In addition to using profitability as a measure of success, the public and many investors are now looking at ESG (Environmental, Social, Governance) standards when evaluating companies and their business models.
“Environmental” guidelines help companies reach sustainability goals and keep them alert to their ecological impacts. “Social” deals with how companies treat employees and how they impact surrounding communities. “Governance” pertains to the behaviour of top decision-makers and how they uphold the rights of shareholders.
The history of ESG began in the 1960s when investors decided to filter out companies involved in businesses that supported the South African apartheid regime or were engaged in tobacco product manufacturing.
ESG was first officially mentioned by the United Nations in 2004 in the report, Who Cares Who Wins, initiated by UN Secretary-General Kofi Annan. The report stated adhering to ESG guidelines would allow businesses to manage their risks more effectively. However, critics of this approach claimed regulations would limit profitability and deter businesses from reaching their full potential.
An ESG valuation scale was established based on multiple criteria including labour practices, carbon footprint, energy efficiency, etc. Some ESG score providers include Sustainalytics (used by Yahoo Finance), S&P Global, the Dow Jones Sustainability Index, Fitch Ratings and Bloomberg ESG Data Services. According to the zero to 100 scale developed by Sustainalytics, companies with an ESG risk rating of 30 and above may have poor performance in one or more of the categories.
Currently, ESG has become even more important as the world has increased its dependency on the ESG standards used by multinational corporations with a global footprint. To a considerable degree, this falls on construction companies as well as on firms in other sectors contributing to construction, including heavy machinery manufacturing and mining.
Based on today’s reporting requirements, publicly listed companies must disclose detailed information, including ESG-related risks, on a regular basis. According to Sustainalytics, the ESG ratings for Lennar, D.R. Horton, Rio Tinto and Caterpillar range from mid to high.
Lennar, one of the largest U.S. construction companies, sports a moderate ESG Risk Rating of 23, with the highest risk value of 8.9 allocated to its environmental-impact behaviour. Currently, Lennar’s homes boast environmentally friendly features such as energy-saving LED lights, water-conserving toilets, and responsibly-sourced hardwood used in flooring. In 2021, Lennar built 11,147 solar-powered homes, helping to reduce homeowners’ energy bills.
According to its founder, D.R. Horton has been the “largest homebuilder in the nation” for the last two decades. According to Sustainalytics, D.R. Horton’s ESG Risk Rating is lower than Lennar’s by one point, with the environmental component carrying the largest weight.
Even though 100 per cent of its homes include energy-efficient thermostats and LED lights, D.R. Horton is also directing significant effort towards improving its environmental impact. The company is reportedly working on incorporating environmentally-friendly building methods.
With respect to its governance position, 43 per cent of the company’s employees are female, and 50 per cent of its board directors are ethnically or gender diverse.
Caterpillar is reportedly the largest global manufacturer of mining and construction machinery. The company has a high ESG Risk Rating of 34, with more than half of its risks lying in the social arena. Although the company contributed $42.3 million of profit to community investments last year, past controversies have contributed to an 18.5 social risk score.
According to Caterpillar’s 2022 Sustainability Report, the company produced 575,000 metric tons of waste during 2022 operations, 89.6 per cent of which was recycled. Since 2018, Caterpillar has decreased its scope 1 and 2 greenhouse gas emissions by 33 per cent. It is also progressing towards more energy-efficient machinery with first production of a battery electric mining truck.
Rio Tinto, among the largest mining companies globally, has a high ESG Risk Rating of 31.6. According to its 2022 Annual Report, Rio Tinto was confronted with safety fines of $339,000 and $109,782 for environmental misconduct. However, the company is striving for a more environmentally conscious future by investing in the construction of an aluminum recycling facility and supporting research to develop technology that will store carbon as a solid.
Today, profitability remains the leading Key Performance Indicator for construction, mining, and heavy machinery building industries. At the same time, ESG has gained a more significant role in the overall evaluation of companies. This becomes evident when access to capital for poor ESG performers is limited (i.e., a form of capital reallocation), as institutional investors use ESG in their investment decisions. ESG guidelines are meaningful drivers for global companies, requiring them to expand their focus beyond the bottom line.
Dmytro Konovalov has over 10 years of experience in equity research and analysis for global markets at leading international financial institutions.