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  • Writer's picturePatricia A. Stewart | CFA

Why Is the “G” in ESG Important to Investors and Risk Management?

Of all the acronyms investors should familiarize themselves with, ESG is one of the most important. ESG stands for environmental, social, and (corporate) governance. It’s a framework that investors use to assess a company’s sustainability and risk profile.

Where investors were only once concerned about what a company did, today, they’re looking at the non-financial aspects of their performance, including environmental, social, and governance factors. This includes how ethical a company is and able to adapt to industry, regulatory, and market shifts.

ESG Important to Investors and Risk Management

  • Environmental: Environmental factors refer to a company’s environmental impact and risk management practices. This includes greenhouse gas emissions, pollution, waste, how they manage natural resources and encroachment, and are prepared to deal with climate risks like climate change, flooding, fires, Black Swan events like COVID-19, etc.

  • Social: The social aspect refers to a company’s relationship with its stakeholders. What is the company’s track record with fair wages, employee engagement, and the communities where it operates. Does the company pay their fair share of taxes, make donations, support community projects, and volunteer?

  • Governance: Corporate governance refers to how a business is led and managed. Is the company’s leadership aligned with what stakeholders expect? Investors also want to know that a company’s accounting is accurate and that internal controls are in place that promote transparency and accountability.

What Does ESG Mean for a Business?

While the acronym ESG has only been around since 2005, it has become a huge factor in influencing where investors park their money.

And the corporate world has taken notice. More than 90% of all S&P 500 companies and 70% of Russell 1000 companies publish ESG reports. Those numbers are expected to climb. A growing number of jurisdictions reporting ESG is either mandatory or under considerations.

The biggest driver of ESG growth has been fuelled by the environmental component of ESG, but the social component is gaining steam too. The war in Ukraine and the resulting global, economic, and societal affects have helped put the spotlight on ESG investing. Since Russia invaded Ukraine in February 2022, more than 400 multinational companies have pulled their business out of Russia.

How Does the “G” in ESG Impact Risk Management?

The one area that receives the least amount of attention but has the most historical data, research, and evidence that points to a company’s long-term success, is governance. Where the environmental and social aspects of ESG show what a company is doing to combat climate change and social topics, governance actually shows how a company operates when it comes to ESG.

Research shows that companies with strong governance practices perform better, have lower cost of capital, and are more productive and efficient than their peers with weaker governance practices. If you ever hear about a company embroiled in a scandal or dealing with internal misconduct, it’s usually a result of failed ESG.

A good example would be the turmoil upending Twitter after Elon Musk took over in October 2022. In the months following the acquisition, Twitter was plagued by layoffs, resignations, and controversy.

It’s not alone; Meta, Theranos, FTX, and Silicon Valley Bank are all recent examples of companies lacking governance oversight and controls. Of those, only Meta is still around.

All of these examples illustrate how financially damaging a lack of strong governance can be to a company. It also goes to show how corporate governance is the core component of ESG.

The fact is, ESG has become increasingly important with investors, regulators, and customers seeking out companies that show they are making sound financial decisions, sustainable growth, and are contributing positively to the environment and society at large.

Businesses that do implement and report their ESG measures tend to have better employee retention and lower turnover rates. Those that implement strong ESG governance practices are also able to price their brands at a premium and have better margins.

What Are Examples of Good & Poor Governance?

The “G” in ESG essentially encompasses risk management and is the litmus test for how well management runs a business. Some of the key performance indicators (KPI) in ESG governance include:

  • Shareholder structure

  • Board diversity

  • Executive compensation

  • Business ethics and conduct

  • Privacy control, data protection, and cybersecurity

  • ESG reporting and disclosure

  • Risk management

  • Financial costs and projected exposure associated with ESG risks

  • Tax transparency and strategy

When a company wants to improve the “G” in ESG, it often takes steps in one or more of these areas.

For investors, governance should be viewed as a way that companies can prevent and control risk. It’s also a way for businesses to create opportunity, a competitive advantage, and enhance profitability.

  • 59% of companies report increased revenue growth from operational ESG investment and more than 50% of companies reported a positive effect of on overall profitability.

  • U.S. companies who were leaders in diversity hiring, employment, and inclusion reported, on average, 28% higher revenue, net income, and 30% higher profit margins.

  • Businesses with diverse management teams helped generate 19% higher revenue from innovation versus companies led by less diverse leadership.

There’s also a downside to ignoring ESG governance. In Germany, under the 2023 ESG supply chain transparency due diligence law, companies operating there with annual revenue over €400 million (CDN$600 million) found to be in violation are susceptible of paying fines of up to two percent of annual revenue.

Companies with operations in Germany hit with fines of more than €175,000 can also be excluded from public contracts for up to three years. That can have a huge impact on a company’s bottom and top line and share price.

The law, which came into effect on January 1, 2023, essentially means any company with operations in Germany must comply with this edict. As the largest economy in Europe and the fourth largest economy in the world, this law will impact tens of thousands of companies around the world.

That’s why its imperative that investors use a wealth management professional who has a comprehensive understanding of international governance laws.

Sharp Asset Management for Your Retirement Planning

If you live in Mississauga, Toronto, or the GTA, working with a private wealth management team that understands the “G” in ESG can create opportunity and mitigate risk.

Sharp Asset Management Inc. is an independent portfolio management firm that is 100% owner operated. We are not affiliated with any financial institution, securities firm or mutual fund company; as a result, our investment decisions are unbiased.

All of our investment counsellors are charter financial analysts, the highest level of achievement, and have over 10 years of experiencing managing portfolios. To learn more about investing with Sharp Asset Management, contact us today.

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