Importance of ESG and why it matters to businesses and investors

November 22, 2021

At the recently concluded United Nations Climate Change Conference of Parties (COP26) held at Glasgow this November, A "historic" climate commitment was brought forward by private companies representing over 450 firms based in 45 countries across the globe. They unanimously agreed that climate action to limit global warming could be done, but everyone will need to do their share: governments, central banks, ESG investors, private sectors, and consumers.

What is ESG?

In recent years, the term ESG has figured prominently in discussions about business ethics, social responsibility, and environmental awareness. But what exactly is ESG?

ESG stands for Environmental, Social and Governance and is closely intertwined with businesses' reporting and investing activity. The term ESG was coined in 2004 by former UN Secretary-General Kofi Annan and followed by the first study released in 2005, "Who Cares Wins," which was jointly developed with the world's largest institutional investors and banks.

  • Environmental (E) pertains to how a company performs as a steward of nature and its resources. It analyses how its business activities impact the environment and manage those environmental risks, especially in direct operations and the supply chain network. Among the areas covered by this component are resource scarcity and management, natural resources preservation, animal treatment and greenhouse gas emissions.

  • Social (S) refers to how a company manages its relationships with its employees, suppliers, customers, and the communities where it operates and its strengths and weaknesses in doing so. The considerations for evaluating a company's social performance on the ESG scale are its working conditions, employee health and safety, human rights, employee relations and diversity, and even how it operates in regions with conflicts.

  • Governance (G) takes a closer look at how a company's leadership performs. These include executive pay, gender equality, audits, internal controls, bribery and corruption, board diversity, and shareholder rights, to name a few. For investors, it is essential to know if a company is trustworthy and what kind of decisions are made behind closed doors.

Why is ESG important in business? 

It's not just governments that are conducting comprehensive inquiries of companies' ESG disclosure data, but regulators, customers, employees, insurers, lenders, and investors as well. Business activities and decision-making are now viewed more closely under the ESG lens.

More and more business owners and financial institutions are looking at ESG as an essential consideration in making investment decisions. In most cases, ESG was established as a significant factor itself, or may at least be a factor to some extent, as more investment firms become conscious about putting their money into enterprises geared towards sustainable development.

ESG serves not only as a framework that financial institutions and investors must report on. It is a crucial element that involves regulators, employees, and everyone else within the supply chain ecosystem. Solutions like Serai Visibility help provide insights into a company's ESG data and their business partners' performance and financial health. By analysing their financial information, a company can spot underlying risks in its supply chain and obtain detailed risk scores and news stories on their partners from data providers.

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The differences between ESG reporting and ESG investing 

Businesses hoping to attract shareholder interest and increase capital inflow should be prepared to be analysed and investigated on their ESG ratings and ESG reports.

ESG reporting

ESG reporting primarily concerns first-party data. A business entity uses an ESG framework to report specific metrics like greenhouse gas emissions, human rights policies, and risk management strategies.

ESG rating providers can then analyse these reports using human skill or artificial intelligence and apply a scoring methodology to assign values to make comparisons. Today, ESG rating agencies can validate a company's self-reported data and use other proprietary data resources to obtain a score.

ESG reports primarily target stakeholders, including customers, employees, investors, researchers, regulators, and rating providers.

ESG ratings

On the other hand, investors use ESG ratings exclusively as the rating or score reflecting a company's exposure to environmental, social and governance risks and how effectively it manages such risks.

An entity's ESG rating comes from third-party ESG rating providers. These are what investors use to research and compare the ESG performance of companies in their portfolios and those they see as prospective investments. The biggest ESG ratings providers are Morgan Stanley Capital International (MSCI), S&P Global Ratings, FTSE Russell, Institution Shareholder Services (ISS), Sustainalytics, and Refinitiv.

A good ESG rating means a company is doing well in managing its ESG risks relative to its peers. On the other hand, a business with a poor ESG rating has higher unmanaged exposure to ESG risks.

ESG rating providers score companies through key issues by industry. For MSCI, the firm chooses 35 key issues that are highly relevant to specific industries. Corporate governance key issues are included for all sectors.

MSCI analyses 80 different exposure metrics and 270 governance metrics to score companies from zero to 10 on each key issue. A low score in these ESG metrics indicates the company is heavily exposed to a particular problem and is not managing the risk effectively. A high score indicates an aggressive effort to minimise the risk.

These issues are also weighted, with MSCI assigning weights to key issues according to their timeline and potential impact. Issues that may create a significant environmental or social impact within two years have the highest importance. On the other hand, issues with a decreased potential for impact and a timeline of five years or more have the lowest weights.

The scores and weights are then combined to produce an industry-adjusted numerical score from zero to 10 for the rated company.

What is ESG investing, and why is it essential?

ESG investing is not new. The practice of ESG investing started in the 1960s. ESG investing evolved from socially responsible investing (SRI), which excluded stocks or entire industries from investments related to businesses such as tobacco, guns, or goods from conflict regions.

From traditional corporate responsibility, institutions are now making more deliberate steps towards emphasising ESG initiatives. Indeed, some of the most prominent financial institutions do not see corporate social responsibility and ESG as mutually exclusive. Instead, both are now seen as a critical part of a company's risk-management strategy and thus worth a more thorough analysis.

ESG investing does not mean picking stocks based on ESG factors alone. An ESG investor adds an ESG review to the traditional investment process. Thus, ESG ratings can be used to supplement a company's financial analysis, with the ESG review providing insight into the risks a company may face.

