There are over half a dozen institutions and nonprofits involved in establishing metrics, providing disclosure guidelines, and constructing surveys in the name of establishing ESG metrics. ESG refers to companies that try to meet higher environmental, social, and governance standards, as well as securities based on those organizations.
Given the growing interest in sustainable investing, and new research that suggests these strategies can be as profitable as conventional investing, investors will benefit from the ability to measure and compare outcomes.
That said, the SEC only recently took steps to propose ESG-disclosure requirements for investment advisors and fund managers, and these have yet to be implemented. As such, there’s currently wide variance in disclosure practices as the industry continues to consolidate.
Those interested in learning more about ESG investing and the standards currently in use, should be ready for a throng of different metrics that can vary widely across industries. We cover nine of the most common below.
What Are ESG Metrics?
While ESG investing actually began in the 1960’s, the investment philosophy didn’t really catch on in the mainstream until the past couple of decades, with the increase in popularity of socially responsible investing (SRI). Socially responsible investing is a broader term in the industry, and can be used interchangeably with ESG, although the two are different.
As noted above, ESG stands for environmental, social, and governance factors, each of which represents a set of standards that can be used to measure the risks and sustainability of a business. Each factor features its own set of qualitative and quantitative metrics on how firms perform in terms of environmental responsibility, social wellness, and corporate governance.
As it stands, two of the most prominent organizations that set disclosure standards for ESG metrics include the Global Reporting Initiative (GRI) and the Value Reporting Initiative (VRI), which is a merger of the Sustainability Accounting Standards Board (SASB) and the International Integrated Reporting Council (IIRC).
While there is much overlap amongst the existing standards for ESG, at their core, each organization seeks to establish a framework that 1) allows firms to accurately represent their ESG metrics, and 2) allows those metrics to be comparable across firms.
The Importance of ESG Metrics
ESG metrics are important because they allow investors to fairly gauge a firm’s impact on environmental issues, societal issues, and issues of corporate responsibility against a set of comparable peers. Since many investors who are interested in ESG strategies are also committed to making an impact with their money, being able to measure outcomes is important.
In theory, companies that perform well in ESG categories have lower costs of capital, are more innovative, and may help to support positive environmental, social, and corporate governance outcomes. However, it can be difficult to properly measure ESG policies across companies, as no official regulations for standardized ESG reporting currently exist.
Still, two recent studies suggest that socially responsible funds tend to outperform conventional mutual funds. The Morningstar “Sustainable Funds U.S. Landscape Report” from February 2022 found that “two-thirds of sustainable offerings in the large-blend category topped the U.S. market index last year compared with 54% of all funds in the category.”
Also, a Morningstar analysis of European-based funds found that the majority of ESG funds outperformed non-ESG strategies over one-, five-, and 10-year periods.
Investors also face difficulty when comparing ESG metrics across different industries. For example, it’s difficult to compare energy companies and financial institutions on emissions-related issues, as the two represent entirely different industries. This can easily lead to apples-to-oranges comparisons, if not monitored closely.
Finally, some of these standards are qualitative and may be prone to subjectivity, which can make the ESG evaluation process difficult to quantify. These can all present challenges if you’re trying to apply ESG principles to your investing strategy. It’s therefore important to identify an appropriate widely accepted set of ESG metrics to ensure that investors evaluate investments using the right framework.
9 Common ESG Metrics Businesses Track
Commonly employed ESG metrics are varied and consist of both qualitative and quantitative metrics across all three sub-categories of environmental, social, and governance.
We break down some of the most commonly tracked ESG factors in the industry, organized by category.
3 Common Environmental Metrics
Environmental metrics measure the long-term ecological sustainability of a firm’s actions. These can be related to emissions, finite natural resources, and the environment, among other things.
Many of these metrics can be tracked on an aggregate basis or relative to another operating metrics (per capita, per unit produced, etc).
• Emissions: Quantifies how much a firm emits in greenhouse gases, or is working to reduce carbon emissions, through its operations.
• Waste: Measures how much waste a company generates or recycles in their operations. Can also deal with a company’s impact on its surrounding ecology.
• Resource Usage: Tracks the efficiency and intensity of a firm’s operations when it comes to using energy, water, or other key resources.
3 Common Social Metrics
Social metrics evaluate how a firm’s policies impact its human capital and society at large. Attempts to quantify these metrics have largely been implemented on a per-occurrence basis or as a rate over time.
• Human resources: Evaluates how a company treats its workforce, frequency/magnitude of any workplace litigation, and employee turnover.
• Labor safety: Tracks a firm’s commitment to safe labor practices via metrics like frequency of workplace accidents and lost productivity.
• Products: Examines a firm’s product quality and sustainability through metrics like number of recalls, complaints, or even frequency of litigation. Can also be linked to environmental when it comes to how product inputs are sourced.
3 Common Governance Metrics
Governance metrics pertain to issues relating to business ethics, mitigation of agency risks, and reporting transparency. These can be measured in terms of how executives are compensated, board policies, and accounting choices, among others.
• Ownership Structure: Reviews how faithful a firm is to its shareholders when it comes to metrics like the number of independent directors on the board, or how voting rights are distributed between management and shareholders.
• Executive Compensation: Measures executive compensation relative to industry standards or company profitability. Can also be tied to social when measuring how compensation structures vary for different genders/minorities.
• Financial Reporting: Tracks a firm’s accounting policies and how comprehensive and accurate they are. Could involve reviewing a firm’s books for key disclosures or frequency of one-off exceptions.
How Can Investors Use ESG Metrics?
Investors will want to adopt a long-term perspective when it comes to evaluating investments using ESG metrics, as the principles of ESG are built off the basis of long-term secular trends when it comes to technology and social issues. The goal is to invest in companies with positive ESG traits while avoiding or underweighting firms with negative ESG traits.
Investors will want to be discerning when investing in specific firms or funds that advertise an ESG approach. The wide range of ESG frameworks mean that some firms may cherry-pick which ESG metrics they wish to disclose. Investment funds and exchange-traded funds (ETFs) that tout an ESG-based approach may use their own proprietary metrics when deciding how to allocate ESG investments; which may make them difficult to compare.
When using ESG metrics, you’ll want to examine all ESG-related disclosures closely and ensure that there’s consistency in the data being reported. Depending on the metric you’re examining, you may wish to avoid making comparisons across disparate industries and focus on identifying “best-in-class” investments for a single industry.
How do Firms Report ESG Metrics?
How each firm reports its ESG metrics depends on its policies regarding disclosures.
When it comes to policy implementation, firms often set ESG targets to meet or exceed guidelines set by governments, non-profits, or agencies; they may survey their own stakeholders and shareholders to gauge how they view company performance on ESG issues, or hire third parties to survey their customer base on their behalf.
Keep in mind, the adoption of ESG frameworks can vary widely by firm and disclosure of these metrics is still voluntary. Additionally, certain metrics may be difficult to quantify and in some cases, management, stakeholders, or shareholders may disagree on the impact of certain ESG factors.
As a result, professional money managers sometimes may solicit the assistance of third-party ESG consultants to obtain an independent assessment of how a company actually performs on ESG metrics.
When used properly, ESG metrics offer another useful dimension for evaluating investments, as it focuses on a unique set of risk factors for firms that typically isn’t captured by using traditional fundamental metrics.
However, the adoption of a unifying set of standards among firms still remains elusive, and will likely remain so until regulators choose to codify their own ESG reporting requirements.
As with any investment strategy, investors will want to manage their expectations appropriately and employ ESG metrics as part of a larger toolbox for investment analysis.
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