It’s hard to deny the impact of climate and societal risks on businesses today. We are more vulnerable to these risks than ever before. With 2023 becoming the hottest year on record and the world getting intricately connected through technology, the importance of climate and societal relationships has never been more pronounced.
It is natural that investors around the globe are rising to this consciousness. Larry Fink, Chairman & CEO of BlackRock, in his landmark annual letter to investors in 2020 asked some thought-provoking questions –
“Will cities, for example, be able to afford their infrastructure needs as climate risk reshapes the market for municipal bonds? What will happen to the 30-year mortgage – a key building block of finance – if lenders can’t estimate the impact of climate risk over such a long timeline, and if there is no viable market for flood or fire insurance in impacted areas? What happens to inflation, and in turn interest rates, if the cost of food climbs from drought and flooding? How can we model economic growth if emerging markets see their productivity decline due to extreme heat and other climate impacts?
Investors are increasingly reckoning with these questions and recognizing that climate risk is investment risk”
And indeed, investors have come up with numerous changes, policies, strategies, checks and controls to protect their interests. Not to mention, many of these interventions have also become talking points to promote positive impact created through the investors’ application of funds.
Sustainability-based Governance
Serious efforts are not possible without backing from the top. While the senior leadership sets the strategic vision and priorities, a specialized committee is generally tasked with governing implementation of ESG measures within the pre- and post- investment process. This includes personnel from different teams right from sourcing and diligence to portfolio management and operations. There is also a rise of new positions such as ‘Chief of Impact’ or ‘ESG Risk Officer’ in the fund hierarchy.
The reporting structure of the Committee may differ from investor to investor but it is common to have its representation in Investment and Risk Management Committee meetings. This integration of sustainability in decision making is perhaps the most critical step in improving the funds’ ESG performance in true sense.
The Committee, akin to its common name ‘Responsible Investing Committee’, chalks out an ESG Risk Management Framework to identify, assess and address sustainability-linked risks of the potential target company/ asset category. It governs aspects such as identifying financially material sustainability risks and opportunities, evaluating impact of physical and transitional climate risks, checking for prevalence of human rights violations in the industry, nature and depth of labour practices, among other things that justify the fund’s investment as being ‘responsible’.
Sustainability-based Strategy
A ‘Responsible Investment Policy Statement’ akin to a thesis in sustainability is important to frisk investment opportunities based on suitable criteria. Investors may adopt different strategies when dealing with ESG linked risks and opportunities.
The fund could opt for a theme-based approach like selecting a sector, say power and energy or a trend, say carbon capture technologies. The strategy could also be norm-based requiring compliance with some minimum national/international standards such as ISO 14001 or certification by Forest Stewardship Council or other internal policies that the Committee may consider sufficient to mitigate sustainability-linked risks. An active positive integration strategy may be deployed by funds to prioritise companies demonstrating superior ESG performance over peers. This may be done by delineating those ESG parameters that are material financially and in the context of the fund’s priorities. Investors may also use an exclusionary strategy to set aside certain high-risk companies or projects that are associated with say high emissions, human rights violations or poor governance practices.
The Policy often provides a method to integrate the strategy with valuation estimates based on the target’s ESG-preparedness. Broadly, this may be adopted in the market-based approach as a premium or discount to transaction or industry multiples vis-à-vis performance of peers. Cashflows may be adjusted to provide for cost savings or revenue enhancements from good practices, as against penalties or demand fluctuations from regulatory and market changes.
The Policy further makes the leadership responsible for taking ownership on sustainability-linked measures and ensuring that requisite processes are designed to meet strategic objectives.
Sustainability-based Processes
The Committee tasked with implementation of the strategy devises numerous processes, controls and monitoring mechanisms to ensure ESG objectives are reflected in the funds’ operations. Some of the processes may include:
Setting fund-level and organisation-level micro ESG targets for the short, medium and long term;
Evaluating or conducting due diligence of opportunities from an ESG lens based on the parameters set-forth in the Policy statement;
Introducing conditions precedent or subsequent to transactions for institutionalising ESG risk mitigation initiatives in the target;
Implementing an internal as well as portfolio-level information system to collect and report on ESG-based information, including greenhouse gas emissions, on a regular basis;
Undertaking external assurance or assessment of reports and other policy measures to improve the quality of information and efficacy of measures;
Instituting review mechanisms to constantly engage with portfolio companies and other stakeholders on ESG aspects.
With allegations of ‘woke capitalism’ tarnishing the valour of ESG reforms, it is important to know that sustainability-linked measures in many ways are addressing current and impending financial predicaments (whether direct or indirect), which is at the core of any for-profit organisation. Investors must ensure authenticity and effectiveness of their ESG commitments and communication to avoid greenwashing and the subsequent criticism. Organisations that have embraced ESG in its true sense have seen the fruits, if not in the form of improved results but at least in the form of reduced risks that would otherwise increase the cost of capital.
For any assistance on your ESG plans, feel free to contact us at info@esgityadvisors.com.
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