What is environmental, social and governance (ESG)?
Environmental, social and governance (ESG) is a framework used to assess an organization’s business practices and performance on various sustainability and ethical issues. It also provides a way to measure business risks and opportunities in those areas. In capital markets, some investors use ESG criteria to evaluate companies and help determine their investment plans, a practice known as ESG investing.
While sustainability, ethics and corporate governance are generally considered to be non-financial performance indicators, the role of an ESG program is to ensure accountability and the implementation of systems and processes to manage a company’s impact, such as its carbon footprint and how it treats employees, suppliers and other stakeholders. ESG initiatives also contribute to broader business sustainability efforts that aim to position companies for long-term success based on responsible corporate management and business strategies.
What are the criteria for ESG?
As the number of ESG funds for managing investments rises, business and IT leaders in companies increasingly are paying attention to ESG as a functional approach to doing business. Each aspect of ESG plays an important role in the effort to increase a company’s focus on sustainable and ethical practices. Here are details on common ESG criteria used by companies and investors.
Environmental factors involve considerations of an organization’s overall impact on the environment and the potential risks and opportunities it faces because of environmental issues, such as climate change and measures to protect natural resources. Examples of environmental factors that can be ESG criteria include the following:
- Energy consumption and efficiency.
- Carbon footprint, including greenhouse gas emissions.
- Waste management.
- Air and water pollution.
- Biodiversity loss.
- Natural resource depletion.
Social factors address how a company treats different groups of people — employees, suppliers, customers, community members and more. The criteria used include these examples:
- Fair pay for employees, including a living wage.
- Diversity, equity and inclusion (DEI) programs.
- Employee experience and engagement.
- Workplace health and safety.
- Data protection and privacy policies.
- Fair treatment of customers and suppliers.
- Customer satisfaction levels.
- Community relations, including the organization’s connection to and impact on the local communities in which it operates.
- Funding of projects or institutions that help poor and underserved communities.
- Support for human rights and labor standards.
Governance factors examine how a company polices itself, focusing on internal controls and practices to maintain compliance with regulations, industry best practices and corporate policies. Examples include the following:
- Company leadership and management.
- Board composition, including its diversity and structure.
- Executive compensation policies.
- Financial transparency and business integrity.
- Regulatory compliance and risk management initiatives.
- Ethical business practices.
- Rules on corruption, bribery, conflicts of interest, and political donations and lobbying.
- Whistleblower programs.
Why does ESG investing matter, and how does it work?
In many cases, customer behavior has changed to focus on more sustainable practices. People increasingly look to recycle, minimize waste and make greener choices on products and to reward businesses that act responsibly. In ESG investing, those goals also influence decisions on investment choices.
Often, both individual and institutional investors who consider ESG issues want to use their money to support companies that align with their own values on environmental sustainability and social responsibility. In addition, such companies could have better long-term financial performance than other organizations because of lower costs, reduced business risks and new marketing opportunities, potentially leading them to outperform in the stock market. ESG investing has seen strong growth as a result.
The process involves several steps to provide relevant ESG data to investors. Companies track internal ESG metrics, which can differ from organization to organization based on the industry, business makeup and corporate priorities. They can then use various ESG reporting frameworks to document and publish the results. Next, different ESG rating agencies analyze the reports and award ESG scores to the companies. ESG investors can factor all of that information into their investment decisions.
ESG funds are nontraditional in that they focus on the following:
- Monitoring performance to evaluate business sustainability.
- Taking a longer-term view that can help improve the financial stability of companies.
- Investing in companies or industries that meet specific ESG-based criteria.
Pros and cons of ESG
The pros of ESG practices for investors and companies include the following:
- Investment returns and sustainability can mix. Sustainability funds can achieve similar or better returns compared to traditional funds, according to 2022 performance data from Morningstar, an investment research, management and technology company.
- ESG can attract new customers for additional growth. Consumers and business customers who factor ESG considerations into their buying decisions are likely to seek out products or services provided by companies that are focused on ESG.
- ESG investing pushes companies to make other positive investment decisions. Organizations with ESG initiatives tend to focus on a wide range of environmental issues and ethical practices. For example, ESG aligns with the triple bottom line, a sustainability-focused accounting framework that companies can use to measure the overall economic value they create and their social and environmental impact.
- ESG helps companies attract and retain high-quality employees. It can boost employee motivation and increase overall productivity by giving workers a sense of purpose.
- ESG can cut costs. When ESG practices are incorporated into the fabric of an organization, operating expenses, energy bills and other costs can be reduced over time.
Potential cons of ESG practices include the following:
- ESG doesn’t follow a one-size-fits-all approach. The approach to ESG that works for one company might not work for another, which complicates both management of ESG initiatives and ESG investing. The need to weave ESG efforts into both day-to-day business practices and long-term strategies adds more complications.
- ESG strategies that aren’t authentic can backfire. Organizations that focus on ESG inconsistently, use it as a brand image ploy or disconnect it from their business strategy likely won’t be successful. For example, a company that engages in greenwashing — a term for making false or misleading claims about environmental actions — could face a customer backlash that affects revenue and the value of its stock.
- Strong stock market performance isn’t guaranteed. While there are success stories, focusing on ESG doesn’t guarantee strong performance by a company’s stock. In addition to other internal factors, changes in market conditions, business trends and the overall economy can negatively affect the performance of companies and ESG funds alike.
