Environmental, Social, and Governance (ESG) considerations and climate change are often conflated in the minds of investors. However, there are important distinctions between the two. In this blog, we lay out the differences between ESG and climate from an investment perspective, and explain how these concepts are incorporated by the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).
What is ESG and Climate Change?
Let’s start at the beginning: what is the relationship between ESG and climate change? ESG refers to the consideration of certain non-financial factors when evaluating an organization or investment. Although these factors typically fall outside of traditional financial analysis, they can have material impacts on an organization’s or investment’s financial performance.
ESG risks are becoming more relevant for businesses. These can manifest in a variety of ways. For example, they could stop a company from obtaining permits to operate in certain jurisdictions or hinder their ability to gain and retain employees and customers. Investors are increasingly paying attention to such ESG risks, in terms of how ESG factors could impact their portfolio companies and vice versa (e.g. by considering a portfolio company’s impact on the environment).
Importantly, ESG risks tend to be intertwined. For example, oil and gas pipeline development in North America often faces opposition from environmental and Indigenous groups, with the former opposing these developments for environmental reasons and the latter opposing them for a combination of environmental and social reasons. Reaction to these protests can include regulation, litigation, and the review of permits, which fall across environmental and social considerations.
Climate Change is the E in ESG
Two things are true about climate change:
- Climate Change Considerations Fall Under the E in ESG.
Climate considerations cover all things related to the causes and impacts of climate change, as well as the transition to a lower-carbon economy.
- Climate Change Will Impact Most ESG Issues.
Climate change, and society’s response to it, is reshaping the broader ESG landscape. Therefore climate change should not be thought of as a subset of the ‘E’ in ESG. Rather, it is a factor relevant to all ESG issues.Because of this, it is more useful to think of ESG and climate change as different lenses through which to analyze organizations, instead of as versions of the same lens. Applying a specific climate lens to organizations and investments should help investors surface richer insights than if they applied an ESG lens alone.
Similarities and Differences Between ESG and Climate Change
Financial institutions face a growing demand for products linked to organizations and investments that seek to minimize ESG risks and their own impacts on the environment and society. To meet this demand, a variety of ESG-related financial products have emerged, including loans, bonds, and exchange-traded funds (ETFs), among others.
Products referencing climate-friendly organizations and investments are also in vogue. These include funds that invest in companies with no or little involvement in the fossil fuel industry, and so-called ‘green bonds, where the proceeds are earmarked for investment in low-carbon activities.
This demand in turn has fuelled the development of a thriving ESG and climate analytics industry, which aims to help investors understand how aligned specific investments are with ESG and/or climate goals. This industry is also working to promote and enhance the disclosure of ESG and climate factors by organizations to improve investor understanding.
The Scaling Demand for ESG and Climate Disclosures
ESG and climate disclosures are in demand from investors, regulators, and other stakeholders. This year, there has been a particular focus on increasing organizations’ take up of climate disclosures, especially those aligned with the recommendations of the TCFD. The G20 endorsed the use of this disclosure framework in July, while authorities in the UK, New Zealand, and China, among others, have taken steps to mandate the publication of climate disclosures by companies.
Efforts to promote broader ESG disclosures are also underway, although in many cases these are not as far along as those supporting climate disclosures. For example, the International Sustainability Standards Board, launched in November, aims to produce a global baseline of sustainability disclosure standards, encompassing multiple ESG issues. However, it is currently prioritizing climate change disclosures in response to the “urgent need for better information about climate-related matters”. Furthermore, the G20 is yet to endorse a broad sustainability/ESG reporting framework.
One reason for the recent emphasis on climate over ESG disclosures may be the challenges involved in estimating the financial effects of other ‘E’ and ‘S’ factors, such as biodiversity loss and the impacts of structural racism, and the lack of quantifiable metrics for these factors. In contrast, research on the financial impacts of climate change is more advanced, and there is broad agreement on which metrics can be used to differentiate organizations by climate impact.
ESG Policy and Regulation
While some ESG issues have been on policymakers’ radars recently, others continue to be overlooked (e.g. executive compensation, a key governance issue). In contrast, climate change has become embedded in the political and policymaking discussions taking place in most countries in the world, with many now committed to tackling further global warming by targeting net zero emissions by 2050.
The intensity of policy and regulatory scrutiny on climate issues is, therefore, greater than it is on ESG overall.
How Should We Think About ESG and Climate Change?
An organization or investment that scores highly on climate change issues may not necessarily score highly on other ESG factors — and vice versa. The precise reasons will vary depending on the type of analysis applied. However, one big driver is that an organization’s ESG profile is determined by referencing a broad range of factors and through comparisons with other entities operating in the same sector(s). A climate profile, on the other hand, relies on a smaller array of variables that typically reference climate science.
The Bottom Line
ESG and climate change intersect and overlap but are the best thought of separately. Climate change and the ways governments, companies, and investors plan to respond to it present specific risks and opportunities that differ from those posed by other ESG factors. At the same time, these other ESG factors will be profoundly shaped by the course of climate change. Understanding this relationship will be key to the financial performance of organizations the world over in the years to come.
Understand Your Organization’s Climate Maturity with Manifest Climate
At Manifest Climate, we strongly support the TCFD recommendations. In fact, we structured our climate intelligence platform around this framework. Climate action is an economic, social and environmental imperative. We can support you on your climate journey. Contact us today.