ESG Basics

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Environmental, Social and Governance (ESG) Issues

ESG Issues

In the 1990s, the corporate social responsibility (CSR) movement emerged and leading companies around the world began measuring their performance on a wide range of sustainability and socially responsible policies and practices. By the beginning of the 21st century, many corporate leaders had acknowledged that companies that measured and managed ESG as well as financial factors were more profitable. That growing consensus became a driver of sustainability or corporate social responsibility reporting in many companies.

In 2003, UNEP FI commissioned reports from nine mainstream research institutions to study the financial materiality of ESG issues.

  • They wanted to know if managing issues like climate change or supply chain would have an impact on the share price of a company. A key finding was that there was “agreement that ESG issues affect long-term shareholder value… and in some cases those effects may be profound.” 

In 2006, the Principles of Responsible Investment were launched by the UN and responsible investment moved into the mainstream.

  • More than 1,200 pension funds and other institutional investors representing more than $45 trillion have become signatories to the principles. Of these, 94 percent have responsible investment policies in place. 

A 2012 DB Climate Change Advisors study by reported that they:

  • “believe that ESG analysis should be built into the investment processes of every serious investor, and into the corporate strategy of every company that cares about shareholder value.”

Their conclusion was that:

  • “Firms with strong ESG performance may now be enjoying both financial outperformance (particularly market-based) and lower risk as measured by the cost of equity and/or debt (both loans and bonds) capital in the short run.” In other words, they are achieving higher rates of return at lower levels of risk.

There are a number of ESG issues that can affect company valuations:

Climate Change

Climate change poses a severe threat to our planet and the global economy. Climate-related events disrupt investment markets and erode the long-term profitability of companies. As extreme weather events wreak havoc on business operations and supply chains, financial risks to investors will be amplified.

Organizations such as  Carbon Tracker warn that current estimates of fossil fuel reserves being accounted for by global energy companies are five times the allowable carbon budget necessary to limit our exposure to catastrophic climate risk. Regulatory and market responses to climate change and the transition to a low-carbon economy make it imperative that investors assess the financial impact of energy companies reducing their reserves to 20 percent of current levels.

Investors and companies that assess climate risks will be better prepared to reduce the impact and provide competitive financial returns.

 Read the Global Investor Statement on Climate Change for more information.

Water Scarcity

The Earth’s supply of fresh water is limited and the demands upon it are increasing. According to the Pembina Institute, it is predicted that climate change and industrial water use in Canada’s oil sands development will decrease the flow of the Athabasca River downstream of Fort McMurray by 30 percent by 2050.

Globally, climate change is already affecting water patterns, leading to droughts in some areas and floods in others.  Water is an important issue to investors because companies, especially companies in water-intensive industries, face significant financial risks. These risks include business interruption (directly through local infrastructure or indirectly through suppliers) and the potential market impact of negative media attention if the company is affecting a local community’s water supply or quality.

Supply Chain

The 2013 collapse of Rana Plaza in Savar, Bangladesh attracted worldwide attention. The deaths of more than 1,100 garment workers show how a company’s business decisions have serious consequences for workers. They also underscore the reputational, operational and legal risks associated with human and labour rights in the supply chain.

Investors recognize the risk inherent in owning companies that are not addressing these issues. In addition to the devastating human cost, the Rana Plaza incident had a significant impact on the reputations of the companies involved. In Canada, thousands of consumers checked their labels. Without remediation, the next step would have been consumer boycotts.

Responsible investors are actively trying to prevent similar tragedies from happening.

Aboriginal and Community Relations

The International Labour Organization (ILO) and the United Nations Declaration on the Rights of Indigenous Peoples have advanced the principle of obtaining the free, prior and informed consent (FPIC) of indigenous people before the approval of any project affecting their lands or territories and other resources.

It is especially important for the extractive sector to obtain and maintain support from local communities, Aboriginal or otherwise. Even if a project has received the necessary regulatory approval, community opposition has the potential to prevent a company’s project from coming to fruition – at great cost to the company.

Say on Pay

Over the past two decades compensation awarded to top Canadian executives has grown at a much faster rate than wages paid to the average Canadian worker. The growth in executive compensation can lead to social inequality, negative media attention and increased regulations.

In the US, the Dodd-Frank Act has mandated shareholder votes on executive compensation or “say on pay” (SOP). According to Mercer, over the past few years, many Canadian companies have adopted SOP policies. Canadian institutional shareholders represented by the Shareholder Association for Research and Education (SHARE) and Meritas Mutual Funds have pressured the companies in their portfolios to adopt SOP policies. 

Read the Canadian Mutual Fund Proxy Voting Survey for more information.

Board Diversity

Boards should reflect the diversity of their workforce and society. There is compelling evidence showing a positive correlation between the presence of women on boards and financial performance. A 2012 global study of 2,360 companies by Credit Suisse showed that companies with one or more women on their board delivered higher than average returns on equity, better average growth and higher price/book value multiples over a six-year period. Studies by Catalyst and McKinsey have shown similar results. Yet the 2013 Catalyst Census reports that women make up just 15.9 percent of directors on corporate boards in Canada.

Canadian securities regulators are proposing amendments to corporate governance disclosure regulations that would require all TSX-listed issuers to disclose the level of representation of women on their boards and in senior management. This transparency is intended to assist investors in their investment and proxy voting decisions.

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