ESG Investing For Dummies 2021 PDF

IN THIS CHAPTER »» Understanding a company’s natural resource usage »» Highlighting effects of company operations on the environment »» Seeing how “green” a company is and its mitigation measures »» Recognizing stewards of the physical environment Chapter 3 Give Me an ‘E’! Defining the Environmental...

IN THIS CHAPTER »» Understanding a company’s natural resource usage »» Highlighting effects of company operations on the environment »» Seeing how “green” a company is and its mitigation measures »» Recognizing stewards of the physical environment Chapter 3 Give Me an ‘E’! Defining the Environmental Sector in ESG I nvestors are becoming increasingly aware of the financial impact of environmental issues on companies in their portfolios. These investors are paying greater attention to issues such as climate change, water usage, energy efficiency, pollution, resource scarcity, and environmental hazards so that they can increase awareness of relevant issues and influence disclosure. The negative impact for companies failing to manage environmental risks includes increasing costs (for example, the need to clean up oil spills), reputational damage due to pollution incidents, and litigation costs. Integrating environmental factors into a company’s strategy can present ­opportunities — for example, using resources efficiently can decrease costs and offering innovative solutions can create a competitive edge. These environmental factors measure a company’s impact on living and non-living natural systems, including the air, land, water, and entire ecosystems. These factors also indicate how a company employs best management practices to avoid environmental risks and capitalize on opportunities that generate shareholder value. CHAPTER 3 Give Me an ‘E’! Defining the Environmental Sector in ESG 45 This chapter outlines how companies manage their natural resource usage both directly and indirectly through their value chain. It also describes how analysis of these factors allows investors to determine whether the companies are meeting their environmental stewardship targets or managing the risks involved. Numerous environmental issues can be relevant to different companies in diverse sectors of the economy, but this chapter focuses on the material issues that both companies and investors need to consider, as such issues may have the greatest impact on both return on investment and sustainability. Outlining a Company’s Use of Natural Resources The environmental sector of ESG reflects on how a company considers its stewardship obligations in terms of protecting the natural environment. The ‘E’ in ESG considers the company’s use of natural resources and the effect its operations have on the environment, in terms of direct operations and throughout its supply chains. Therefore, a company’s environmental disclosures provide an insight into its efforts to reduce material risks and opportunities for stakeholders. Those companies that fail to anticipate the effects of their practices on the environment may face financial risk. Failing to act or protect against environmental “accidents” can lead to sanctions, prosecution, and reputational damage, which reduces shareholder value. In the following sections, I describe the different environmental factors that companies need to consider when investing. CO2 or GHG? Climate change and carbon emissions The key environmental target that most nations have targeted is net-zero emissions by 2050, which indicates that all man-​made greenhouse gas (GHG) emissions must be removed from the atmosphere through reduction measures that reduce the earth’s net climate balance. This should primarily be achieved through a rapid reduction in carbon emissions, but where zero carbon can’t be achieved, offsetting through carbon credits (a permit that allows the holder to emit a certain amount of CO2 or GHG) seems to be the preferred approach. However, the risk of relying on carbon credit offsets rather than rapid decarbonization is that companies can maintain emissions at a steady level, using carbon credits to reach net zero, which negates the need to actually reduce their own emissions. 46 PART 1 Getting to Know ESG To meet the internationally agreed-upon target of confining the rise in global average temperatures to well below 2 degrees Celsius above pre-industrial levels, science suggests that most fossil fuel reserves need to remain in the ground. The emergence of carbon pricing and decreasing technology costs implies that lowcarbon energy sources will be more attractive and the demand for fossil fuels will fade, leading to the demise of the companies that explore, mine, and burn them. Moreover, any fall in oil prices decreases the incentive for producers to drill for many fossil fuel assets. This has led to an even steeper fall in the price of carbon credits, or Certified Emission Reduction (CER) units. These developments have led to the divestment of many fossil fuel stocks by asset managers, from both a sustainability and investment performance perspective, and have prompted further analysis of the relative carbon footprint of individual stocks and a call for pension funds to disclose their aggregate carbon footprint. However, some ESG investors argue that simply selling a stock to investors who don’t care about climate change will have zero impact on the overall climate program. A more positive approach would be to encourage engagement with management of fossil fuel companies to encourage a shift away from current production approaches and move more toward the development of a renewable energy infrastructure. In addition, divesting particular energy and utility stocks may create divergence away from benchmark investment performance. These approaches require an assessment of a company’s carbon (greenhouse gas or GHG emissions) strategy, exposure, and long-term approach to decarbonizing their business. A range of low-carbon