What is ESG?

The term ESG or Environmental Social Governance is about making a difference – for business and the world. It’s about creating sustained outcomes that drive value and fuel growth, whilst strengthening the environment and societies.

It also represents risks and opportunities that will impact a company’s ability to create long-term value using sustainable concepts at its core including climate change and resource scarcity, safety issues, data security; board diversity, executive pay, and tax transparency. 

The Environmental aspects include the energy consumption of the company, water, waste management, resources it needs including raw material sourcing and its hazardous nature, use of natural resources, regions or areas before-mentioned sourced from, and the consequences for the company and living beings as a result. Companies that do not consider these environmental risks may face unforeseen financial risks and investor scrutiny. E thus encompasses carbon emissions and climate change vulnerability. Every company uses energy and resources; every company affects and is affected by, the environment. Thus, how a company manages its environmental impact is a very important profile to the company. 

The social criterion examines the relationships the company has and the reputation it fosters with people and institutions in the communities where it does business. The culture of the company is under the spotlight here.  This includes labor relations and management, employee happiness index, health and safety, diversity and equity, inclusion, data privacy and security, and customer relations. Every company operates within a broader, diverse society.  

Governance considers a company’s internal system of practices, controls, and procedures a company adopts to govern itself, make effective decisions, comply with the law, and meet the needs of external stakeholders. It tracks integrity, transparency, and industry best practices and includes dialogue with regulators. Factors considered are the company’s leadership, board governance, business ethics, intellectual property protection, audit committee structure, internal controls, shareholder rights, bribery and corruption, lobbying, political contributions, and whistleblower programs. 

ESG Importance for Firms

Companies with strong ESG performance have demonstrated higher returns on their investments, lower risks, and better resiliency during a crisis. There is increasing pressure on companies to adopt the best ESG practices from consumers, investors. Investors and funds base their investment decision increasingly on the ESG performance of companies. Also, the brand image of a company is now closely linked with ESG 

While earlier government regulatory compliances called for a portion of environmental and social standards, increasingly these now encompass a wider set of ESG metrics to report on. This has now grown to encompass the whole supply and distribution chain. It opens access to increasing governmental green subsidies and green tax and any failure can lead to huge penalties and brand image damage 

Surveys reported show this increasing pressure on organizations from consumers, investors, employees, and how boards are reacting to it. 83% of consumers think companies should be actively shaping ESG best practices. 91% of business leaders believe their company has a responsibility to act on ESG issues. 86% of employees prefer to support or work for companies that care about the same issues they do. 

ESG of a company is increasingly crucial to its shareholders. This has led to individual investors and investment funds increasingly investing based on ESG ratings of companies. This is seen as a safeguard from risks of E and as a responsibility to future generations Surveys show 79% of Global investors say that ESG risks are an important factor in investment decision-making. 

Investors poured 51 billion dollars into ESG-impact funds in 2020, more than doubling such investments within a year. Investors increasingly believe businesses can do well by doing good. The long-term advantages of advancing ESG are apparent to companies too, with 92% of business respondents agreeing that companies with commitments to ESG policies will outlast competitors without. Sustainability funds and portfolios are now up to $37.8 trillion by the end of 2021.  $649 billion went into ESG funds in 2021, accounting for “10% of worldwide fund assets. $4 trillion of institutional assets are now invested in ESG portfolios. ESG assets are projected to be at $53 trillion by 2025 Task Force on Climate-related Financial Disclosures (TCFD) has almost doubled the organizations following it within a year. According to TCFD’s data published in October 2021, more than 2,500 organizations with a combined market capitalization of over $25.1 trillion support its recommendations. 

Businesses need to take proactive steps now to be better positioned for success as data and reporting get more regulated and standardized.  It is not just large companies with a global footprint that will be impacted, but also all those SMEs around the world that provide raw materials and distribution channels. Customers too will need to be involved. 

