How ESG Due Diligence Can Reduce Portfolio Risks
By: Julianna Eng & Mary Kate Henderson (Lookthrough Research)
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In 2010, Deepwater Horizon, the largest oil spill in history cost BP $65 million dollars. This environmental disaster caused a sharp decline in BP’s share price and it took four years for the company to recover to pre-spill valuation. While BP shareholders lost money, owners of ESG indexes like the MSCI ESG Leaders index were not significantly impacted by this disaster. The ESG shareholders were protected from Deepwater Horizon related financial loss because an ESG screen had removed BP from their portfolio due to the lack of proper governance reactions to previous smaller spills.
ESG is typically referenced as the environmental, social, and governance considerations of a company, but in application, its impact is more nuanced. One of the most influential utilizations of ESG is the mitigation of risk oversight. This can be conducted through ESG due diligence, which is an assessment of a business’s current ESG standing.
What is ESG Due Diligence and how does it work?
The first step in ESG due diligence is the identification of risks by industry and geography. Once these sector risks are determined, a company’s exposure to these risks is screened. For example, an environmental risk, like exposure to extreme weather due to climate change, can have negative effects for the agriculture industry. Frameworks like SASB have developed charts that identify ESG issues likely to impact company performance by industry in order to streamline this first step.
The second step in ESG due diligence is the assessment of the company’s ESG health. The assessment of ESG health can be measured through company-specific questionnaires and engagement with the management team. These assessments determine the efforts and processes of a company to mitigate and identify their ESG risks. ESG health is an indication of the efficiency, corporate culture, consideration of macro trends, and brand value for a company.
The third and final step in ESG due diligence is the analysis of collected information. ESG analysis can be done independently and in reference to ESG standards and benchmarks. Independent ESG analysis entails the tracking of one company’s ESG data and comparing progress with company goals and policies. In addition to independent ESG analysis to determine a company’s unique risk exposures, benchmarks can help determine if a company is mitigating ESG risks in the same capacity as their sector counterparts. The ESG due diligence process not only helps to aid in business valuation, but it can also benefit internal and external stakeholders.
Turnover Risk
Robust ESG structure can boost corporate culture and attract workers who value companies with social responsibility agendas, which reduces turnover risk. Specifically, the millennial cohort is focused on ESG metrics, like diversity and inclusion, when considering employment options. Additionally, once employees are recruited, companies that have better employee benefits programs experience a lower churn risk. Therefore, the ability to showcase ESG commitment will increasingly lead to the better attraction and retention of talent.
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Adaptability to Macro Trends
ESG due diligence results can help forecast a company’s ability to adapt to social and environmental macro trends. For example, a company’s performance in the “E” category of ESG due diligence can indicate their readiness to meet the demands of changing environmental policy or trends, like carbon reduction.
Additionally, a company’s performance in the “S” category of ESG due diligence can assess its ability to adapt to increased societal demands to address institutional racism and lift up the communities they engage in or reside by. ESG due diligence can help identify companies that are leaders or laggards in social justice efforts.
The global push for ESG-disclosure being required by the government and other stakeholders is another macro-trend that can be synthesized by ESG due diligence, which in turn, can help indicate a company’s future performance. The EU has required ESG disclosure since 2018 and many other countries are not far behind. Although the US is currently voluntary, in the future, the SEC or major stock exchanges may start to level on ESG policy with their European peers. Notably, depending on the country, there may be financial implications for the failure to comply with national regulations.
Retaining Revenue
ESG due diligence can also protect brand value because investors find value in companies that prioritize ESG. Demonstrated commitment to ESG due diligence will attract investors and customers who believe that environmental and social initiatives are morally or financially important to a company’s success. Additionally, some customers are willing to pay more for sustainable products which means that in order to stay competitive, company’s need to prioritize ESG due diligence to mitigate the risk of losing this group of customers and investors. In conclusion, more investors are demanding ESG integration into the due diligence process or a dedicated company committee that conducts ESG-specific due diligence.
Conclusion
The ESG due diligence process helps to determine a company’s exposure to turnover risk, ability to adapt to macro trends, and the brand value that ESG considerations can provide. Efforts to improve the ESG due diligence process will protect businesses from risks that are not screened in traditional financial due diligence, but can have significant financial implications. Increasing recognition of these material financial benefits of ESG due diligence will accelerate the already established set of ESG due diligence adopters. Investors no longer view ESG consideration as ethical, but as another way to improve their returns. The influence of ESG on risk oversight and its role in improving societal and environmental impact proves that ESG is here to stay.