benchmarks have been developed to help investors track their investments in relation to their carbon exposure or potential risk. Asset owners are increasingly concerned that hydrocarbon-based assets will become “stranded” over time due to climate change concerns. (In this context, stranded refers to assets that turn out to be worthless due to the transition to a low-carbon economy.) The stranded assets concept was pioneered by the UKbased non-governmental organization (NGO) Carbon Tracker (CT), which provides research and analysis on this issue (https://carbontracker.org/terms/ stranded-assets/). The CT approach focuses on the valuation of companies, which includes projections of the future value of their coal, oil, and gas inventories. The stranded asset concept is worrying asset owners as they question what happens to assets that are worth less than their projected value due to changes linked to energy transition that spans the typical lifetime of pension scheme assets, which can be 40-plus years. Therefore, investors need to be fully aware of initiatives that require companies to report on the repercussions of the future value of their assets on their business model, and what impact that may have on the value of their investments. CHAPTER 3 Give Me an ‘E’! Defining the Environmental Sector in ESG 47 Moreover, financial regulators have recognized the significance of scenario analysis for measuring climate risk through the inclusion of scenario analysis in the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) recommendations. Visit www.tcfdhub.org/scenario-analysis/ for more information on how the TCFD has developed a framework to help companies and other organizations more effectively disclose climate-related risks and how scenario analysis is used to explore alternatives that may significantly alter the basis for “business as usual” assumptions. Clean and green: Energy efficiency Energy efficiency is most often associated with clean technology companies where green energy businesses are looking to decrease hydrocarbon-sourced energy consumption by displacing it with clean energy sources, or to integrate systems to improve energy usage. Because of the numerous alternatives to working toward and investing in energy efficiency, it’s challenging to classify and define companies based on fields or themes, as some of the world’s historic hydrocarbon energy companies are investing heavily in transitioning away from coal, oil, and gas. The definitions of how firms are categorized and compared by industry and sector by established data/index providers such as Morgan Stanley Capital International (MSCI) or Financial Times Stock Exchange (FTSE) Russell can be useful for investors. Visit www.msci.com/gics and www.ftserussell.com/data/industryclassification-benchmark-icb. The International Energy Agency (IEA; visit www.iea.org/) is the global authority for energy efficiency data, analysis, and policy advice. They help governments realize the huge potential of energy efficiency, guiding them on growing, implementing, and quantifying the impacts of policies to alleviate climate change, improve energy security, and develop economies while delivering environmental and social benefits. They track global policy progress in over 200 countries, regions, and states, and global investment in energy efficiency as published in the World Energy Investment report. As of 2016, energy efficiency investment represented 13.6 percent of the US$1.7 trillion invested across the entire energy market. Such investments are directed into different fields, with approximately 58 percent focused on buildings, 26 percent allocated to transport, and 16 percent assigned to industry. The types of services or infrastructure projects benefitting from alternative fuels and renewable energy include generation, transmission, and distribution of electricity from renewable sources such as wind, solar, geothermal, biomass, wave, and tidal (more information on these investment themes is found in Chapter 10). 48 PART 1 Getting to Know ESG A crisis awaits: Conservation of water The world is facing a global water crisis! However, while the world has increasingly recognized the significance of environmental sustainability, there is less focus on the forthcoming water crisis. This lack of urgency can be attributed to the fact that the water crisis isn’t seen as a global crisis — in the way that climate change is seen as a shared and global problem — but rather a group of local ones. Moreover, observers fail to differentiate between the interdependent facets of the water crisis — namely, water access, pollution, and scarcity. However, there are some positive signs that organizations, such as the United Nations, are better defining and evaluating impact companies in the water and sanitation sectors. To move further forward, global cooperation among distinct stakeholders is required to appreciate that water issues in one area impact economies in other areas, especially where they contribute to disruptive conflict, and companies can’t ignore local problems when they impact global supply chains. Public-private partnerships are required to address these issues, but they need access to precise data and information; otherwise, the wider economy will suffer from resource reduction and a company’s results will be vulnerable to stakeholder criticism caused by a negative reputation. Water is in focus in Europe, where the vast majority of investors see it as a concern, but perhaps this is driven by the establishment of the European Union (EU) Water Framework Directive. In addition, the World Economic Forum (WEF) has cited water as a driver of global risk, for everything from conflict to health crises and mass migration. And note that water security is one of the United Nations’ Sustainable Development Goals (see Chapter 1). Therefore, water is considered a multi-impact investment because it affects the microclimate, food