ESG: Best practices for the energy industry
ESG, the focus on environmental, social and governance impacts of a business, is gaining attention from investors, communities, and regulators. For energy companies, the evolving reports are bringing significant challenges — and opportunities. Here’s what you need to know.
ESG is the acronym created to describe the environmental, social and governance impacts of an entity. At its heart, ESG represents a fundamental shift in focus on returns from shareholders to benefits to stakeholders with the goal of harnessing the creative power of individuals and teams to generate long-term value for an entity’s stakeholders, including members of society and the environment in which the entity operates. A key assumption in this shift is the idea that businesses cannot have long-term success in failed societies. While ESG has shined its light on social and governance factors for entities that operate throughout the energy industry, the most dramatic impact it is currently having is bringing additional attention to environmental factors given the resource intensive nature of the industry as well as the overall role energy plays in our society and daily lives.
The role of ESG in today’s marketplace
Investors and their capital providers are increasingly focused on ESG risk factors in today’s market economy, as many find these factors helpful in understanding a company’s long-term value creation strategy. As “net-zero” pledges and governmental mandates continue to make headlines along with the broader discussion of long-term energy sources, including renewable and alternative energy as well as the energy transition, sustainability and environmental factors are playing a large role in capital allocation. According to the sixth-annual Institutional Investor Survey conducted by Morrow Sodali Global, LLC in 2021, 98% of investors surveyed are giving more focus to ESG topics when it comes to investment decisions. According to the Harvard Law School Forum on Corporate Governance, the trend of capital inflows into ESG-oriented investing reached $1.65 trillion in the fourth quarter of 2020. This is a trend that, the Forum states, may result in board accountability for performance against ESG criteria that matches, and in some cases exceeds performance against traditional financial measures.
Credit rating agencies are also beginning to incorporate ESG factors into credit risk profiles, including Fitch Ratings, Inc. recently developing ESG relevance scoring systems to determine the impact of ESG factors on individual credit ratings. Large investment firms continue to report on sustainability factors of companies within their portfolios, with many firms stating their belief that climate risk and investment risk are interconnected in today’s marketplace. This belief has resulted in a push by these capital allocators to ensure their portfolios are ESG integrated and that material ESG risks are considered in investment strategy decisions.
According to a July 2021 speech given by Gary Gensler, chairman of the U.S. Securities and Exchange Commission (SEC), investors want to understand climate risks of target companies. Climate risks can broadly address various topics within the ESG umbrella. Gensler cites an increase in investor demand for disclosure requirements around such topics, sparking a drive by the SEC to respond. A March 2021 public statement issued by then SEC Acting Chair Allison Herren Lee invited the public to participate in commentary regarding climate change disclosures and posed several pointed questions for consideration regarding the topic, as the SEC looks to propose rules on ESG reporting and disclosure in the near term.
On the international front, the IFRS Foundation, a nonprofit accounting organization responsible for developing a single set of high-quality global accounting standards, is working to develop international sustainability reporting standards. Erkki Liikanen, chair of the IFRS Foundation Trustees, delivered a June 2021 keynote speech that stated a current goal of the foundation is to develop an approach to sustainability reporting that provides global comparability for investors.
How entities are responding
While some entities are responding to ESG reactively based on stakeholder or investor demands, others are viewing ESG as a way to describe their long-term value creation strategies to investors and other stakeholders. According to the Center for Audit Quality (CAQ), as of summer 2021, 95% of S&P 500 companies had detailed ESG or similar information publicly available, commonly disclosed under the branding of sustainability reporting. As with many compliance and reporting changes, larger and publicly traded companies have been largely leading the way on ESG and similar disclosures. However, smaller, privately held companies are increasingly amplifying their reporting and disclosure on ESG matters, and per a December 2020 Foley and Lardner, LLP publication, private entities are also facing an increasing amount of interest in ESG information from a variety of formal and informal stakeholders.
Current ESG reporting in the energy industry
Entities currently disclosing ESG and related matters overall utilize various standards and reporting frameworks, which typically include both qualitative and quantitative information. Current qualitative information has been centered around sustainability, core values, and net-zero emissions targets and pledges to showcase how these factors generate both shareholder and stakeholder value. These disclosures also discuss social impacts, such as community relations, workforce health and safety, biodiversity impact considerations, and overall, near and far-term stakeholder impact. Current quantitative disclosures dive into the metrics used for reporting and measurement, progress toward targets identified in qualitative information, safety performance data, energy used in manufacturing, water management figures, and air quality and greenhouse gas and energy data encompassing scope 1, 2, and 3 greenhouse gas emissions. Further quantitative disclosures cover energy use, and other environmental data such as water use, waste management, and social performance data.
