When one thinks of environmental, social and governance (ESG) investing, one should think of transparency. In other words, they should think of additional sources of information that help identify unseen risks and justify shareholder value. This investing style is known as ESG integration. Private equity investors use ESG integration as a value-creation tool by analyzing material and non-financial factors during due diligence and ongoing monitoring. These material factors are centered around the Sustainability Accounting Standards Board (SASB) materiality map, which identifies material ESG information using more than 1,000 qualitative and quantitative factors across 77 industries. To understand how it works, let’s analyze energy management and worker injury rates.

Energy is a source of both emissions and expense. Using due diligence questionnaires, private equity investors gain valuable insight into how efficiently a target company manages its energy costs and emissions and compare this information to internal benchmarks. Companies with material energy costs, such as data centers, real estate and manufacturers that have a successful energy strategy, will be assigned higher valuations. Furthermore, as emissions are increasingly regulated, the capital costs of implementing an emissions reduction program will also impact a target’s valuation.

Worker injury rates can also provide insight into how well a manufacturer manages its workforce. High injury rates indicate ineffective safety standards but can also allude to much deeper problems. Poor safety is often accompanied by sloppy management and poor product quality. The consequences of poor safety often result in production downtime, higher insurance premiums, lost customers and, in the worst cases, fines and lawsuits.

Increasing ESG Transparency

Unfortunately, public company investors don’t have access to the same meaningful ESG information as private equity investors. This lack of access puts public company investors at a disadvantage and means they are generally blind to most ESG risks and opportunities. The scary part is that unforeseen ESG risks can significantly impact shareholder value. Examples include the expensive SolarWinds hack, the BP disaster and the PG&E bankruptcy – along with countless others.

The IFRS Foundation is seeking to level the playing field by requiring companies to provide meaningful ESG transparency. In 2021, the IFRS created the International Sustainability Standards Board (ISSB) with the following key objectives: 1) develop standards for a global baseline of sustainability, 2) meet the information needs of investors and 3) provide comprehensive sustainability information to global capital markets.

In 2023, the ISSB released IFRS S1 and S2 that will require companies to disclose industry-specific sustainability information alongside financial statements. IFRS S1, General Requirements for Disclosure of Sustainability, outlines sustainability-related disclosures that are financially material to specific industries. IFRS S2, Climate-related Disclosures, outlines required disclosures that are in line with the Task Force on Climate-related Financial Disclosures (TCFD). Both S1 and S2 only consider ESG information that is financially meaningful and that allows investors to make informed, rational investment decisions.

The ISSB sustainability disclosure requirements are based on the SASB materiality map and the TCFD. These are the same standards used by private equity investors to identify ESG risks and opportunities. Required ISSB disclosures are reported in the annual Sustainability Disclosure Statements and may be subject to audit. Like other IFRS standards, each jurisdiction determines the specific reporting requirements. The ISSB’s work is currently supported by the G7, the G20, the International Organization of Securities Commission (IOSCO), the Financial Stability Board plus Finance Ministers and Central Bank Governors from more than 40 jurisdictions. The American Institute of CPAs (AICPA) is also evaluating ways to adapt ISSB’s work in the USA.

By using due diligence questionnaires and internal benchmarks, private equity investors are able to evaluate material, non-financial ESG information that can identify potential ESG risks and opportunities. After ISSB sustainability standards are broadly adopted, investors in public companies will have access to the same material financial ESG information as private equity investors. By evaluating companies' sustainability disclosure statements, public investors will be in a position to reward better companies with higher share values while punishing the laggers. More importantly, investors may be able to avoid ESG surprises that can degrade share prices in an instant.