What is environmental, social and governance (ESG)?
Environmental, social and governance (ESG) is a term used to represent an organization's corporate financial interests that focus mainly on sustainable and ethical impacts. Capital markets use ESG to evaluate organizations and determine future financial performance. While ethical, sustainable and corporate governance are considered non-financial performance indicators, their role is to ensure accountability and systems to manage a corporation's impact, such as its carbon footprint.
What are the criteria for ESG?
Companies are paying attention to ESG as a functional approach to doing business as the number of ESG investment funds rises. Each criterion of ESG plays an important role in the effort to increase focus on sustainable and ethical investments.
Environmental factors involve how much an organization considers the protection of natural resources. These factors include the environment, climate change, energy consumption and use and its overall impact.
Examples of environmental factors include:
- Air and water quality
- Energy performance
- Carbon footprint, including greenhouse gas emissions
- Natural resource depletion
- Waste management and pollution
Social factors address how an organization treats people, including these examples:
- Community relations, including the organization's connection and impact on the local communities in which it operates and serves
- Customer satisfaction
- Data protection and privacy policies and efforts
- Efforts to fund projects or institutions that help poor and underserved communities globally
- Employee diversity, equity and inclusion (DEI)
- Employee engagement and relations
- Health and safety
- Human rights, including child labor and slavery
- Labor standards
Governance examines how a corporation polices itself, focusing on internal system controls and practices to maintain compliance. Governance focuses on transparency, industry best practices, organization management and associated growth initiatives.
Examples of governance include:
- Company leadership
- Board composition, including diversity and structure
- Corruption and bribery
- Donations and political lobbying
- Executive compensation and policies
- Tax strategy, including audit committee structure, internal controls and regulatory policies
- Whistleblower programs
Why does ESG investing matter, and how does it work?
Over time, consumer behavior has changed and focused on becoming more sustainable. Consumers look to recycle, minimize waste and make greener choices. This behavior also influences decisions around finances and investment choices.
As a result, investors want to use their money to finance companies committed to these practices. ESG investing, also known as sustainable investing, has seen exponential growth as investors seek to provide capital for companies whose values on environmental sustainability and social responsibility align with their own.
ESG funds are non-traditional in that they focus on the following:
- Monitoring performance to evaluate business sustainability
- Measuring the financial stability in the market
- Investing in companies or industries that meet specific ESG-based criteria
Pros and cons of ESG
Pros of ESG practices include the following:
- Investment returns and sustainability can mix. Sustainability funds can achieve similar or better returns compared to traditional funds, according to a 2021 report from Morningstar, a financial services company.
- ESG can attract consumers for additional growth. Consumers seek more sustainable product options or services provided by companies that are focused on ESG.
- ESG investing helps make other positive investment decisions. ESG organizations tend to focus on ethical practices.
- ESG-focused organizations often outperform in the stock market. ESG organizations often take more calculated risks, which can minimize risks for investors and make an ESG organization a more reliable long-term investment.
- ESG attracts and retains quality employees. It can boost employee motivation and increase overall productivity by giving a sense of purpose.
- ESG can cut costs. When ESG practices are incorporated into the fabric of an organization, companies can reduce costs over time, such as operating expenses.
Cons of ESG practices include the following:
- ESG does not follow a one-size-fits-all approach. The approach that works for one company might not work for another. An organization must choose to weave its strategy into both its day-to-day practices and long-term strategy, making it more difficult to decide where to focus on the environmental criteria.
- ESG strategy must be authentic and not only in communications. Organizations that attempt to focus on ESG inconsistently, use it as a brand image ploy or are disconnected from the business strategy will not be successful.
- Strong market performance isn't guaranteed. While there are success stories, focusing on ESG does not guarantee strong company performance in the market.
- Creating a diverse investment portfolio can be difficult. For investors focused on an ESG-led investment strategy, it may be harder for a financial advisor to create a balanced portfolio that aligns with one's long-term strategy.
- Detailed performance reporting across each ESG criteria point can be challenging. Most ESG factors aren't tied directly to financial data, resulting in additional effort to provide tangible performance results. Further, knowledge gaps reside between ESG information and supply chain as reporting standards and frameworks are not consistently applied.
While ESG is the face of sustainable investing, it is not the only option for those interested in the approach. Although ESG and the following are often they are talked about interchangeably, some differences exist:
Socially responsible investing (SRI). SRI focuses on investments in one's portfolio that match an investor's environmental and social values. It excludes companies that manufacture or profit from harmful practices that oppose ESG criteria. SRI concentrates on the investor's values above a company's policies and procedures. Comparatively, ESG investing strategies focus on high standards across a company's social and governance policies with a clean environmental record.
Corporate social responsibility (CSR). CSR investing focuses on a company's impact on society across social, environmental, economic and operational factors. CSR emphasizes doing good and providing positivity. An example of a CSR-driven organization would be a shoe company that gives away a pair of shoes for each pair purchased.
Impact investing. This strategy focuses on helping an organization achieve specific goals that are beneficial to society or the environment. For example, a company produces a tangible environmental or social good by funding clean energy or non-profit research.
Conscious capitalism. Unlike the previous strategies, conscious capitalism refers to a socially responsible economic and political philosophy. Conscious capitalism focuses on the premise that businesses should operate ethically while pursuing profits. The strategy emphasizes that an organization should serve its entire ecosystem, not just prominent stakeholders and leadership. Other conscious capitalism beliefs include the following:
- Organizations should have a higher purpose beyond pure profits to inspire and engage their key stakeholders.
- The focus should be on the entire business ecosystem to crate and optimize value across all stakeholders.
- Conscious leadership follows the collective "we" vs. "me" mentality to drive the business.
- Conscious culture is the sum of the values and principles that constitute the social and moral fabric of a business.