What is ESG?
ESG—environmental, social and governance—describes areas that characterize a sustainable, responsible or ethical investment.
The Financial Times Lexicon defines ESG as “a generic term used in capital markets and used by investors to evaluate corporate behaviour and to determine the future financial performance of companies.” It is used by investors to evaluate corporations and determine the future financial performance of companies. It adds that ESG “is a subset of non-financial performance indicators which include sustainable, ethical and corporate governance issues such as managing a company’s carbon footprint and ensuring there are systems in place to ensure accountability.” They are factors in investment considerations, used in risk assessment strategies incorporated into both investment decisions and risk management processes.
ESG refers to a class of investing that is also known as “sustainable investing.” This is an umbrella term for investments that seek positive returns and long-term impact on society, the environment, and the performance of the business. There are several different categories of sustainable investing. They include impact investing, socially responsible investing (SRI), ESG, and values-based investing. Another school of thought puts ESG under the umbrella term of SRI. Under SRI are ethical investing, ESG investing, and impact investing.
ESG are three central factors in measuring the sustainability and ethical impact of a company. ESG factors, though non-financial, have a material impact on the long-term risk and return of investments. ESG is incorporated into risk mitigation, compliance, and investment strategies. Companies that use ESG standards are more conscientious, less risky, and are more likely to succeed in the long run.
According to Environmental, Social and Governance Issues in Investing: A Guide for Investment Professionals, “There is…a lingering misperception that the body of empirical evidence shows that ESG considerations adversely affect financial performance.” It adds that, “For investment professionals, a key idea in the discussion of ESG issues is that systematically considering ESG issues will likely lead to more complete investment analyses and better-informed investment decisions.”
Responsible investors evaluate companies using ESG criteria as a framework to screen investments or to assess risks in investment decision-making. Environmental factors determine a company’s stewardship of the environment and focus on waste and pollution, resource depletion, greenhouse gas (GHG) emissions, deforestation, and climate change. Social factors look at how a company treats people and focuses on employee relations and diversity, working conditions, local communities, health and safety, and conflict. Governance factors take a look at corporate policies and how a company is governed. They focus on tax strategy, executive remuneration, donations and political lobbying, corruption and bribery, and board diversity and structure.
The European Federation of Financial Analysts Societies (EFFAS) has defined topical areas for the reporting of ESG issues for use in financial analysis of corporate performance:
- Energy efficiency
- GHG emissions
- Staff turnover
- Training and qualification
- Maturity of workforce
- Absenteeism rate
- Litigation risks
- Revenues from new products
ESG risks and activities
Environmental risks created by business activities have actual or potential negative impacts on air, land, water, ecosystems, and human health. Company environmental activities considered ESG factors include managing resources and preventing pollution, reducing emissions and climate impact, and executing environmental reporting or disclosure. Environmental positive outcomes include avoiding or minimizing environmental liabilities, lowering costs and increasing profitability through energy and other efficiencies, and reducing regulatory, litigation, and reputational risk.
Social risks refer to the impact that companies can have on society. They are addressed by company social activities such as promoting health and safety, encouraging labor-management relations, protecting human rights and focusing on product integrity. Social positive outcomes include increasing productivity and morale, reducing turnover and absenteeism, and improving brand loyalty.
Governance risks concern the way companies are run. It addresses areas such as corporate brand independence and diversity, corporate risk management, and excessive executive compensation, through company governance activities such as increasing diversity and accountability of the board, protecting shareholders and their rights, and reporting and disclosing information. Governance positive outcomes include aligning interests of shareowners and management, and avoiding unpleasant financial surprises.
Why is ESG good for business?
According to TriLinc Global LLC, “ESG standards provide another level of due diligence, which is in the best interest of shareholders. When the UN launched UNPRI [the Principles for Responsible Investment] in 2006 and watchdogs like Bloomberg and MSCI started tracking ESG, it became abundantly clear that this was not a short lived fad….ESG weeds out unsustainable companies with outdated practices and harmful side effects, while also minimizing risk for investors as they invest in more responsible companies with a greater likelihood of succeeding in the long run.”
Some might call ESG an investment philosophy; others might call it core values. When a business wants to act sustainably, it takes action in these various areas of interest represented by ESG in order to give value to its investors. ESG outlines the main areas that a company should consider when investing.
In Bigger Than the Bottom Line: Why ESG is Good for Business, Bank of America Vice Chairman Anne Finucane and illycaffè Chairman Andrea Illy discussed the growing importance of ESG investing in Bloomberg’s The Year Ahead summit in New York. Here were some key takeaways:
- ESG was a bolt-on to the side of business-as-usual for many years.
- Companies have reevaluated their place in each of these spaces (environment, social and governance) in the last five years.
- One of ESG’s equivalents is the so-called triple bottom line (economic, social and environmental sustainability).
- Sustainable companies are builders of profit as well as builders of society. Stakeholders include shareholders and customers, as well as employees, local communities, etc. Profit is a means to develop share value, social sustainability and environmental sustainability, rather than the end-all, be-all for a company.
- Sustainability, ESG or responsible growth, is an investment, not a cost. The whole idea of ESG is that you are a sustainable company and that you are doing business responsibly. This means transparency and applying ESG standards and policies to one’s operations. In 2015, Bank of America reevaluated its practices and established more businesses with renewables, adjusted its employee contracts, and promoted diversity in the company and senior management. The company made $16.5 billion in that year.
- The financial services industry predicts at least US$13 trillion in additional growth in the renewable energy sector.
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