ESG consists of x3 pillars, as outlined in the prior post (https://www.deveresg.com/post/introduction-to-esg-environmental-social-and-governance). In the following articles, we will take a deeper dive into each of those three pillars.
The ‘E’ pillar of ESG refers to the physical environment. The physical environment is a shared, common resource comprised of land, water, air, biodiversity (flora, fauna, avifauna), and the processes that interconnect them. It is imperative that all industrial, commercial, public, and private activities that utilise or impact these shared resources are sustainable, fair, and equitable in nature, and are well managed. Sustainable implies actions/practices maintained over the long term that do not deplete net global natural resources or cause harm to the environment. Sustainable also infers the preservation of the environment for future generations. Fair refers to treating all groups impartially and without bias, while equitable is the recognition that some sectors may require more support than others- the latter two points will be returned to when considering the ‘S’, or social, in ESG (and please also visit my sister website dedicated to research in sustainable food systems and sociology/anthropology www.ecofooddev.com where I also discuss such matters in greater detail, for example, the Just Transition).
Organisations and companies of all scales and in all regions must ensure that they measure and manage their impacts on the environment. Investing governed by ESG principles is a sustainable investment method that:
prioritizes optimal environmental, social and governance outcomes/factors,
helps to foster sustainable business practices,
aids in the transition of current business practices to more sustainable methods,
and is a framework to enable global businesses to attain their climate targets while also practicing social equity.
ESG investing has suffered in that a united and clear definition of what it means took time to emerge. Such a lack of clarity invites significant risk in the implementation and assessment of ESG investment strategies/portfolios as well as in compliance with emerging ESG regulation. To tackle this, the ‘E’ pillar was initially focussed upon, and environmental concerns given primary emphasis (one might argue appropriately so), specifically climate change in the form of carbon emissions. Hence, the main goal of the environmental pillar of ESG has been to reduce carbon emissions (greenhouse gas emissions), which is a significant and primary cause of climate change. However, the definition of the ‘E’ pillar is increasingly recognised as being a broader topic related to natural resource management and environmental risk, particularly in relation to biodiversity loss which goes hand in hand with climate change. Hence impact measurement and management criteria can be developed for a sector/organisation/company within this pillar using a wide variety of metrics.
Why is the 'E' important?
Environmental impacts and the environmental performance of organisations are of key business concern for a wide array of reasons. Firstly, as alluded to in previous posts, not only do organisations have an impact on the environment, but the environment also has an impact and presents significant risk to businesses. Globalization changed global production practices, which has also led to increased risk exposure in the face of climate change. Any type of international trade will result in a global supply chain and all the inherent risks in the management of that supply chain. Resource change because of climate change threatens supply chains, for example water scarcity, water quality degradation, or agri-food issues such as crop failure and land loss. Such threats sit alongside changing consumer demands, global pandemics, and geopolitical upheaval - often instigated in part due to climate change and resource scarcity. Such phenomena threaten to upend global supply chains. Particularly affected are SMEs, who are more exposed to such risks and uncertainties. Though risk management plans account for fluctuations and for events that can test or stretch a company or organisation, we are now witnessing repeated extreme events, which go beyond usual supply chain risk assessment, and financially threaten not only organisations and businesses, but national and global economies. COVID-19 starkly exposed the fragility of global supply chains in the face of such extreme events, in particular increased demand volatility (e.g., PPE), and the dependency of global economies on single or limited sources (e.g., overreliance on production in certain regions of the world).
Stakeholders are also increasingly concerned with environmental factors and performance, and progressively require greater communication with regards to environmental outputs. Arvidsson & Dumay (2021) outline how investors seek to include ESG performance in their investment processes. They highlight that investors/shareholders are driving demands for more information on ESG performance and want to know how companies are contributing to sustainable development. The demand is driven by the recognition that climate risk equates to investment risk. They cite the example of major investment funds like BlackRock, who are adjusting their investment strategies to prioritise sustainable development. This shift is necessary because in a low-carbon economy, certain assets become worthless or even liabilities, leading to stranded resources. Investors now realise the importance of understanding the connection between climate change and investment risk, and as a result, there is a growing demand for reliable climate change and ESG performance information that meets investment standards. Environmentally focused investing can bring about opportunities for organisations. Companies that adopt a forward-thinking approach can take advantage of emerging regulations, shifting demographics, and investment trends. By prioritising sustainability and adapting their business practices, these companies can maintain a competitive edge as well as positively contribute to the world around them. Simply put, according to S&P Global research, companies that include environmental goals in their growth strategies don't perform worse than other companies. In fact, they may even do better. The S&P 500 ESG Index, created in 2019, ranks companies based on their environmental, social, and governance (ESG) criteria and excludes underperforming ones. This index aligns with the risk and return profile of the S&P 500 and gives more exposure to companies that limit their greenhouse gas emissions, set reduction targets, and report on their ESG analysis. Importantly, the S&P 500 ESG Index doesn't significantly outperform or underperform the regular S&P 500 Index.
