The Relation between ESG score in Business and the Carbon Footprint

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Many institutional investors and fund managers around the world are giving higher consideration to sustainable activities in their activities with the purpose to address physical, liability, and transition risks because of climate change. ESG ratings and indices have gained attention as investment assessment tools to provide to these activities, including to support a low carbon transition. Furthermore, international initiatives such as the Central Banks and Supervisors Network for Greening the Financial System (NGFS) have developed with the purpose to better align with transitions to low-carbon economies and improve risk management associated with the transition and physical risks of climate change[1]. As well, ESG (Environmental, Social, and Governance) investing started in 2004, with a call to action from former UN Secretary-General for the major financial institutions inviting them to participate in a joint initiative to integrate ESG into capital markets, within the framework of the UN Global Compact. As a result, ESG investing has increased in importance worldwide, with increased awareness and adoption rates[2].

Furthermore, COVID-19 pandemic has brought to the spotlight the materiality of ESG-related risks and the deep linkages between businesses and their stakeholders across the value chain. ESG methods can help open a meaningful amount of information about the management of and readiness for sustainability risks, including environmental and climate risks, when seeking long-term value. In the context of economic recovery, ESG risk management could present a strong role by ensuring that material sustainability risks are managed[3].

The relationship between carbon emissions and overall ESG rating is not necessarily compatible although targeting a higher ESG scores generally leads to lower GHG emissions in itself, , e.g., companies with low carbon emissions may have reduce overall ESG ratings due to corporate governance concerns. Investors can target ESG-related purposes, such as reporting and reducing the carbon footprint. ESG score for an organization is a statistical measure of how it is perceived to be performing on a wide range of environmental, social, and governance (ESG) issues. These can either be notable to the company, or important to the stakeholders as a non-financial[4].

Environmental, Social, and Governance (ESG) investment outcomes are frequently being used as a tool to evaluate alignment with low carbon economies, climate-resilient transition pathways, and to identify financially material environmental risks this is due to market members give greater awareness and attention that climate transition presents material and non-material financial risks to companies and a broader range of stakeholders,  To meet the growing demand for this form of sustainable investment, ESG evaluation providers and investment funds are working to integrate metrics aligned with environmental resilience, climate risk mitigation, and strategies toward renewable energy among others. There are two progress are occurring in sustainable finance that relates to the purpose of ESG. First, there is a growing commitment by institutional investors to increase the climate resilience of economies, corporations, portfolios, and assets, in turn, reduce carbon emissions. The second factor, the clear growth of institutional investors using ESG methods with the purpose to enhance the long-term value of their investments, as measured by higher risk-adjusted financial returns. Furthermore, including risks from climate change and stranded assets because of the climate transition is increasingly recognized as a primary factor to this assessment[5].

Moreover, institutional investors and central banks are using ESG metrics and methodologies, and the Environmental score, to rebalance their portfolios to better incorporate climate risks. Numerous central banks in OECD countries are now also in the process of integrating ESG assessments into their investment approaches as one of the various tools to strongly align portfolios with a transition to low-carbon, climate-resilient economies.

there is a weak correlation between the Environmental ‘E’ score and the ESG score it confirms that investing in high-scoring ESG portfolios does not necessarily mean that includes companies that have received high ratings for managing their carbon emissions or risk management with respect to climate change. Also, while the E score includes several distinct environmental metrics, the analysis found a positive correlation between some ESG raters’ high E scores of corporate issuers and high levels of carbon emissions and waste. As well, investing in high E scores may, in some cases, inadvertently result in a greater carbon footprint in portfolios.

In addition, there is a positive correlation between transition policies adopted and the E pillar score for all three providers ESG. This confirms that long-term policies are shown in E pillar ratings in opposition to measures of negative environmental output e.g., carbon emissions. This means that these policies could be one of the main drivers of high E pillar scores.

On the other hand, other types of investment products may provide more targeted tools for investors to rebalance portfolios away from companies with carbon-intensive outputs or supply chains. However, highly tailored low-carbon or carbon-transition portfolios may have asset formation and risk components that deviate from standard market benchmarks that are most used by institutional investors.

Finally, as a growing number of investors seem to invest in the environment and climate transition outcomes, a major regulated and comparable approach across E rating providers may support more sustainable capital realignment away from carbon-intensive economic activities.

 

Reference.

  1. NGFS (2018), First Progress Report, Network for Greening the Financial System, October 2018, https://www.banque-france.fr/sites/default/files/media/2018/10/11/818366-ngfs-first-progress-report-20181011.pdf
  2. Boffo, R., C. Marshall and R. Patalano (2020), “ESG Investing: Environmental Pillar Scoring and Reporting”, OECD Paris, oecd.org/finance/esg-investing-environmental-pillar-scoring-and-reporting.pdf
  3. ESG Ratings: How can a business’ environmental and social impact be measured? https://earlymetrics.com/esg-ratings-how-can-a-business-environmental-and-social-impact-be-measured/
  4. Making sense of the environmental pillar in ESG investing, https://www.oecd-ilibrary.org/sites/bebb0add-en/index.html?itemId=/content/component/bebb0add-en#section-d1e4652
  5. What is an ESG score and how is it calculated? https://www.alva-group.com/blog/what-is-an-esg-score-and-how-is-it-calculated/

 

[1] NGFS (2018), First Progress Report, Network for Greening the Financial System, October 2018, https://www.banque-france.fr/sites/default/files/media/2018/10/11/818366-ngfs-first-progress-report-20181011.pdf

[2] ESG Ratings: How can a business’ environmental and social impact be measured? https://earlymetrics.com/esg-ratings-how-can-a-business-environmental-and-social-impact-be-measured/

[3]Making sense of the environmental pillar in ESG investing, https://www.oecd-ilibrary.org/sites/bebb0add-en/index.html?itemId=/content/component/bebb0add-en#section-d1e4652

[4] What is an ESG score and how is it calculated? https://www.alva-group.com/blog/what-is-an-esg-score-and-how-is-it-calculated/

[5] Boffo, R., C. Marshall and R. Patalano (2020), “ESG Investing: Environmental Pillar Scoring and Reporting”, OECD Paris, www.oecd.org/finance/esg-investing-environmental-pillar-scoring-and-reporting.pdf

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