What Is ESG?
Early last month, the acronym “ESG” was sprinkled across headlines. Pressure and scrutiny surrounding the label had intensified, with Securities and Exchange Commission examiners cracking down on fund managers’ use of the term.
These efforts are a marker of how serious attitudes towards ESG have become. But, of course, for those who may be unfamiliar with the acronym, the significance would be lost. Let’s look at the history of this newly important acronym, and see if it will be relevant to your business endeavors.
The meaning of ESG
Short for Environmental, Social, and (Corporate) Governance, ESG refers to the three broad issues that “socially responsible investors” are concerned about. Coined in 2005, the term has come to represent the rise of environmental, social, and governance factors being integrated into investment processes and business decision-making.
Short for Environmental, Social, and (Corporate) Governance, ESG refers to the 3 broad issues that “socially responsible investors” are concerned about.
Evolving from prior movements of sustainable or socially responsible investing, ESG introduced a distinct framework that companies could integrate into their strategies and—more significantly—be evaluated on.
The measurability of ESG has been key in its prominence. Rather than having positive impacts relegated to a footnote, businesses could get rated and ranked according to ESG standards by third-party agencies. These ESG ratings can then be used to inform internal strategies and decisions, as well as help investors pick which companies they want to support.
While there is no global standard for assessing ESG goals, policies, or factors (different regions, industries, and agencies tend to have their own guidelines), the three categories are widely understood as follows:
The Environmental factor of ESG refers to the impact that a company has on the environment and climate change. The category is broad, but some common issues and efforts include:
- Greenhouse gas emissions
- Waste management
- Energy efficiencies
- Carbon footprints
- Water usage and pollution
- Land use and deforestation
- Animal treatment
- Raw material sourcing
When it comes to setting goals that fall under ESG frameworks, a recent survey by Insider found that environmental issues are the most common concern for business decision-makers. Greenhouse gas emissions and water consumption took the top two spots, with 36.5% of respondents having formal goals in those areas. Carbon offsets were fifth at 26.2%.
The Social category is similarly broad and pertains to the human and societal impact of a company. This can start with the way an organization treats its employees and customers and is increasingly expanding to include overall attitudes and actions toward greater systemic issues.
Some examples of concerns that fall under this are:
- Labor, health, and safety standards
- Equal employment opportunities
- Fair wages and pay equity
- Diversity and inclusion
- Community relations
- Privacy and data security
- Mental health
- Human rights
- Equity and social justice
In light of the pandemic, health and safety have emerged as the top social factor that decision-makers are focused on, with 30.9% of respondents having several organization-wide goals that fall under the category. Immediately following it, in the fourth spot, is equity and social justice at 26.9%.
Interestingly, despite many businesses prioritizing environmental issues, a recent survey has found that fair wages are a greater concern for investors. While 65% of respondents had marked a preference for investing in a company that pays fair wages, only 53% preferred environmentally friendly companies.
This factor partly involves the “governing” of the E and S categories, such as through sustainability oversight and compliance processes. More generally, though, Governance involves the impact of how a company operates (as opposed to what it does).
As described by RegTech provider Cube, it is “the manner in which a company governs itself, makes ethical decisions, deals with conflicts of interest, meets the needs of stakeholders, and complies with the laws of its jurisdiction.”
See the factors that fall under Governance below:
- Makeup and structure of the corporate board
- Executive compensation
- Ethics and compliance
- Political contributions and lobbying
- Bribery and corruption
While crucial, Governance issues tend not to be as prioritized as the other categories. The first Governance issue to show up on the list of top ESG goals was ranked 8th, with 19.1% of business decision-makers having formal goals surrounding ethical practices and anti-corruption, according to Business Insider.
Why is ESG so important?
While the term was coined less than 20 years ago, the essence of ESG is not a new development.
The idea that businesses could and should take responsibility for their impact on the environment, society, and ethics had been building up over decades. At the same time, business owners, investors, and consumers increasingly sought to go beyond evaluating companies by just financial performance, eventually leading to what we know as ESG today.
In part, the importance of ESG has been driven by the increased awareness of environmental and social issues. Empowered by information and subjected to countless global crises, more and more people—including those at the head of corporations—feel they have the moral obligation to have a positive impact or, at the very least, to not have a negative one.
Empowered by information and subjected to countless global crises, more people—including corporate executives—feel a moral obligation to have a positive impact or, at the least, to not have a negative one.
The significance of these issues has also been driven by the fact that ESG has financial implications. ESG ratings are now the “talk of the boardroom” as organizations see the metric as a key to decision-making. Consider the following stats:
- Companies with high ESG scores experience lower costs of capital, lower equity costs, and lower debt costs (MSCI).
- Better ESG scores correlate to about a 10% lower cost of capital (McKinsey).
- ESG funds are just as, and in some cases, more lucrative than conventional funds, while also being less risky (Insider).
Though there are challenges to definitively proving causality, the positive relationship between ESG performance and financial performance is theorized to be explained by its effect on the below:
- Business growth. High ESG performance attracts value-driven consumers, investors, and talent, driving growth and innovation.
- Lowered costs and risks. A focus on resource efficiency can help cut costs of operations, while strict adherence to ESG-related regulations and guidelines leads to lower risks of regulatory consequences, such as being subjected to high carbon taxes or scrutinized by the SEC for greenwashing.
The bottom-line? ESG initiatives are no longer just a nice-to-have. In a world filled with value-driven consumers facing countless global crises, companies won’t be allowed to take a backseat and shirk their social responsibilities—nor should they want to. ESG is here to stay and will likely continue to grow in importance.
The question for you to consider as a shareholder, employee, or business owner, is: What do you value and to what extent are you prepared to put your values into action? ESG scoring and information means there is much less room for you to say “It’s complicated” and walk away from the responsibility to move closer to behaving in accordance with what you espouse.
Photo by Naja Bertolt Jensen