ESG Considerations for Corporates

Debt and shareholders are increasingly shifting from a shareholder to a stakeholder perspective by prioritizing ESG (Environmental, Social, and Governance) factors when choosing where to invest. As such, corporate issuers need to incorporate these factors when setting their goals and in their operating, investing, and financing decisions.

ESG is increasingly relevant for the below three reasons:

• Increased financial significance of ESG factors for corporate issuers stemming from notable losses because of governance failures, social issues, and environmental disasters.
• Growing interest in the environmental and social impact of investments, especially among younger people who want their wealth to be managed in alignment with ESG principles.
• Increased emphasis on climate change and social policy by government stakeholders forcing corporate issuers to adapt accordingly.

Historically, companies used to treat ESG factors as negative externalities whose costs were not borne by the company or its investors. However, due to strong regulations and increased stakeholder awareness, companies are now internalizing ESG costs into their financial statements.

Introduction to Environmental, Social, and Governance Factors

Environmental Factors

When an ESG element is anticipated to have an effect on a company’s long-term business model or its results, it is deemed to be material. Generally, investors consider the following environmental factors as material:

• Climate change.
• Pollution and waste.
• Resource and land use.
• Ecological footprint.
• Biodiversity.

Climate can be described as either a physical or a transition risk. It manifests as a physical risk when severe weather damages/ destroys assets. Physical risk can be insured against. On the other hand, climate change as transition risk refers to losses associated with transitioning to a low-carbon economy resulting from regulations or shifts in consumer demand, for instance, the revenues of a coal producing company may decrease if consumers shift to a renewable energy source. Transition risk is difficult to assess.

Strategic or operational choices based on subpar governance procedures or poor judgment can give rise to adverse material environmental effects that may be costly in terms of expenses like legal fees, clean-up expenses, regulatory fines, and reputational damage.

Social Factors

Social factors pertain to the impact of the company’s practices on:

• Employees and human capital.
• Customers.
• Community in which it operates.

By minimizing social risk, a company can lower its costs through increased employee productivity, lower employee turnover, and reduced legal and reputational risks.

Governance Factors

Stakeholder management and corporate governance address the following issues:

• Ownership and voting system of the company.
• The suitability of board members’ skills and experience to meet present and future company requirements.
• How well management compensation aligns with the company’s performance.
• The level of shareholder rights compared to other similar companies.
• The company’s proficiency in managing long-term risks and sustainability.

Analyzing the above provides valuable insights about sources of risk and management quality. This information is often found in sustainability reports, annual reports, and issuer’s proxy statements.

Evaluating ESG Risks and Opportunities

• Once an ESG risk has been identified, their financial impact must be quantified in terms of how they positively or negatively affect the firm’s future discounted cash flows.
• Significant long-term adverse ESG-related events typically have an immediate and disproportionate impact on equity claims since they represent residual claims to future company cash flows.
• Although adverse ESG-related events impact the value of debtholder claims, their effect is generally less pronounced compared to equity, except in cases where the company’s ability to fulfill interest and principal payments is adversely affected.
• The effects of adverse ESG-related events often differ depending on the maturity of the debt. For example, a coal company facing long-term risks from potential asset write-downs due to regulatory changes or shifts in demand would likely have a greater negative impact on debt maturing in ten years compared to short-term debt maturing in twelve months.

In conclusion, analysts assess the potential positive and negative effects of significant ESG-related factors, whose financial impacts are reflected in a company’s projected financial statements and ratios. They use future expected cash flows discounted at an appropriate rate and employ sensitivity or scenario analysis to evaluate different outcomes for debt and equity holders.

Question

Which of the following is most likely an example of a social factor under environmental, social, and governance risks?

1. Deforestation.
2. Shareholder rights.
3. Equality and diversity.

The correct answer is C.

Equality and diversity are examples of social factors. Other examples of social factors include human rights and community relations.

A is correct. Deforestation is an example of an environmental factor. Other examples of environmental factors include waste management and energy efficiency.

B is incorrect. Shareholder rights are an example of a governance factor. Other examples of governance factors include bribery and corruption, and executive compensation.