As ESG factors become integral considerations across many types of analysis, investors are seeking more and clearer information about what these mean, including their relevance and materiality. Currently, the world is not projected to stop emissions growth by 2025 and is on a path toward global warming of about 3.2°C, which would lead to severe damage to nature, communities and businesses. The world’s emissions need to peak before 2025 under both the 1.5°C and 2°C scenarios proposed by the Paris Agreement, according to a recent report by the Intergovernmental Panel on Climate Change.
Investors need to understand how their portfolios could be impacted by the financial risks of climate change. They also need to understand how companies are positioning their businesses to take advantage of new opportunities in the transition to a low-carbon future, which could lead to disruptive change for many sectors in the near term.
Establishing the right path for your ESG journey Financial materiality assessments – identifying ESG factors that are likely to affect the financial condition or operating performance of a business – have increasingly become the starting point of a company’s ESG journey. These assessments provide guidance and serve to define ESG metrics and shape the blueprint of a company’s ESG strategy. While the key, financially material topics for a company may not significantly change year over year – unless there is a substantial shift in a company’s structure, such as a merger, acquisition or divestment – there are topics companies should monitor every year, such as changing stakeholder expectations, expanded regulations and emerging trends.
Assessing future long-term climate risks and the financial implications for a company’s revenue became a pivotal topic for organizations in early 2020, following the ‘Letter to CEOs’ written by BlackRock CEO Larry Fink. This letter prompted an influx of interest from corporations looking to align with the recommendations of the TCFD, which was established in 2015 by the Financial Stability Board. Its aim was to provide recommendations for more effective disclosure to bring the consistent visibility investors need to channel investments to sustainable and resilient solutions, opportunities and business models.
Formulating an ESG strategy ESG initiatives no longer take a siloed approach with responsibility being assigned to just a few. While early-stage ESG initiatives may still begin in the sustainability office, as they mature they are more often being driven by legal counsel or IR, with accountability and responsibility being shared across various departments and business units. Recent projects for Scope 3 supply-chain analysis and TCFD reporting, for example, typically incorporate team leads, including procurement, finance, IR, product, enterprise risk management and corporate communications to understand and disseminate the findings and analysis.
Procurement teams have a central role to play in driving supply-chain sustainability and engaging with top-tier suppliers to drive down emissions in their upstream supply chains. The chief procurement officer must take leadership in embedding sustainability in the procurement process and strive to achieve Scope 3 emission reduction targets by setting clear KPIs and expectations for suppliers.
Adequate sustainability strategies should incorporate a collaborative approach across business lines. An organization should seek to educate, cultivate and communicate a holistic ESG strategy for an integrated approach, where sustainability is embedded within each business function. This moves it from an aside or afterthought to a key value driver, whether it is to realize efficiency gains, net-zero efforts, diversity, equity & inclusion initiatives or board-directed initiatives.
This is effectively implemented when companies make ESG part of their employees’ goals, performance evaluations and incentive structures. Designating ESG responsibilities to ‘ESG champions’ or through voluntary participation is not enough to drive implementation or sufficient action.
Executive pay should also be tied to ESG performance. Early adopters of this strategy have tied executive compensation programs to goals that incorporate equality – such as gender balance and ethnic diversity – and sustainability metrics, such as increasing spend with suppliers that are reducing their carbon impact. All the key functions within an organization should seek to speak and understand the context of ESG and what it means for each of their business units.
Identifying gaps between investors’ ideal reports and actual company metrics Investors have shifted their focus from looking at backward historical environmental performance to long-term and forward-looking issues relating to corporate governance, transition and physical climate risk analysis at the asset level – that is, not just what companies are doing right now, but also how they are preparing and stress-testing their businesses for future risks and opportunities.
Managing expectations on measuring Scope 3 emissions: Scope 3 emissions as defined by the Greenhouse Gas Protocol include all indirect emissions that occur in a company’s upstream activities from all the purchased goods, services and raw materials it is procuring to its downstream value chain, including when customers use the products. For most companies, greenhouse gas emissions from Scope 3 account for the largest proportion of their overall footprint.
Scope 3 emissions can be hard to measure in some industries and difficult to reduce because they are ultimately out of a company’s direct control. Only 42 percent of companies in the 2021 S&P Global Corporate Sustainability Assessment (CSA) report on at least one source of Scope 3 emissions1. While there are large gaps in Scope 3 disclosures, this is also where the greatest opportunity for emission reduction lies. Companies can flex their procurement spend to engage their suppliers to act on reducing their emissions.
Reporting climate risk using quantitative scenario analysis: Almost 60 percent of the companies in the S&P 500 have at least one asset at high risk of physical impact from climate change2. Companies can test for physical risks − from rising sea levels or an increase in extreme weather events like hurricanes, flooding and wildfires − and quantify the associated financial impact. For example, The Climate Service, now part of S&P Global, quantifies a company’s financial value at risk based on an asset’s location, type and value, plus its ownership structure.
Data from the CSA shows that only a quarter of surveyed companies are currently using scenario analysis to test for transition risks. Transition risk scenario analysis takes a forward-looking approach to evaluate the policy, regulatory, technological, legal, market and reputational costs to a business associated with moving to a greener economy.
Setting interim and long-term targets aligned with climate science: The path to 2050 – the typical end-date for corporate net-zero targets – cannot be traveled without credible signposts in the next few years. Investors are paying special attention to this area, and investor-led groups have specifically called for companies to show their 2030 interim goals. Interim targets also indicate how serious a company is about its goal, which can affect its CSA sustainability scoring positively as it pertains to emissions and disclosures. A fully developed net-zero target should include both direct and indirect emissions. Transparency and accountability will be key going forward to ensure companies are not just setting targets, but are also taking concrete action along the way to ensure the goals are met.
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Footnotes 1The S&P Global CSA is an annual evaluation of companies’ sustainability practices. It covers more than 10,000 companies from around the world and focuses on sustainability criteria that are both industry-specific and financially material 2S&P Global sustainable data
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