Global investment in environmental, social and governance (ESG) has tripled over the past few years. Moreover, the number of business leaders acknowledging the importance of ESG has been on the rise and the number of companies publishing sustainability reports has now reached an impressive level. On the other hand, experts have warned that countries with poor ESG ratings risk losing investment opportunities which could negatively impact economic growth in emerging markets.
Introduced in 2006 by the United Nations, the concept of ESG paved the way for a new era in corporate responsibility, becoming a platform for understanding how companies manage risks across three dimensions and contributing to higher transparency in reporting.
What is ESG?
ESG is a valuable platform that provides an understanding of how a company manages risks across three distinct dimensions: environmental, social, and governance. When properly implemented, it leads to sustainable and inclusive progress over time and ensures long-term competitiveness. On the other hand, ESG reporting provides stakeholders with a comprehensive understanding of a company’s impact, beyond merely its financial performance, and helps to promote sustainable business practices.
The first pillar, environmental, refers to the organization’s impact on the environment and its approach to managing the related risks. This includes direct and indirect CO2 emissions, the responsible use of natural resources, and the company’s ability to withstand physical climate risks such as climate change, flooding, and fires.
The social aspect of ESG evaluates a company’s relationships with its stakeholders. This includes metrics related to human capital management such as fair wages and employee engagement, as well as the organization’s impact on the communities within which it operates.
Corporate governance in ESG analysis evaluates the leadership and management of a company. The focus is on understanding the alignment of leadership incentives with stakeholder expectations, the protection and respect of shareholder rights, and the existence of internal controls that promote transparency and accountability among top management.
Why is it important?
Successful firms are incorporating ESG strategies that boost both financial and social outcomes and environmental impact while ensuring long-term competitiveness. A comprehensive approach to ESG allows organizations to mitigate risks and take advantage of opportunities, whether through the routine examination of activities, policies, and reporting or through aspects such as tackling climate change, responsible investments, or addressing gender pay gaps. How a business chooses to identify, address, measure, and report on its ESG priorities significantly impacts how it safeguards people and capital and generates value.
KPMG’s 2022 Global CEO Outlook reveals that a rising number of business leaders recognize the growing importance of ESG issues with 69% of the CEOs surveyed stating a significant increase in stakeholder demand for transparency and reporting on ESG matters, up from 58% in 2021. Moreover, 72% of CEOs expect stakeholder scrutiny surrounding ESG topics such as climate change and gender equality to continue to intensify. Despite this, over one-third of the CEOs surveyed believe their organizations face challenges in effectively communicating their ESG efforts.
The trend of sustainability reporting is also on the rise, with KPMG’s 2022 Global Survey of Sustainability Reporting revealing that 79% of the leading 100 companies in every country surveyed publish sustainability reports. This figure climbs to an impressive 96% among the top 250 companies globally (G250). Investment in ESG has also seen a significant surge in recent years with global spending rising from approximately US$11.35 trillion in 2012 to US$30.7 trillion in 2018.
Fig.1. Investment in environmental, social, and corporate governance worldwide from 2012 to 2018 (in billion U.S. dollars)
Source: Statista
There are several reasons why ESG has gained importance in recent years:
- Increased Awareness and Understanding of ESG Issues: Climate change, social inequality, and corporate governance scandals have brought ESG issues to the forefront of public attention. Companies and investors are now more aware of the impact their actions can have on society and the environment.
- Investor Demands: Investors are increasingly looking to invest in companies committed to sustainability and responsible business practices. ESG analysis provides investors with a comprehensive understanding of a company’s impact beyond financial performance.
- Long-Term Sustainability: Companies prioritizing ESG issues are more likely to be sustainable over the long term. This is because they are better positioned to mitigate risks, such as regulatory penalties and reputational damage, and take advantage of opportunities, such as new market opportunities created by the transition to a low-carbon economy.
- Improved Performance: Studies have shown that companies prioritizing ESG issues have better financial performance. This is because ESG considerations often lead to more efficient operations, improved risk management, and stronger stakeholder relationships.
A risk of diverting capital from developing countries
The adoption of ESG practices by companies has become increasingly popular as a means of mitigating risks and taking advantage of opportunities. However, the growing focus on ESG ratings may also result in the potential risk of finance being diverted from emerging markets.
A recent study has found that ESG strategies may direct capital away from emerging markets by screening out investments that do not meet benchmarks on issues such as corruption and inequality. Diverting finance from developing countries can have a significant impact on growth, as the annual shortfall in investment required to meet the UN’s Sustainable Development Goals in developing countries is currently at US$4.3tn, according to the UN Conference on Trade and Development.
According to Moody’s, the financial ratings agency, approximately 60% of developing countries’ sovereign credit ratings are being negatively impacted by ESG factors. The report states that the credit impact of ESG factors varies significantly. While the credit impact for advanced economies is assessed as “neutral to low” for the majority of cases, it is “highly negative” or “very highly negative” for approximately 60% of emerging markets.
Companies in developing countries with poor ESG ratings risk being excluded from investment opportunities which could impact economic growth in these markets. While the full impact of this trend is not yet clear, the potential risk of financial exclusion is a concern that must be monitored moving forward.