Environmental Indicators
When we talk about the climate, it can often feel like a very vague term. We know there is a problem, we know it’s big, but where do we start in terms of measuring it accounting for it, monitoring it? Some suggest focusing the "E" pillar of ESG on climate change mitigation alone. This aligns with decarbonization literature and helps companies and investors make clearer decisions. It also offers a measurable benchmark for investments in this area, similar to how other resource management issues have been addressed using such tests.
However, various metrics are established to measure climate change and biodiversity loss (biodiversity loss being an element not to be ignored as it goes hand-in-hand with climate change). For example, in the assessment of companies' environmental impact, S&P Global incorporates four factors: greenhouse gas emissions, water use, waste and pollution, and land use and biodiversity. S&P Global Ratings' ESG Evaluation also considers potential social and governance risks to determine an entity's ability to operate successfully, including an evaluation of its preparedness to anticipate and adapt to long-term environmental disruptions. These factors ultimately contribute to determining the ESG score.
Generally, metrics of environmental impact include:
GHG emissions (Scope 1, 2, 3 & total)
Carbon footprint
GHG intensity
Fossil fuel sector
Non-renewable energy consumption and production
Energy consumption intensity per high impact climate sector
Biodiversity (and protected areas)
Emissions to water / water footprint
Hazardous waste ratio
The environment can be broken into three broad categories: climate change, resource depletion (especially fresh water), and pollution (both air and water). Oftentimes these factors work together to compound their effects. For example, floods are becoming more common and affecting greater numbers of communities. Other environmental effects are more direct and observable, such as the proliferation of oil slicks in water or smog hanging in the air.
For example, overpopulation is a critical issue with wide-ranging environmental and social consequences. It leads to pollution, food shortages, hunger, civil unrest, and inadequate medical care. Another example is water scarcity, which directly impacts both nature and humans. The scarcity of water (and in particular clean, fresh water) is likely to increase poverty levels, mass migration, regional pressures on natural resources, and deforestation.
Investors consider biodiversity loss and climate change as major sustainability concerns, with deforestation being the most urgent aspect. Agriculture, responsible for 23% of global greenhouse gas emissions and 71% of deforestation, stands as the largest polluter worldwide. Forests not only provide food for 22% of the world's population but also absorb 40% of global carbon emissions. The close link between carbon emissions and climate change contributes to the rise in more frequent Category 4 and 5 storms, massive forest fires, and flash floods in urban areas.
The environmental impact of plastic production, usage, and disposal is extensive. While plastic has been used for many years, its global production and consumption experienced a significant surge in the 1960s due to its lightweight nature, cost-effectiveness, and versatility. Plastic not only contributes substantially to greenhouse gas emissions during its life cycle but also during manufacturing and decomposition processes.
Plastics primarily emit carbon dioxide (CO2), but they also release other gases like methane and ethylene. Methane, being 28 times more potent than CO2, is a significant greenhouse gas emitted by plastics. Moreover, methane takes a long time to break down in the environment, leading to significant global warming impacts even in small amounts released. Apart from greenhouse gas emissions, plastics pose a threat to wildlife and waterways as they degrade into small particles. These particles are consumed by animals and enter the food chain, posing risks to human health. The performance of plastics in landfills is another concern, as methane is collected under plastic liners and utilized for energy. To address these issues, considering design, repurposing, repairing, and recycling at each stage of the circular economy can be potential solutions. Incorporating these strategies into the environmental aspect of a company's ESG (Environmental, Social, and Governance) strategy can contribute to mitigating the impacts of plastic production and usage.