The move to netzero and low carbon footprint may result in plant closures and risk of stranded assets, or assets that turn out to be less valued than expected as a result of the transition to a low-carbon economy. ESG helps in effective communication tactics of the company with its employees, shareholders, and community without affecting brand image 

Existing and Incoming Protocols and Regulations 

An example of how the organizations part of the supply chain also get affected is The Greenhouse Gas (GHG) Protocol. It categorizes greenhouse gas emissions into three groups or ‘Scopes’. Scope 3 includes all other indirect emissions from a company’s value chain. The GHG Protocol classifies Scope 3 emissions as all indirect emissions that result from assets not controlled or owned directly by the organization but that occur in its value chain. That is why it is often called value chain emissions.  

The EPA of USA has a registry and mandatory GHG reporting rule which includes automobile and engine manufacturers to report from 2011. CARB has its regulation on this from 2007. 

ECHA substance of concern SCIP, US, and EU conflict minerals act and regulations, California prop 65, EU regulation on chemicals REACH and EU end of life vehicle directive are some of the regulations existing in the E sphere.  Some of the existing regulations and protocols in the S sphere are OECD due diligence guidance, French duty of vigilance law, and similar such bills across EU nations and EU parliament. German Supply chain due diligence act is involving both E and S spheres. 

USA SEC has publicly stated it will propose a rule to require climate-related disclosures in public filings. In the EU, the new Sustainable Financial Disclosure Regulation (SFDR) has made sustainability reporting mandatory. 

Applicable from march 2021, The Sustainable Finance Disclosure Regulation (SFDR) sets specific rules for how and what sustainability-related information financial market participants and financial advisers in the EU need to disclose. 

The EU’s proposed Corporate Sustainability Reporting Directive (CSRD) will include required disclosures on E, S, and G topics for all large companies and all companies listed on EU-regulated markets, including US subsidiaries located in the EU. These reporting requirements are expected to be detailed[17]. They are being developed by the EFRAG (European Financial Reporting Advisory Group) in cooperation with GRI. Notably, third-party assurance is expected to be required. The rules are likely to be finalized in 2022 for an effective date of January 2023.  CSRD has a format and includes the standards that companies have to meet in their reports. This is in addition to the taxonomy regulation and SFDR.  In the UK, large companies will be required to report on climate risks by 2025. 

Reporting Standards, Frameworks and Metrics 

Just as financial reporting is prepared per accounting frameworks like US GAAP, IFRS, ESG standards and frameworks allow companies to disclose standardized information. They provide consistency and comparability, and they benefit from due process, enabling investors to make more informed decisions. 

The GRI (Global Reporting Initiative) standards are organized as three foundational universal standards, which were updated in October 2021, plus 34 supplemental topic-specific standards (e.g., procurement practices, emissions, and customer privacy). They are also developing industry-specific standards, with one published so far (oil and gas). A company may use the full set of standards, incorporating both the universal standards and supplemental areas based on its material ESG topics, or it may use only selected standards or metrics. 

TCFD (the Financial Stability Board’s Task Force on Climate-related Financial Disclosures) recommendations are designed to apply across industries, organizations, and jurisdictions and encompasses suggested disclosures within four pillars: governance, strategy, risk management, and metrics & targets. 

In 2020, WEF-IBC—a joint effort of the World Economic Forum and the International Business Council, a consortium of 120 of the world’s largest companies—issued a proposed set of “Stakeholder Capitalism Metrics.” These metrics were developed based on existing standards and are intended to help companies align their financial reporting with disclosures on ESG matters. The WEF’s objective is also to accelerate convergence among the leading private standard setters. This report is a follow-up to the draft for consultation, Towards Common Metrics and Consistent Reporting of Sustainable Value Creation, launched in January 2020. 

The International Sustainability Standards Board (ISSB) is a new board formed by the IFRS Foundation at COP26. The goal of the ISSB is to establish a global baseline for reporting, beginning with a focus on providing decision-useful information to investors on climate leveraging existing frameworks. In conjunction with the establishment of the ISSB, the IFRS Foundation intends to consolidate the Climate Disclosure Standards Board (CDSB, an initiative of CDP, formerly known as the Carbon Disclosure Project) and VRF to lay the technical groundwork for a global sustainability disclosure standard-setter for the financial markets. 

