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ESG moves from the margins to the mainstream

Once viewed as "nonfinancial," such data is increasingly demanded by investors, stock markets and governments.

The following is adapted from State of Green Business 2018, published by GreenBiz in partnership with Trucost.

Environmental, social and governance issues are often described by businesses and investors as "nonfinancial," suggesting they have no materially significant impact on the bottom line, either as a risk to revenue or an opportunity for business growth.

There’s a growing recognition by companies and investors that this view is mistaken — that ESG matters are fundamental to business performance and should be disclosed in financial reports. Businesses are also coming to realize that integrating ESG concerns into core business and financial decisions will generate new streams of data that can be used to enhance growth and sustainability.

Climate change is driving this. At COP23 in Bonn, Germany, world leaders discussed progress towards the Paris Agreement to limit global warming to 2 degrees Celsius by putting a price on carbon through emissions trading schemes and carbon taxes. So far, 42 national and 25 local governments have implemented carbon pricing initiatives or are planning to do so.

There’s a growing recognition that ESG matters are fundamental to business performance and should be disclosed in financial reports.
To assess the anticipated impact of rising carbon prices, Trucost analyzed the greenhouse emissions and financial performance of almost 100 companies operating in 16 countries in three sectors — automobile manufacturing, chemicals manufacturing and power generation. It found that 30 percent of profits in the automobile sector could be at risk by 2050, while the chemicals sector could have 60 percent of its profit at risk and the power sector could have its profits wiped out entirely, with 150 percent of its profits at risk.

The social impacts of a company's operations also can have serious financial effects. In 2017, shares in Tahoe Resources fell when the Canadian mining company was forced to halt production at its Escobal silver mine in Guatemala — the third largest in the world — after the Guatemalan supreme court suspended its license. The court found that the government had violated the rights of indigenous people by failing to adequately consult them before issuing the license. Tahoe Resources is also facing a lawsuit in Canada over alleged violence at the mine in 2013.

On the positive side, research by Bank of America suggests that progressive ESG practices improve company performance. It found that the top 20 percent of companies in terms of ESG ratings from 2005 to 2010 experienced the lowest (32 percent) volatility in earnings per share in the subsequent five-year period. By contrast, companies with the worst environmental, social and governance records averaged 92 percent volatility.

Despite this evidence that ESG matters are a financial issue, companies are too often blind to it. KPMG's survey of 4,900 companies worldwide (PDF) in 2017 found that three-quarters fail to acknowledge the financial risks of climate change. Of those that do, most provide only a narrative description of the potential implications. Just 2 percent quantify the risks in financial terms.

This soon could change as a result of the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), set up by the Financial Stability Board, whose members include financial authorities such as the Board of Governors of the Federal Reserve System, the U.S. Securities and Exchange Commission and the U.S. Department of Treasury.

The TCFD recommends that companies and investors publish forward-looking information on the financial implications of climate change in annual reports and financial filings. This could include a 2-degree-Celsius scenario analysis — an assessment of the implications of a range of pathways in the transition to a low-carbon economy, in which energy is generated largely from renewable sources.

And the TCFD is not concerned only with carbon. The recommendations clearly state that the financial performance of organizations also may be affected by other climate-related environmental impacts, in particular, water scarcity and water quality, and organizations should report on these as well.

Research by Bank of America suggests that progressive ESG practices improve company performance.
An issue to watch in 2018 and beyond is what progress companies and investors make towards implementing the TCFD recommendations, and whether policymakers decide they have to force the pace. The EU's High-Level Expert Group on Sustainable Finance has suggested that the TCFD recommendations could be implemented by revising legislation on non-financial reporting.

Stock exchanges are playing an important role in mainstreaming ESG disclosure. Fifty-eight stock exchanges, representing over 70 percent of listed equity markets, have joined the Sustainable Stock Exchange Initiative (PDF). Twelve exchanges incorporate ESG reporting into their listing rules, and 15 provide formal guidance to issuers. A further 23 stock exchanges have committed to introducing new ESG reporting guidance. Stock exchanges in Asian countries such as Singapore and Malaysia are being the most proactive on ESG, in contrast to those in the United States, raising the prospect of American companies competing for capital with Asian companies that have much greater transparency on ESG.

These emerging requirements to disclose on the financial implications of ESG factors should be seen as an opportunity by companies and investors to gain insight into their business, revealing ways in which risks can be managed, waste and inefficiency reduced and opportunities for growth identified.

To do this, companies are looking for analytical tools that make sense of ESG data in business terms and integrate it into decision-making processes. For example, to help assess exposure to evolving regional carbon pricing mechanisms, some companies are using Trucost's Corporate Carbon Pricing Tool. The results can be used by sustainability managers to make the business case to the chief financial officer for investing in low-carbon technology. They also can be used to calculate an internal price of carbon. Some 1,400 companies already have factored an internal carbon price into business plans — an eightfold leap in take-up (PDF) in the last four years.

The London-based investment manager Schroders recently launched its Carbon Value at Risk tool, designed to help investors more accurately assess the risks that higher carbon prices pose to their portfolios. Schroders shows that some 20 percent of the profits generated by global companies are at risk if carbon prices rise to the levels required by the Paris Agreement. In the most exposed sectors such as construction, steel and commodity chemicals, some 80 percent of profits are at risk.

Similar tools have been developed to assess the financial implications of water scarcity and pollution, such as Trucost's Water Risk Monetizer, which helps companies assess water-related risks at specific sites in potentially vulnerable areas. Doing so can help make the case for investment in water stewardship projects using metrics such as revenue at risk and increased operating costs, and by creating a water "shadow price" to assess the financial return on a particular project.

For investors, the Natural Capital Declaration has created a Corporate Bonds Water Risk Credit Tool, which allows users to integrate water stress into company credit analysis for water-intensive sectors including power utilities, beverages and mining.

The take-home message is that 2018 should be the year we stopped using the term "nonfinancial" reporting to describe ESG issues as more investors understand its financial implications and demand that it be integrated into decision making.

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