ESG factors investors consider

What are environmental, social and governance factors?

Environmental factors concern the natural world: climate change, air and water pollution, biodiversity, deforestation, energy efficiency, waste management and water scarcity. Social factors concern people and relationships: customer satisfaction, data protection and privacy, gender and diversity, employee engagement, community relations, human rights and labor standards. Governance factors are standards for running a company: board composition, audit committee structure, bribery and corruption, executive pay, lobbying, political contributions and whistleblower schemes.

ESG factorsissues investors weigh beyond the financial statements

• Environmental Memorize conservation of the natural world
  • Climate change Memorize physical and transition risk
  • Pollution Memorize air and water
  • Resources Use it water scarcity, deforestation, biodiversity
  • Efficiency Use it energy and waste management
• Social Memorize people and relationships
  • Customers Memorize satisfaction, data protection and privacy
  • Workforce Use it engagement, diversity, labor standards
  • Community Use it relations, human rights
• Governance Memorize standards for running a company
  • Board Memorize composition, audit committee
  • Ethics Use it bribery and corruption, whistleblower schemes
  • Pay and politics Use it executive pay, lobbying, political contributions

Environmental	Social	Governance
carbon emissions and climate exposure, pollution of air and water, loss of habitat and forests, energy and waste efficiency, water supply	product safety and customer satisfaction, data privacy, workforce diversity and engagement, relations with local communities, human rights, working conditions	board makeup, audit committee set-up, anti-corruption controls, executive pay, political donations and lobbying, whistleblowing arrangements

Governance has long been the easiest to evaluate. Shareholder voting rights, board makeup and pay practices are widely available and quantifiable, and the cost of poor governance has long been understood. Environmental and social analysis evolved more slowly, because it is less clear which factors will affect performance, how and when. The questions on governance are usually answered in proxy statements, annual reports and sustainability reports.

Why does ESG matter more now?

Three reasons explain the growing importance.

1. Bigger financial impact. Shareholders and lenders have both suffered large losses from environmental disasters, social controversies and governance failures.
2. Client demand. Interest in the environmental and social effects of investments is growing, especially among younger clients managing inherited wealth or pension savings.
3. Tighter regulation. Governments are prioritizing climate and social policy and revising rules that force companies to change how they operate.

Environmental and social harms were once treated as negative externalities : costs borne by society rather than by the company and its investors. Greater awareness and stronger rules are forcing companies to internalize those costs in their income statements, explicitly or not. ESG factors were once seen as intangible or qualitative. Better analysis and disclosure now make more of them quantifiable.

Which ESG factors are material?

An ESG factor is material when it is believed to have a significant effect on a company’s results or business model. Materiality varies by industry. Water use is central for a beverage maker, data security for a payments company, and carbon emissions for a utility. An analyst has limited time and prioritizes the factors that matter for the business in front of them.

Environmental: physical and transition risk

Climate change is often split into two kinds of risk.

Climate riskhow climate change can hurt a company

• Physical risk Memorize damage from severe weather
  • Asset damage Use it flooded warehouse, storm-hit plant
  • Often insurable or diversifiable Use it across sites and insurers
• Transition risk Memorize losses from moving to a lower-carbon economy
  • Regulation Use it carbon taxes, emission limits
  • Demand shifts Use it customers switch to cleaner products
  • Stranded assets Memorize reserves that become uneconomic early

Physical risks are damage to or loss of assets from severe weather, which is expected to become more frequent. They can often be insured against or diversified across sites. Transition risks are losses from the move to a lower-carbon economy, through regulation, technology or shifting demand. A maker of parts for petrol engines loses orders as carmakers move to electric drivetrains.

Stranded assets are a particular transition risk: emission-intensive reserves or plants that may become uneconomic before the end of their expected life. A gas field planned to run for 25 years may have to shut after 12 because of new rules or prices too low to cover its costs. Analysts find this hard to judge, given the uncertainty about regulation and break-even prices.

Poor environmental standards, safety breaches or unsustainable business models can also cause costly events such as spills or contamination, with fines, lawsuits, clean-up costs and damage to reputation.

Social: people, customers and communities

Social factors cover a company’s treatment of employees and its human capital, customers and communities. Pay, turnover, health and safety, training, morale, diversity, customer data privacy and local relations affect how well performance can be sustained. Managing social risk well can cut costs through higher productivity, lower turnover and less litigation. Data privacy and security is a prominent example: a breach can bring large fines, lawsuits, remediation costs and lost customer trust.

Governance: how the company is run

Governance covers ownership and voting structure, whether board skills match the company’s needs, how well management pay is tied to results, how strong shareholder rights are compared with peers, and how well long-term risks are managed. A bribery scandal can force a shake-up of the board and senior managers and the introduction of new controls.

How do ESG factors reach the valuation?

The process is similar for equity and credit analysis. First identify the material factors. Then quantify their effect in financial terms: how the future cash flows, or the discount rate, change. Finally run sensitivity or scenario analysis to weigh outcomes for debt and equity.

$$V = \frac{CF}{r}$$

Which claim reacts first?

Equity is the residual claim, so a major adverse event usually hits it immediately and disproportionately, often with a sharp share price fall. Debt is finite and fixed, so it is usually less affected, unless the company’s ability to pay interest and principal is threatened. Then spreads widen, ratings may fall, and in extreme cases lenders can force bankruptcy and lose money in liquidation. The effect on debt also depends on maturity: a stranded-asset risk looming in ten years weighs more on ten-year debt than on debt due in twelve months.

Exam tip ESG shock: equity first and hardest. Debt only when repayment is threatened.

Go deeper Why ESG scores from different providers disagree

Providers pick different factors, weigh them differently and rely on different disclosures, so one company can score well with one and poorly with another. Scores are a starting point. An analyst still has to judge which factors are material for the industry and what they do to cash flows and risk.

Go deeper What usually follows a governance scandal

When a serious governance failure such as systematic bribery comes to light, the fallout tends to follow a pattern: fines and legal costs, departures at the top, new directors who understand the operations, tighter central control over units that had too much freedom, and new compliance rules. For the analyst, the order of the market reaction matters. The share price falls first and most; the cost of debt rises and the rating may be cut only as the costs start to threaten repayment.