It is important to differentiate between sustainability and ESG, because even though they are always correlated, they differ in their definitions. Sustainability is based on actions aimed at the environmental and social areas. ESG is the financial risk management of the investment in projects.
The five pillars that support ESG are Environmental Management, Safety Management, Occupational Health Management, Social Responsibility and Environmental Responsibility.
Even though many still believe that ESG is a set of passing initiatives or a fad, these actions have come to be the new guides for investors, companies and society as a whole. ESG is not new; the foundations for this set of actions have been built since the 1990s. The acronym as we know it today, ESG, took shape after the publication of the Responsible Investment Principles (PRI) program by the UN in 2005, where coordination was offered to banks, companies and researchers concerned with sustainability issues.
Historical Evolution Of ESG
Over the past thirty years, there has been an evolution in the principles and actions that have shaped ESG as we know it today:
1992: The United Nations Earth Summit, held in Rio de Janeiro, where the United Nations Framework Convention on Climate Change (UNFCCC) and the United Nations Convention on Biodiversity were signed.
1997: Creation of the Global Reporting Initiative (GRI), with the objective of creating the first accountability mechanism ensuring that companies adhere to the principles of responsible environmental conduct. This was later expanded to include social, economic, and governance issues.
2000: The Government Pension Fund of Norway and the largest pension fund in the United States, CalPERS (California Public Employees Retirement System), committed to 100% integration of sustainability principles over 15 years.
2006: The Principles for Responsible Investment (PRI), a set of six investment principles that encourage the incorporation of ESG issues into investment practice, was launched by the United Nations. The principles were developed “by investors for investors.” These are voluntary principles, but they have attracted signatories from more than 60 countries, representing a financial volume in excess of US$ 100 trillion.
2009: The Global Impact Investing Network (GIIN) was created, an organization dedicated to increasing the effectiveness of impact investing.
2011: The Sustainability Accounting Standards Board (SASB) was created, an organization to develop sustainability accounting standards.
2012: A new edition of the International Finance Corporation (IFC) Sustainability Framework was published, which includes Environmental and Social Performance Standards that define responsibilities for managing environmental and social risks.
2015: The United Nations (UN) Sustainable Development Goals (SDGs) were established. They serve as a blueprint to significantly change the world, ending global poverty, protecting the planet and ensuring prosperity for all by 2030. Additionally, 195 countries have adopted the first universal, legally binding global climate agreement with the Paris Agreement (a much more extensive follow-up to the original Kyoto Protocol in 1997).
2016: The Global Reporting Initiative (GRI) converted its reporting guidance to the first global standards for sustainability reporting, introducing a modular, interrelated framework that represents global best practices for reporting economic, environmental and social impacts.
2017: The Task Force on Climate-Related Financial Disclosures (TCFD) published its recommendations on climate disclosures. They were based on four thematic areas that represent core elements of how organizations operate: governance, strategy, risk management, and metrics and goals. These thematic areas are designed to interact and inform each other.
2017: In a new European Union (EU) Pensions Directive, member states have an obligation to “allow Institutions of Occupational Retirement Provisions (IORPs) to take into account the potential long-term impact of investment decisions on factors ESG.”
2019: This year marks the tenth anniversary of the United Nations Sustainable Stock Exchange initiative. Most global stock exchanges are part of the initiative.
2020: The final EU taxonomy report (developed by the Technical Experts Group [TEG] on Sustainable Finance) was published, which contains recommendations on comprehensive taxonomy design and guidance on how companies and financial institutions can make disclosures using the taxonomy to improve coverage of reported data.
2020: COVID-19 initiated a major shift in investor perceptions of social factors, whose impact is critical and constructive in mitigating risk and creating long-term value. Demonstrations in the US against racism also highlighted the interconnections in the way companies address social issues, including the treatment of employees and inequalities, in their long-term sustainability strategy. These events, coupled with ongoing environmental issues, will be a game-changer for ESG investment.
The ‘E’ in ESG is for Environmental issues, particularly those that have a growing financial impact on companies, and their investors are aware and very attentive to their investment portfolio. These investors are paying more attention to issues such as climate change, pollution, energy efficiency, conscious water use, resource scarcity, and potential environmental risks so they can raise awareness of relevant issues and influence disclosure.
The negative impact for companies that do not manage environmental risks include increased costs (e.g., the need to clean up collapsing sewage dams, or contain oil spills), reputational damage due to pollution incidents, and litigation costs, which can cause operations to be paralyzed and brand reputation to be damaged.
The integration of environmental factors into the strategy of companies can represent good opportunities. For example, efficient use of resources can lower costs, and offering innovative solutions can create a competitive advantage. These environmental factors measure a company’s impact on living and nonliving natural systems, including air, water, land, and ecosystems. These factors also indicate how a company employs best management practices to avoid environmental risks and capitalize on opportunities that generate shareholder value.
What does the ‘S’ mean in ESG? Is it Sustainability? Or Stakeholder? It is actually the Social factor. While the focus on the ESG family has grown in recent years, the broader market is still struggling to agree on what aspects the ‘S’ should lead to in company evaluation and integration into investment decisions.
Companies have made real strides in disclosing their environmental impact and governance standards, while their social impact and performance measurement are relatively poor. This can be explained by the urgency surrounding climate change issues and improved governance control even before the 2008 financial meltdown, both keeping the ‘S’ in the shadows.
