Since its first appearance in a 2004 report by the UN Global Compact, the use of the term environmental, social and governance (ESG) has spread rapidly, driven by pressure from the capital markets (e.g. the financial industry and institutional investors). This rapid spread is based on the understanding that ESG is not merely a superficial slogan, but a social and environmental risk factor that is connected to daily lives.
Effective management of, and response to, ESG-related issues have become essential for companies, due to: visible signs of climate change; spread of infectious diseases such as Covid-19 and the various changes it has caused; active expression of opinions by consumers on the internet and social media; investors’ requests for information and active participation in corporate governance; credit rating agencies that evaluate ESG aspects of companies; and each nation’s efforts to establish and implement ESG-related regulations, such as reduction of carbon emissions by nations including those in the EU, establishment of standards for taxonomy, and expansion of public disclosure obligations.
Importance of ESG and need to measure ESG impact
Businesses need to manage ESG properly while disclosing various information as required by laws or investors. If a company fails properly to manage its value chain ESG (i.e. internalisation) or disclose information (i.e. communication with the outside), the costs of responding to regulations and the capital markets (e.g. ratings agencies) will increase. Such a failure would in turn lead to unnecessary expenditures and loss of market opportunities as the importance of ESG grows in the financial markets and consumers’ needs become increasingly linked to social and environmental issues.
As ESG has become one of the key issues in corporate management, investors and companies now use ESG ratings to evaluate companies. However, ESG ratings are criticised at times as their results are inconsistent between ratings agencies and the evaluation method and results fail to reflect accurately the impact on society and the environment. As of March 2022, there are more than 100 ESG ratings agencies, and these agencies often produce different evaluation results even for the same target company due to the differences in their evaluation methods.
An article published by Bloomberg Businessweek in 2021, ‘ESG Mirage’, pointed out that ESG ratings are not effective in substantially enhancing a company’s ESG policy as they only measure the potential impact of society and environment on ‘companies’ without measuring a company’s impact on the environment and society. The article analysed every increase in the ESG rating that ratings agency MSCI awarded to S&P 500 companies between January 2020 and June 2021. It found that, among the factors behind the increase in rating, governance factors accounted for 42%, followed by social (32%) and environmental (26%) factors.
Some increases in rating based on environmental factors were affected by regional risks that were unrelated to a company’s efforts or performance (for example, a company located within a region with sufficient water would have a low water stress level which in turn would reduce relevant risks leading to a higher rating). Moreover, for the governance factor, companies gained high scores merely for having certain internal policies (e.g. human rights policies) even if the companies had not taken any specific actions to further such policies. Therefore, rating methods that enable companies to obtain higher ratings without taking any substantive action appear to be problematic.
ESG rating has been designed as a tool for investment that mainly reflects ESG risks based on the impact on corporate value – i.e. long-term profit of companies. Therefore, the ratings may fail to reflect sufficiently the level of social and environmental impact that a company has on stakeholders. Further, factors such as differences in evaluation methods and scoring mechanisms among the agencies and complexity of the rating systems make it difficult for companies to utilise the evaluation results as a tool for managing ESG performance.
Ultimately, a tool to complement/offset the weaknesses of current ESG rating systems is necessary, and ESG impact measurement and valuation can be an option. ESG impact measurement and valuation measures the impact that a company has not only on its shareholders, but also on other stakeholders including employees, suppliers, environment, and local residents, and enables the company to convert its impact into monetary terms. The ESG impact measurement and valuation is unique as it expresses the impact in terms of monetary value, which can in turn be used to describe activities in various areas in a more easily understandable form.
There are many initiatives that are developing methods for measuring and evaluating the impact as well as the standardisation of such methods. These include the Capitals Coalition, Redefining Value Initiative, Impact Valuation Roundtable, Value Balancing Alliance (VBA), Harvard Business School impact weighted account (IWA) and New York University Stern Center return on sustainability investment.
A 2019 Harvard Business Review report stated that more than 56 companies have experienced the ESG impact measurement and valuation. Further, as of March 2022, more than 20 companies (excluding consultancies) have participated in VBA, which is a private initiative for standardisation of impact measurement methods.
ESG impact measurement and valuation provides the following three advantages as a tool in promoting ESG management.
1. Easier to understand in decision-making process
ESG impact measurement and valuation visualises the ESG impact, which is dispersed throughout different areas such as environment and society, in a monetary value. This attribute enables companies to consider the results in their decision-making process along with many other factors that are also expressed in financial values.
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“ESG rating has been designed as a tool for investment that mainly reflects ESG risks based on the impact on corporate value” |
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In other words, both positive and negative impacts that a company has on the environment and society may be converted into a more understandable indicator. A method where different factors are displayed in different units (e.g. kg for fine dust or percentage for crime rate) undermines a comprehensive understanding of multiple factors, which may ultimately result in omission or underestimation of certain impacts in the decision-making process if the decision maker lacks understanding of any specific quantity unit.
