What is Environmental, Social, and Governance (ESG) and sustainability in 2023?
SUMMARY DEFINITION: WHAT IS ESG?
ESG defined at the company level, this evaluation process involves identifying the critical relationships essential for supporting its business and the resources it depends on to fulfill its purpose for the foreseeable future. If any of these relationships (e.g.: vendors, customers, banks) become adversely affected by an environmental, social, or governance event directly associated with the company, and if such an event poses a potential material financial impact on its cash flow, then that risk must be disclosed both transparently and promptly.
For the resources (e.g.: employees, physical assets, water) upon which the company relies to achieve its purpose, any physical risks (wildfires, storms, floods) or transitional risks (changes in consumer preferences, policy, or reputational risks) that jeopardize these resources should be disclosed in a clear and timely manner. For each significant risk, a mitigation strategy outlining the company's action plan to preserve and protect its business should be shared. Additionally, any considerable transitional opportunities (efficiencies or cost-savings) that promote a more sustainable business purpose and increase cash flow should be disclosed, along with a strategy for capitalizing on these opportunities.
Risks and opportunities should be evaluated in the short, medium, and long term to the best of the company's capabilities. To understand a company’s ongoing internal risk management processes - specifically the identification, assessment, and management of these risks and opportunities - it's crucial to disclose its governance activities at both the board and management levels.
For an interested stakeholder or investor to assess its performance over time in terms of mitigating risks and maximizing opportunities with potential financial significance, a company should present pertinent metrics and targets, ensuring the data is clear and consistent. This information should be communicated in a comprehensive and transparent manner, maintaining reliability and comparability year after year.
For a company to excel in its mission, a balance of influence between the company and the communities it serves is imperative. Companies should act ethically, display integrity, and consistently show themselves to be both dependable and adept in realizing their purpose sustainably. Furthermore, they should openly demonstrate their dedication to their objectives, align with community values, and respond to community needs without delay.
THE EXTENDED DEFINITION OF ESG
Per summary the definition of ESG, it is important to first re-iterate that at the organizational level, the evaluation process involves identifying crucial relationships and resources that are pivotal for sustaining a company's business and fulfilling its long-term objectives. Should these relationships, such as those with vendors, customers, or banks, suffer due to an environmental, social, or governance event closely tied to the company, and if such an event could materially impact the company's cash flow, the associated risks must be disclosed with transparency and expedience.
A company must also clearly and promptly disclose any jeopardizing physical risks, such as wildfires, storms, or floods, as well as transitional risks stemming from shifts in consumer preferences, policy changes, or reputational issues, that threaten the resources it depends on, including employees, physical assets, and water. Accompanying each significant risk, a mitigation strategy should delineate the company's plans to safeguard its operations. Similarly, any substantial transitional opportunities that might enhance sustainability and cash flow, such as efficiencies or cost savings, should be reported along with a strategy to capitalize on these prospects.
Assessment of these risks and opportunities should be conducted over the short, medium, and long term to the fullest extent of the company's ability. To comprehend the company's ongoing internal risk management processes - which include the identification, evaluation, and management of these risks and opportunities - it is essential to disclose its governance activities at both the board and management levels.
ESG defined for stakeholders and investors, means they have to assess a company's performance over time in managing risks and capitalizing on opportunities with financial significance, the company should provide relevant metrics and targets. The clarity and consistency of this data are crucial, and it should be conveyed in a manner that is both comprehensive and transparent, ensuring reliability and comparability year after year.
The success of a company in achieving its mission hinges on maintaining a balanced influence with the communities it serves. Companies must act ethically and with integrity, proving themselves reliable and adept at achieving their purposes sustainably. They should also openly commit to their goals, align with community values, and swiftly address community needs.
