ESG from a Value/Risk Point of View

Two Sides of the Coin

A company can “do ESG” as (i) value creation and/or as (ii) risk management.

Value Creation

“Doing ESG” can create value by finding and exploiting opportunities for improving ESG performance. For example, it is common for a company to reduce costs by being more efficient in energy or water usage,

Closely related to that, a company may find that there are product extension opportunities that are related to ESG, for example, energy, water or natural resources management technology that can be acquired and commercialized.

Risk Management

We use the term “risk management” expansively to include compliance with obligations.

Note that risk management indirectly creates value. A risky company is less valuable and less attractive to lenders and investors.

Traditional Compliance Obligations

Traditionally, businesses have had to be in compliance with:

  1. the laws of each jurisdiction in which they operate,
  2. the duties they agree to — notably contractual, and
  3. the rights of shareholders.

Meeting such requirements and expectations fills the days of everyone in a company, from top management down through the rank and file.

ESG: Stakeholders and the Environment

In the latter half of the 20th Century, another category of expectations arose, and the people associated with those expectations, along with a company’s owners, came to be called “stakeholders”.  These people include employees, customers, suppliers and people in the communities in which the companies operate.

The interests of non-shareholder stakeholders are increasingly referred to as “ESG factors” — ESG standing for environmental, social and governance factors. Because most of ESG is thus far not required by law, ESG is sometimes called “soft law” — “expectations with consequences” — and businesses increasingly believe they have to satisfy those expectations or suffer adverse consequences. Some ESG factors have been incorporated into laws, or have been otherwise baked into governmental, commercial or financial regimes that can be quite coercive. We see this as a trend: “soft law” getting “harder”, less optional.

ESG now commonly also refers to avoiding harm to the environment and the non-human creatures that inhabit our planet,

ESG risks comprise a whole new category of risks to be managed. McAlan is a pioneer in considering ESG management to be an important component of overall risk management.

What ESG Means to Investors and to Operating Companies

ESG refers to a kind of investing. It also refers to the conduct of operating businesses. ESG investors and companies that use ESG principles may embrace the theory of “stakeholder capitalism”  (recognizing obligations to people who ar not shareholders) — or they may not —  but they share a belief that their decisions should take account of considerations and metrics not reflected in traditional financial statements.

Investors and operating companies often have different perspectives on ESG:

  • ESG investors demand that issuers of securities be responsive to ESG considerations. The historical background of ESG is “socially responsible investing” or “SRI”. Over time much of the “beyond the financials” thinking, and the terminology used, came to be called “sustainable investing” and “responsible investing”. For such investors “ESG” is now the semi-official term of choice and the relevant unifying concept.
  • On the other hand, beginning in the second half of the last Century, social and political reformers developed and advocated for the concept of “corporate social responsibility” or “CSR”, and the related terms “stakeholder capitalism”, “conscious capitalism” and “sustainable business” came into usage. All of these denoted “beyond the financials” values and thinking. The uptake of these concepts by the business community has moved from antagonism or cautious approval to a much broader and increasing acceptance. This has been accompanied by an almost general understanding of the concept and terminology of ESG.

Examples of ESG Factors

The consistent characteristic of ESG is the grouping of what we at McAlan call “factors” into three categories: environmental, social and governance. Here are some, but not all, of the factors:

In the environmental category, :

  • Climate change and carbon emissions, which may result in
    • assets becoming impaired, and
    • adverse consequences to contributors to climate change
  • Utilization of “natural capital” (such as biodiversity and raw materials sourcing)
  • Pollution and waste management
  • Energy efficiency
  • Use of green technologies and renewable energy
  • Air and water pollution
  • Deforestation
  • Habitat degradation
  • Water scarcity
  • Packaging
  • Biodiversity

In the social category:

  • Health, safety, and human capital development
  • Product and consumer safety
  • Community relations
  • Social opportunities
  • Customer satisfaction
  • Data protection and privacy
  • Diversity and inclusion
  • Employee engagement
  • Community relations
  • Human rights
  • Labor standards

And in governance:

  • Regulatory compliance
  • Board and executive oversight
  • Board independence
  • Shareholder rights
  • Internal controls
  • Accountability
  • Transparency and ethics
  • Board composition
  • Audit committee
  • Bribery and corruption
  • Business model resilience
  • Data privacy
  • Executive compensation
  • Lobbying
  • Political contributions
  • Whistleblower schemes

We see all these as risk factors, and believe they should be managed accordingly.

In our opinion, a company’s risk management — including compliance management — is another factor in the Governance category, perhaps the most important of all.