supply, industrial chain, health, productivity, and the environment overall. This confirms that water is fundamentally linked to other impact themes and has wide applicability to business and the investment community. Water management, technology, distribution, and conservation are some of the issues that organizations face, following years of poor water and waste management practices. There is increasing pressure for water-themed investments given the huge number of people who lack access to securely managed sanitation and drinking water services. Meanwhile, water-related perils are responsible for 90 percent of natural disasters. However, most firms still lack a water-efficiency policy, and even fewer of them have set targets for water efficiency. The only bright spot is that the momentum appears to be building and institutional investors have noticed, as water now ranks among their top three ESG concerns. Stock index providers are designing more sustainable indexes that explicitly cover water and sanitation companies, while analysis of some of the major global indexes by Ceres (www. ceres.org/) found that 50 percent of component companies face medium to high water risks. CHAPTER 3 Give Me an ‘E’! Defining the Environmental Sector in ESG 49 There is no Planet B: Air and water pollution Pollutant emissions are a major risk for both air and water supplies. Healthy ecosystems rely on a complex web of elements that interact, directly or indirectly, with each other. Damage to any of these elements can create a chain reaction, endangering all kinds of environments due to the air and water pollution created. An unintended benefit of the COVID-19 pandemic is the slowdown in global economic activity, which has led to reduced air and water pollution. However, when the U.S. Environmental Protection Agency (EPA) suspended enforcement of environmental laws during the outbreak, stating that polluting the air or water will be allowable as long as the violations are “caused by” the pandemic, there may be unintended drawbacks as well. Human behavior has been stressed as the major cause of air pollution, especially in cities. Beijing’s smog cloud has been “clear” for many years, but there have been important developments in air- and water-quality metrics more recently due to social and government attention. Nonetheless, air pollution has caused damage to crops, forests, and waterways. Moreover, the effect of air pollution leads to the formation of acid rain, which harms trees, soils, rivers, and wildlife. Similarly, human behavior is also to blame for the major cause of water pollution: microplastics. Primary microplastics are tiny particles found in cosmetics or as microfibers shed from clothing and other textiles, such as fishing nets. These microplastics have been specifically produced for commercial use, while secondary microplastics result from the breakdown of larger plastic items, such as water bottles. These microplastics find their way into our rivers, from where they become a major source of plastic waste flowing into the oceans. Estimates suggest that over 1,000 rivers are accountable for 80 percent of global annual emissions, which range between 0.8 and 2.7 million metric tons per year, with small urban rivers being among the most polluted. These are examples where, to reduce the problems of air and water pollution, companies should be more aware of their impact in these environmental areas. Transition risks can include new regulatory restrictions that increase costs for the most polluting factories, or the withdrawal of licenses to operate due to pollution or poor environmental standards. In addition, World Bank data suggests that most countries have explicit regulations on water and sanitation companies, yet not all countries accept or follow basic conditions defined by the World Health Organization. Consequently, several companies that are obligated to offer sustainable water and sanitation services embrace voluntary certifications to achieve their sustainable and responsible goals. However, this isn’t true for the entire industry, particularly in emerging 50 PART 1 Getting to Know ESG markets and developing countries, where greater adoption is required. For example, Asia (excluding Japan) produces over ten times more water pollutants than the rest of the world combined! Companies may implement procedures that offer access to water but at an increased cost to customers, including low-income groups. As a result, when evaluating industries in this field, it’s essential to clarify whether companies observe national and international principles. For example, companies that score highly on the Carbon Disclosure Project (CDP), which runs a global disclosure system for investors, companies, cities, states, and regions to manage their environmental impacts, can be found here: www.cdp.net/en/ companies/companies-scores. Live and let live: Biodiversity The effects of human action on the natural world are deeply harmful, and as our population increases and the search for economic growth continues, the threat will only increase. Damage to ecosystems across the world, and the resulting loss of biodiversity, has collected fewer headlines than other sustainability challenges, even though the biodiversity crisis is a direct risk to humankind. Part of the problem is that it’s difficult to quantify due to the heterogeneity of ecosystems, making the correct response difficult to identify. Clearly, biodiversity loss is directly related to the climate emergency, and more companies, governments, and the public are recognizing this. For example, the protection of the ecosystems found in natural forests is a key solution to mitigating global warming. Extinction rates are multiple times higher than the historic rate, and approximately 1 million species are at threat out of a total of 8 million plant and animal species on earth. However, companies have consistently struggled to evaluate