Environmental, Social and Governance (ESG) criteria refer to a set of standards that socially responsible shareholders and investors look for in a company’s operations in order to evaluate its impact on the world. It used to be a universal understanding that the primary objective of investors and companies was to maximize profits for shareholders without any consideration of other factors such as environmental or social impacts (Chen, 2020). However, with a rise of the ‘responsible investment’ movement, ESG is considered as a fiduciary responsibility on part of the shareholders in European and US markets. ESG now has a great effect on any company’s capacity to attract and retain funding shareholders and investors who adopt a ‘socially responsible’ investment approach before putting in their money (Kell, 2018).
The term ESG was first devised in 2005 in a study entitled “Who Cares Wins” in which former UN Secretary General invited CEOs of fifty top financial firms to take part in a joint initiative with the aim of finding ways to incorporate ESG into investment and capital markets. As a result of this initiative, a report was produced that outlined three main categories that can impact a company and its investment value as well as create more sustainable markets with better outcomes for overall society. These criteria or set of standards used as a tool by conscious and socially responsible investors to screen their potential investments consisted of three main areas, and they were i; environmental ii; social and iii; governance (Kell, 2018).
ESG criteria
Environmental criteria examine issues related to climate change, toxic waste management, environmental accountability and environmentally friendly products and services. Some of the environmental-related questions that the companies need to answer are as follows (The Global Compact – Who Cares Wins, 2004):
- How well a company addresses and acts upon climate change and related risks?
- How it manages its waste and toxic releases?
- How well a company adopts new regulations that expand the limits of environmental accountability and how well a company understands the emerging markets for environmentally friendly products and services?
Social criteria focus on issues related to workplace health & safety, human rights issues at its premises as well as buyers’/suppliers premises and pressure by civil society to improve transparency & accountability leading to reputational risks if not managed properly. Some of the relevant factors in this case are as follows (The Global Compact – Who Cares Wins, 2004):
- the importance of a company’s relationship with employees, customers, suppliers and communities.
- Effective workplace health and safety policies in place in case of an emergency or accident.
- Human rights and legal issues at its premises as well as at their client’s and supplier’s.
Governance criteria look at company’s accountability & board structure, internal controls, executive pays & disclosure practices, audit structure, transparency in tax and anti-corruption assessment (The Global Compact – Who Cares Wins, 2004).
Importance of ESG
The importance of ESG can be gauged from various studies which confirm that companies pursuing high ESG performance outperformed competitors, experience lower cost of capital, less volatile earnings and created long term benefits in the form of positive brand image, adaptability and innovation. All these factors led to high shareholder value and improved financial results (Czaplicki, 2019). Companies with high ESG score are more likely to outperform in competing for investments and demonstrate better awareness of any potential management failure, threats or emerging risks. They are also more likely to attract customers that have more sustainable products to offer.
A study by leading asset manager Amundi, showed that between 2014–2017, its portfolios with high ESG scores outperformed competing investments. Moreover, Morgan Stanley Capital International (MSCI) reports that high ESG value companies experience lower cost of capital, less volatile earnings and lower market risk compared to low-value ESG companies. Additionally, KPMG reports some examples of long term benefits created by ESG activities includes better retention rates and a more positive brand recognition amongst their staff and customers, create evolving business models that minimize the impact of disruption from technology/regulation and lead to technological advancements that promotes innovation and improves efficiency (Czaplicki, 2019).Socially responsible investors tend to invest more in companies that have better ESG rating; therefore these companies are able to attract more investors.
According to McKinsey and Company, a strong ESG proposition links to value creation in five essential ways and these are: i; Top line growth (attract customers with more sustainable products) ii; Cost reductions (lower energy consumption), iii; regulatory and legal interventions (earn subsidies & government support) iv; productivity uplift (boost employee motivation) v; Investment & asset optimization (avoid investments that pose long term environmental threats) – (Henisz, Koller and Nuttall,2019).
Growing concept of ESG
Over the past ten years, an increasing number of stock exchanges and investment security regulators all around the world have acknowledged companies ESG score as a crucial element in screening material for investors. Global sustainable investment in 2019 tops $30 trillion, up 68% since 2014 and tenfold since 2004 (Henisz, Koller and Nuttall, 2019).Sustainability Rating Agencies (SRA) are increasingly evaluating companies to produce ratings principally intended to deliver stakeholders with information, facts and statistics on several ESG pointers. These pointers collected by SRA’s are an indicator of how well firms and companies manage their different non-financial issues, risks, threats and opportunities. The rise in the utilization of ESG ratings in investment decision making is constituting a larger drift in the direction of an audit society (Clementino and Perkins, 2020). Moreover, list of signatories to the Principles for Responsible Investment (PRI) which is the primary structure for investors willing to integrate the ESG principles while making investment decisions supported by United Nations, has rapidly grown which indicates the growing consciousness of ESG worldwide. Another indicator of the increasing consciousness and attention to ESG ratings is the usage of ESG data collection services (Hayat and Orsagh, 2015).
The ESG score of a company is often integral to its ability to continue operating. A poor ESG score can spell disaster for even the most financially successful of organizations. The impact of a poor score is often damage to the company’s brand, reputation, and stock price, e.g. Facebook was repeatedly accused of collecting and sharing user information without having acquired proper consent in 2019. As a result, Facebook was removed from a list of socially responsible companies from S&P’s index. This affected not only the company’s reputation but also its stock price and it may be a factor as to why the site is no longer growing like it once did. As Facebook’s example shows, no company is above the power of the ESG criteria. Ensuring a good ESG score is thus vital for any business that wants to continue growing and delivering results (The Ultimate Guide to ESG Data 2020, 2020).
Impact of ESG on Credit Ratings
S&P Global Ratings has long considered Environmental, Social, and Governance (ESG) factors in its credit ratings as ESG risks and opportunities have the potential to affect creditworthiness. ESG factors are considered in the assessment of business risk (specifically, its competitive position); financial risk (through cash flow/leverage assessment and financial forecasts); and management and governance. The management and governance assessment includes consideration of environmental and social risk management. The criteria are based on the proposition that if a company can effectively manage ESG risks, then its credit profile may improve. Alternatively, weak management with a flawed operating strategy or an inability to execute its business plan effectively is likely to substantially weaken a company’s credit profile (ESG in Credit Ratings, 2020).
Investors demand ethical analysis to help them avoid companies liable to crises. Credit rating agencies increasingly view risks through an ESG lens when they assess if corporate bond issuers will be able to pay back their obligations and stay in business. Pushed by investors who believe issues such as the move to a low-carbon economy and good governance inform their decision-making, and the fact that ESG credentials help companies avoid expensive crises, the credit rating agencies are trying harder to explain how Fitch Ratings plans to publish ESG “relevance scores”, which will show how ESG factors affect individual credit rating decisions. Earlier, Standard & Poor’s Global Ratings had said it would include information on how ESG factors influenced credit ratings. Moody’s Investor Services does not have an ESG scoring system, but related issues in particular governance are considered in credit decisions. According to Moody’s, said social issues such as how a company manages health and safety can still be material to credit quality. As per Moody’s, there are four potential channels through which social issues affect credit quality: reputational, operational, litigation and regulatory risks (Credit rating agencies turn attention to ESG risk, 2019).
Source from: MERatings