ESG Considerations for Corporates

Debt and equity investors are progressively adopting a stakeholder viewpoint rather than a strictly shareholder-focused one. They prioritize Environmental, Social, and Governance (ESG) factors when making investment decisions. As such, corporate issuers need to incorporate these factors when setting goals regarding operating, investing, and financing decisions.

ESG is increasingly relevant for three main reasons:

• They have more significant negative financial effects on a company’s fair value. Both debtholders and shareholders have lost substantial capital due to social controversies, poor governance, or environmental disasters.
• Increasing interest in the social and environmental effects of investments, especially among the younger demographic. Many young investors demand that their newly acquired or inherited money be handled using investing techniques that consider significant ESG concerns.
• Governments are increasingly prioritizing social policies and climate change. They have revised regulations forcing corporate issuers to align their business practices with the strict ESG criteria.

In response to stakeholder awareness and tightening restrictions, investors are incorporating environmental and societal costs into company financial statements and forecasts.

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, it is deemed to be material. The environmental factors that are material include:

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

For instance, climate can be described as a physical or transition risk. Climate change can be a physical risk because bad weather destroys assets. Physical risk can be insured.

Climate change as transition risk refers to losses associated with transitioning to a low-carbon economy resulting from regulations or shifts in consumer demand.

Strategic or operational choices based on subpar governance procedures or poor judgment can negatively impact the environment. Expenses such as legal fees, clean-up expenses, regulatory fines, and reputational damage can be costly.

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.

These questions and areas provide 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

Recall that debt and equity investors have different claims on a company. The influence of ESG factors on corporate cash flows depends on how they impact the value of debt and equity claims:

• Once identified, the financial impact of material ESG factors 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. These 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.