Environmental, social and governance factors take center stage

Clairma T. Mangangey

We are increasingly seeing the need for accelerated change in businesses to pave the way for recovery from the COVID-19 pandemic. Digital transformation has become necessary for many to continue operations, and the rules for capital markets are being rewritten as the pandemic’s economic and social impact plays out worldwide.

This poses the question of how investors will direct capital to support economic recovery. Based on the findings of the 2020 EY Climate Change and Sustainability Services (CCaSS) Institutional Investor survey, institutional investors are raising the stakes in assessing company performance through environmental, social and governance (ESG) factors as they look to build insight into long-term value. Companies unable to meet investor expectations in terms of ESG factors risk losing access to capital markets.

ESG information is more important than ever. The survey showed that investors were increasingly dissatisfied with the information received on ESG risks compared to 2018. At 98%, the majority of the investors surveyed signaled a move to a more rigorous approach to evaluating non-financial performance, while 91% also identified how non-financial performance played a pivotal role in investment decision-making.

To meet the expectations of investors, companies must prioritize building a more robust approach to analyzing the risks and opportunities from climate change, build strong connections between financial and non-financial performance, and instill discipline into non-financial reporting processes and controls in order to build confidence and trust.

Capital markets are heavily considering the potent impact of environmental disruption, with the failure to consider social and environmental risks leaving many to wonder how well-prepared capital markets are to withstand such shocks. Investors from the survey are building their understanding of the ESG reporting universe, factoring in disclosures made as part of the Task Force on Climate-related Financial Disclosures (TCFD) framework in their investment decision-making. While regulators look to companies to play a leading role in rebuilding global economies, investors are more concerned about whether risks such as climate change will be sufficiently addressed.

The survey notes that 72% of investors conduct a methodical evaluation of non-financial disclosures, which is a significant jump from the 32% who said that they used a structured approach in 2018. Though the research shifts toward a structured approach, the quality of the approach remains critical. The research also shows significant investor appetite for a formal framework that allows companies to communicate intangible value, allowing investors to evaluate long-term value-creation strategies. Companies should ensure a connection between nonfinancial and financial reporting to provide investors a comprehensive view of their plans to create, communicate and measure long-term value.

Expectation gaps between investors and companies could come at a significant price, where companies may find it harder to access capital, and investors may respond to a lack of risk insight by raising a company’s risk profile. Investors may come to their own conclusions should companies choose not to engage in ESG or weigh performance solely towards positive aspects. A growing area of disconnect is how companies disclose ESG risks in their current business models, and research shows dissatisfaction with risk disclosures rose across all areas since 2018.

Environmental risk in particular is a key issue for investors, and when asked, the TCFD framework emerged as the most valuable way companies can report on this ESG information. The research also points to concerns about the provided information, with risk management highlighted as the area where investors received the least developed information. Some companies disclose that they have processes to manage climate risks in their organizational risk management system but described in general terms without the necessary connection between climate-related risks and overall risk management.

With ESG performance seen as a core element in investment decisions, it is likely that the trend of using non-financial information to determine the value of a business is likely to continue in the post-pandemic world. Investors look not only at the resiliency of a business, but also on its focus on long-term value creation.

Climate change plays a key role in investor considerations because investors seek to understand what it means to companies, as well as gauge how business leaders adapt to climate risk due to its potential to disrupt supply chains and damage infrastructure.

Because ESG risks will play a key role in how investors understand a company’s resilience maturity, credible ESG disclosures will be essential. Investors will only find environmental and climate change disclosures useful if they have confidence in what is reported. The investor community will therefore play an active part in driving companies toward non-financial assurance, and companies that will want to communicate their story to investors to access capital must respond to this demand.

With investors increasingly using non-financial factors when it comes to assessing a company’s performance, they also seek a formal framework to measure and communicate intangible value, as well as establish closer connections between ESG and mainstream financial reporting.

Rather than distracting us from the necessity of driving a sustainable future, the COVID-19 pandemic actually reinforces it. Transitioning to a decarbonized future is a critical component to long-term company resilience as well as that of the economy, while strong ESG frameworks and strategies will be critical to recovery. Recovery itself will be closely observed by investors, and companies and national economies with an agenda for climate-resilient growth and the ability to withstand systemic shocks will have the highest potential of being seen as an attractive prospect.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views reflected in this article are the views of the author and do not necessarily reflect the views of SGV, the global EY organization or its member firms.

Clairma T. Mangangey is the Climate Change and Sustainability Services Leader of SGV & Co.

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