ESG (which stands for Environmental, Social, and Governance) is a set of criteria that companies can use to report their performance in these areas, and that financial institutions can use to assess the ethics and sustainability of their loan or investment portfolios.
When they are solidified, ESG scores may be based on an assortment of factors such as energy use, usage and stewardship of natural resources, cybersecurity, conservation practices, the treatment of employees, the diversity of leadership, and more.
ESG initiatives are on the rise, and although metrics and scoring methods are still forming and have not fully manifested into active regulation yet, the actualization of ESG reporting requirements is accelerating.
Many companies are struggling to meet their goals and the pressure of the ensuing requirements is causing confusion and unrest for businesses, particularly in the financial realm. The impact of investment and loan portfolios will need to be valued on an extraordinarily granular level in terms of ESG metrics, as lenders, banks, and investors will be held accountable for their ESG viability.
Just as water risk translates directly to business and financial risk, success – or lack thereof – in the ESG reporting will also translate to the same end. As this becomes clearer, actions are being taken. Some prominent banks already tie executive compensation to hitting ESG targets.
A report by Bloomberg shows that “half of the respondents said their company performs ‘very effectively’ relative to environmental metrics, but less than 40% said the same about their company’s achievements on social and governance factors.”
As of 2021, companies in Europe are more likely than U.S. businesses to have “formal ESG reporting processes in place,” but this is expected to change as agencies like the SEC roll out stricter reporting requirements. Major firms like PricewaterhouseCoopers call this a “paradigm shift” that will require businesses to take charge of ESG data.
With better, granular data and a thorough understanding of the three types of capital, investors and financial institutions will be better able to meet reporting requirements and identify and reduce financial risk.
This guide will take a deep dive into ESG reporting as the new normality unfolds, and will be updated regularly as new regulations are rolled out.
ESG Investing Principles
ESG investing principles revolve around understanding and mitigating risks associated with three types of capital: financial, natural, and social.
Financial capital has historically been the dominant form of capital, in part because it’s the easiest to quantify in terms of a currency value. It’s the type of capital that, in effect, influences the decisions that impact natural and social capital; the latter two have typically been considered in the capacity that they, themselves, influence and serve financial capital.
In recent years, this perspective has been changing, and ESG investing principles seek to account for all three types of capital. The well-being of nature and society is now seen as a contributor to the long-term sustainability of investments and the security of financial capital.
Businesses and operations that steward and optimize natural resources and invest time and focus in the communities they operate in will be able to depend on those resources for a long time to come. It’s the reason why sustainable agriculture has been linked to better ROI, and why impact investments are quickly becoming more profitable than traditional investments.
Not all ESG initiatives are up to par, though, and some corporate actions have fallen short of their promises and declarations, resulting in “greenwashing,” or claiming to meet ESG criteria without the data to back their claims up.
“The sheer volume of sustainability commitments coming out of the industrial sector makes it difficult to parse which efforts are significant and which are more akin to checking a box,” Bloomberg notes.
As ESG investing becomes more commonplace, and as reporting requirements become standardized, financial institutions will need to have more consistent, in-depth, granular data to work with to make decisions on loans and investments.
By focusing on three key areas – data collection, measurement, and mitigation – they can mitigate risks to all three kinds of capital.
Read more about ESG investing principles here.
Why Companies’ ESG Data Will Be in High Demand
At least $12 trillion dollars – a quarter of all U.S. investments – are now in companies that profess certain ESG standards, according to Forbes. But as new regulations bring about more thorough ESG reporting requirements – and as banks themselves may be required to report on the overall sustainability of their investment portfolios – it will no longer be enough to rely on ESG scores from third-party agencies.
Bloomberg notes that many investors “prefer raw ESG data to ESG scores because it allows them to customize the data sets for their needs”. ESG initiatives vary so widely that it’s important for financial institutions to be able to make their own assessments based on the relevant criteria in their industry.
For example, ag professionals and lenders can turn to water GIS data to assess the sustainability of water resources in a given region and its effect on financial capital. The immense benefit of granular datasets, particularly in the form of GIS, is that it provides a complete picture at multiple resolutions. Those that don’t stay on par with ESG requirements may find themselves behind the curve and at risk of diminishing the value of their capital.
Ultimately, being able to interpret ESG data directly will help stakeholders at all levels identify the connection between all three types of capital. This will lay the groundwork for more successful ESG risk mitigation and reporting strategies.
Read more about collecting and understanding ESG data here.
Financial Capital and Its Role in ESG Risk Mitigation
Despite its position as the largely dominant form of capital in the modern world, financial capital is remarkably dependent on the other two types of capital: natural and social. Because issues such as water scarcity and resource depletion aren’t typically represented on balance sheets, ESG reporting is a key way of demonstrating that link on paper.
In the long-term, natural capital can constrain financial capital when resources run out or become more expensive due to scarcity. At the same time, social capital can impact financial capital in both positive ways (community support for corporate initiatives) or in negative ways (boycotts, worker strikes, increased regulations). Financial institutions must make an effort to account for all three types of capital in their decisions.
ESG reporting can help to identify these risks early on and provide an opportunity to mitigate them. For example, agricultural lenders can perform water risk assessments before approving a loan or a land deal to ensure there’s sufficient natural capital.
Learn more about financial capital and ESG risk mitigation here.
Natural Capital and Its Role in ESG Risk Mitigation
Natural capital refers to anything from water resources, to forests, minerals, fossil fuels, and entire ecosystems – anything upon which a business or organization depends. The number of items that act as natural capital to businesses may be surprising.
Putting a value on these resources can help to “inform more sustainable choices, including market-based conservation, which can be crucial for protecting nature from unrestrained consumption.”
For example, the value of water can be measured in terms of the crops it supports, as well as the electricity it generates or the municipal users it can serve. The true value of a forest could be measured in terms of lumber, as well as the headwaters it supports, which contribute to a healthier ecosystem.
These calculations require complex data collection and analysis, but as ESG reporting requirements increase, this data must be more readily at hand.
Financial institutions can use this data to identify links between natural and financial capital and uncover risks that are less obvious when each type of capital is considered separately. As water risk translates to business risk, a risk to natural capital will be a risk to financial capital.
Ultimately, decision-makers can use ESG data to direct financial capital in more efficient and productive ways, while meeting sustainability targets and reporting requirements.
Learn more about natural capital and ESG risk mitigation here.