Environmental, Social and Governance (ESG) are three key factors used to measure a company’s sustainability and social responsibility performance. While the acronym has recently gained attention, ESG risk failures are widely known. They can take the form of regulatory interventions, reputational damage, and investment risk over labor practices, civil rights, market manipulation, data privacy or environmental degradation.
ESG ratings are mostly used to assess a company’s sustainability performance and level of risk in addition to traditional profitability criteria (balance sheet and P&L analysis). While not all ESG metrics may directly impact a company’s profitability, they all impact reputation and can indicate a lack of preparation for long term risks or potential exposition to regulatory action. Other ESG metrics may have direct financial impacts such as Climate Change and require proper risk quantification and mitigation.
Why ESG Is Important
For buy side firms, ESG data and ratings has become a component of risk management and investment strategy. Several research and recent trends have shown ESGs impact in creating higher value, pointed to shifting wealth trends, and led to additional corporate disclosures and potential regulations.
- Value Creation: Recent analysis has shown that companies with consistently high ESG performance have, on average, 3.9 times Operating Margin and 2.7 times Total Return to Shareholders compared to low ESG performance firms1. This material gap illustrates the power of effective ESG companies and how critical ESG risk management is for performance.
- Shift in Wealth: Individual investors are increasingly ESG conscious. One in four investment dollars is now flowing into ESG funds and ESG assets and investments rose from $4T in 2012 to $12T in 2018. There is also a massive transfer of wealth occurring from boomers to millennials who have very different values and expectations. A recent UNGC-Accenture survey showed that 47% of customers expected brands to translate their values into innovative services; 43% were willing to walk away if expectations were not met2. This presents opportunities for asset managers who make early moves on ESG investing services and products.
- Risk Management: ESG issues are often highlighted by news media when investors suffer sudden and substantial losses on listed equities—losses that are attributed to poor management of risks posed by one or more of these ESG issues. A 2019 study by Bank of America found that ESG failures resulted in a loss of over $500B in market value for 24 ESG related events such as data breaches, accounting scandals, and sexual harassment3. This was measured by looking at peak to trough valuations for 12 months after the events for companies in the S&P 500. ESG failures can have significant financial and reputational costs that take years to recover
- Regulatory Readiness: The UK and European Union have been leading the implementation of new regulations for ESG and Climate Risk, while Asia has largely followed closely. There is an expectation that the United States could move forward with initiatives to mandate stress testing for climate risk, embed ESG into risk management frameworks, implement Green/Brown Taxonomies and increase transparency through better climate disclosures
- Investor Transparency and Activism: The demands of institutional investors are driving change for asset managers and capital raising enterprises. Major institutional investors such as BlackRock, Vanguard, and State Street have begun mandating disclosures and threatened to take actions against Boards that do not comply. To make this information comparable and useful for investors, several data providers including traditional rating agency produce ESG ratings. Because there is no universal standard or requirement for ESG disclosures or data, ratings and methodology can vary significantly. An MIT study found that ESG rating correlation was 0.61 vs a 0.99 corrtion for credit ratings by Moody’s and Standard & Poors4. Other firms provide underlying metrics to ESG, such as Owl Analytics and S&P Global. These can be used to create custom ratings (by applying tailored weighting) or dive deeper into specific company strengths and risks.
- Reduction in Cost of Capital: ESG is also an opportunity when it comes to innovative lending products and has the potential to reduce cost of capital for firms with strong ESG performance. In 2019, Shell signed a $10B credit facility that included potential incentives on interest and fees for progress made toward its Net Carbon Footprint intensity target5. More recently AB InBev singed a $10.1B credit facility linked to improving water efficiency in breweries, increasing PET recycled content in PET primary packaging, sourcing purchased electricity from renewable sources and reducing GHG emissions6.
ESG impacts for corporates are more focused on compliance with investor disclosure requirements and potential regulations, as well as improving ESG performance to retain investors, customers, and employees. To be successful, ESG risk management would have to be integrated into existing frameworks and supported by clear responsibilities.
ESG Challenges and Integration
For all its potential opportunities, ESG poses several challenges for buy side firms as they integrate ESG into existing risk management frameworks.
- Governance: ESG has a broad scope and impacts numerous risk types and business lines. Because of this, leadership needs to take the initiative to set companywide ESG governance standards. This includes the Board, senior executives, and Risk Committees. While the CFO is typically responsible for ESG (e.g. investments, cost of capital, and reporting), the CRO should take on the mandate for specific areas to facilitate a comprehensive approach. This may include an ESG lens for reputation risk, regulatory change management, and governance processes. In addition to clear roles, define a purpose statement and priorities for ESG and climate risk management. Review products, talent, culture, and external partnerships for sustainability alignment, risks, and opportunities.
- Strategy and Framework: Firms have aspects of ESG in their existing risk frameworks but would need to identify gaps and opportunities for improved management. Integrate ESG into risk management framework across risk types and define risk appetite. Additionally, understand how ESG could impact existing products and services or necessitate the launch of new offerings. A risk readiness assessment can be used to analyze ESG maturity against peers. This can then provide a roadmap towards an integrated sustainability operating model.
- ESG Data Accessibility: ESG data is readily available or cost effective to attain. Since not all companies are disclosing data and measurement methodologies differ, comparison across firms can be difficult even for the same metrics. Additionally, not all data disclosed is granular enough or relevant to be useful in making credit or investment decisions. While the convergence of standards would help, firms should be proactive in developing and implementing ESG data and reporting strategies while still keeping an eye out for changes.
- Disclosures: Regulators, supervisors and exchanges are moving towards making ESG disclosures, such as TCFD, SASB, and World Economic Forum mandatory. Assess what changes to existing processes and capabilities are needed to report and ESG disclosures. For international firms, this poses a particular challenges as different countries may have different requirements. Firms should consider tools or processes to monitor and scan through emerging regulations on a real time basis and assess against current frameworks.
ESG is rapidly becoming a critical component of risk management and a key value driver. To find out more on the topic or how Accenture can help in your ESG Management Journey, please contact the authors and stay tuned for additional posts on regulatory change, sentiment analysis, and data strategy.
- Percentage-points premium over companies with low ESG performance, annual average 2013-2018. Research analysis of Arabesque S-RAY® and S&P Capital IQ data. Number of companies analyzed = 7,761. Outputs from panel econometric regression models with coefficients significant at the 5% level. Operating profit = earnings from continuing operations, defined as earnings before tax including unusual items less income tax expenses.
- UNGC-Accenture CEO Study; 9/24/2019
- Chris Flood; “ESG Controversies Wipe $500bn off value of US companies”; Financial Times, 12/14/2019
- Mayor, Tracy; “Why ESG Ratings Vary so Widely”; 8/26/2019
- Shell Press Release; 12/13/2019
- AB InBev Press Release; 2/18/2021