Environmental, social, and governance (ESG) factors are non-financial factors that investors can use to make informed investment decisions. While the term was coined only twenty years ago, topics that fall under ESG were already being assessed as part of the investment process because they could still impact the financial success of the company or asset. Standards and frameworks have been developed to help provide comparable data to make decisions and to provide transparency on investment strategies. ESG in the investment process has translated into companies monitoring material topics and making improvements in their own operations. While the ESG landscape is everchanging, in recent years, we are seeing these standards and frameworks translated into regulations, meaning ESG is here to stay.
Understanding how the ESG landscape has evolved over time provides additional context as to how ESG is integrated into investment and business decisions. Aligning investment decisions with personal values wasn’t something new, as socially responsible investing had already been going on since the seventies[1]. With time, investors started to understand that evaluating risks, such as human rights and impact on the environment, could have positive effects on their portfolio.
In 1997, the Global Reporting Initiative was started and released standards, which have since been expanded upon, for sustainability reporting. The framework makes data more consistent and comparable to be used for decision making. The term ‘ESG’ was officially used in the ‘Who Cares Wins’ report published by The Global Compact in 2004 which provided recommendations on how to integrate the issues into analysis and asset management[2]. Over the last two and half decades, numerous boards and organizations have released their own set of standards and frameworks to report on. It is often referred to as the ‘alphabet soup’. Having so many ways of reporting make it challenging for companies to decide which framework is best to use and makes data and strategies less comparable.
As a result of this, in 2021, the International Sustainability Standards Board (ISSB) was established with the goal of establishing standards for a global baseline of sustainability disclosures that meet the information needs of investors.[3] The ISSB released International Financial Reporting Standards (IFRS) Sustainability Disclosures Standards (IFRS S1 and IFRS S2) in 2023 which bring together previously established standards focused on ESG, sustainability, and climate-related disclosures. These IFRS sustainability standards are expected to be adopted into regulatory requirements by over thirty countries.
As multiple jurisdictions aim to meet climate-related goals, the channeling of capital towards sustainable activities and assets will remain a major focus. The need for transparency on where capital is flowing and for data to understand which activities and assets are sustainable remains a challenge, but ESG standards and regulations aim to close this gap.
[1] The history of ESG: A journey towards sustainable investing, Tom Krantz, 8 February 2024
[2] Who Cares Wins Connecting Financial Markets to a Changing World, The Global Compact, December 2004
[3] About the International Sustainability Standards Board, IFRS Foundation 2024
Reporting on ESG factors has been a way to provide investors with information needed to make informed decisions. Some investment strategies have set goals or objectives they are trying to achieve, such as decarbonization, so need to ensure that their investments will align with those objectives. In other instances, evaluating ESG factors in due diligence processes can help identify new risks that may impact the company’s financial performance. Having this information allows investment teams to decide whether to invest or if they invest, how they will mitigate that risk going forward. Oftentimes, reporting frameworks require companies to disclose how they are identifying risks and opportunities for the company, their strategy to mitigate them, and the governance to ensure the strategy is carried out. Investment teams can use this information to decide if the company is well positioned to deal with risks that may arise in the future.
ESG integration can be used for value creation and to find new opportunities for companies. Some investment strategies will utilize ESG only for risk management, while others will use it to identify ways to strengthen the company’s business proposition. Companies may start to integrate ESG and sustainability into their overall long-term business strategy. This may include working with new businesses or organizations or marketing to a different group of customers. Companies that achieve certain certifications (e.g., ISO, EcoVadis) can increase brand reputation and loyalty. ESG can foster innovative ideas leading to new service offerings or the development of new products and technologies. Expanding business capabilities allows companies to penetrate new markets and makes them less susceptible to changing market conditions.