how their activities affect biodiversity, partly due to the exceptional complexity of the living systems that their value chains interact with. Investments in biodiversity contribute directly to the full range of UN Sustainable Development Goals (SDGs). Conserving biodiversity and ecosystems preserves the ability of our planet to sustain our prosperity. Biodiversity finance combines ­conventional capital with financial incentives to fund sustainable biodiversity management. It can include private and public financial resources, and ­investments in commercial businesses that create positive biodiversity outcomes. However, most funding originates from public funds, including domestic public budgets, biodiversity-positive agricultural subsidies, and international transfers of public funds, and these activities haven’t been well communicated on a national scale. Moreover, without specific information on recipient-country expenditures and priorities, development partners have been unwilling to promise support to reach biodiversity management goals and objectives. Investors tend to lump the associated risks in with industries such as mining. CHAPTER 3 Give Me an ‘E’! Defining the Environmental Sector in ESG 51 Therefore, investors are demanding more information on biodiversity to ensure any risks are well managed. Meanwhile, increasing awareness that assets can become stranded through biodiversity loss is escalating the response. For example, biodiversity issues on agricultural land diminish its capacity to grow crops and can lead to the land becoming stranded. Financial organizations need to support the growth of methodologies to gauge biodiversity loss, conservation, and enhancement. More data is required to quantify biodiversity risks to enable integration into valuation tools. Investors should allocate assets toward companies that work in environmentally sustainable ways and create biodiversity-positive technologies while embedding biodiversity protection. And companies need to further disclose the impact of their economic activities on biodiversity. Some tools are currently being developed that compare how companies respond to material biodiversity risk, which should help investors understand how companies are mitigating “known unknown” risks, as well as compare how they balance economic returns with sustainable benefits. Many hope that such indicators will realize for biodiversity loss what the tools highlighting CO2 emission levels achieved for climate change (I cover CO2 earlier in this chapter). These indicators will need to identify any correlation between biodiversity and the success of the economy and allow investors to place an economic value on biodiversity. The COVID-19 pandemic should accelerate the focus on sustainable investing in general and biodiversity more specifically. Still, the pandemic shows that when biodiversity is destroyed, the system that supports human life is also affected, as the loss of biodiversity provides an opportunity for pathogens to pass between animals and people more freely. However, the risk is that policymakers and companies spend too much time focused on the fallout from the pandemic, including increasing debts, balance sheet damage, and weaker profits, such that other biodiversity issues remain in the background. See the forest for the trees: Deforestation The EPA defines deforestation as the “permanent removal of standing forests.” However, such removal can occur for different reasons and has a variety of destructive consequences. Reports suggest that 80 percent of deforestation results from extensive cattle ranching and logging for materials and development. It has been happening for thousands of years, primarily since humans evolved from hunter-gatherer to agricultural-based societies and needed larger swathes of land to facilitate farming and housing. Modern requirements have converted this into an epidemic, leading to the loss of animal and plant species, due to their loss of habitat, as well as the following issues: 52 PART 1 Getting to Know ESG »» Healthy forests act as carbon sinks by absorbing carbon dioxide. Therefore, cutting down forests releases carbon into the atmosphere and reduces their ability to act as carbon sinks in future. »» Trees also help manage the level of water in the atmosphere by regulating the water cycle. In deforested areas, there is less water in the air that is returned to the soil, resulting in dryer soil and an inability to grow crops. Furthermore, trees help the land retain water and topsoil, providing rich nutrients to sustain additional forest life, without which the soil erodes and washes away, causing farmers to move on and perpetuate the cycle. »» The barren land left behind due to these unsustainable agricultural routines is more susceptible to flooding, especially in coastal regions. This also has an effect on seagrass meadows, a group of marine flowering plants, which are one of the world’s most productive ecosystems. They constitute an important CO2 sink, which is responsible for about 15 percent of the total carbon storage in the ocean. »» As large amounts of forest are cleared away, indigenous communities, which rely on the forests to maintain their way of life, are also under threat. The governments of countries with native rainforests generally attempt to evict the indigenous tribes before the clearing occurs. Four main commodity supply chains — beef, soy, palm oil, and pulp and paper — are predominantly sourced from regions with high deforestation risk. The production of these commodities is worth hundreds of billions of dollars annually across the tropical forest regions of Latin America, Southeast Asia, and Sub-Saharan Africa. Within these four commodities, analysts suggest that 50 to 80 percent of current production is linked to past deforestation. The extent of production related to deforestation can differ by location, but avoiding further deforestation, while