The Three Pillars of ESG (Part 1): E for Environmental

If you’re here, you’ve probably heard a decent amount about ESG Investing already, and presumably already know that “ESG” stands for Environmental, Social, and Governance. These are specifically identified issues generally agreed upon as important for society as a whole, broken down into three categories; AKA “The Three Pillars of ESG Investing.” All ESG-based analysis is fueled by the assessment of factors inside these three pillars. Environmental factors (the ‘E’ of ESG) are specific to just one of the three pillars.

ESG Environmental Factors

In practice, ESG is a tool that combines social-good metrics and traditional, economic-focused investment analysis with an overarching aim: to better identify risks, opportunities, and projected financial performance in companies. But what, exactly, does all of that mean? This blog post is the first of a three-part series digging deep inside each of the individual pillars, and how each is applied in ESG investing.

First up, the one most commonly associated with ESG: Environmental.

 

ESG Standards & Regulations

First, an important point: There is currently no requirement for ESG disclosure in the United States, and thus, there is no regulated standard for what goes into ESG reporting. This means that, while usually driven by what investment companies require, organizations get to decide themselves what they report.

Some investment companies, per the Green Business Bureau, require disclosures that align with frameworks provided by organizations such as the Sustainability Accounting Standards Board (SASB) or the Task Force on Climate-Related Financial Disclosures (TCFD). Others create their own systems that are inspired by such frameworks. Overall, there are many other frameworks that can help guide ESG reporting and analysis; both for companies doing the reporting, as well as for firms doing the analysis.

Because of this, not every ESG analysis is based on the exact same valuation of environmental factors. Regardless, there are a number of factors that are most frequently reported and used for analysis.

 

What Makes Up The ‘E’ Pillar?

Factors relating to the environmental pillar of ESG analysis include:

Climate change and carbon emissions

How much carbon does the company release into the atmosphere, directly and indirectly, thus contributing to—or, in some cases, taking away from—climate change?

Air and water pollution

Do the company’s activities pollute the air or the water? How much?

Biodiversity

Biodiversity is defined by the UN as “the variety of living components of nature,” and many human actions have led to a loss of biodiversity in ecosystems. Does the company contribute significantly to this biodiversity loss?

Deforestation

Another very self-explanatory one; does the company contribute, directly or indirectly, to deforestation? What about reforestation?

Energy efficiency

How much energy does the company use? Does this energy come from renewable sources, or finite ones that contribute to climate change? If the company is an energy company itself, what types of energy does it generate?

Waste management

As prescribed by National Waste Associates, does the company take extensive efforts to minimize waste, reuse certain parts of their waste chain, and recycle as much remaining waste as possible?

Water scarcity

With water scarcity already affecting more than half of the world’s population and the issue on track to only get worse, is the company using water responsibly?

 

How the ‘E’ Might Affect the Bottom Line

It’s easy to see how these environmental factors affect nature and, in turn, society. But how do they affect the bottom line?

There are numerous ways that this can happen. One very obvious one is a scandal based on a disaster; perhaps the highest-profile example in recent memory was the Deepwater Horizon oil spill, which caused a gigantic fall in BP’s market cap one year out.

But disasters aren’t the only consideration when it comes to environmental factors and potential financial health.

At a big-picture level, governmental regulations such as the European Climate Law, could force organizations to meet a set of requirements, thus harming companies that are ill-positioned to adhere to these standards. Conversely, this could help organizations that are already in or near alignment with them.

Environmental consideration can help on a more granular level as well. Reduction of waste and energy use, if done in the right ways, can save companies money. Environmentally friendly behavior could potentially improve a brand’s image, forging a bond with a certain (and growing) set of consumers. It could even attract dedicated employees who are seeking purpose and satisfaction in their work, which could in turn be a financial boon for the company.

 

How the ‘E’ is Calculated

In analyzing a company on an ESG basis, an ESG score is assigned from calculations that are based on all three of the factors.

Just as there is no standard for ESG reporting, there is no standard for how ESG analysis is conducted in terms of assessing ESG scores. Certain factors might be weighted higher or lower, depending on who is doing the analysis.

Regardless, all ESG-based analyses tend to blend these factors into their overall calculation of ESG score, sometimes dividing them into larger categories.

For example, Refinitiv in May 2022 arranged environmental factors into three different buckets—resource use, emissions and innovation—divided further into “themes” (for resource use: water, energy, sustainable packaging, and environmental supply chain; for emissions: emissions, waste, biodiversity, and environmental management systems; and for innovation: product innovation and green revenues, research and development and capital expenditures). The scores in these categories were then weighted—15% each for emissions and resource use, 13% for innovation—and applied to the final overall score.

This is just one way environmental topics are woven into an overall ESG score calculation. MSCI, one of the top sources of ESG ratings, in its December 2022 methodology breakdown listed a wide array of environmental categories. Everything from decarbonization to green bonds percentage was included as part of their calculation (with specific percentage weights not revealed).

 

The ‘E’ Has Come a Long Way (Baby)

The origins of ESG go all the way back to the 18th century with values-based socially responsible investing (SRI). ESG has come a long way since then, and it’s no longer just exclusionary investing but, in the words of Charles Schwab, an analysis strategy that “…determines how well each company is addressing risks relevant to its business.”

Some of these risks, quite obviously, are environmental. And no matter who is doing the analyzing, ESG analysis helps to determine just how much these risks hurt—or how much the lack of risks helps—companies. This analysis is then passed on to investors so they can be better positioned to take advantage of opportunities that very well could pay off in the short and long term.

 

---

At Rowling & Associates, we are dedicated to acting in your best interests and firmly committed to your financial well-being. Please don’t hesitate to contact us directly if you have any questions about how we integrate ESG analysis to manage your investments. We’ll be happy to walk you through our investment selection process and discuss any concerns you might have regarding your own personal portfolio.

---