Entities currently disclosing ESG and related matters overall utilize various standards and reporting frameworks, which typically include both qualitative and quantitative information.
Greenhouse gas emissions
Many energy companies have been reporting on greenhouse gas emissions stemming from their day-to-day operations. The disclosures encompass their short- and long-term strategies to manage emissions coupled with an analysis of the entity’s performance against those targets. In consideration of the scope of what is addressed in the reporting, entities work toward capturing emissions data from throughout the organization’s value chain and group them into three categories; scope 1, 2 and 3. Scope 1 emissions are direct emissions from sources owned or controlled by the entity and may include those stemming from vehicles and equipment, stationary sources, on-site landfills and wastewater treatment, as well as fugitive emissions. Scope 2 emissions are indirect emissions from sources owned or controlled by an entity and may include those from the purchase of or generation of electricity, heat, or steam purchases from a utility. Scope 3 emissions are from sources not directly owned or controlled by an entity but related to its activities and may include those from transmission and distribution, purchased goods and services, business air travel, employee commuting, contracted solid waste, and contracted waste wastewater treatment.
Energy management in manufacturing
Energy involved in the supply chain of solar and wind equipment and the related impact on the environment is a key element for renewable and alternative energy companies in consideration for disclosure to stakeholders. Given the use of energy in manufacturing of solar and wind technology, which may be purchased from the grid, and accounts for a considerable portion of the manufacturing costs of such technology, disclosures around the topic can cover the percentage of electricity that is purchased from the grid and what percentage is renewable. Entities may further consider the disclosure of energy used in the transportation of such equipment to end-users, with similar considerations around the source of energy used.
The sourcing of raw materials is also an important consideration for renewable alternative energy companies. Due to the limited worldwide supply of critical components used in many renewable goods and processes, such as rare earth minerals and those used in electrical components, mineral resources disclosures around this topic can create transparency in supply chain management by covering the management of risks associated with the use of critical materials, and more specifically, the environmental risks associated with their supply chain. Furthermore, human rights considerations around the production of sourced materials can be identified for disclosure. Such factors can cover materials sourced from workforces where forced labor or unsafe or harsh working conditions are employed.
Water management is another main topic of disclosure to stakeholders for companies across the energy industry. As water plays a significant role in operations of energy companies across the industry, areas of consideration around the topic can include the use of water in hydraulic fracturing fluids, produced and flowback water, water scarcity in mining communities, and water contamination risks. The disclosures cover topics such as total freshwater usage, flowback generated, including amounts discharged, injected, recycled, etc., and number of incidents of noncompliance associated with water quality standards.
Air quality considerations for energy companies take a deeper dive on emissions beyond greenhouse gasses and consider topics like volatile organic compounds, particulate matter, and gasses such as sulfur dioxide and nitrogen dioxide. Given that such compounds can be released from stationary combustion sources used in drilling operations, storage vessels, flaring of natural gas, smelting, or refining activities, ESG disclosures typically cover quantities of these compounds released from operations as well as an entity’s responses for reduction of such emissions, including process improvements and preventative monitoring and testing.
Biodiversity impacts contemplate habitat loss and alteration through land use for exploration and development activities, disposal of waste, development and subsequent remediation of mines and wells through the alteration of landscape, vegetation removal, and impact to wildlife habitats. Disclosures on this topic typically cover a description of environmental management policies for active sites, volume of hydrocarbon spills, percentage of proved reserves near sites deemed to house endangered species habitats or sites with conservation status, as well as mine sites where acid rock drainage is present or expected.
Since energy companies often rely on support from local communities and strive to be a good neighbor, community relations disclosures can often be a venue for disclosure of the good the entity is already doing. Additionally, as entities often need buy-in from the community for obtaining permits and leases as well as the ability to conduct operations efficiently and in agreement with plans with municipalities and local governments, community relations disclosures give them the opportunity to publicly address the actions they take to address these concerns. Companies generate disclosures around this topic covering their risk management strategy and opportunities with community rights and interests, as well as the number and duration of nontechnical work delays. These disclosures may also include the number of community service hours and charitable donations an entity and its staff may contribute each year to the local community, as well as the amount of taxes paid to the local municipalities.