- Creating a diverse investment portfolio can be difficult. For investors focused on an ESG-led investment strategy, it might be harder to create a balanced portfolio that aligns with long-term goals.
- Detailed performance reporting across different ESG criteria 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.
Alternatives to ESG investing
While ESG investing is now the most prominent form of sustainable investing overall, it isn’t the only option for those interested in similar approaches. Although ESG investing and the following alternatives are often talked about interchangeably, some differences exist:
Socially responsible investing (SRI). SRI focuses specifically on investments in organizations that match an investor’s environmental, ethical and social values. For example, it excludes companies that manufacture certain products or profit from practices that harm the environment. SRI concentrates on the investor’s values above a company’s financial performance. Comparatively, ESG investing strategies focus on high standards of corporate behavior but often also consider business performance together with ESG criteria. In addition, ESG investing typically is based on more quantitative data because of the use of ESG scores and metrics.
Impact investing. This strategy focuses on helping an organization achieve specific goals that have social or environmental benefits. For example, impact investing could support a company that is working to develop renewable energy technology or promises to donate a percentage of its profits to charitable groups. Impact investing can also help promote corporate social responsibility (CSR) initiatives in companies. CSR is a self-regulating approach that emphasizes doing good and taking positive actions, such as a shoe company giving away a pair of shoes for each pair purchased.
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 shareholders, other prominent stakeholders and company 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 create and optimize value for all stakeholders.
- Conscious leadership follows the collective we vs. me mentality to drive the business.
History of ESG investing
Socially responsible investing practices began to take shape in the 1960s and 1970s. For example, activists started pushing academic institutions and companies to divest their stock holdings in organizations that did business in South Africa to protest against the apartheid system then in place there.
In 1971, two United Methodist ministers opposed to the Vietnam War launched the Pax Fund, the first U.S. mutual fund open to the public that used social and environmental criteria in investment decisions. Initially, the fund avoided investing in weapons manufacturers — it later added tobacco, alcohol and gambling companies and heavy polluters to the list. Still in existence, it’s now owned by London-based Impax Asset Management and called the Impax Sustainable Allocation Fund.
The South Africa divestment campaign accelerated in the 1980s, and a broader push to divest holdings in tobacco makers began among public health organizations, universities and public pension funds. In 1990, investment research firm KLD Research & Analytics created the Domini 400 Social Index to help guide socially conscious investors — one of the first SRI indexes, it included 400 companies that prioritized social and environmental responsibility. It’s now called the MSCI KLD 400 Social Index and owned by MSCI Inc., which acquired KLD in 2010.
In 1995, the Washington-based Social Investment Forum Foundation, now known as the US SIF Foundation, published a report on sustainable investing trends in the U.S. that said $639 billion in total assets were being managed using SRI strategies. The latest version of the now-biennial report, published in December 2022, put that figure at $8.4 trillion for ESG and sustainable investments overall, which US SIF said amounted to 12.6% of all the investment assets under professional management in the U.S.
The sustainable investing movement gained more momentum with the founding of the Carbon Disclosure Project in 2000. Now known simply as CDP, it created a platform for companies to report on their carbon emissions and footprints. Two years later, a group of 35 institutional investors requested climate disclosures from 500 large companies, which helped to normalize such reports.
The term ESG was popularized by “Who Cares Wins,” a report first published in 2004 by a group of 18 banks and investment firms that was organized by the United Nations. The report offered recommendations on how to better incorporate ESG issues into asset management, brokerage services and related research activities. It was followed a year later by the so-called Freshfields Report, another U.N.-backed document that was prepared by the London-based law firm Freshfields Bruckhaus Deringer and outlined a legal framework for integrating ESG criteria into investment decisions.
The U.N. then asked another group of institutional investors to develop the Principles for Responsible Investment (PRI), a set of six ESG investing principles that was published in 2006 and continues to be promoted by the PRI Association. The evolution and growth of ESG investing picked up pace from there with the formation of more ESG reporting initiatives, including the Climate Disclosure Standards Board (CDSB) in 2007, the Sustainability Accounting Standards Board (SASB) in 2011, the Taskforce on Climate-Related Financial Disclosures in 2015 and the Workforce Disclosure Initiative in 2016.
More recently, key developments include the following:
- 2020. The World Economic Forum and the Big Four accounting firms released a standardized set of stakeholder capitalism metrics to make ESG reporting by companies more consistent and easier to compare.
- 2021. The European Union’s Sustainable Finance Disclosure Regulation went into effect, creating new sustainability reporting requirements for financial services and investment firms.
- 2022. The U.S. Securities and Exchange Commission similarly proposed rules amendments with more detailed disclosure and reporting requirements for investment funds that use ESG criteria. Also, the CDSB and the SASB standards were consolidated into the International Financial Reporting Standards (IFRS) Foundation, which plans to create a unified set of IFRS Sustainability Disclosure Standards.
- 2023. The EU’s Corporate Sustainability Reporting Directive went into force in January. Eventually, it will require 50,000 companies to file annual reports on their business risks and opportunities related to social and environmental issues and how their operations affect people and the environment.
Hundreds of ESG funds are now available to investors in the U.S. alone. ESG investing has become a political issue, though. For example, Congress in March 2023 approved a resolution proposed by Republicans to block a 2022 federal rule that allows retirement fund managers to consider ESG factors in their investment decisions. However, President Biden vetoed the measure, leaving the rule in place.