Greenhouse Gas Emissions (GHGs)
It is widely accepted that harmful greenhouse gas emissions originate primarily from the transportation and electric utility sectors. In the United States, the world's second-largest emitter overall, recent data indicates that more than half of carbon emissions can be attributed to the transportation sector (27%) and the electric utility industry (25%) alone. The oft-cited required response within these sectors is the shift towards electrification, as highlighted by Jones and Ginley (2021). Electrification programs directly tackle the majority of emissions and also contribute to reducing other emission sources, such as those from commercial and residential heating. Therefore, to accomplish the objectives of the "E" pillar (environmental sustainability), it is essential to prioritize electricity procurement, both in its direct and indirect forms, above or at least equal to any other programmatic goal. We will return to strategies to tackle carbon emissions in further posts.
The sources of GHG emissions are well understood and measurable, according to the International Energy Agency (IEA). The mathematics of carbon reduction show that certain sectors, such as transportation and electric utilities, need significant emissions reductions, while other sectors may not require drastic changes to meet internationally recognized decarbonization goals. This has been discussed by experts like Gerrard and Dernbach (2018) and Vandenbergh and Gilligan (2020). The uncomfortable fact is that certain industries and geographies emit disproportionately greater amounts of harmful emissions than other industries and territories.
When analysing an organization's carbon footprint, it involves measuring the total amount of greenhouse gases emitted by that organization, event, product, or individual. Greenhouse gases (GHGs) include carbon dioxide, methane, nitrous oxide, and related compounds. To make them comparable, they are converted to carbon dioxide equivalents, where one tonne of carbon dioxide has a global warming potential of one.
The reported emissions are then categorized into three "Scopes."
Scope 1 greenhouse gas emissions refer to emissions released directly into the atmosphere as a result of an organization's activities. They are often called direct emissions. Examples include emissions from manufacturing processes (e.g., cement production), burning diesel fuel in trucks, or fugitive emissions like methane from coal mines or coal-burning for electricity generation.
Scope 2 greenhouse gas emissions are indirect emissions released into the atmosphere due to the consumption of energy commodities. For instance, if a power station burns coal to generate electricity, the greenhouse gas emissions resulting from the coal burning are attributed to the power station as scope 1 emissions. If that electricity is then transmitted to a car factory and used to power machinery and lighting, the emissions associated with generating the electricity are considered scope 2 emissions for the factory.
Scope 3 greenhouse gas emissions encompass emissions beyond scope 2 and are generated in the broader economy. They occur as a consequence of a facility's activities but originate from sources not owned or controlled by the facility itself. Examples of scope 3 emissions include the extraction and production of purchased materials, transportation of purchased fuels, the use of sold products and services, and business-related air travel on commercial airlines.
Regulation governing the E in ESG
The global response from regulatory bodies to address environmental risks has been fragmented, with Europe taking a proactive stance by implementing environmental reporting standards and advocating for a transition to carbon-neutral energy. The European Union (EU) has introduced initiatives to encourage sustainable investment and has recently introduced the Corporate Sustainability Reporting Directive (CSRD), which mandates large companies to disclose a comprehensive range of environmental, social, and governance (ESG) metrics by 2025. In contrast, the United States has shown mixed responses, lacking a cohesive federal environmental policy. Emerging economies are grappling with the challenge of balancing economic development with the need to prepare for a cleaner future (BDO, 2023).
Regarding individual disclosures, the following areas are of particular importance:
Supply Chain Due Diligence: Organizations face mounting pressure to ensure that their supply chains operate without causing harm. Germany and Norway have already implemented regulations, and the EU's proposed Directive on Corporate Sustainability Due Diligence (CSDD) aims to address adverse human rights and environmental impacts associated with supply chains.
Electric Vehicles: Policymakers are utilizing mandates and incentives to promote the adoption of electric vehicles. The U.S. offers federal incentives through the IRA, and state and local governments provide various incentive programs. California has implemented regulations requiring all new vehicles to be zero emissions by 2035.
Greenwashing: Regulators are taking steps to combat greenwashing through legislation and rules focused on preventing misleading environmental claims. Singapore, Australia, the EU, Switzerland, the United Kingdom, and the United States have either introduced or proposed measures to mitigate greenwashing practices.
