IEEFA: Climate change takes investors beyond the balance sheet to ESG

Stakeholders now look beyond corporate balance sheets – to environmental, social and governance (ESG) parameters – to ascertain a company’s true worth. The existential threat of climate change, attributed almost entirely to the burning of fossil fuels, is gradually bringing increased scrutiny of the sustainability of businesses, particularly in the energy sector.

Climate risk concerns and emissions policies have driven a historic reallocation of capital in low carbon segments of the energy industry. The clear winners are renewable energy technologies such as solar and wind.

The increase in scrutiny is not limited to the carbon intensity of industries either and has extended to cover the social impacts and implications of businesses. Corporations are increasingly expected to be sustainable, not just in their conduct towards the environment, but also in their interaction with stakeholders.

Sustainability is fast taking centre stage in corporate boardrooms, as the shift from shareholder wealth creation to stakeholder “value creation” accelerates. Today, corporations are expected not just to mint profits, but also to exercise ethical and moral responsibilities toward stakeholders (investors, employees, customers, regulators, community and suppliers). A clear message is being delivered around the world – balance sheets are no longer the sole determinants of a company’s worth.

Heeding calls from stakeholders, organisations have begun to disclose their ESG performance among non-financial performance metrics. These metrics, not commonly part of mandatory financial reporting, are increasingly appearing in annual reports or standalone sustainability reports.

Stakeholders Impacted by Organisation’s ESG Footprint

Source: IEEFA Analysis

What is ESG?

ESG looks beyond financial statements and considers a company’s impact on stakeholders. ESG metrics help investors and others understand the company’s environmental footprint, its relationships with stakeholders and its internal governance mechanisms to manage these, while also acting on risks and opportunities arising from its ESG profile.

The concept, which has been around since the 1950s, gained a fresh lease of life in the early 2000s, just as climate policy started getting crystallised. In 2006, the United Nations Principles for Responsible Investing (UNPRI), the world’s leading proponent of responsible investment, came into being. The world’s top institutional investors came together and pledged to consider ESG factors in their investment decision-making. As of April 2021, UNPRI has more than 4,000 signatories from over 60 countries representing over US$120 trillion of assets.

Major factors

Source: IEEFA Analysis, CFA Institute

Individual facets of ESG 

Environmental factors are the major driving force within ESG as the world grapples with the adverse effects of climate change and as climate advocacy increases. Over the past decade, the top five global risks have shifted from economic to environmental and social issues. As of June 2021, financial institutions across the globe committed to more than 1,370 fossil-fuel divestments and phase-outs, according to Bloomberg NEF’s ‘Unpacking the Baggage of ESG Regulation’ report.

The Global Climate Risk Index 2021, based on the impact of extreme climate events such as storms, floods and heat waves, ranked India as the seventh worst-affected country. In India, climate risks are a prime concern for the government, given the potential for severe physical and economic damage. Indian companies stand to lose Rs7.14 lakh crore (~ US$100bn) to climate change if they do not take mitigation measures over the next five years, according to the Carbon Disclosure Project’s (CDP) 2020 annual report.

As the world’s fourth-biggest emitter of carbon dioxide, India has set ambitious goals to mitigate climate risks. At COP26 in Glasgow, India committed to getting 50% of its energy from renewable resources by 2030, and by the same year reduce total projected carbon emissions by one billion tonnes and eventually reach net zero by 2070. Among the raft of measures to achieve these goals are clean electricity, ethanol-blended fuels, electric vehicles and green hydrogen. With the government firmly backing the green shift, at least the environmental part of ESG is likely to be a closely watched space.

Social factors, the least appreciated aspect of ESG, are gaining prominence. A company’s relations with its employees, customers, regulators and community can determine whether a project flounders or flourishes. Over the years, investors have gained a more nuanced understanding of the links between poor social practices and company risks, and have increased the pressure on companies to exercise greater social consciousness.

Corporate governance, historically a reference to the relationship between shareholder interests and management self-interest, is also expanding to focus on relationships with a broader set of external stakeholders. Emerging core issues are pay inequality, board independence, gender diversity and an overall mechanism and strategy to manage ESG risks and opportunities.

ESG risks and opportunities

A company’s ESG risks can lead to several types of financial and reputational damage, but also offer potential opportunities.

Environmental: Increasing operating costs due to higher pricing of greenhouse gas (GHG) emissions; write-offs and early retirement of assets due to enhanced emissions reporting obligations and substitution of products with lower emissions options; reduced demand for goods and services due to change in customer choice; costs to adapt/deploy new practices and processes while transitioning to lower emissions technology.

Social: Impacts on company profitability and reputation due to labour disputes or strikes;
reduced demand from customers or litigation due to safety risks in products or services; disruption of operations or supply chain due to geopolitical conflicts; demographic or consumer changes shrinking market for the company’s products.

