Environmental, social and governance practices, or ESG, have taken centre stage among middle market businesses as firm managers increasingly must demonstrate to investors, employees and other stakeholders that they are committed to the practices.
Over the past number of years, organizations like the Sustainable Accounting Standards Board, the International Sustainability Standards Board and other similar organizations have made significant progress toward developing a common reporting framework.
Yet the practice of how firms integrate ESG at an operational level, including into the investment decision-making process, is still in its infancy. So how can companies implement ESG guidelines into their operations? Here are three examples:
Shadow pricing: This is a technique used to more directly account for externalities that a company generates as a result of the products and services it sells. Recognizing that carbon taxes will increase dramatically over the next several years around the world, companies in carbon-intensive industries are increasingly using a pricing method known as shadow pricing to account for carbon in their investment models. Using a shadow price that reflects the social cost of an added ton of carbon dioxide, which can be several multiples higher than a carbon tax, would better align the company to societyâ€™s long-term objectives. It would also extend this practice to other socioeconomic and environmental impact categories including water usage, health and safety.
ESG due diligence: This is another sustainability integration technique that organizations can use in a merger and acquisition context. Due diligence, in combination with shadow pricing, can help assess the alignment of a company and its stakeholders. Many asset managers already account for some of these factors in their own due diligence, but that may not fully account for all stakeholder groups or all ESG-related risks. Organizations like the CFA Institute provide some examples detailing how a range of asset managers integrate ESG considerations into the investment decision-making process. As ESG proliferates, the art and science of ESG due diligence will need to develop and expand. But even now ESG due diligence can be quite powerful at helping organizations more fully integrate sustainability considerations into their strategies and operations.
Pricing in risk: Some industries are advanced at accounting for ESG-related risks. The insurance industry, and property and casualty insurers in particular, have developed sophisticated models to assess climate change risk. Charging higher premiums to insure properties in areas more affected by climate change - think of vacation homes on coastlines - can lead to development funnelling away from those regions. Doing so could also lead to lower premiums across the board and benefit all consumers. Other industries can use these methodologies to more directly account for the impact of climate change on their business.
If the objective of corporate sustainability is to better align an organization's success with the long-term objectives of society, then companies need to understand at a quantitative level how they embed sustainability into their operations and how they have aligned their success to their stakeholders' success.