How ESG Became Integral to Calculating Risk

ESG represents an analysis of companies through the lens of the environmental, social and governance stance of an organization. These are factors that used to be called non-financial, but have increasingly been shown to be financial or “material”. That is, they are related to the performance of an organisation in the longer run, and the performance of an organisation's share price in some respects in the shorter run. Climate change has become a focus of ESG recently. This is almost a separate carve-out, although the climate change aspects are captured by the environmental factors that are analysed.

ESG is about the risks and opportunities that an organisation faces in its operations and throughout its entire value chain. This can include such things as carbon emissions from an environmental perspective, health and safety policies from a social perspective and the operations of the board from a governance perspective. All these have become more important in recent times as drivers of better-behaving companies. For example, the U.S. Business Roundtable is just one of many organizations that has changed its focus from maximising corporate profits to also including a company’s impact on the environment and society overall.

Green Investing Takes Hold

Given the link between ESG issues and corporate performance, financial markets have recognized the opportunity to create products that are linked to the ESG behaviours of companies. For example, we are seeing substantial growth in debt linked to sustainable bonds, or climate bonds. These facilities are created using performance metrics, such as carbon intensity, and linking good behaviour to a lower rate of funding for an organisation. Investors are increasingly focussed on these types of products as they strive for greener investments.

While some are sceptical about returns from ESG investments, there is enough evidence today to disprove any naysayers. There are many factors that go into an investment strategy, and incorporating ESG considerations has been shown to actually increase performance in some cases.^[1] In fact, more than half of the ESG-linked funds outperformed the S&P 500 in the first several months of 2021.^[2]

The focus on ESG has increased substantially over the last 18 months, with a shift towards sustainable investing during the COVID-19 pandemic. In 2020, assets under management tied to ESG ETFs nearly tripled, from just under $60 billion U.S. to more than $170 billion, with flows of $81 billion, according to data compiled by S&P Dow Jones Indices. There has also been an increased focus on ESG through the issuance of sustainably-linked loans.

A Bit of History

Looking at the history of sustainable investing, it started with ethical choices that excluded certain activities and was followed by avoiding controversial corporate behaviour. It has now grown to include the way stakeholders view risks in their supply chains. On its own, climate change has an important role because it impacts all aspects of our society – regardless of where you are located, or if you are a company or an individual. This includes seven physical hazards: heatwaves, cold waves, water stress, hurricanes, wildfires, flood and sea level rise.

Science has been telling us for a long time that climate change is a risk that needs to be considered. Initiatives like the Taskforce on Climate-related Financial Disclosure (TFCD) have moved things forward, gaining the attention of central banks, financial institutions and corporations. TCFD put forward a framework that involves assessing an organization’s governance, strategy and risk management, plus calculating metrics for climate risk.

Along with companies, cities and financial institutions, 131 countries have now set or are considering a target of reducing emissions to net zero by mid-century.^[3] These net zero targets are an extension of the climate reporting and take into account a trajectory to reduce emissions as much as possible to achieve a 1.5⁰ Celsius world in line with the goals of the Paris Agreement, and then offset remaining emissions by using quality carbon credits.

Taking Action in Australia

There is a lot of discussion in Australia about climate change, and all financial regulators have some degree of climate reporting in their guidelines, although there are no mandatory requirements at the moment. While voluntary reporting is encouraged, it is not leading to the quality and consistency that is essential for investors to be able to integrate climate risks and opportunities into their decision-making. Since climate change is a known risk and is impacting many facets of Australian life – agriculture, housing, coastlines and more – there is an urgent need for consistent reporting. A plan for Australia to adopt mandatory financial disclosure, entitled “Confusion to clarity: A plan for mandatory TCFD-aligned disclosure in Australia”, was released in June by major investor networks.^[4]

The Australian economy is driven by exports, with coal being very important, especially thermal coal as a fossil fuel used to generate electricity. Emissions from this coal are a major contributor to global warming. Australia needs to focus on transitioning to a low-carbon economy by capitalizing on renewable energy through solar and wind. The country should change its focus on fossil fuels and invest more heavily in renewable energy solutions to be a leader in this area.

Tools to Help Evaluate ESG Performance

Company ESG scores are a useful measure to evaluate performance. An ESG score is derived from an assessment of those risks that are deemed to be material to an organisation, meaning they can impact the financials. The scores typically involve collecting hundreds, if not thousands, of data points at the organisational level, which are then aggregated. With the S&P Global Corporate Sustainability Assessment (CSA),^[5] this results in an overall ESG score and individual E, S and G scores, as well as scores for elements within these three categories. An overall score that is closer to 100 represents a company that has stronger ESG credentials.

Another place to glean important insights is by looking at a TCFD report. While not every company has one available, the bigger companies in Australia do, including the larger banks. As an investor or a stakeholder looking at an organisation through their reporting, it is important to consider two areas of exposure. One is transition risk, which is an earnings risk exposure from a carbon price shock. The other is physical risk, which is exposure to the seven hazards that were mentioned earlier. A more detailed evaluation at the asset level can also be conducted using S&P Global Trucost’s Physical Risk Dataset that contains 2.7 million+ assets mapped to 15,000+ companies.