Workforce health and safety
Workforce health and safety considerations address the risk for hazardous working conditions present across the energy industry, with an increased focus on field workers. Entities can create transparency and social equity by disclosing the total recordable incident rate, Mine Safety and Health Administration all-incidence rate, fatality rate, near-miss frequency rate, as well as discussion of management’s mission to cultivate a culture of safety for all workers and contractors.
Beginning the process
Given the breadth and depth of ESG topics, the various states of current reporting and disclosure, and the varying ways in which ESG topics can be addressed, quantified, reported on, and disclosed, it can be difficult to determine the direction to take when approaching the topic of ESG reporting and disclosure. A few topics that an entity can consider when starting this process include:
- Identifying stakeholders. ESG factors can be viewed through a lens that considers all stakeholders, internal and external. Internal stakeholders can be identified as investors, lenders, employees, and creditors, among others. External stakeholders can be identified through consideration of an entity’s impact on the economy, environment, and people. These bodies can include governments, consumers, business partners, societal organizations, communities, or vulnerable groups. It’s vital for an entity to understand the link between internal and external impacts to create value-added disclosures for all stakeholders.
- Materiality. The discussion on what ESG factors should be focused on can be rooted in materiality, from the perspective of both the impact on the entity’s enterprise value as well as the impact on all stakeholders, including the external stakeholders, and environment in which the entity operates. Some topics and factors may be qualitatively or quantitatively immaterial to the current enterprise value of the entity; however, they may be viewed as material and impactful to external stakeholders. Other topics may constitute a material impact to the entity itself yet have a de minimis impact to external stakeholders. Thus, companies should apply the concept of dual materiality and scope in factors that impact both the entity as well as the environment in which the entity operates.
- Capturing and presenting the data. Entities may currently have a large amount of disaggregated data that can be used to quantify or address many of the elements of key ESG factors, provided this data can be cleansed and compiled in a meaningful way. With the evolving need for reporting and disclosures concerning ESG factors, entities will be well served in mapping the ESG factors they identify as material to current data sources and identifying gaps in existing data, recognizing areas where more data will be needed to adequately address such factors. Entities should also consider the owner of the data, such as internal sources or external sources (e.g., data from contractors), as well as its relevance and reliability, when identifying any data and reporting gaps.
Recognizing the role of assurance
There are currently no regulatory requirements for third-party assurance on an entity’s ESG factors or similar reports. However, a 2019 McKinsey & Company survey found that 97% of investors felt that sustainability disclosures should be audited in some way. As information reported by an entity needs to be credible and well supported for investors and other stakeholders to rely on it, particularly for decision-making, independent assessments of such information can enhance the reliability of the data.
97% of investors felt that sustainability disclosures should be audited in some way.
According to the Center for Audit Quality, as of June 2021, more than half of the S&P 500 companies had some form of assurance or verification over ESG metrics, a percentage that is expected to grow as investors and stakeholders continue to demand such reliable data for decision-making.
Currently, there are multiple frameworks (principles-based guidance on information structure, preparation, and covered topics) and standards (consistent, comparable metrics for disclosure) involved in establishing factors to be considered for ESG disclosures and how these factors should be measured. The frameworks and standards each have differing focuses, with some broadly discussing a variety of ESG elements, while others place a heavy emphasis on individual elements, such as greenhouse gas emissions and environmental impact.
The lack of any current requirement for which frameworks and standards to use and which elements of such to report and disclose presents unique challenges around clarity, consistency, and comparability for reporting entities. While multiple regulatory bodies and industry groups continue to advocate for the creation of a common framework or standard, the evolution of such will continue to bring changing factors for entities to monitor.
The lack of any current requirement for which frameworks and standards to use and which elements of such to report and disclose presents unique challenges.
While stakeholder capitalism, corporate social responsibility, and ESG aren’t brand-new concepts, their heightened emphasis in the current marketplace may result in many entities starting from early stages in the identification of a broader group of stakeholders, aggregation of relevant data, and crafting of decision-useful disclosures.
Although ESG reporting can be thought of by some as just a compliance exercise, others are viewing it as an opportunity to showcase their impact on, and response to, topics of concern held by external stakeholders.
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