Governance: Multiple directorships of board members leading to conflict of interest; lack of experienced board members in navigating an energy company through the transition; excessive executive remuneration eroding trust in business; scandals due to lax compliance on information disclosure, auditing, accounting or regulations

The above risks are not usually mentioned in mandatory financial reporting, but can have far-reaching consequences for companies. On the flip side, companies stand to benefit immensely from better management of ESG issues.

On the environmental front, businesses can reduce operating costs through the use of renewable energy and reducing water consumption. By better management of social aspects, such as labour relations and exposure to supply chain partners in geopolitical hotspots, companies can avoid disruption to their normal operations. The governance structures that help companies appreciate opportunities and foster a culture of trust and collaboration with stakeholders are a prerequisite “g” for dealing with ESG opportunities and risks. These aspects have become more significant than ever following the global COVID pandemic and ensuing supply chain disruptions.

Institutional investors are at forefront of ESG push

Institutional investors, arguably among the largest shareholders in companies across the globe, are leading the ESG push. According to a 2020 study of institutional asset owners globally, 95% are integrating or considering integrating sustainable investing in all or part of their portfolios. It is of higher importance for institutional investors such as insurers and pension funds to incorporate these metrics in investment decision-making as they are typically long-term patient investors who will be among the most affected by ESG risks.

Institutional investors are also backing activist investors aiming to shake up corporate boardrooms to be more responsible on ESG matters. In May 2021, activist investor Engine No. 1 engaged in a proxy battle with ExxonMobil, electing three directors to ExxonMobil’s board to help drive a green energy strategy. Another, Third Point, called in October 2021 for Royal Dutch Shell to split its business lines into multiple successor entities.

In India, institutional ownership has been steadily increasing over the years, both domestic and foreign. Businesses are increasingly aware of higher scrutiny by investors on ESG matters. State Bank of India has been under pressure from its global investors such as Blackrock and Norway’s Storebrand ASA to stop funding coal projects, while others such as Amundi and AXA have sold off their holdings of the bank’s green bond over its ties to Adani Group’s coal project in Australia.

Impact of COVID-19

When COVID-19 struck, investors dubbed it the 21st century’s first “sustainability” crisis. The pandemic disrupted businesses globally regardless of the strength of their balance sheets. Instead, typically under-reported business issues, such as employee health and safety, labour unrest, workforce diversity, unsettling geopolitical events and evolving customer preferences, came to the fore. Company boards tackled issues ranging from rewriting their business strategies and continuity plans to managing an entirely new set of social and economic risks, revisiting how they conduct their core business and focusing on employee well-being and experiences.

The pandemic highlighted that beyond financial crises, which have in the past led to the breakdown of world economic order, physical risks such as those stemming from climate change or geopolitical uncertainties potentially cause much more havoc. According to a survey of global institutional investors by Ernst & Young, 90% of investors give greater importance to companies’ ESG performance post the pandemic and 86% said corporate decarbonisation is key to their investment.

Regulatory environment warming towards greater ESG disclosures

ESG disclosures are gaining ground in the regulatory environment. By August 2021, 86 countries had issued sustainable finance and ESG disclosure policies, which expanded from just 18 in 2010 to 47 in 2020. This growth is in response to greater non-financial disclosure expectations of investors and the rapidly expanding landscape of ESG standards, ratings and investment instruments. Rising climate action is also leading countries to set individual pathways to achieve carbon neutrality.

In May 2021, the Securities and Exchange Board of India (SEBI) announced that it will roll out a new set of ESG disclosure standards known as the Business Responsibility and Sustainability Reporting (BRSR) standards, requiring the top 1,000 listed companies to report on their ESG parameters from April 2022 onwards.

Via these standards, investors will better understand the ESG footprint of companies, their ESG strategies and their progress on this front in a format that will also facilitate comparison across companies and sectors. This initiative will invite scrutiny by investors, regulators and other stakeholders as the ESG standings of these companies become public.

Examples of ESG Regulatory Landscape Across the World

US SEC to issue new regulations mandating climate-related disclosures by U.S. listed companies.

In December 2021, Singapore Exchange (SGX) mandated that all issuers must provide climate reporting in their sustainability reports.

At COP26, International Financial Reporting Standards (IFRS) Foundation announced the formation of a new International Sustainability Standards Board.

In November 2021, the Hong Kong Stock Exchange (HKEX) published guidance to listed issuers on climate disclosures.

In October 2021, the UK Government brought in rules requiring UK based companies to disclose climate-related financial information.

In October 2021, the New Zealand parliament passed the Financial Sector Amendment Act 2021 requiring companies to make climate-related disclosures.

In May 2021, the Securities and Exchange Board of India (SEBI) announced that it would require the top 1000 listed companies to report on their ESG parameters.

This article first appeared in Carbon Copy. Part 2, Why ESG strategies are fast becoming a mainstay in corporate financial planning, will follow on 30 March.

Shantanu Srivastava is an energy finance analyst at the Institute for Energy Economics and Financial Analysis (IEEFA).

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