However, the COVID-19 setting, ‘S’ has been brought into the spotlight and is now attracting much more investor attention than it did previously. The configuration of the crisis is unparalleled, and ‘S’ related factors are now among the most pressing issues for companies globally. The uncertain future will define the reputation of this company depending on how it engages and relates the ‘S’ with its stakeholders in a clear and transparent way.
Investors have found the ‘S’ the most difficult to analyze, measure, and integrate into investment strategies. The qualitative nature of social performance and the wide range of related issues contribute to the difficulty of building consensus in the industry. Therefore, it has often been seen as an interface between the ‘E’ and the ‘G’, while the lack of data and consistency in companies’ social reporting has added an additional layer of complexity.
Corporate governance primarily describes the systems a company uses to balance the competing demands of its various stakeholders, including employees, customers, suppliers, shareholders, financiers, and the community.
Through this process, it provides the framework for achieving a company’s objectives, covering all aspects of organizational behavior, such as performances measurement, planning, risk management, and corporate disclosure. Altogether, it ensures adequate oversight to ensure long-term sustainability value creation with due consideration by all stakeholders.
As such, corporate governance has always been an important topic in its own right, before taking on additional meaning within the wider ESG universe.
Therefore, among the ‘E’, ‘S’ and ‘G’ factors, it can be considered the most relevant of performance, as it controls the general purpose and strategy of a company and how risks are mitigated. If the company does not start with ‘G’, the other issues will not be identified or managed, so it is harder to resolve them if a crisis situation occurs.
Consequently, the ‘G’ in ESG is considered a mandatory element of any due diligence process, with some investors placing increasing emphasis on it as the core component of their investment approach. Furthermore, governance data, unlike environmental or social data, has been accumulated longer, and the norms and standards for what good governance encompasses have been widely debated and accepted.
Of course, all of this is analyzed in the context of the pandemic and how corporate governance contributes to managing the current crisis and any similar scenarios in the future. After all, governance can be seen as the quality of leadership, and leadership is essential in times of crisis.
Risk Mitigation for Investors and Companies
The main growth factor for the pursuit of ESG agenda initiatives is that with them the exposure to business risks is mitigated. In other words, these initiatives guarantee greater security for investors and, consequently, a gain for the companies that use the agenda as well as for the society that benefits.
Many investors consider the global environmental future to be the highest priority ESG issue for investors. Problems such as climate change induced by greenhouse gases, deforestation, biodiversity, and pollution have serious implications. To understand global environmental changes in recent decades, it is necessary to focus on the connections between environmental systems, predominantly the atmosphere, biosphere and hydrosphere, and human systems, which include economic, political, cultural, and social systems. These systems interact where human actions create environmental changes, directly altering aspects of the environment, and where environmental changes directly impact human values.
Major contributors to the accumulation of greenhouse gases include the burning of fossil fuels for heating and power generation, and the use of chlorofluorocarbons (CFCs) as refrigerants and aerosols. Air pollutants include sulfur dioxide, carbon monoxide, lead, and nitrogen dioxide, which are all byproducts of power generation and industrial processes. Furthermore, stratospheric holes in the ozone layer are considered a direct result of the accumulation of CFCs in the upper atmosphere.
Therefore, to tackle climate change and decarbonize the global economy, it is necessary to generate political action, financial support, and social change. The COVID-19 pandemic has shown that, in the face of an impending humanitarian crisis, an enormous amount of political action can be implemented very quickly. Furthermore, societies have changed their behavior in a matter of weeks, and there has been plenty of financial support for these measures. The scale and pace of the shift to environmental concerns has not been anywhere near comparable, but the pandemic could be a catalyst for more environmental action, with a greater emphasis on climate change after the crisis.
It is now the last decade to address the UN Sustainable Development Goals (SDGs), which set targets in 2015 for the world to become safer and more sustainable by 2030, based on the principle of “leaving no one behind.” To achieve these challenging goals, companies and policymakers must share responsibility for mitigating and adapting to the risks of the climate emergency. This is further supported by the business cases for environmental change, as companies that manage sustainability risks and opportunities tend to have stronger cash flows and higher valuations over time, and particularly lower borrowing costs.
In addition to the possible financial impacts that can affect companies that do not meet an ESG agenda, there are socio-environmental risks that can be negatively associated with the company’s image, which can cause operations to stop and denigrate the brand.
The professionals that companies are looking for to work in this area of ESG management are not just professionals who issue sustainability data reports, but also who mainly understand the metrics of data produced, and know how to recognize whether they are true or not.
Professionals to work in this area are in high demand recently. They must have a holistic view of the business, the materiality of the company, and know how to relate to internal and external stakeholders. And, mainly, knowing how to integrate these topics into the company’s vision and actions.
1. Environmental, Social, and Governance (ESG) Investing, A Balanced Analysis of the Theory and Practice of a Sustainable Portfolio, John Hill
2. ESG Investing for Dummies Brendan Bradley
3. Transparency in ESG and the Circular Economy Capturing Opportunities Through Data Cristina Dolan and Diana Barrero Zalles
ABOUT THE AUTHOR
João Vitorino is Mechanical Engineer, MBA in Project Management and in Product and Services Engineering. He also has a postgrad in Industrial Valve Design Engineering. He has more than 15 years of experience in the market focused on equipment for the industrial area, mainly Oil and Gas. He is a valve consultant for Valve World Magazine and Fugitive Emissions Journal. Today he is the Director of JCV Industrial Solutions, which operates in the Brazilian market with equipment and solutions for the industry.