By Natanya Taylor, Head of Property & Casualty, Retail business; Richard Stock, Head of Property & Casualty and Dharshini Navaratnam, Associate Consultant from Hymans Robertson
In this article, we will provide a brief overview of what ESG is, look at why firms should focus on social and governance standards, what that focus might look like, and the possible challenges when embedding social and governance standards.
What does ESG really mean?
One way of looking at ESG is as a framework for how a firm manages risks and opportunities around sustainability issues, while also considering social responsibility standards when making business decisions.
The Environment (“E”) pillar is significant, and reducing the impact on the environment through targeting climate neutrality sits at the heart of this pillar. Common metrics used to measure the E include greenhouse gas emissions (separated into Scope 1, 2 and 3 emissions), energy management, waste management and water management.
The Social (“S”) pillar refers to a firm’s relationship with stakeholders including customers, clients and its supply chain. S metrics are based on people and relationships and include data protection and privacy, labour rights, human rights, employee well-being and community relations.
The Governance (“G”) pillar refers to how a firm is led and managed, which includes internal controls to promote transparency and accountability of leadership, board composition and policies to prevent bribery and corruption.
Why should firms focus on Social and Governance standards?
Firstly, considering the different aspects of ESG holistically can help manage investment, underwriting and operational risks. For example, firms considering the Social and Governance side of ESG operationally may reduce the potential likelihood of accidents and casualties.
One of the main causes of accidents is human error. Firms which have appropriate risk and control procedures in place and provide safer working conditions with fewer distractions (where staff are engaged and equipped to react to situations that might lead to an accident) can reduce their likelihood of harm to their people, the environment and property. Similarly, insurers who look to embed holistic ESG standards and challenge current underwriting policies, are likely to reduce their underwriting risk.
The Deepwater Horizon blowout is a wider cross-practice example of where the above practices might have helped prevent exposure to a claim. A presidential panel named to study the accident found that the Deepwater Horizon blowout and oil spill in the Gulf of Mexico was an avoidable accident caused by a series of failures by parties involved in drilling and policing the well.
Another reason to consider Social and Governance standards is that many investors demand it. Investors are increasingly looking for companies with good ESG practices. Natixis Investment Managers did a global survey of financial professionals in 2020 and of individual investors in 2019 and found that 71% of survey participants of varying generations and asset levels agreed with the statement “I want to make a positive social impact with my investments”. As such, it won’t be long before these wider ESG considerations are tied directly to financing, investment and underwriting decision-making.
Companies can also improve their reputation by considering Social and Governance standards, as it demonstrates they have transparent plans that focus not only on helping the environment, but also in supporting aspects such as diversity, equal opportunities and ensuring ethical business decisions. Firms can be seen as more ethical, reliable, and trustworthy by their customers, leading to better customer loyalty.
Companies that focus on ESG often have better operational efficiencies and cost savings, leading to increased profitability over time. Gard is one of the world’s leading marine insurers and its CEO, Rolf Thore Roppestad, said “Meeting with maritime authorities from across the world, for example, that is highly valuable for us. As part of our outreach program, we try to have meetings and workshops on a regular basis with maritime authorities and other key stakeholders across the world. This makes it easier for us to collaborate when something goes wrong”. Their engagement with maritime authorities paid off in 2017 when the Blue Star Patmos ferry ran aground off the Greek Island of Ios and Gard had already put a plan of action in place with the Greek maritime authorities. The ship was salvaged before it became a total loss which would have led to substantial damage to the environment and a much larger financial loss.
Companies that focus on ESG holistically also tend to be more successful in attracting and retaining employees. This is particularly true for millennials who represent an increasing share of the workforce.
Lastly, and equally importantly, new regulations are continuously being introduced and strengthened requiring companies to adhere to ESG standards holistically.
How to develop S and G metrics
Within the S and G pillars there are both quantitative and qualitative metrics that are typically used and should be considered. Unlike many other financial metrics, the quantitative metrics for S and G require a variety of measure types, not just a monetary value. The very important qualitative metrics tend to describe qualities, characteristics, strategies, processes and actions. The quantitative metrics also play an important role and tend to include the number of years committee members remain on committees, the tracking of the diversity of decision-makers within firms, employee satisfaction surveys and employee volunteer hours.
Diversity, Equity and Inclusion ("DEI") are at the heart of the Social pillar and are vital to create an inclusive firm. Equality legislation in the UK has developed over several decades, resulting in a multitude of statutes. Many of these were consolidated in the milestone Equality Act of 2010. Valuing diversity and providing equal opportunities help lead a firm towards inclusion. Although there are quantitative metrics to show a firm’s DEI progress, we believe the best measures remain qualitative and include a firm’s DEI policies, for example, a shared parental leave policy.
The G in ESG refers to those policies and procedures that shape a firm’s governance practice, which is crucial for ensuring effective management and oversight, and also for effective risk identification and mitigation processes. The policies are usually built around initiatives that include a code of ethics, compliance, responsible supplier policies and transparency of organisational structures.
Challenges
One of the key challenges with ESG is the nature and variability of the many potential metrics. Furthermore, a good proportion of ESG metrics are qualitative, and where metrics are quantitative, data availability is often a limitation.
As humans, we like to simplify and look at things linearly. If we do that with ESG change just won’t be sustainable. It’s imperative to ensure our decisions fit all three strands of ESG, and that we consider both short- and long-term impacts of our actions. For example, we might like to offset our carbon emissions by investing in forestry. This might seem like an easy win, but forest offsetting schemes are often found on land that may have been used by indigenous or local communities to farm their own crops and support their own livelihoods; and often the rights to this land have not been secured. Using this land to plant new trees may help the environment in terms of carbon offsetting, but it may also lead to possible famine. This very real scenario shows the importance of ensuring decisions fit all of the ESG and making sure any changes made in relation to ESG are sustainable.
Another key challenge is individual accountability. Individually, we can help drive climate neutrality with communication and asking questions – for example, when working with third party providers asking what their ESG policy is and how they make it sustainable. Sustainable ESG can also be embedded through good communication and training, for example, by firms ensuring all staff understand what good looks like and the signs of something that might not be good. A more robust approach involves firms not just relying on their Risk functions to be raising potential issues, but instead helping and encouraging all staff to take personal ownership.
There are a lot of challenges, but there is a real opportunity to improve business (and societal) outcomes when ESG and sustainable practices are embedded in companies. Leading companies have also now realised that acting on ESG principles, especially the S and G side, is a chance to win trust of customers, society, and investors.
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