ESG DEFINED: REGULATORY LANDSCAPE 2023
Regarding the regulation or mandatory implementation of these practices, significant progress has been made this year, with further advancements expected in 2024. In June 2023, the International Sustainability Standards Board (ISSB) introduced two sustainability disclosure standards, IFRS S1 and IFRS S2, which have been supported by numerous countries, including Canada, Australia, Hong Kong, Japan, Malaysia, New Zealand, Nigeria, Singapore, and the UK. In Canada, the Canadian Securities Administrators (CSA), in cooperation with the Canadian Sustainability Standards Board (CSSB), are finalizing their climate disclosure proposal for companies. This effort is meticulous, aiming to be in harmony with the new international standards and to reflect the specifics of Canadian capital markets and investor needs.
Moreover, the United States Securities and Exchange Commission (SEC) is finalizing its ruling on climate-related risks. It is anticipated that once enacted, public companies will be mandated to report risks and opportunities that are "reasonably likely to have a material impact on their business, operational results, or financial health." The SEC's comprehensive initial proposal, published in March 2022, includes a requirement for companies to report greenhouse gas emissions across all scopes, from direct emissions (Scope 1) to those within a company’s supply chain (Scope 3), affecting both public and private entities. For instance, a major publicly listed company such as Coca Cola has committed to reducing its total greenhouse gas emissions by 30% by 2030, a pledge that depends on the concerted effort of its extensive network of suppliers.
DISCLOSURE OBJECTIVE AS IT RELATES TO DEFINING ESG AS IT EVOLVES IN 2023
Despite resistance from various parties, the principal objective of these disclosure mandates is to ensure corporate resilience and the sharing of information that is beneficial to the primary users of general-purpose financial reports for making resource allocation decisions. This means that any risk or opportunity with the potential to impact a company’s cash flow should be made transparent to investors, enabling them to make informed decisions to protect their interests without any omission, obfuscation, or misrepresentation of information. This approach emphasizes transparency and fairness, particularly crucial when catastrophic climate events are disrupting supply chains, altering consumer preferences, and destroying infrastructure, thereby heightening fear, uncertainty, and doubt in the financial markets.
DEFINING ESG: IDENTIFICATION OF RISKS AND OPPORTUNITIES
In the identification of risks and opportunities, the new ISSB standards suggest that companies can align their disclosures with SASB Standards. These are categorized under a General Issue Category for industry-agnostic comparisons, as well as industry-specific topics under the Sustainable Industry Classification System (SICS) that cover 77 industries for peer comparability. At times, companies may also refer to the CDSB Framework Application Guidance for Water-related Disclosures and the CDSB Framework Application Guidance for Biodiversity-related Disclosures.
Having industry-specific topics offers many benefits, including alignment with investor expectations on what companies should report in the core content of a disclosure, which should encompass governance activities, strategies, risk management, and metrics and targets related to sustainability and climate-related risks and opportunities. It also facilitates greater comparability. As disclosures become more prevalent, investors will need access to evaluation tools like the ESG and Sustainable Engagement Framework (ESEF). Designed for investors and executives, the ESEF provides a clear method for evaluating consistency across portfolios and indices. It enables users to effectively assess the ESG components and relate them to enterprise value. Additionally, it harmonizes various disclosure frameworks and highlights companies with robust ESG practices.
When the SEC was considering its Climate-Related Disclosure requirements, it based its proposal, released in June 2022, on the Taskforce on Climate-Related Financial Disclosures (TCFD), a forward-looking framework. On July 10, 2023, one year after the SEC proposal was released for consideration, the TCFD was fully embedded into the ISSB standards. This means that the SEC proposal, despite having nuances specific to the US, is highly reflective of the new international standards. One notable nuance is the difference between the US definition of materiality and the definition used in the ISSB standards.
ESSENTIAL COMPONENT
In a year marked by rapid environmental and social changes, it is incumbent upon companies to provide disclosures that are relevant to the issues of the day. Regulators must also fulfill their role, enforcing these standards to protect the integrity of markets and the interests of all stakeholders. For investors, the necessity to promptly interpret and act on this information is paramount. The fast pace of change demands swift and informed decision-making, based on comprehensive, transparent, and reliable corporate disclosures. ESG and Sustainability is now a critical component of sustainable investment, essential for the long-term health of our global economic systems.