For example, where ESG impacts should be considered in addition to the amount of investment (i.e. financial cost) and expected profit (i.e. financial value) for each investment option in a development project performed by a constructor, it would be impossible comprehensively to compare each option against the others or to understand the ESG impact vis-à-vis financial costs or value if different factors (e.g. the number of affected residents, level of emissions or size of the habitat destroyed by the project) are measured in different units. However, if the impacts from various factors are converted into a currency unit, ESG factors and the financial costs/values may be compared in parallel.
This means, in the example above, the project option that has the optimal (financial and ESG) impact can be selected. Having that said, however, it should be understood that not all impacts can be converted into monetary value.
2. Easier communications with stakeholders
Monetary value is understandable to every stakeholder in the capitalist system.
In other words, stakeholders may easily understand the impact of corporate activities that are converted into a monetary unit, and their heightened understanding ultimately increases the transparency of corporate information. Detailed examination of the impact analysis results for each stakeholder group enables companies to map out a supplementary plan for groups that create insufficient positive impacts or contribute to creation of negative impacts.
For example, by comparing the impacts on communities where its offices are located, a company may establish a plan to contribute to vulnerable people or other residents (e.g. construction of cultural facilities) in a region with a low assessment of positive impact. In addition, an increase in communications with stakeholders will lead to more concerted efforts for ESG activities thereby improving the efficacy of corporate activities.
3. Customisable application in accordance with a company’s needs
The results of measurement converted into a monetary figure can be applied in a more flexible manner based on where the focus is placed. The measurements can be divided into two categories depending on the object being measured.
The first category entails a method that measures the impact that a company has on society and the environment. It measures the comprehensive impact on stakeholders outside of the company. This approach is adopted by the IWA of Harvard Business School and the VBA, among others.
The second category of measurement converts profits and losses of corporate values caused by ESG factors into monetary value comparable to that of general corporate risk assessment (i.e. ESG is viewed as a risk factor). Conversion of ESG impacts into monetary values typically refers to the first category of measurement, but the second category may also be used in corporate management, and the information on monetary terms under the second method can be included in risk/opportunity analysis section of the carbon disclosure project or TCFD reports, etc.
To illustrate how the two categories compare, assume that greenhouse gas emissions by a chemical company with its place of business in South Korea increased by 100 tons between 2020 and 2021, and the company emits a total of 50,000 tons. Under the first category, the environmental damage throughout the world can be calculated by multiplying the total emissions of greenhouse gases in 2021 (i.e. 50,000 tons) by the damage cost (e.g. $100/ton). The company may disclose to stakeholders the increased impact (100 tons times $100/ton) compared to the previous year and also publicise its goals and plans to reduce the emissions.
Under the second method, the company may calculate the costs for purchasing carbon credits by multiplying the difference in the emissions by the price of carbon credits in Korea (e.g. $20/ton) and also calculate the (current or potential) costs for reducing greenhouse gas emissions through internal reduction facilities. The company can then compare the two costs to establish a plan to control greenhouse gases in the following year.
Given that the results from the two methods have different objectives, they can be used together.
ESG impact measurement and valuation method
Under the ESG impact measurement and valuation method, ESG impact is measured and evaluated in accordance with the following process:
Identification of corporate activities connected to ESG factors and areas of impacts created (air pollution, human rights, etc.);
Determination of the scope (e.g. up to tier 3 suppliers) and degree of measurement (upon considering the possibility of data collection, implementation of pilot measurement, etc.);
Securing the data on corporate activities and correlation coefficients from highly reliable sources (internal collection of data and research); and
Conversion of the quantified outcomes (expressed in the form of data) into monetary terms (research).
In particular, in the process of securing and quantifying the data on the outcomes of corporate activities connected to ESG after identification of activities and determination of scope, the quantified figures are calculated based on the assumption of zero corporate activity or in comparison with the market average of impact creation (i.e. baseline). Here, the baseline can be defined and applied in various ways depending on the object or context of measurement.
Further, in the process of converting the impact into monetary terms, an appropriate method (e.g. cost-based method or revealed preference method) can be applied and subsequently adjusted for time or location.
ESG impact measurement and valuation can be conducted for any sector of corporate activities including management, upstream (supply chain), product services or community services. In particular, the product service sector is closely linked to market opportunities and serves as an indicator to represent a company’s business model. Measurement of the product service sector is complicated given that a large volume of external market information and statistics are required, and the level of contribution may be reflected in the measurement depending on the characteristics of the relevant product.
The impact of a product by a financial company can be calculated from its financial portfolio (green finance). In order to calculate this indirect impact, the impact calculated from companies or projects within the portfolio and the financial company’s contribution to such impact may be required, and carbon accounting method (e.g. the Partnership for Carbon Accounting Financials), can be applied to the calculation of a financial product’s contribution level.
