The Rising Importance of ESG

What is ESG?

ESG stands for Environmental, Social and Governance and is a framework designed to measure the degree to which industries and organizations prioritize sustainability and ethicality over profit.

Let’s break down each part of ESG:

• Environmental assesses ecological contribution and how organizations address sustainable issues of climate change, renewable energy, recycled packaging and water management.
• Social refers to how businesses respond to human rights and geopolitical issues as well as manage intraorganizational policies related to labor, diversity and working conditions.
• Governance informs organizational transparency and ethical business practices and includes reporting on executive pay, corruption, company policies, conflicts of interest and tax strategy.

Importance of ESG

While ESG has always been on the mind of the public, the COVID-19 (coronavirus) pandemic and war in Ukraine have recently accelerated its importance among individuals as well as organizations.

• Consumers: According to PricewaterhouseCoopers (PWC) 2021 Consumer Intelligence Survey, 83.0% of consumers believe companies should be actively shaping ESG practices. Conscientious consumers stated they are willing to spend more on a company’s products or services if they are eco-friendly or socially aware. Conversely, 76.0% of consumers stated they would cut ties with businesses whose standards are not up to par.
• Employees: ESG performance can help companies not only attract high-level talent but also make sure they stick around. According to PWC, 86.0% of employees prefer to work for a company that cares about the same issues as they do. Companies that implement a well-organized ESG strategy will be more desirable to work for. This is becoming of growing importance as Gen Z and Millennials make up a rapidly increasing percentage of the labor force; these groups place a higher value on environmental and social issues.
• Businesses: Having a strong ESG approach can help businesses reduce operational costs through various sustainability methods, as well as improve their growth and outshine competitors. Investors are rapidly adopting ESG-funds, which have grown rapidly over the last five years to 2021. According to Morningstar Direct, ESG funds reached almost $70.0 billion, an increase of 35.0% from 2020. This also represents a significant increase from 2017, when funds reached only $5.0 million.

How do companies use and measure ESG?

Companies use ESG as a way to present their various social or environmental impacts, which may not be directly stated in their financial statements. This type of information can be reported in many forms but is most commonly presented as a sustainability or ESG report, which is typically released alongside annual fillings.

Companies will often require the assistance of organizations such as the Global Reporting Initiative (GRI) to help disclose ESG related information.

The way ESG is measured can vary since operators will be in charge of metrics and usually have their own criteria for determining ratings. For example, MSCI Inc. (MSCI) calculates a company’s ESG rating based on how it compares to its competitors.

Additionally, different criteria can be used when accessing a rating depending on the industry. For example, carbon emissions and environmental footprints are more significant when assessing a manufacturing operator compared with a financial institute.

ESG: Banks and regulation

Social and responsible business practices are quickly becoming extremely important within lender-borrower relationships. Although no rules or regulations currently exist at the federal level requiring ESG disclosure, the US Securities and Exchange Commission (SEC) has recently proposed a rule requiring companies to disclose environmental information as it relates to climate change.

Despite this proposal, many institutions have already begun using ESG information in evaluating new and existing loans while also actively introducing these same criteria to help manage portfolio risk.

Planning ahead

Moving forward, lenders are projected to set aside a greater share of funds for projects and organizations that address ESG concerns. This poses a significant risk to borrowers that are identified as having social or ethical hazards by being shut out of the credit market.

Tips for commercial banking:

• Incorporate any ESG-relevant information into credit write-ups.
• Offering green loans and continuing to invest in ESG-related projects, including diversity, renewable energy, energy-efficient buildings and affordable housing. With the Biden administration restricting lending for overseas fossil fuel companies, more stringent rules may come in the near future. Banks should keep this in mind when evaluating potential clients. Stay tuned for Part 2 where IBISWorld highlights specific industries that are likely to be affected due to increased ESG importance.
• Provide preferential rates for sustainable lending. Banks can draw up sustainability-linked loans that reward companies for meeting ESG benchmarks. These metrics are supplied through internal key performance indicators or third-party companies. In May 2021, US loans linked to sustainability goals reached $52.0 billion, up from $13.3 billion in 2020.
• Provide visibility through ESG or sustainability-related reports. While ESG disclosure is not required yet, it has been gaining traction as of late. Getting a head start by generating reports that outline ESG targets, goals, metrics and developments are beneficial for both current and potential clients.
• Continue investment in ESG training for employees. Becoming an ESG-centric business starts from the bottom up and staff should be informed on its importance. Transparency on objectives and overall strategy will enable both parties to be on the same page, enabling a smoother transformation.