Currently businesses are not only expected to make profit and grow on a financial level but also to contribute to the positive change in the society and to take responsibility and improve the impact on the environment. The main principle that helps investors to meet those requirements is sustainability. In the social – environmental context it refers to the support of human and ecological well-being, health, and vitality over time and in the corporate context, it refers to the ability of an entity to consistently create and protect value over the long-term.
One of the practices that focuses on benefiting the society and the natural environment is called sustainable investment. Sustainable investing seeks to achieve the dual goals of creating both financial returns and positive social and/or environmental impact. The main principle of sustainable investing is to make capital allocation decisions based on socially responsible and ethical strategies. It can fall into a multitude of categories, including improving access to quality education, clean energy, gender and racial equality, the sustainability of agriculture or food systems, and waste management.
The term that is crucial when talking about sustainable investment is ESG. It is an acronym for Environmental, Social, and Governance. It is an umbrella term to frameworks designed to be integrated into an organization’s strategy and help the investors understand how an organisation is managing risk and opportunities related to environmental, social and governance criteria. ESG-aligned investing is concerned with both inward-facing and internal risks and opportunities and how they affect company performance. An ESG-oriented investor seeks to identify and mitigate material ESG risks and capitalize on value creation opportunities to improve returns. Every company experiences some degree of ESG risk exposure and value creation opportunity, regardless of how “clean” the company or industry may be. What differentiates weak, moderate, and strong ESG performance is how well the company has mitigated those risks and capitalized on ESG opportunities, as well as how it continues to do so. ESG comprises a vast variety of issues, including:
In less than 20 years, the ESG movement has grown from a corporate social responsibility initiative launched by the United Nations into a global phenomenon representing more than US$30 trillion in assets under management. In the year 2019 alone, capital totaling US$17.67 billion flowed into ESG-linked products, an almost 525 percent increase from 2015, according to Morningstar, Inc.
The mitigation and management of ESG risks and opportunities
The term risk mitigation or risk management in the context of principles of the ESG refers to the practice of addressing risk exposure through programs, policies, procedures, practices or other methods in order to reduce the likelihood of the ESG risk actualizing and having a negative impact. Risk management is concerned with reducing potential downside.
Risk management takes into consideration the ESG risks as well as the ESG opportunities. ESG opportunities apply to situations when the adaptation of some program, policy, procedure or practice allows an asset to benefit where it would not otherwise have. The benefits may not only be societal or environmental e.g. the reduction of environmental harm due to the usage of green energy, but also strictly economical e.g. the asset fetching a “green premium,” paying less for utilities or experiencing increased tenant satisfaction. In addition, ESG opportunities may arise from the same activities that mitigate risk; for example, installing solar panels will help mitigate climate change transition risks as well as capitalize on an opportunity to reduce utilities costs.
ESG risk and opportunity areas include:
• Climate change adaptation
• Energy and water management
• Environmental compliance and ecological impacts
• Management of tenant sustainability impacts
• Employee engagement, diversity, and inclusion
• Employee health and safety
• Healthy buildings and communities
• Supply chain management
• Business ethics and regulatory compliance.
When it comes to the environmental risks, risk management allows investors to mitigate the physical and transition risks. The physical risks include rising sea levels, extreme level conditions e.g. wildfires, flooding and severe storms and in the economical sense, the additional costs associated with property damages or heightened insurance rates. Following the rules of ESG risk management, the investors may begin by utilizing the analysis of risk exposure points such as location and building structure and therefore choose to reprice or forgo investments in properties based on high exposure to physical risks. When it comes to transition risks e.g. mandated integration of green energy, greenhouse gas reduction requirements and technological shifts to accommodate low-carbon solutions—to real estate investments, investors might consider engaging with policymakers to determine where regulation is going and get ahead of potential requirements, integrating green energy or low-carbon technologies into development plans.
Another example of dealing with environmental risk and opportunities in practice are programs that focus on energy and water efficiency. Poor energy and water management can be needlessly costly, thus manifesting in higher utility bills. Special programs designed in accordance with ESG rules often result in lower overall utility costs in the long term. This include small conversions such as the usage of LED lighting, energy-efficient appliances or window treatment and large investments e.g. adoption of solar energy.
An example of social opportunity is the reduction of labor and litigation costs. In order to achieve that, the investors and employers have to be sure that the employees are recruited and treated in an equitable and inclusive manner and avoid excessive turnover or employee dissatisfaction through employee engagement initiatives. To mitigate risks in this area, investors may choose to develop and train on policies including employee handbooks, diversity and equal employment opportunity policies, anti-discrimination and anti-harassment policies, as well as employee health and safety programs.
When it comes to the governance, one of the main fields of risks as well as opportunities is the supply chain. The risks may include purchases of unecological materials, contracting with unethical suppliers or investing in products that have a huge negative impact on the environment. It is crucial for investors to be aware of the supply chain implications of their purchases. Management of social and environmental supply chain risks frequently involves tracing inputs; identifying and engaging with product sources; utilizing assessments and audits to document and evaluate input lifecycles; and maintaining a supplier code of conduct that details supplier standards.
Responsible investment -RI
Since the mid-nineties, responsible investment regulation has increased significantly. Regulatory change has also been driven by a realization among national and international regulators that the financial sector can play an important role in meeting global challenges such as climate change, modern slavery and tax avoidance. We can observe a visible increased demand for grater activity and transparency in responsible investment.
The Principles for Responsible Investment Initiative (PRI), which was established in 2005 by the United Nations, defines responsible investment as a “strategy and practice to incorporate environmental, social and governance (ESG) factors in investment decisions and active ownership. It complements traditional financial analysis and portfolio construction techniques.”
There are six basic strategies of the RI:
An example of usage of responsible investment in practice is the ESG-linked loan. It usually offers a discount when a company outperforms its sustainability goals. ESG-linked loans offer access to preferential interest rates based on sustainability improvements, leverage capital incentives for meaningful sustainability impact, and demonstrate to stakeholders a commitment to sustainability. One of the first loaners were a global finance institution – ING and a Dutch health technology company – Phillips. Their interest rates were linked to an ESG rating assessed by independent third-party ratings agency. Nowadays, more and more companies are interested in this lending trend, specially those in the food and agricultural sector. Since the ING’s first loan in 2017, more than 15 similar loans have been created.
The ideas presented in this article, already had a huge impact on the society and environment. Companies and investors pay much attention to the ESG principles and put work in order to implement them. Even though, these ideas represent a crucial step in the right direction, we still need more work, regulations and actions in order to meet the goals set up by the SDG by 2030.