supporting restoration and rehabilitation, will require changes from all ­producers. Furthermore, a report on climate change and land released by the Intergovernmental Panel on Climate Change showed that 11 percent of greenhouse gas ­emissions are caused by poor forestry and land-use management, including ­commodity-driven deforestation. In 2019, institutional investors representing US$16.2 trillion in assets under management and coordinated by two organizations — Principles for Responsible Investment (PRI) and Ceres — demanded that companies take urgent action due to the destructive fires in the Amazon, which were partly due to the accelerating rate of deforestation in Brazil and Bolivia. They argued that deforestation and loss of biodiversity not only are environmental problems but also have major negative economic consequences that need more effective management of agricultural supply chains. In addition, large corporations have been wary of the reputational risk if their supply chains are linked to these issues and have pledged to exclude CHAPTER 3 Give Me an ‘E’! Defining the Environmental Sector in ESG 53 deforestation from their supply chains. Meanwhile, pension funds are considering divesting holdings in transnational commodity traders operating in such ­countries. As a result, it’s likely that they will need to shift to deforestation-free methods in the future. Don’t throw your future away: Waste management The traditional model of waste management is changing. Collection methods, waste-to-energy solutions, and innovations are all essential elements directing us to a circular economy model (an economic system aimed at eliminating waste and the continual use of resources). Focus on waste is impacting all companies that produce products, and they all need to consider how they take greater ownership of the waste they produce throughout their production cycle. As populations have grown and urbanization has increased, the work of waste management companies has become increasingly vital. The market size of global waste management is anticipated to grow at a compound annual rate of 5.5 percent from 2020 to 2027, becoming a US$2.34 billion marketplace (go to www.alliedmarketresearch.com/ waste-management-market for more information). The market can be broken down into municipal, industrial, and hazardous wastes, where collection and disposal services are provided. The collection services include areas such as storage, handling, and sorting, while disposal services focus on landfills and recycling. The key mantra of waste management companies should be to take care of the environment by managing and reducing waste (some refer to this as the 3Rs: the reduce, reuse, and recycle approach). Their main objective, assuming a sustainability focus, is to reduce and reuse waste materials wherever possible, thereby avoiding further waste, minimizing pollution, and endorsing recycling. Ideally, they should encourage waste-to-energy development by converting waste to energy when it’s not recyclable. Finally, they need to ensure and promote proper solid waste management, especially when removing and safely managing toxic or environmentally harmful materials like solvents and industrial waste. However, the continuing introduction of new legislation and regulation will drive new policies that will demand new technologies and products, particularly in helping to achieve net-zero carbon emissions and to protect biodiversity. Governments have played a key role in many OECD (Organization for Economic Cooperation and Development) countries by providing support for waste management investments, including grants, loans, and tax exemptions that support investments made by businesses and specialized producers. But major investments in a range of new technologies will be required, such as chemical recycling and turning residual waste into fuels and chemicals, while new systems of data collection will be needed to monitor the fulfillment of obligations. 54 PART 1 Getting to Know ESG Studying the Effects of a Company’s Operations on the Environment Businesses don’t operate in a vacuum. In a global economy reliant on crossborder trade, convoluted supply chains, and diverse workforces, companies are constantly challenged by environmental issues as well as product safety and ­relationships with regulators and local communities. Therefore, managing these factors is simply part of maintaining a competitive advantage in today’s economy. A company needs to use best management practices to avoid environmental risks and capitalize on opportunities that produce long-term shareholder value. Where companies earn excess profits by externalizing the cost of environmental and social issues upon the communities in which they operate, investors risk paying the price when this is corrected, and costs are internalized to the company’s financial statement. In recent years, shareholders have experienced considerable losses following the negative environmental impacts of oil spills, mine explosions, and unsafe products. While there isn’t just one solution to circumvent such catastrophes, identifying material environmental impacts and mechanisms to reduce these can help mitigate risks and even identify new opportunities. The following sections discuss two working areas of a company’s impact on the environment: direct operations and supply chains. Direct operations Evaluation of environmental issues can reduce costs by, for example, minimizing operating expenses (such as raw-material costs or the real costs of water and carbon). Therefore, when analyzing the comparative resource efficiency of companies within given sectors, investors should look for correlation between resource efficiency and financial performance. Studies suggest that companies with more developed sustainability strategies will outperform their peers. One approach is to integrate environmental policies into their operations strategy and