For some companies, improving the bottom line doesn’t have to come from increasing profits, but can come through decreasing costs. Often, by better managing resources within operations, companies can reduce costs. Finding innovative ways to reduce the amount of material used initially in a process, or ways to maximize the material used, can provide savings in material costs. Waste disposal costs can be reduced by decreasing the amount of waste produced through resource efficiency or waste minimization efforts. Other efforts, such installing energy management systems, leak detection systems, or on-site renewable energy, will have upfront costs, but after the pay-back period, can generate savings over the long term. For businesses with complex logistics, finding efficiencies in routes can save both time and money. Staying on top of regulations, such as environmental, health and safety, and ESG, and ensuring compliance will also help prevent fines associated with non-compliance.
Hiring and retaining quality and productive employees is crucial for any business. Increasingly, ESG is playing a role in potential employees’ interest in a role and current employees’ decision to stay. Companies with ESG initiatives show that they have values above just making money, which can be important for employees who are looking to align their jobs or careers with personal values. In fact, 75% of executives in U.S say that ESG initiatives have a positive impact on employee engagement[1]. This helps establish a workplace culture where employees are proud to work for their employer and are likely to be more productive and stay at the company longer. ESG initiatives also focus on attracting and maintaining a more diverse and inclusive workforce. This cultivates a workplace where people can feel more valued as individuals. Understanding what is important to your current employees and to the potential employees you are trying to attract will help grow your business, maintain a positive reputation, and have a strong workforce.
[1] Survey: ESG Strategies Rank High with Gen Z, Millennials, Kathy Gurchiek, 21 March 2023
It’s not just employees and potential employees who are interested in a company’s approach to ESG issues. , for some investors, investing in funds that will not only perform well, but also have environmental or social objectives is important. Companies that are actively contributing to causes such as decarbonization, waste minimization, or human rights, may have increased opportunities to attract new capital. Some asset managers have more specific approaches to investing and will take a more thematic approach or have certain goals they are trying to achieve with the fund. Businesses that are already taking the initiative to positively impact the environment and the communities in which they operate may have better access to this capital. Green loans can also be given to companies looking to invest in larger sustainability projects. In a competitive market, access to green capital is an advantage and an incentive for companies to become more sustainable and take on new ESG initiatives.
[1] Survey: ESG Strategies Rank High with Gen Z, Millennials, Kathy Gurchiek, 21 March 2023
Customers are one the most important stakeholders for a company as they are the main source of profit. Whether your customers are other businesses or direct consumers, understanding what issues are important to them is essential to maintaining strong relationships with them. ESG topics are increasingly becoming more important. In complex supply chains, as companies look to decrease their scope 3 emissions, they are looking for suppliers that also have decarbonization targets or are low carbon. Organizations may conduct supplier due diligence or adhere to responsible procurement procedures to ensure that that the companies they do business with meet a set of standards or align with their values. Businesses that abide by human rights standards, have strong ethics, and are conscious of their impact on the environment will fare well in these situations and can maintain these customer relationships. Consumers are also more conscious of the impact of their purchasing power and are willing to pay a premium for sustainably made or sourced products. Engaging with stakeholders is a crucial action companies can take to understand what issues are important to their stakeholders so they can focus on and make improvements in those areas.
Being sustainable means that a company can operate over a long period, while mitigating harm to people and the environment but to do this, companies must be adaptable. There will be new regulations that are enacted they will have to follow, some that may require significant changes to operations, there will be changing customer demands, and there will be new technologies that come into the market. With a changing climate, companies may face more frequent and extreme weather events, changing climate patterns, and may struggle to obtain insurance coverage, all of which can significantly change how a company operates. Understanding the potential risks for the areas where companies operate over the short and long term can give important insights to use in decision-making. Incorporating ESG into the company’s overall business strategy will allow them to stay on top of the changing landscape so that they can stay adaptable and successful over the long term.
While it’s hard to say what the direct consequences of ignoring ESG are, it can be certain it’s here to stay. With so many countries and jurisdictions implementing ESG legislation, many companies will have to incorporate ESG into their operations and reporting efforts. With complex and global supply chains, even if your company does not integrate ESG, your business may still be exposed through customer requests and demands. A good way to understand what the consequences will be for not integrating ESG into your business strategy is to understand if your most influential stakeholders find it important.