s management of, and impact on, environmental resources. Social measures speak to its management of human capital and relations with customers, suppliers, and the community; governance factors track the company’s leadership, internal controls, and relations with shareholders. While ESG criteria fall into three broad categories, these issues are often interlinked.
As organizations scramble to meet community demands for information on sustainability and social responsibility practices within their operations and across their supply chains, the percentage of firms publishing sustainability reports and ESG performance data has surged. Specific, consistent metrics for ESG performance are evolving and reporting has, in great part, remained a voluntary activity. But regulatory bodies have begun to move toward establishing reporting standards.
Evaluating environmental risks
The environmental portion of ESG takes into account a company’s use of natural resources and the impact of its operations and global supply chain practice on the planet. These factors can include everything from its emissions, use of toxic chemicals, and waste management to its role in water pollution and effect on biodiversity and deforestation.
The growing demand for renewable energy, along with more sustainable transportation networks and green infrastructure, continue to be top concerns. Calls for commitments to reaching net-zero greenhouse gas emissions and carbon neutrality have also put added pressure on companies around the world.
As businesses focus on the corporate practices and the environment, data and the development of new reporting metrics play a crucial role in understanding sustainability-related risks. For market participants in the EU, the sustainability disclosure requirements under the Sustainable Finance Disclosure Regulation (SFDR) and the Taxonomy Regulation have introduced new incentives to provide more complete ESG data.
U.S. financial regulators have been slower to require the disclosure of environmental impacts and risks. While almost half of the companies listed on the S&P 500 disclose climate risks, no uniform standard exists. In recent developments, the Securities and Exchange Commission, Federal Reserve, and other regulators are moving toward updating required reporting related to climate change-related risks and costs.
In March, the acting chair of the SEC issued a request for comment on climate disclosure, an announcement later supported by the current chair. Mandatory disclosure will provide more consistent, comparable data on how businesses are affected by — and how they attempt to mitigate the costs of — climate change. Of course, compliance with new regulations will require U.S. regulators to issue clear data standards.
With the ESG disclosure rules likely, financial institutions have begun to reassess their lending and investment practices to limit exposure to carbon producers and other companies not keeping to sustainability goals. Activist investors and financial institutions are also forcing a re-assessment of the risks in failing to improve corporate sustainability practices. In May, the hedge fund Engine No. 1 succeeded in ousting ExxonMobil board members in its bid to force the company to diversify its energy portfolio and move from a reliance on fossil fuels.
Addressing social factors
Social factors receiving the most scrutiny from shareholders and stakeholders alike include indicators of a company’s diversity and its management of its workforce and worker rights issues in its supply chain. The unrest in the past year has forced corporations to address calls for social justice and implement policies that combat implicit bias and systemic racism. The events helped strengthen ongoing efforts toward incorporating diversity, equity, and inclusion into corporate boardrooms and workplace environments.
Perhaps also spurred by recent events, Nasdaq has proposed a new rule related to board diversity and disclosure. The rule would require companies to have at least two diverse directors, including one who identifies as female and one who identifies as either LGBTQ+ or as an underrepresented minority (Black or African American, Hispanic or Latin, Asian, Native American or Alaska Native, Native Hawaiian or Pacific Islander, or two or more races or ethnicities).
The SEC, with its announcement to revisit climate change disclosures, has also signaled its intention to consider ESG disclosures that encourage the reporting of workforce and board diversity metrics.
Identifying new corporate governance factors
Corporate governance has traditionally referred to the rules and processes dictating the board of directors’ management of operations and the practices supporting transparent decision making, legal financial practices, and protection of employee and shareholder rights.
Within the framework of ESG concerns, new measures of corporate governance have emerged. Executive compensation has received attention and board management of regulatory, legal, and reputational risks have also emerged as metrics.
Tracking ESG-related reputational and financial risks
Legal action has become a tactic in pressuring corporations to reform business practices and manage ESG-related risks. Company boards have also shown signs of their willingness to have executives answer for governance and compliance failures within a corporation. In reaching a settlement with U.S. authorities related to the 1Malaysia Development Berhad (1MDB) corruption scandal, Goldman Sachs moved to claw back executive pay. The board agreed to revoke compensation from former senior leaders and reduce the compensation of current executives.
As consumer awareness and media scrutiny intensify around issues related to sexual misconduct and discrimination, shareholders have turned to lawsuits as a way to hold corporations accountable. Alphabet, the parent company of Google, settled a series of shareholder lawsuits over its handling of sexual harassment, illegal conduct, and discrimination claims.
As part of the settlement, Alphabet will create an advisory council focused on diversity, equality, and inclusion; the company plans to spend more than $300 million over the next decade on diversity initiatives. The settlement sets new corporate governance standards for the tech industry.
Shareholders of Pinterest sued the company, its executives, and board alleging breach of fiduciary duty, arguing that its executives failed to address claims of discrimination against women and employees of color in the company. The lawsuit claims that executives and board members engaged in, or ignored discrimination and retaliated against, those who challenged company leaders. Pinterest faced intense criticism after two Black female employees reported their negative experiences at the company and, in following months, its former COO sued claiming discrimination and retaliation.
A nonprofit organization that promotes human rights and corporate accountability filed a lawsuit that accuses tech giants of sourcing cobalt from Democratic Republic of Congo mines employing child labor. Cobalt is an essential element in the lithium-ion batteries that power smartphones, laptops, and electric cars. Filed on behalf of Congolese parents and children, the case against Apple, Google, Microsoft, Tesla, and Dell could have widespread consequences.
The emphasis on ESG accelerates
In addition to exposing glaring deficiencies in the global supply chain and inequities in resource distribution, the year under COVID-19 brought forth challenges to the social order and questions of social justice. Businesses faced intensified scrutiny over their sustainability and social responsibility practices, a trend that appears only to be accelerating.
Reporting requirements on corporate diversity and environmental practices appear to be forthcoming and monitoring of vendors and workplace compliance has gained new emphasis. A long-term, sustainable approach to measuring against ESG performance factors and mitigating related risks has become more important than ever.
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