ESG (Environmental, Social, & Governance)

What Is Environmental, Social, and Governance (ESG) Investing?

ESG, standing for Environmental, Social, and Governance, represents an organic extension of the sustainability lens that all businesses showcase.

Until a few years ago, businesses focused on the three P mantra:

• People
• Products
• Planet

However, frameworks have evolved as ventures expand across domains and geographies.

This higher-level framework revolves around the environment, social responsibilities, and governance practices, providing stakeholders with insights into the business's environmental, social, and governance practices to manage associated risks and opportunities.

Used originally purely for investment decisions, the concept has come a long way into being a core consideration for end-to-end decision-making across stakeholders such as customers, employees, and suppliers.

Taking a trip down the lane, we come across multiple strategies and frameworks on corporate philanthropy and environment protection, such as EHS - environment, health and safety framework, corporate sustainability, and CSR - corporate social responsibility.

While this draws its roots from all these histories, it has evolved into a structure that maximizes holistic stakeholder well-being alongside supporting investment and capital allocation decisions.

Integrating the Environmental-Social-Governmental practices leads to conscious value creation by assessing existing business practices and adjusting them to global standards.

Sustainable businesses hold a comparatively positive reputation in the market and amidst customers, creating a loyal customer pool. Furthermore, reduced risks, greater revenues, and improved bottom lines are a few more benefits for a sustainable organization.

What Does ESG Stand For?

As we all know, the acronym comprises three primary pillars promoting a culture of sustainable, environment-friendly, and ethical practices in conducting business operations. 

1. Environmental Pillar

One of the oldest pillars, environmental practices, existed long before the framework came into existence. This pillar looks at the interaction between the environment and the venture risk management framework.

Tracking environmental efficiencies, emissions, carbon footprints, resource consumption, recycling efforts, and resiliency to environmental changes is what forms this criterion. But, broadly, how environmentally friendly are the organization’s policies?

To get started, a few questions to be asked by the organization under this bucket are - 

• What impact do the company’s strategies, actions, and initiatives impact the environment?
• Are the products and services offered sustainable?

2. Social Pillar

The community facet of doing business comprises the social pillar. It refers to aligning an organization's business practices, values, and mission with consumers, employees, investors, and stakeholders’ expectations.

Shared values directly contribute to the popularity of the business with the mass. This makes integrating social aspects with the business strategy an important step in the value creation chain.

Organizations must proactively consider the implications of their decisions and activities on society. Key topics under this pillar usually aim at issues such as human rights development, equal opportunities, diversity, equity and inclusion, and data privacy, to state a few.

Unlike the environmental pillar, which can be directly measured, performance on the social front is a little tricky to quantify. Since it deals with people and opinions, it is measured against constantly changing factors and landscapes.

Some preliminary questions to understand the social performance of a business can be -

• What is the correlation between company behavior and societal impacts?
• How does the company incorporate socially favorable practices?
• How positive is public opinion towards the business?
• How employee-friendly is the company culture?

3. Governance Pillar

Transparency, ethics, and leadership are what form the governance pillar. It refers to how a company is managed and presented. Sound governance policies and practices promote trust amidst the mass.

It is analyzed by asking a mix of questions, such as - 

• Are the goals of the company aligned with stakeholder expectations?
• How are shareholder rights viewed?
• How does the management promote transparency and accountability?
• Is the work environment safe and fair?

This pillar sets the tone for a company’s past, present, and future. Good governance and ethical operations directly result in improved performance and stakeholder satisfaction.

ESG and Value Creation

The interrelation between Environment-Social-Government and value creation is substantially huge to be ignored by any decision maker.

As environmental, social, and governmental concerns are taking precedence in today’s world, understanding this connection has become more important than ever.

There are five drivers in particular, which act as the difference makers. They can be understood as follows -

• Strong Env-Soc-Gov performance drives top-line growth by affecting consumer preferences, enhancing relations with authorities, entering new markets, and expanding into the existing ones.
• It aids in substantial cost reduction by leveraging resource efficiencies to tune down operational costs, thereby improving financial performance.
• By showcasing robust external values, organizations successfully obtain increased government support, reduced interference, and eased regulatory pressure. 
• A sense of higher purpose uplifts employee spirits and curbs employee attrition. Strong Env-Soc-Gov propositions help organizations attract cream talent and showcase enhanced productivity metrics.
• A robust Env-Soc-Gov policy results in optimal investment decisions and capital allocation, adhering to sustainability trends.

Balancing the tradeoff between shareholders’ wants and stakeholders’ interests requires businesses to take a long-term view. Forging deep connections with various stakeholders contributes to value creation by building sustainability in the business model.

On the other hand, playing the short-term game by letting go of stakeholder motives for financial gains erodes value in the simplest of terms. Being proactive on the Environmental-Social-Governmental front can be a source of heavy competitive advantage.

Investing and ESG Funds

Sustainable Investing has been a buzzing term lately, and every investor is looking to hop onto the trend of building a sustainable portfolio. The measures provide further clarity on the sustainable investing concept.

Investing in such socio-economic policies lays down non-financial factors that investors use to measure the sustainability of an investment decision. In addition, it considers various environmental, social, and governance factors to analyze a proposal further.

Investors broadly consider the following E, S, and G criteria when making investments:

Often heard across discussions, socially responsible investing, impact investing, or ethical investing are terms that overlap with Env-Soc-Gov investing.

To summarize, socially responsible investing means building a sustainable portfolio, whereas E, S, and G are grading measures on which the investments are evaluated.

ESG Investing Importance

Currently, consumers have shifted to making more sustainable and ethical choices. As a result, they prefer products, services, and brands that emphasize reducing waste, recycling materials and undertaking greener initiatives.

