Unpacking ESG - a primer
ESG is about companies managing risk.
E - risks of an environmental nature S - risks which have social/societal dimensions G - governance related risks
Environmental Risk Factors
Companies and investors are increasingly concerned about business risks driven by environmental factors. This trend is mirrored by the advent of new regulations and reporting requirements which force organisations to account for their environmental impact. In parallel, there have been notable shifts in public sentiment which have sensitised the consumer-base to issues of sustainability. As a result, businesses which act recklessly on environmental issues risk being shunned in the marketplace.
Across the globe however, unease is growing over a more tangible class of risks; a series of direct threats posed by environmental damage itself. Physical risks driven by climate change (flooding, droughts, wildfires, storm damage) adversely impact business-critical functions such as production & distribution, while correlated regional food & water shortages suppress labour-force productivity and industrial output. Aside from climate change, biodiversity loss is known to drive agricultural fragility and, in doing so, jeopardises food production. Very recently, the COVID-19 pandemic has highlighted the risks posed by zoonotic pathogens, and stimulated fresh enquiry into possible links with habitat destruction and poor animal welfare standards.
From a business perspective, these concerns are not purely operational in nature - they are problematic for how we finance commercial activity. Even when environmental risks are forecast 10-20 years in the future, these already translate to present-day elevations in the cost of insurance, long-term borrowing, mortgages, and declines in the value of collateralised assets. For this reason investors, keen to preserve their capital, are demanding (quite aside from regulatory pressure) that investee companies disclose and demonstrate the actions they are taking to (a) limit exposure to environmental hazards, and (b) limit contribution to or exacerbation of environmental risks themselves.
For each potential risk, there is often a corresponding opportunity. Companies which develop financially viable methods of limiting, buffering or - better still - reversing environmental damage are greatly rewarded by investors. This is especially true of companies which find ways to mitigate climate-related risks because - perhaps uniquely - climate risks are both global AND long-term in nature. Credible solutions to climate-related problems will therefore find traction in a durable global market over the long-term.
Social & Societal Risk Factors
Companies exist because they serve the needs / desires of society - in one form or another. They also depend on a wide range of stakeholders including consumers, employees, upstream producers and suppliers, and downstream distributors / retailers. However the web of social stakeholders also extends to the realm of politicians and regulators who have various degrees of power to grant, revoke, or curtail a company's 'license to operate'.
The dependence on societal stakeholders has implications for revenue generation, and is therefore of interest to investors who wish to preserve and grow their capital. Companies which are callous toward changing consumer sentiment on any issue (whether materially related to the product or not) are inviting revenue risk and - in turn - increase their cost of borrowing and ability to deliver investment return. In a similar way, companies which exploit employees or neglect health & safety risk legal penalty, higher staff turnover, and loss of expertise.
For these reasons, investors are demanding that investee companies develop robust social policies which protect stakeholder interests more widely. Although shareholder value still has legal priority in many jurisdictions, preservation of that value relies heavily on continued buy-in from, and material and intellectual contribution from a wide variety of social stakeholders. When companies breach these implied social contracts, investors bristle at the corresponding revenue risks that may develop as a consequence.
Governance Risk Factors
Investors are also concerned that investee companies demonstrate strong and ethical governance - both in terms of decision outcomes, and in terms of the checks & balances that ensure good decision-making in the first place. Governance structures can be likened to a 'brain' through which all other risks (including environmental and social factors) are filtered. For this reason governance features as a critical indicator for risk management.
Good corporate governance is served (or threatened) by several inter-related functions including: board composition, independence & renewal, executive compensation, equality, transparency, hiring & tendering policies, legal compliance safeguards, and proper disclosure of political contributions. Increasingly, board diversity (or lack thereof) is understood by investors to have material impacts on company performance. This is because diversity of gender, race and other demographic background has been shown to enhance decision-making.
A 2017 study by Cloverpop (see the infographic below) reviewed around 600 business decisions across a selection of companies and found that diversity of age, gender and geography enhanced outcomes in a linear fashion. Understanding the reason behind this is crucial - the greatest vulnerability of decision-making is not lack of information or lack of strategic insight (both of which are fixable). Instead the most insidious risk is unconscious bias because, by definition, it lies beneath our radar. Diversity provides the only structural protection against this as input from different perspectives immunises companies against group-think.