What is ESG? Making It Easy To Understand
ESG stands for environment, social, and governance and it’s a measure of how well companies are managing risks related to each of those categories. Investors want to know that their money is safe, and a company’s ESG score gives them an indication of how prepared that company is to manage its future environment, social, and governance (ESG) risks.
Companies that have good ESG scores are sometimes grouped into an ESG fund offered by different financial services companies. However, many people confuse this to mean that every company listed in the fund is an environmentally and socially responsible company. That isn’t always the case. While ESG impacts are a consideration, remember that ESG is all about informing investors how well a company is managing its ESG risks.
Let’s take a closer look at ESG risks vs ESG impacts.
First, there are the ESG impacts that business activities have related to people and the planet. How many tons of carbon does a business emit each year? What is a company’s relationship like with the community it serves? How much water does it use? What is employee satisfaction like? Some areas are easy to measure with numbers (like carbon emissions), whereas others require a more qualitative approach. A business’ ESG impacts help to determine their ESG risks, which is the ultimate goal of ESG.
ESG risks are the main driver behind ESG reporting. Investors want a clear understanding of how businesses are managing risks related to our changing natural environment, the regulations associated with the energy transition, the evolution of societal norms and laws, the management of supply chain disruptions and human rights issues, and the corporate governance structure that makes it all happen.
Let’s break down the E’s, S’s, and G’s to take a closer look at ESG risks.
There are two main parts to environmental risk: physical and transition.
Physical climate risks consider business assets that are at risk of significant damage due to extreme weather events, rising sea levels, and changes in climate. Dry conditions leading to a forest fire is a physical risk to a logging company or to a business that has an office close to a wildfire-prone area.
Transition climate risks consider the world’s transition to a low-carbon economy. Laws, regulations, and reporting requirements all create transition risks. Can a mining company adapt when the government imposes a strict emissions cap? Does a bank have a robust net-zero strategy complete with science-based targets? (Because governments around the world are mandating that they do.) These are examples of transition risks.
Failure to be prepared for physical climate risks can cause damage to company infrastructure, forcing disruptions and incurring repair costs. Failure to comply with transition risks can bring hefty fines or temporary shutdowns. These risks can affect the bottom line of a company and are important for investors to know about.
Under the social category are things like labour rights, working conditions, supply chain issues, and community relationships. When we trace materials through the supply chain to its original source, sometimes you find things you wish you didn’t. Forced labour, child labour, and other human rights abuses are unfortunately a reality in the supply chains of some raw materials. How do companies manage these issues? Germany has a law requiring its large companies to examine their supply chains for human rights abuses. A similar EU law is incoming. Are companies ready for that?
The discovery of human rights abuses in a company’s supply chain would not only be a horrific finding for humanity, but it would shatter that brand’s reputation. Companies that have conducted supply chain due diligence and can assure the responsible sourcing of materials are properly managing this component of their social ESG risks.
The ’G’ considers corporate governance and checks that structures are in place to manage the ‘E’ and ‘S’ factors. This includes things like goal setting, science-based targets, strategies to reach those targets, as well as methods in place to measure, track, and report on progress. The ‘G’ also looks at the board of directors of companies for conflicts of interest, corruption or bribing concerns, and the diversity of the board and executives.
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