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ESG Matters are Now Considered Material Risks

Environmental and social issues have taken hold in mainstream media, as people become conscious of the negative consequences of pollution on climate and the environment.

Along with the growth of social media and lightning-fast dissemination of information, this is an area that organizations, and their boards, cannot afford to get wrong.

According to the International Organization of Securities Commissions (IOSCO), Environmental, Social and Governance (ESG) matters are now considered material risks.

In January 2019, the IOSCO published a statement setting out the importance of including ESG matters when disclosing material to investors’ decisions.

IOSCO maintains in its Objectives and Principles of Securities Regulation that, “securities regulation has three key objectives: protecting investors, ensuring that markets are fair, efficient, and transparent, and reducing systemic risk.”

With regard to this principle, IOSCO emphasizes that ESG matters, though sometimes characterized as non-financial, may have a material short-term and long-term impact on the business operations of the issuers as well as on risks and returns for investors and their investment and voting decisions.

Robert Eccles, professor of management practice at Saïd Business School at the University of Oxford, says that the global investment community’s interest in environmental, social, and governance issues has finally reached a tipping point. In his article for the Harvard Business Review, The Investor Revolution, Eccles says that, “ESG issues have become much important for long-term investors.” This is because large asset management firms and pensions funds are now pressuring corporate leaders to improve sustainability practices in material ways that both benefit their firms’ bottom line and create broader impact. They are also advocating for uniform metrics and industry standards.

Key trends in ESG

The Harvard Law School Forum on Corporate Governance and Financial Regulation lists the following key trends in ESG:

  • Impacts are increasing and increasingly important
  • Transparency is the new normal
  • Reputation is an indispensable asset
  • The workforce cares
  • Business value is at risk
  • The responsibility of board members

It can be challenging for boards to connect global issues, such as climate change, water scarcity, or human rights, to the organization’s operations, strategy, and risk profile. But given that ESG concerns both influence and are influenced by operations, finance, risk, compliance, legal, human resources, and other considerations, leadership teams have ample opportunity to leverage ESG for the long-term good of the organization, its stakeholders, and society.

Consumers seek out companies known for sustainable practices and are willing to pay a premium for sustainably produced food and clothing or space in a LEED-certified building. Such consumers often represent a substantial, loyal, and affluent minority. Sustainable products are brought to market at costs increasingly comparable to those of traditional versions.

Investors look to ESG

The ESG concerns of specific investors vary, as does their view of organizational responses, but all need information to help them make investment decisions. They want insight into management’s posture on ESG topics and the associated issues and risks, as well as plans and responses.

Investors realize that ESG activities can have negative or positive financial consequences and they want to anticipate and account for the operational, regulatory, and reputational impacts of ESG issues. They see the link between ESG and the value of the business, but they cannot forecast value and factor in related risks without better ESG information.

Public disclosure allows businesses to demonstrate progress and benchmark their own practices and reporting. Public disclosures put management in control of ESG matters. When investors do not receive ESG data directly from the company, they will turn to other sources for that information. It is pertinent, then, that the organization to provide accurate data and develop the narrative context for its ESG practices to communicate the right message.

However, companies that are working to enhance their disclosures often produce results lacking the relevance, transparency, and comparability that would really benefit stakeholders. Most communicate combined information rather than reporting on specific geographies and lines of business; this information does not help investors to compare companies with different geographical footprints and different degrees of value chain integration. Investors would need further investigation and analysis to make those comparisons, when they are even possible.

Financial institutions consider ESG factors in their lending and investing decisions, with others moving quickly in this direction. Although these institutions might not have considered organizations’ ESG profiles in the past, they now realize that ESG risks could affect their future financial performance.