Understanding the “E” in ESG

Environmental considerations were once seen as tangential pieces of the economic equation, but issues such as climate risk, water scarcity, extreme temperatures and carbon emissions are now threatening to dampen economic growth. The state of the environment can directly affect a company’s competitive positioning. As such, managing environmental factors has become a core component of the new frontier in ESG—that is, the investing practice of managing environmental, social and governance risks and opportunities. Understanding environmental risks is understanding the "E" in ESG.

While ESG factors are the fundamental framework for measuring a company's sustainability, the environmental portion of ESG considers how that company performs as a steward of the natural or physical environment. The "E" takes into account a company’s utilization of natural resources and the effect of its operations on the environment, both in its direct operations and across its supply chains. In other words, the environmental factor examines a company’s environmental disclosure, impact and efforts to reduce carbon emissions — issues that represent tangible risks and opportunities for stakeholders and stockholders alike.

Companies that neglect to consider the effects of their policies and practices on the environment may be exposed to greater financial risk. Without taking appropriate action to curtail carbon emissions or protect against environmental incidents like oil spills or mining explosions, companies can face governmental or regulatory sanctions, criminal prosecution and reputational damage, all of which risk harming shareholder value.

As such, S&P Global assesses companies’ environmental footprints by assessing four factors: greenhouse gas emissions, water use, waste and pollution,  land use and biodiversity. S&P Global Ratings’ ESG Evaluation weighs potential social and governance risks to determine an entity’s capacity to operate successfully, along with a preparedness assessment of its capacity to anticipate and adapt to a variety of long-term environmental disruptions, ultimately determining our ESG score.  

Climate change is expected to increase the frequency of climatic events like hurricanes, floods, heatwaves and wildfires adding an extra layer of uncertainty to the multifaceted framework for measuring a company's sustainability. Climate risk can impose significant financial implications, especially for those companies that fail to adequately plan for the likely impacts of climate change in the form of increasing investment in new sources of energy or technologies. Already, climate change has played a role in determining companies' long-term creditworthiness due to potential losses in infrastructure and property. Alaskan oil and gas operators, for example, face a long-term, existential threat to their infrastructures from thawing permafrost. As such, the assessment of a company’s environmental profile has gone from being a cherry-on-top to a key driver of decision-making.

“Companies' awareness and engagement with climate and environmental issues seems to be increasing rapidly,” Richard Mattison, CEO of Trucost, part of S&P Global Market Intelligence, explains. “Eighty percent of the world’s largest companies are reporting exposure to physical or market transition risks associated with climate change and a similar share are engaging in reducing corporate emissions.” Five years ago, S&P Global estimated the direct costs of addressing climate risk for the U.S. economy: a direct loss of real economic output of 5.2% by 2100. The most recent estimates suggest that these consequences could be far worse.

S&P Global research shows that companies that embed environmental goals in their growth strategies suffer no statistically significant performance disadvantage at individual and portfolio levels, and may actually outperform their peers. The S&P 500 ESG Index, launched in April 2019, introduced ESG criteria to the S&P 500 by periodically ranking companies within industries and excluding those that have been underperforming. This index was designed in alignment with the S&P 500’s risk and return profile, and accounts for environmental risks by providing greater exposure to companies that limit the scope of their greenhouse gas emissions, set targets for reduction and include performance and reporting on their ESG materiality analysis. Importantly, the S&P 500 ESG Index has not significantly out-or underperformed the S&P 500 Index; in fact, choosing a sustainable investing strategy does not hurt returns. The S&P 500 and green-minded S&P 500 ESG Indexes have consistently tracked at virtually the same rate of momentum, with the S&P 500 ESG Index offering similar or better performance alongside the benefits of ESG.

The global regulatory response to the threat of environmental risks has been disjointed. In Europe, regulators are taking an increasingly active role in mandating standards for environmental reporting and pushing toward a carbon-neutral economy through the energy transition. Over the past three years, the EU has developed an ambitious initiative to push ESG factors into the mainstream capital markets by redirecting capital toward sustainable investment. Meanwhile, the response in the U.S. has been mixed, with a patchwork of regulation and deregulation that has yet to result in cohesive federal environmental policy on energy transition, decarbonization, and climate risks. Other emerging economies have tried to find a middle ground — encouraging economic development while attempting to prepare for a cleaner future.

The lack of global consensus includes regulators and policymakers, too; these groups lack a common framework to communicate the standards and practices of environmental stewardship. Similarly, a dearth of shared terminology, benchmarks and policies has posed a challenge to investors and companies attempting to account for environmental risk. Still, sustainability is a strategic imperative for forward-looking firms and the assessment of corporations’ environmental footprints has moved from a simple measure of corporate responsibility to an investment proposition.