Chapter 3
Give Me an ‘E’! Defining the Environmental Sector in ESG
IN THIS CHAPTER
Investors are becoming increasingly aware of the financial impact of environmental issues on companies in their portfolios. These investors are paying greater attention to issues such as climate change, water usage, energy efficiency, pollution, resource scarcity, and environmental hazards so that they can increase awareness of relevant issues and influence disclosure. The negative impact for companies failing to manage environmental risks includes increasing costs (for example, the need to clean up oil spills), reputational damage due to pollution incidents, and litigation costs.
Integrating environmental factors into a company’s strategy can present opportunities — for example, using resources efficiently can decrease costs and offering innovative solutions can create a competitive edge. These environmental factors measure a company’s impact on living and non-living natural systems, including the air, land, water, and entire ecosystems. These factors also indicate how a company employs best management practices to avoid environmental risks and capitalize on opportunities that generate shareholder value.
This chapter outlines how companies manage their natural resource usage both directly and indirectly through their value chain. It also describes how analysis of these factors allows investors to determine whether the companies are meeting their environmental stewardship targets or managing the risks involved. Numerous environmental issues can be relevant to different companies in diverse sectors of the economy, but this chapter focuses on the material issues that both companies and investors need to consider, as such issues may have the greatest impact on both return on investment and sustainability.
Outlining a Company’s Use of Natural Resources
The environmental sector of ESG reflects on how a company considers its stewardship obligations in terms of protecting the natural environment. The ‘E’ in ESG considers the company’s use of natural resources and the effect its operations have on the environment, in terms of direct operations and throughout its supply chains. Therefore, a company’s environmental disclosures provide an insight into its efforts to reduce material risks and opportunities for stakeholders. Those companies that fail to anticipate the effects of their practices on the environment may face financial risk. Failing to act or protect against environmental “accidents” can lead to sanctions, prosecution, and reputational damage, which reduces shareholder value.
In the following sections, I describe the different environmental factors that companies need to consider when investing.
CO2 or GHG? Climate change and carbon emissions
The key environmental target that most nations have targeted is net-zero emissions by 2050, which indicates that all man-made greenhouse gas (GHG) emissions must be removed from the atmosphere through reduction measures that reduce the earth’s net climate balance. This should primarily be achieved through a rapid reduction in carbon emissions, but where zero carbon can’t be achieved, offsetting through carbon credits (a permit that allows the holder to emit a certain amount of CO2 or GHG) seems to be the preferred approach. However, the risk of relying on carbon credit offsets rather than rapid decarbonization is that companies can maintain emissions at a steady level, using carbon credits to reach net zero, which negates the need to actually reduce their own emissions.
To meet the internationally agreed-upon target of confining the rise in global average temperatures to well below 2 degrees Celsius above pre-industrial levels, science suggests that most fossil fuel reserves need to remain in the ground. The emergence of carbon pricing and decreasing technology costs implies that low-carbon energy sources will be more attractive and the demand for fossil fuels will fade, leading to the demise of the companies that explore, mine, and burn them. Moreover, any fall in oil prices decreases the incentive for producers to drill for many fossil fuel assets. This has led to an even steeper fall in the price of carbon credits, or Certified Emission Reduction (CER) units.
These developments have led to the divestment of many fossil fuel stocks by asset managers, from both a sustainability and investment performance perspective, and have prompted further analysis of the relative carbon footprint of individual stocks and a call for pension funds to disclose their aggregate carbon footprint. However, some ESG investors argue that simply selling a stock to investors who don’t care about climate change will have zero impact on the overall climate program. A more positive approach would be to encourage engagement with management of fossil fuel companies to encourage a shift away from current production approaches and move more toward the development of a renewable energy infrastructure. In addition, divesting particular energy and utility stocks may create divergence away from benchmark investment performance.
https://carbontracker.org/terms/stranded-assets/). The CT approach focuses on the valuation of companies, which includes projections of the future value of their coal, oil, and gas inventories. The stranded asset concept is worrying asset owners as they question what happens to assets that are worth less than their projected value due to changes linked to energy transition that spans the typical lifetime of pension scheme assets, which can be 40-plus years. Therefore, investors need to be fully aware of initiatives that require companies to report on the repercussions of the future value of their assets on their business model, and what impact that may have on the value of their investments.
