What is ESG?

Investors have traditionally focussed on potential returns they can earn from the shares, bonds or other securities in which they invest by considering their financial characteristics.

Investors who invest sustainably, however, take more than just financial factors into account. They realise that doing good business should not only increase shareholder value but also stakeholder value and lead to a sustainable business.

Stakeholders include more than just investors. Employees, management, board members, customers, suppliers, distributors, communities and regulators are all stakeholders who should benefit from what an entity does.

Environmental, social and governance (ESG) factors provide a framework for making investment decisions for investors who want to earn returns by investing sustainably.

These investors want their investments to promote good environmental, social and corporate governance practices.

Environmental

The environmental factors used in an ESG framework seek to assess the impact a company’s business activities have on the environment, what the company is doing to mitigate that impact and any environmental risks the business faces.

To consider this, a fund manager or investor may consider a company’s:

• Carbon footprint;
• Greenhouse gas emission;
• Use of natural resources;
• Impact on the environment in which the business operates;
• Impact on biodiversity;
• Involvement in deforestation;
• Raw material sourcing;
• Energy efficiency;
• Contribution to air and water pollution;
• Toxic emissions and waste management practices;
• Conservation of water and other natural resources;
• Treatment of animals;
• Reporting on its impact on the environment; and
• Carbon offsets. 

A mining company may be regarded as having a negative impact on its environment, but some of its negative practices may be mitigated if it is also involved in mine rehabilitation, water and soil treatment and the prevention of acid drainage.

Consideration may also be given to any environmental goals for the country in which the business is located. South Africa, for example, committed at the 2021 United Nations Climate Change Conference, commonly referred to as COP26, to target carbon dioxide equivalent emissions of between 350 to 420 metric tons by 2030 and entered into a partnership with a number of developed countries to fund a transition away from its reliance on coal and other high-carbon emissions without sacrificing jobs.  

Social

An ESG framework will also seek to assess the impact a company’s business activities have on the community in which it operates.

An analysis of the social impact of a business will take into account a company’s:

• Relationships with its employees - their health, safety, diversity, training and qualifications, staff turnover and labour relations;
• Health, safety and financial implications of its products on its customers;
• Relationships with and impact on the community in which it operates;
• Relationships with and impact on its customers – their satisfaction with the goods or services and brand loyalty, health, safety and data privacy;
• Observance of human rights;
• Commitment to diversity among its employees and directors; and
• Contributions it makes to social upliftment.

While many South African companies are focussed on improving diversity through transformation, their efforts may be negated by a failure to address gender pay equity, unconscious biases such as racism or ageism.

Governance

Governance is the G is the ESG framework and focusses on how well a company is managed by it's management and its board of directors.

Considerations are focussed on an entity’s corporate governance. Factors considered include:

• Involvement in bribery or corruption;
• Conflicts of interest;
• Composition of the board;
• How transparent the company’s auditing process is;
• How the executives are paid;
• Contributions to political causes;
• The business ethics;
• The lobbying the company is involved in; and
• Whether whistle-blowing is encouraged and how whistle-blowers are treated.

South African asset managers have a strong focus on governance when assessing which companies in which to invest. This is as a result of numerous governance failures. Many local companies have adopted the King IV Code of Corporate Governance.  

Good governance can be key to having good environmental and social practices, but typically require a special focus.