ESG ratings can also be used to screen stocks of firms that have proven themselves to be responsible corporate citizens and committed to sustainable business practices.

ESG does produce dividends

By 2025, Bloomberg calculates that global ESG assets will exceed USD 53 trillion, representing more than a third of the USD 140.5 trillion in projected total assets under management (AUM). By the end of 2021, it is expected to increase to USD 37.8 trillion.

Why are these figures significant? The S&P Global Market Intelligence analysed 26 ESG exchange-traded funds (ETF) and mutual funds with more than USD 250 million AUM. The firm's report stated that from 5 March 2020 (when the World Health Organization officially declared COVID-19 a pandemic) until 5 March 2021, around 19 of those funds (73%) performed better than the S&P 500. It is interesting to note that the increase happened during a global crisis.

The takeaway from this? ESG investments perform well, if not better, than traditional investments. Ethical investments can protect companies from risk and yet still allow them to create a positive impact.

What are the benefits of ESG investing? 

A well-run company that understands its responsibility about the environment, its people and its customers is more likely to exhibit a greater level of resilience and outperform its industry peers.

By leveraging the power of modern technology tools such as Serai Visibility, enterprises who wish to act, improve, and strengthen their ESG strategies to attract better investments can view their supply chain partners' ESG activities. Such platform tools can even provide a complete map view of global disruptions such as natural disasters and even COVID-19 to assess the impact and make better business decisions in real-time and pragmatic long-term investments.

The benefits extend beyond profitability as well.

1. Implementing robust ESG programs can increase stock liquidity.

Institutional and even individual investors are infusing sizeable fund inflows into corporations and capital markets that have shown a proactive stance in governing and operating in an ethical and sustainable way.

The growing number of indices that measure and rank companies based on ESG benchmarking created by investment research and consulting firms also make it easier to analyse which businesses are better, ESG-wise, than their peers. Investment firms are now incorporating ESG valuations in their portfolio risk assessment, with the certainty that capital can be directed to firms with strong ESG practices and programmes.

2. ESG initiatives unlock competitive value. 

A company that can recognise the importance of adapting to constantly changing socio-economic and environmental conditions is better positioned to identify strategic opportunities and confront challenges.

Employers who take the initiative to improve labour conditions, enhance team diversity, immerse and give back to their communities, and stand firm on their sustainable and environmental policies also bolster their company brand.

3. ESG investors aim for long-term value. 

A majority of ESG investors choose and make their investments based on their values. They are also more interested in what happens in the next five or ten years than the next quarter. As such, investors who follow an ESG mandate are more interested in building long-term value over a multi-year period rather than simply buying and selling stocks for quick returns.

4. Being proactive about ESG can reap cheers instead of jeers. 

Climate activists today, such as Greta Thunberg, are raising more severe concerns and putting themselves at the forefront of the battle to compel governments and enterprises to take climate change more seriously. Whereas they initially campaigned against companies, they target management teams and company boards who fail to take a more proactive stance on environmental and social issues.

It doesn't need to be said that a stringent and assertive company addressing ESG issues can become a catalyst for change in an entire industry and set the bar for its peers. Transparency about their ESG data can also minimise their exposure to activists' intervention. Such issues as gender pay equality and diversity are seen positively and bode well for how a company is seen by present and future investors.

5. Companies that have strong ESG values attract and retain the best talent. 

The oldest millennials (those born in 1981, called Generation Y or Gen Y) turn 40 in 2021, while Generation Z (Gen Z) came of age in an era of increasing climate concerns and significant environmental, societal and health disruptions such as COVID-19, increased carbon emissions, political instability, and racial discord.

Their concerns now include healthcare, disease prevention and unemployment. However, climate change and environmental protection remain top priorities, ranking first for Gen Zs and at No. 3 for millennials.

Millennials are now full-grown working adults and increasingly choose sustainable investing to support businesses aligned with their values. Members of Gen Z who are entering the workforce are knowledgeable enough to conduct their due diligence about the companies they want to be associated with. Thus, attracting talent who is passionate about the organisation, who feel valued and are loyal is an intangible benefit that strengthens the company and improves overall productivity.

What are the consequences of not embracing ESG? 

As corporations transition from an increased awareness of ESG to taking a more proactive stance, directors are also considering the impact ESG has on their roles in overseeing strategy and succession planning. This shift in thinking comes from investors and stakeholders, who ensure that boards effectively acknowledge and respond to ESG issues.

Institutional investors wield considerable influence in allocating capital, share prices and electing board members. Corporations are now increasingly pressured to do more than provide quarterly and annual reports. Questions on how environmental impact, resource risk mitigation, and gender diversity are being addressed are valid points that major investors know could significantly impact the bottom line.

ESG is no longer just the latest buzzword, trending hashtag on social media, or a temporary "feel good" exercise for the sake of appearance. Just as business owners concern themselves on how to deploy financial and human capital, companies also need to reflect on what their customers, employees, shareholders, and stakeholders need.

Companies that follow a robust and sensible ESG policy and adapt it to changing demands are better positioned to attract better human capital. They are also given greater flexibility and a more comprehensive financial platform by investors to establish more reliable supply chains, avoid conflicts and minimise risks, and continue to be innovative about creating new products and services. All these will make a huge and positive impact on their shareholders, stakeholders, customers, employees, and the greater community.

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