The VRF (Value Reporting Foundation) had been formed by the merger of the SASB (Sustainability Accounting Standards Board) and the IIRC (International Integrated Reporting Council). The CDSB was formed as an international consortium of business and environmental NGOs “committed to advancing and aligning the global mainstream corporate reporting model to equate natural capital with financial capital.” The CDP, SASB, GRI, and TCFD are the top four reporting standards and frameworks used by global big corporations. 

Frameworks like the UN Sustainable Development Goals or the WEF/IBC reporting framework can be helpful guides, organizations must also involve and engage directly with employees, regulators, NGOs, and local communities. 

Corporate GHG Emissions Inventory Verification is recommended by many standard setters, such as CDP and the Global Reporting Initiative (GRI), and in some instances, is required by regional regulatory bodies such as the California Air Resources Board (CARB). Companies using the CDP’s framework are already required to get third-party assurance of GHG emissions from independent accredited verification providers. Other assurance is voluntary but provides users with confidence in the information. 

SASB standards are available for 77 industries across 11 sectors. The Standards address five dimensions of sustainability: Environment, Human capital, Social capital, Business model and innovation, Leadership, and governance. 

Companies need to identify the ESG topics and metrics that are material to the company’s core strategy and long-term value creation to help prioritize and channel efforts.  They thus need to leverage established frameworks and standards and engage with stakeholders to get their input. 

The metrics to be assured need to be provided using a suitable framework, whether established (e.g., SASB, GRI, TCFD) or based on custom metrics, against which to compare management’s disclosures. Once a suitable framework is established, there are various levels or degrees of assurance at the option of management: examination, review, or certification/verification. 

The wide adoption of ESG ratings is the result of asset managers signing the United Nations Principles for Responsible Investment (PRI). PRI, which as of 2017 had 1,800 signatories from over 50 countries representing $70 trillion, encourages asset managers to incorporate ESG factors into their investment decisions. 

ESG Rating Agencies 

Some agencies rate the ESG performance of a company and report and rank them to aid public and fund managers.  The top four rating agencies are MSCI, Sustainalytics, REPRISK, ISS E&S 

MSCI evaluates 37 key ESG issues, divided into three pillars (environmental, social, and governance) and ten themes: climate change, natural resources, pollution & waste, environmental opportunities, human capital, product liability, stakeholder opposition, social opportunities, corporate governance, and corporate behavior.

Sustainalytics looks at what it defines as key ESG issues and indicators. It splits them into three pillars: environmental, social, and governance. Sustainalytics examines at least 70 indicators in each industry. It also breaks down ESG indicators into three distinct dimensions: preparedness, disclosure, and performance. 

RepRisk focuses on 28 ESG issues connected to the Ten Principles of the UN Global Compact, which encourages global businesses to adopt socially responsible policies and report on their implementation. It divides these into environmental, community relations, employee relations, and corporate governance issues. RepRisk also includes ESG risk exposure for both a two-year and a ten-year timeframe using a scope of 28 ESG issues and 45 “hot topic” tags.

ISS E&S Quality Score evaluates 380+ factors (at least 240 for each industry group) divided into environmental and social factors. Areas include management of environmental risks and opportunities, human rights, waste and toxicity, and product safety, quality, and brand. The offering is touted as being very similar to the company’s well-known governance score.

In India too, similar rating agencies are coming up. ESGRisk.ai, a wholly-owned subsidiary of Acuité Ratings & Research Limited, is India’s first ESG rating company with an India-specific assessment framework. Acuité Ratings & Research is a bond and bank loan rating agency accredited by RBI and registered with SEBI. 

Need for ESG Automation 

Data visualization and transformation tools can further enhance the quality of ESG data and reporting as companies move towards integrated reporting. Digitization and technology help companies navigate multiple sources of data to create a central source of key ESG data and metrics, real-time reporting, and analytics to inform internal decision-making and provide high-quality external disclosures and reporting. It allows the executives to act faster to make ESG driven changes. Automation of ESG also helps in reduction in cost and time for regulatory compliance reporting. 

At APA engineering Automated solutions are available in the E sphere for ECHA substance of concern SCIP, US and EU conflict minerals act and regulations, California prop 65, EU regulation on chemicals REACH and EU end of life vehicle directive IMDS.  Please contact [email protected] for further queries 

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