functions, incorporating operations such as product design, technology choice, and quality management. Companies that don’t acknowledge the consequences of environmental problems on the operations function may not succeed in the future in a competitive market, so this element of operations strategy needs to be aligned with the corporate strategy. Large companies are transferring sustainability from the bottom line to the top line. They are becoming more sustainable and implementing changes tied to their direct operational control. For example, strengthening distinctive competence in terms of operations objectives contributes toward a competitive advantage. The CHAPTER 3 Give Me an ‘E’! Defining the Environmental Sector in ESG 55 environmental properties that an organization can control determine whether a particular activity, product, or service creates emissions, waste, or land contamination. Other issues that a company may be able to influence include the environmental performance or extended life of product design, minimizing the use of material resources and energy in packaging, and improving the biodiversity of land use. Therefore, organizations should ensure that environmental inspections are undertaken on a regular basis to mitigate factors that could impact the company. While larger companies have more resources for such activities, it’s equally important for small and medium-sized businesses to consider the influence of external factors on operations, as they may be more vulnerable to such issues. Moreover, this helps organizations take advantage of opportunities before their competitors, tackle issues before they become substantial problems, and support plans to meet shifting demands. Supply chains Companies can’t always control indirect environmental factors, such as those in the supply chain, but they can influence suppliers and users to reduce, minimize, or eliminate the impacts that are caused. Sustainable procurement is firmly on the agenda, and companies don’t want to be linked to suppliers with questionable business models, as this generates negative media coverage. Many firms have implemented a supplier code of conduct that requires suppliers to follow the core principles of the UN Global Compact (see Chapter 1) within the areas of human rights, labor standards, environment, and anti-corruption. Suppliers are obligated to impose similar principles on their suppliers. In many industries, the vast majority of issues around sustainability are external and related to providers across the supply chain. In particular, for companies in some industry sectors, suppliers’ operations are responsible for over two-thirds of a company’s total CO2 emissions. Large, multinational companies are the ones looking to improve on this the most, as they realize the importance and weight that supply chains have, and their priority is in finding ways to hold their suppliers accountable. Many have begun to apply a risk-based approach, where they focus efforts on areas with the greatest impact, recognizing that supplier subdivision is an ongoing process. Potential suppliers are prescreened on a number of factors, such as country, sector, and reputational risks, including compliance with sanctions. Based on the prescreening, high-risk suppliers are further assessed, which then determines whether additional engagement is pursued to advance sustainability performance. This can include developing a company’s technological systems, scoring suppliers, making public targets, or considering an interindustry collaboration. 56 PART 1 Getting to Know ESG However, one of the clearest barriers is the struggle to monitor complex supply chains and find the know-how to assess suppliers’ sustainability, particularly when there’s a lack of support from top management or government agencies. The companies that have applied sustainability scores, using a supplier scorecard, can distinguish and choose between suppliers with comparable quality and cost while estimating how eco-friendly the suppliers are. Firms using public targets will claim that they’ll only work with suppliers that use low-carbon technologies or have waste reduction programs. Moreover, some companies request suppliers to set their own reduction targets and urge them to, for example, deploy renewable energies or start providing biodegradable or recycled packaging materials. Finally, through industry collaboration, where a collaborative network is formed with suppliers, intermediates, or civil society, companies can help improve the broader industry. Whatever the approach, suppliers must be encouraged to share their sustainability challenges so that both sides generate better solutions together. Defining “Green” for a Company Reports suggest that from 2007 to 2009, eco-friendly product launches increased by more than 500 percent. More recent surveys have found that two-thirds of senior management see sustainability as a revenue driver, and half anticipate that green initiatives will present a competitive advantage. This striking change in the corporate mindset over the last ten years reflects a developing consciousness that environmental responsibility can contribute to growth and differentiation. Supporters of green companies argue that it’s more efficient to go green than to continue adding toxic chemicals to the atmosphere and the environment overall. However, challengers dispute the environmental claims of some “green companies” as exaggerations and have raised allegations of greenwashing (see ­Chapter 6 for further information), where a company is claiming to be green when its practice suggests it is not. To appreciate the advantages of a green business, you need to understand what the term means. If a company makes a determined attempt to decrease its negative environmental impact, it can rightly claim to be “going green.” Typical measures include starting recycling and reusing procedural programs, as well as buying green products