Tax: Governments are employing tax incentives to encourage sustainable activities, providing organizations with opportunities to participate in these programs. The U.S. Inflation Reduction Act (IRA) extends tax credits for energy transition initiatives, while the EU has reached a provisional agreement on a carbon tax and proposes utilizing tax benefits to expedite the adoption of sustainable technologies.
Assurance: Regulators are incorporating independent assurance requirements into disclosure rules to enhance the credibility of climate-related information. The EU's CSRD takes a gradual approach to implementing assurance requirements, while both New Zealand and the proposed rules by the U.S. Securities and Exchange Commission (SEC) also address the issue of assurance.
Aviation: Governments are striving to reduce emissions from the aviation sector by promoting more efficient aircraft and the use of sustainable aviation fuel (SAF). The U.S. offers incentives and has launched initiatives to support SAF projects. The EU and other countries have proposed or implemented regulations to increase the use of SAF and reduce emissions (BDO, 2023).
In summary, organizations must closely monitor regulatory developments, ensure alignment of their ESG strategies with new requirements, and consider seeking third-party assurance for a comprehensive set of ESG metrics. Transparency, responsible procurement practices, and strategic planning are crucial in meeting regulatory obligations and promoting sustainable business practices.
Current and Future Needs within the field of ESG
Data
Empirical data
To understand the environmental aspect of ESG, empirical research and data on the energy transition are needed. While the "E" in ESG can be quantified, it lacks theoretical development in certain important areas. It is crucial to establish standard metrics and performance units for organizations to align and measure their environmental performance. The necessary data exists, and there is no excuse not to utilize it, particularly through science-based targets (SBTi) that provide methods and guidance for setting environmentally sound targets. This data is essential to allocate capital effectively according to ESG guidelines.
By incorporating this data and understanding actual environmental performance, rather than just focusing on reporting quality, we can develop a comprehensive theory of ESG, especially the environmental aspect. This will enable the establishment of standardized metrics and units, facilitating accurate benchmarking across industries. Benchmarking allows companies to evaluate their ESG performance against industry standards and best practices. The European Commission has introduced green benchmarks to help investors assess investment opportunities based on climate-related factors.
For investors, benchmarking enables a comparison of different investment options and provides measurable targets for improved investment returns. Testing methods like backtesting, the INVEST framework, return on investment (ROI) calculations, and unit testing are commonly used to evaluate investment strategies and determine their success in generating higher returns.
Sociological & Technical
Trahan and Jantz (2023) explore the intersection of ESG investment and socio-technical pathways. With the emergence of new technologies, it is crucial to assess their sustainability within the larger system. This assessment involves examining both emissions and investment returns. The specific outcomes will vary depending on the product and approach being considered. Incorporating diverse perspectives is essential to gaining a comprehensive understanding of climate change theory and its impacts. Instead of focusing solely on secondary metrics, companies should prioritize the social and technological factors that contribute to emissions in the first place. This broader perspective on socio-technical pathways introduces a new management challenge.
To account for the secondary effects of emissions resulting from changing socio-technical systems, guidelines are necessary. Changing socio-technical systems refer to the need for society to alter its interaction with technology in order to reduce greenhouse gas emissions. This includes changes in consumer behaviors and expectations, such as shifts in food consumption and energy usage (e.g., transitioning to electric cars). It encompasses a broader transformation in how we live and work.
Secondary effects of emissions involve unintended changes in greenhouse gas emissions or carbon stocks that arise from a project or activity. These effects can have positive or negative impacts on the environment and human health. Examples include reduced visibility and health impacts from particulate emissions produced by the combustion of biofuels and fossil fuels, acid rain and health impacts from sulfur dioxide emissions, damage to plants and human health effects from ozone emissions, health impacts from carbon monoxide emissions, greenhouse gas emissions from fuel combustion leading to global warming and climate change, unintended changes in GHG emissions or removals associated with a GHG project, and the reduction of regulated pollutants through carbon dioxide capture from point sources.
In conclusion, the "E" pillar of ESG, which focuses on the environment, plays a crucial role in sustainable business practices and investment strategies. With the recognition that climate risk equates to investment risk, companies that prioritize environmental goals and adapt their practices can not only maintain a competitive edge but also positively contribute to the world while not significantly affecting returns. In upcoming posts, I will delve into the 'S' and 'G' of ESG, and ESG regulatory and reporting mechanisms.
Key takeaways
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References
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