ESG refers to the Environmental, Social and Governance characteristics of a company or business. These facets of the business contribute to the risks and opportunities it is exposed to now and in future.
Environmental refers to a company’s dependency and impact on ‘natural capital’, the stock of renewable and non-renewable natural resources. This includes how the business impacts (or is impacted by) climate change, what natural resources it produces or uses and whether it contributes to pollution or waste.
All of these factors affect how susceptible the company is to reputational and regulatory risk, asset devaluation (including unusable ‘stranded assets’), and compensation claims (for example the 2010 Deepwater Horizon oil spill which severely affected the oil company BP). Environmental factors can also be opportunities. Companies building windfarms are benefitting from increasing demand for renewable energy.
Social factors include how the company affects customers, looks after its employees, deals with suppliers, and interacts with the communities in which it operates.
Again, handling these issues badly can lead to reputational risk and, in extreme cases, the withdrawal of the company’s social license to operate (for example payday lenders like Wonga which collapsed after the UK government clamped down on the extremely high interest rates they charged). Social factors can also represent opportunities, like the construction of social housing or responsible micro-finance.
Governance (or corporate governance) is the process by which a company is managed and overseen and includes factors like board structure, to create proper accountability, and management remuneration to create alignment of interest with shareholders.
Governance failure can have serious consequences The US company Enron which collapsed into bankruptcy after, amongst other failings, staff being rewarded based on short-term share price movements and the CFO being given free rein to create off-balance sheet vehicles to hide debt and inflate profits.
As defined by the UN PRI, ESG Integration is “The systematic and explicit inclusion of material ESG factors into investment analysis and investment decisions”.
It is important to note, however, that ESG integration does not prohibit any specific investments as long as material ESG risks are identified and taken into account as part of the investment decision.
For example, funds properly integrating ESG can invest in oil companies, they just must be aware of the risk of some of their oil reserves becoming uneconomic due to changing environmental standards and be confident the price of the shares reflect this.
1.2 Stewardship
According to the Financial Reporting Council in The UK Stewardship Code 2020,
“Stewardship is the responsible allocation, management and oversight of capital to create long-term value for clients and beneficiaries leading to sustainable benefits for the economy, the environment and society.”
