What is ESG?
ESG stands for Environmental, Social and Governance. ESG is the framework that is used to determine how sustainable an organisation or company is. It is typically used as a screening tool by the fund management industry to identify material risks and growth opportunities.
It is common to use the terms ESG and sustainability interchangeably, but there are some differences between the two.
The term sustainability refers to meeting our own needs without compromising future generations' ability to meet theirs. Sustainability in business means ensuring the company's whole value chain has a positive impact on the environment and society, thereby creating long-term value. Sustainability is used as an umbrella term, whereas ESG principles are much more specific and data driven.
The environmental factor in ESG considers both how a company impacts the environment and how environmental factors impact the company. The environmental challenges we face today bring both financial risk and opportunity that investors and organisations need to manage. The major environmental challenges are climate change, biodiversity loss, deforestation and resource depletion. As biodiversity and natural resources continue to decline, climate change accelerates. The world is heading for a 3°C rise in global temperature by 2050. To avoid the most catastrophic impacts of climate change, we must limit global warming to 1.5°C. While there are challenges, there are also many innovations and new market opportunities from a climate-resilient world.
While the environment quite rightly commands a lot of airtime, social issues are equally in the spotlight for investors. Human rights, diversity and inclusion, equal pay, avoiding exploitative labour and modern slavery present major risks and opportunities for business across complex global supply chains. Since the COVID-19 pandemic, there has been a renewed focus on employee welfare, including mental health and wellbeing.
Stakeholders are increasingly holding companies to a higher standard of governance, demanding that they demonstrate a real commitment to being part of the solution and not the problem. ESG has moved from narrow activism to a sphere of risk management for corporate boards.
Investors want to see a ‘purpose-led’ business with a holistic and credible approach to managing their material ESG risks and opportunities. This is about being proactive and not reactionary. Being a ‘Sustainable Organisation’ means placing sustainability at the heart of the business to credibly manage material, environmental and social impacts. To get there, corporate governance, accountability, stakeholder engagement – ensuring transparency and taking a long-term view – are required.
The evolution of ESG
The last ten years have seen an evolution of ESG from a ‘nice to have’ component to one of the most profound areas of structural growth from both an investment and corporate perspective.
Incorporating sustainability into investment decisions signals a desire to influence societal and environmental outcomes through investment choices. Importantly, in contrast to other growth initiatives that asset managers have tried, ESG is a feasible solution and readily achievable as it provides value beyond investment performance.
Institutional investors, driven by heightened scrutiny of their own ESG credentials, are setting a much faster pace – driving ESG disclosure requirements and increased engagement for all PLCs in their equity portfolios. Those companies that do not engage and respond will be discarded or left on the sidelines. Given the scale of AUM growth, the opportunities for those companies that can effectively and authentically exhibit their own ESG narrative are also very significant.
Regulation is also evolving at a rapid pace; as part of the EU Taxonomy, 2021 saw the launch of the EU’s Sustainable Finance Reporting Directive (SFDR) and, in the UK, mandatory Task Force on Climate-related Financial Disclosures (TCFD) is now required for all premium-listed UK companies.
Managing sustainability risks and opportunities is a growing priority for companies. Urgent environmental and social challenges, such as climate change and modern slavery, are creating a growing range of policy, legal and market challenges for businesses to navigate – that is where our team can help.
Companies are also under increasing pressure, not just from their stakeholders but society at large, to develop a deeper understanding of their environmental, social and governance responsibilities.
Davy Horizons is a sustainability consultancy that specialises in helping organisations understand changing stakeholder and societal expectations by defining and operationalising bespoke sustainability plans to drive their long-term success