and services. Most countries have laws that order environmental compliance to varying degrees. For some companies, going green can indicate anticipating future regulation and getting ahead of the curve. The EPA launched an Action Agenda in 2020 with wide-ranging plans to decrease carbon CHAPTER 3 Give Me an ‘E’! Defining the Environmental Sector in ESG 57 emissions, promote sustainability, and provide enticements for being ahead of the “green curve.” (Go to www.epa.gov/sites/production/files/2016-07/ documents/ej_2020_factsheet_6-22-16.pdf for details.) In the following sections, I define what the term “green” means for a company: managing externalities and following the 3Rs (reduce, reuse, and recycle). Internalizing (or managing) externalities It will come as no surprise that, while generating wealth for investors, economic activity also creates externalities or impacts. The majority of externalities are negative! They also have associated costs that aren’t entirely covered by the entity that creates them. In particular, a negative externality assumes an indirect cost to the public that causes harm to people in the surrounding area; one example would be toxic gases that are released from chemical firms or mines. Rather than the company paying for the cleanup, the public or local government has to bear the indirect cost to clean up the problem. Internalizing, or managing, the externality means shifting the burden from external to internal. This is generally achieved through taxes, which are levied when the externality reaches a certain point and a “penalty” is imposed, thereby discouraging these activities. Conversely, government can provide subsidies to stimulate activities that address the problem, such as limiting the effect of externalities on the community. However, because regulators don’t always have full information on the externality, it’s difficult to impose the right penalty or subsidy. Moreover, historically, externalities have continued because of the lack of information needed to recognize them adequately. Therefore, as externalities become more transparent, they should be easier to internalize, creating the link between ESG factors and financial returns. Policy changes will require companies to reflect the cost of externalities in their business models. This generates a risk to future returns for investors, but is it acceptable for them to “turn a blind eye” to such activities? Investors are now aware of the potential cost of litigation for failing to protect their investments against environmental risk and have been placed in the spotlight for not building such risk considerations into their investment decision-making. The 3Rs: Reduce, reuse, and recycle The 3Rs that refer to the three basic skills taught in schools — reading, (w)riting and ’rithmetic — will be familiar to children and adults alike. However, the 3Rs of sustainable living — reduce, reuse, recycle — are probably more familiar to our children than adults as they are already better educated on the amount of waste we throw away! 58 PART 1 Getting to Know ESG With the cost of goods and materials rising, using resources efficiently and reducing business waste makes sense financially and for the environment. Moreover, the cost of sending waste to landfills is increasing, as are the restrictions on what can be sent. Increasingly, penalties are levied if waste isn’t handled appropriately or the right paperwork hasn’t been completed before it leaves your premises. Using the 3Rs also helps minimize the amount of space needed for landfill sites. Some index providers have launched indexes focused on companies that reduce, reuse, or recycle. One example of this is the Solactive ISS ESG Beyond Plastic Waste Index, which includes companies focused on plastic waste. Investment in such products is intended to alleviate the waste problems caused by production of plastics (for more information, visit www.solactive.com/beyond-plastic-waste/). Reduce Reduce the amount of waste you produce. Reducing waste in the first place is the preferred method of waste management, as you’re immediately protecting the environment. You can reduce waste by doing the following: »» Purchasing durable, long-lasting goods »» Seeking products and packaging that are toxic free »» Redesigning products to use fewer raw materials in production, or to aid in recycling Reuse In a world with so many disposable items, the idea of cleaning an item and using it again is alien to most people. When purchasing a new item, look for a product that can be used repeatedly rather than used once and thrown away, or buy or rent secondhand items. The items you reuse may end up being waste, but by reusing them, you’re reducing the overall amount of waste produced. Here are some examples of what you can do: »» Refill bottles and reuse boxes. »» Purchase refillable items and durable coffee mugs. »» Use cloth napkins or towels. Recycle Recycling prevents the emissions of many greenhouse gases and water pollutants, saves energy, and generates less solid waste. Also, when products are made using CHAPTER 3 Give Me an ‘E’! Defining the Environmental Sector in ESG 59 recovered rather than original materials, less energy is used during manufacturing, fewer pollutants are emitted, and pollution caused by the extraction and processing of original materials is reduced. In summary, recycling does the following: »» Prevents emissions of many greenhouse gases and water pollutants »» Saves energy and stimulates the development of greener technologies »» Reduces the need for new landfills and incinerators Detailing a Company’s Performance as a Steward of the Physical Environment The term environmental stewardship has been used to describe activities such as reducing harmful activities or pollution, purchasing more sustainable products, and replanting trees and limiting harvests. Stewardship itself embodies the responsible planning and management of resources