Introduction
As a responsible investor, it is not only vital to understand non-financial risks posed to (and by) companies, but also what they are doing to mitigate these.
In the case of single materiality, this might mean how a company is preparing to adapt to climate change, and in the case of double (or single-outward) materiality, this might mean what it is doing to mitigate the risks it poses to external stakeholders, including the environment.
However, not all risk mitigation measures are created equal, and how can investors distinguish between companies that simply state they are working to limit risks (be they inward or outward) and those which are making systematic efforts to do so?
In the case of limiting outward risks to the environment, enter the environmental management system.
What is an EMS?
An environmental management system (EMS) is a formalised system constituting policy documentation, procedural documentation and controls, and associated processes. It is effectively a tool for ensuring systematic efforts are made by companies to identify and address their environmental impacts, from air, ground, and water pollution, to waste generation and water extraction.
According to the International Organization for Standardization (ISO), an EMS should include the following “components”:
(I) An environmental policy. This is a statement that acts as a foundation for the system, and mandates its existence; it should outline an organisation’s commitment to environmental sustainability.
(II) A planning process. This requires organisations to define environmental objectives, establish appropriate targets that need to be met as part of these objectives, and then establish programmes designed specifically to meet its targets.
(III) An implementation phase. In essence, this means actually doing the things that need to be done to meet targets and objectives. Resources such as time, finances, and staff must be allocated to programmes and projects, and responsibility for their implementation assigned.
(IV) A checking process. To determine if measures are being implemented correctly, and if progress is being made, organisations must establish a protocol for regular monitoring of performance against targets and objectives.
(V) Management review. Finally, an EMS must facilitate a formal review of the system itself. This is to evaluate the effectiveness and suitability of the EMS, and to ensure that any problems are identified and rectified.
Another common (if not universal) characteristic of well-designed management systems - be they environmental or otherwise - is the incorporation of a “plan, do, check, act” (PDCA) cycle.
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PDCA cycles are a cornerstone of continuous improvement. They require repeat identification and rectification of any failings or inefficiencies within a system, often on an annual basis, and by extension help to ensure that management systems remain optimised. The “check” stage usually involves a comprehensive audit by a company’s environmental manager or equivalent, and - depending on the size of the organisation - a supporting team.
Value to Responsible Investors
When it comes to the value of EMSs for responsible investors, the presence (or lack) of an EMS can act as a valuable indicator when assessing company efforts to mitigate environmental impacts. For example, the implementation of EMSs may be widely practiced in certain sectors (namely those which are associated with significant environmental risks), and so the lack of an EMS may render a company to be above an investors risk tolerance.
Alternatively, the implementation of an EMS by a company in a sector where this is less common may show leadership, and render the company a particularly attractive investment opportunity, from an environmental perspective. Both strategies (i.e. avoiding laggards and promoting leaders) can allow investors to signal that the implementation of EMSs is an important consideration for investors, and thus work to encourage change among companies.
Furthermore, for investors seeking to demonstrate their responsibility efforts by working with companies to encourage change, EMS implementation can be a valuable topic for engagement. By encouraging investee companies to implement an EMS, investors may be able to demonstrate that they have been able to directly influence company activity for the better.
EMS implementation also requires the collection of data, which investors may be able to use to evidence the impact they have had to potential clients and other stakeholders. This could be, for example, data illustrating that companies have reduced emissions, waste generation rates, and water use rates following the implementation of an EMS.
Benefits of Certification
While EMS implementation can demonstrate to investors and other stakeholders that companies are taking systematic efforts to limit their impacts, and is likely preferable to seemingly disjointed and ad hoc activities, the quality of these systems can vary from company to company.
Fortunately for investors, however, companies can take a further step to prove that their EMSs are following widely accepted standards - certification. One of the most widely adopted and well-regarded environmental management standards that companies can be certified to is the ISO’s 14001 standard, which requires companies to be audited by an accredited certification body on an annual basis.
As such, certification not only acts as a form of assurance for investors, but can also be used as another indicator by which to compare companies. Investors may, for example, view companies with certification more favourably than those without, and even compare certification coverage rates between companies. This is often expressed by companies as a proportion of sites or employees covered by certification, or even the proportion of revenue generated at sites/activities covered by certification.
Certification can also be another area for engagement. If an investor has been successful in encouraging a company to implement an EMS, pushing for certification (or increased coverage of certification) is arguably a natural next-step, assuming a company did not achieve full certification to begin with. Similarly, for companies that have already implemented an EMS, but not achieved full certification, investors may seek to encourage the company to pursue this goal.
Data regarding certification rates within funds or portfolios can also be used by investors to demonstrate their engagement credentials, assuming they have been successful in their efforts. It is also high-quality evidence in that it is quantitative, comparable, and based on a widely used standard.
Conclusion
Whether a responsible investment strategy is based on risk minimisation, engagement, or both, the presence of an environmental management system (and especially one which is certified to the ISO 14001 standard) can be a valuable indicator for investors. It is an indicator that provides clear insight and an easily comparable metric regarding corporate efforts to mitigate environmental impacts, and can therefore act as a core pillar of ESG assessments, as well as a tangible (and potentially highly effective) area for engagement.