For example, if a bank lends $1 million for a project for generating power from renewable sources with a project cost of $2 million, the ratio of the bank’s investment against the size of the project (asset value) can be deemed the bank’s contribution. In this method, the financial company’s contribution gradually declines as the loans are repaid.
ESG impact measurement and valuation cases
The impact of a company’s activities was measured in terms of monetary value for the first time in 2003 by Infosys. Since then, many companies including Puma (from 2011) and Kering Group (from 2012) have measured the impact of their activities on environmental aspects, including supply chains, in monetary terms under the name of environmental profit and loss (E P&L). Kering Group shares, and jointly develops, the method of measurement and valuation with Capitals Coalition and VBA, and allows its consumers to view the monetary value of the environmental impact through an app.
In South Korea, SK Group adopted the double bottom line approach from 2018, measuring the impact of the activities of its 17 affiliates in various industries including energy, communications and chemicals in monetary terms and sharing the results through press releases, etc. SK Group has established an internal data system through continuous improvement and expansion of the measurement method and is directly utilising the impact in corporate management by connecting the monetary value with personnel assessment. Many other Korean companies in both the public and private sectors have measured their own ESG impact and disclosed the outcomes.
Challenges to, and aims of, ESG impact measurement and valuation
Although converting the ESG impact into monetary terms has significant advantages and potential, there are many issues to be resolved. Conversion requires the collection of more data (on corporate activities/value chains, many correlation coefficients, market information, statistics, monetisation coefficients, etc.) compared to typical quantitative indicators, and this in turn requires more time and cost.
Moreover, a standardised method and underlying theories must be developed for the measurement results to be compared between companies much like the ESG ratings. These must be addressed through numerous discussions.
However, the ESG impact measurement and valuation will be an essential factor for businesses and other entities to respond properly to ESG because (i) it may enable ESG evaluation, which used to be a mere qualitative evaluation, to become more quantitative and quantified; (ii) the companies that have unwillingly accepted qualitative ESG evaluation due to industrial trends or requests by investors/external organisations can now visualise the realistic effect of the measurement and develop more forward-looking policies; and (iii) upcoming trends such as TCFD also involve conversion of the ESG impact into monetary value.
In conclusion, businesses need to endeavour to engage in various discussions to resolve issues in the ESG impact measurement and valuation and to develop more appropriate methods of measuring impact under the ESG impact measurement and valuation method and contribute to the opening of a true ESG era.
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Seung-Kook Synn
Senior foreign attorney
Yoon & Yang
T: +82 2 6182 8502
Seung-Kook Synn is a senior foreign attorney at Yoon & Yang specialising in corporate legal affairs, including governance, international transactions, intellectual property rights, antitrust and risk management.
Prior to joining Yoon & Yang, he worked as a general counsel and senior vice president of corporate sustainability management for SK Group, a South Korean major conglomerate including SK Telecom, SK Energy and SK Hynix. The introduction of a full-scale compliance programme for SK’s flagship companies is his signature achievement.
Based on his experience as an in-house counsel, Seung-Kook provides tailored legal solutions, particularly in governance issues, to corporate clients. He is a graduate of Yonsei University and later completed his LL M at Cornell Law School and his JD at Vanderbilt Law School. He is admitted to practise in New York.
Keun Woo Lee
Partner
Yoon & Yang
T: +82 2 6003 7558
Keun Woo Lee is a partner at Yoon & Yang, where his main practice areas consist of intellectual property protection, privacy protection and trade secrets protection. He also works on matters including e-commerce and other technology, media and telecommunication areas.
In addition, Keun Woo has represented various clients in criminal proceedings pertaining to personal information, as well as providing advisory services to corporations’ chief officers in charge of protecting personal and corporate information.
As a key member of the firm’s ESG group, Keun Woo has been of ESG TF of Korean Bar Association and participated in internal and external seminars, webinars and forums as a guest speaker or contributor, particularly on environment and social issues. He is a graduate of Seoul National University College of Law and has also completed an LL M at the University of Southern California Gould School of Law.
Hee Yang
Consultant
Yoon & Yang
T: +82 2 6003 7674
Hee Yang is a consultant at Yoon & Yang specialising in ESG.
Previously, Hee worked at the civil environmental business department of POSCO E&C conducting environmental projects such as water treatment and waste and business development. She also worked for the ESG team at PLAN M, a management consulting company advising and consulting on the ESG impact measurement projects for private and state-owned companies.
At Yoon & Yang, Hee provides consulting and advice by measuring the ESG impact of the firm’s strategies so that clients will build more effective management strategies. She is a graduate of Seoul National University majoring in chemical and biological engineering.