Customers’ personal preferences tend to affect investment decisions, as an outcome of which investors now want to provide capital to companies committed to such causes. 

A company with a well-rounded Environmental-Social-Governmental score is more likely to raise funds from primary investors, secondary investors, and the public.

The emergence of Env-Soc-Gov funds has been gaining momentum in the last five years, with impact investing and socially responsible spending taking the driver’s seat in financial decision-making. Unlike traditional funds, Env-Soc-Gov funds focus on the following:

• Monitoring performance to assess the sustainability of a business.
• Evaluating market stability vis-a-vis the financial stability of the company.
• Investing in Env-Soc-Gov-compliant ventures and industries, focusing on a certain cause. 

As of 2020 beginning, U.S. assets under management using Environmental-Social-Governmental strategies grew to $17.1 trillion, a 42% increase from the $12 trillion value at the beginning of 2018.

What is ESG Reporting?

Besides being ethical, environment-friendly, and socially responsible, companies want to shine through the public lens. Reporting performance across Env-Soc-Gov metrics is the pathway to this.

This reporting includes disclosures about an organization’s environmental initiatives, social policies, and governance data. The primary motive is to highlight

• the company’s performance on Env-Soc-Gov activities,
• improve transparency, and
• motivate other ventures to be responsible.

The Reports highlight efforts undertaken by the company under each pillar in detail. They usually adopt an effort outcome approach by putting forth the impact of such activities on the environment and society. It is an essential strategic tool for highlighting the company’s ideology.

As a result, Environmental-Social-Governmental reports effectively demonstrate goal achievement and progress.

This proves the genuineness of a company’s efforts on this front. It also instills a public belief that the Env-Soc-Gov measures announced are not mere announcements or empty promises.

Env-Soc-Gov reports provide a concise summary of the quantitative and qualitative aspects of Env-Soc-Gov efforts taken by an organization, aiding investors in screening potential investments, aligning values and beliefs, and avoiding non-sustainable investments.

ESG Reporting Frameworks

Env-Soc-Gov reporting has taken precedence in a significant chunk of G7 Summit meetings. But unfortunately, a universal standard of reporting on this matter does not yet exist.

However, regional reporting frameworks, voluntary standards, and legislative provisions have been framed to facilitate Env-Soc-Gov reporting across geographies. Organizations have also been seen to include Env-Soc-Gov reports in their annual business reports.

The European Union (EU) is said to have one of the most complex sets of Env-Soc-Gov regulations. However, the EU's Green Deal is their promise to fight climate change and environmental degradation by leaving no person or place behind.

Some notable frameworks are :

• The EU Taxonomy
• The Sustainable Finance Disclosure Regulation
• New Corporate Sustainability Reporting Directive (CSRD) 
• Global Reporting Initiative (GRI) 
• The Sustainability Accounting Standards Board (SASB)
• The Task Force on Climate-related Financial Disclosures (TCFD) 

With more than 80% of the top 100 companies reporting on sustainability facets, the relevant question is, when will we get a standardized framework for ESG reporting?

ESG Score

Like credit scores or bond ratings, third-party agencies score companies based on their Env-Soc-Gov efforts across a curated set of criteria, known as the Env-Soc-Gov score. The score is based on a blend of Env-Soc-Gov metrics.

It displays the organization’s capability to satisfy its commitments, performance, and exposure to environmental, social, and governance factors.

At present, multiple agencies are assigning Env-Soc-Gov scores. The most popular ones are -

• Bloomberg ESG Data Services 
• RepRisk 
• Sustainalytics ESG Risk Ratings
• Dow Jones Sustainability Index Family

Usually found on a 100-point scale, Env-Sov-Gov scoring methods vary from firm to firm based on the mix of metrics and weighting schemes. Common factors include

• annual reports,
• resource utilization records,
• compensation schemes,
• employee and financial management,
• board structure, etc.

The higher the score, the better the company is known to fulfill Env-Soc-Gov criteria. Criteria selected are customized according to the company being scored. Usually, it is a balanced mix of the factors stated above. 

Alternative sustainable strategies

Although the most popular, Env-Soc-Gov is not the sole approach to framing a sustainable and value-aligned portfolio. Here are some other strategies to attain this goal.

1. Impact Investing

This approach aims to solve impactful global problems through highly focused investments. More focused on the intent of investment than the returns, impact investing can be across sectors such as green energy, poverty, health care gaps, housing fairness, and affordability.

Impact investors usually invest in early-stage ventures in developing or underdeveloped regions, resulting in lower return rates. Due to this aspect, investors typically take impact investing with a sincere motive of revamping social equity.

2. Conscious Capitalism

Conscious capitalism, an emerging concept, lays down a belief that the founders, owners, and C-suites need to act with utmost faith and high ethical standards while operating for profits.

Conscious capitalism is navigated by four fundamental principles being:

1. Higher purpose
2. Stakeholder orientation
3. Conscious Culture
4. Conscious Leadership 

Conscious capitalism principles are usually imbibed in the company’s leadership style, resulting in a high Env-Soc-Gov score, thus naturally shifting investors to conscious ventures.

3. Socially Responsible Investing  

This strategy aids investors in balancing investment choices with their value chains. In addition, it promotes investment in companies that match your social beliefs and environmental values.

Socially responsible investing focuses on whether the investment aligns with investors’ values. In contrast, Env-Soc-Gov is more holistic as it also considers the impact of a company’s practices, policies, and measures on long-term profitability while upholding investors' core values.

Researched and authored by Krupa Jatania | Linkedin

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Carbon Credits
• Climate Finance
• Green Bond
• Greenwashing
• Sustainable Development Goals SDG