and can be applied to the environment and nature, economics, or property. Such actions can also be differentiated, from local to global efforts, or in rural and urban contexts. Many environmental issues are seen on a global scale, which suggests that local actions can’t meet those challenges; however, engaging in local stewardship actions and initiatives can be the catalyst to ensure involvement in promoting broader sustainability issues. Business initiatives that improve environmental impact are increasing in number, but there is a growing consensus that transformations need to take larger steps than those that are currently underway. Many businesses don’t fully understand the driving forces that promote environmental sustainability in the context of their own operations. Without understanding these forces, they are likely to sub-optimize their transformation initiatives and fail to realize the expected value. More work is required to establish clear definitions as well as a framework in different contexts to effectively support material activities. Environmental stewardship is considered a growth area, with business leaders taking action to apply environmental sustainability principles. They need to create insights that allow them to better understand the driving forces behind their actions and better align initiatives to achieve business value. The actions in the following sections can help. 60 PART 1 Getting to Know ESG Managing operations to reduce emissions and promote sustainability Most firms understand that by building a business model that reduces reliance on fossil fuels, they should benefit from opportunities that the new ways of doing business create. And in doing this, they expect to lower operational costs, improve resilience in their energy supply, and attract more investors who are concerned about carbon risk. Greenhouse gases (GHG) can be reduced considerably in manufacturing, where they control the operations, and even in supply chain processes such as distribution and retail. Indeed, some companies are intending to support the generation of more renewable energy than they need to make the surplus available to the markets and communities in which they operate. This would help some companies reach their target of becoming carbon-positive in their factories and site operations by 2030. Eco-design programs are being developed to reformulate products to use fewer but higher-performing ingredients, particularly in the use of their most GHGintensive products. Interestingly, most of the GHG footprint for many products occurs when people use them at home. Therefore, innovation and research and development (R&D) are also focused on delivering the products while considering the climate change challenge. Tackling these issues requires transformational changes to broader systems in which firms operate, and so government policy will need to dictate the right context for change and business action so that all sectors can work in collaboration on given projects and initiatives. (I discuss GHG in more detail earlier in this chapter.) Collaborating with others to create solutions for environmental issues Unfortunately, business collaboration has been the greatest contradiction within corporate sustainability. Numerous efforts by companies to collaborate on the most complex issues facing civilization, such as climate change, resource exhaustion, and biodiversity loss, have been unsuccessful mainly due to self-interest, lack of a shared purpose, and an absence of trust. Companies have embraced sustainability, and many have effective ongoing programs in areas they can tackle on their own — for example, rationalizing manufacturing processes or decreasing their fleet emissions. However, when tackling collaborative answers to systemic problems, little progress has been made. CHAPTER 3 Give Me an ‘E’! Defining the Environmental Sector in ESG 61 Collaborative governance is often stressed as the answer to different environmental problems. However, cooperation around environmental issues in a complex world is difficult to achieve as different players want different things, diverse environmental issues are related to each other in dissimilar ways, and given groups have differing amounts of influence on certain questions. So, can collaboration lead to a better environment? Research shows that the capacity to resolve environmental problems is in part associated with the way such networks are structured and in the patterns of collaboration between players. For example, where there is a risk of one player freeriding on the efforts of others, the conflict may be improved by linking such players with a third entity to form a triangular cooperation, in the hope that peer pressure will resolve the issue. It can also make a difference based on whether the problem is temporary or more permanent. When it’s temporary, it can be more successful where the network chooses a coordinator or leader to hold it together. The Environmental Collaboration and Conflict Resolution (ECCR) is a process whereby neutral, third-party facilitators work with agencies and stakeholders using collaboration, negotiation, structured dialogue, mediation, and other approaches to prevent, manage, and resolve environmental conflicts. This decade will determine whether civilization can develop a more socially and ecologically sustainable society. A vital part of that target requires a better understanding of how cooperation can be improved and become more effective, both among private stakeholders and public institutions. Continued leadership from businesses, governments, cities, and regions is required to maintain leadership in areas such as deforestation; business commitments to act; science-based targets and zero pledges; policy reform to level the playing fields; and financial disclosure to allow markets to correctly price risk and capital to flow to more sustainable investments. 62 PART 1 Getting to Know ESG