Table of Contents
ESG stands for environmental, social, and governance criteria that investors can use to evaluate whether companies are making positive changes in these areas as well as addressing specific ESG risks that can impact company performance.
Environmental factors refer to the ways a company is protecting the physical environment. Social criteria govern the treatment of workers, communities, customers, suppliers, and vendors. Governance factors track issues of leadership, fraud prevention, transparency, and more.
Key Points
• Environmental, social, and governance factors help investors evaluate a company’s sustainability-related risks and opportunities alongside its financial performance.
• How companies address environmental, social, and governance issues may help mitigate certain ESG-related risk factors.
• There is currently no universally accepted set of standards for measuring an organization’s commitment to ESG goals or targets, and ESG disclosures remain largely voluntary in many jurisdictions.
• There are numerous nonbinding frameworks and voluntary standards that companies may use to establish their own ESG criteria and metrics.
• Investors may invest in ESG-focused exchange-traded funds (ETFs) and mutual funds or in companies that align with their ESG investing goals.
What Is ESG?
Environmental, social, and governance factors generally fall under the umbrella of socially responsible investing (SRI) or impact investing. Investors can use the ESG pillars to assess a company’s performance beyond standard financial metrics:
• Environmental factors may include fossil fuel vs. renewable energy use, air, water, and ground pollution mitigation, carbon management, and regulatory compliance.
• Social factors may include fair labor policies, support for worker safety and diversity, community relationships, and customer satisfaction.
• Governance factors may include executive board composition, ethics and transparency in management and accounting, fraud prevention, and other oversight measures.
Lack of ESG Standards
While there’s general agreement about the importance of sustainability across industries, there still isn’t a universally accepted set of ESG standards used by all companies or the regulatory bodies that oversee them. Rather, many companies rely on a mix of voluntary and/or proprietary standards that different organizations adopt according to their needs.
That said, in recent years, there has been a concerted effort on the part of policymakers and regulatory agencies to establish ESG frameworks and disclosure rules, both to ensure that companies are held accountable for managing certain risk factors and that investors are afforded some reliability in terms of their investment choices.
Currently, though, the lack of consistent, transparent ESG metrics makes it difficult for investors to evaluate companies’ progress toward ESG targets.
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ESG Concerns
As interest in ESG and green investing strategies in general has risen, as reflected by fund inflows, a growing number of investors (and consumers) are concerned about ESG-related risk factors. Increasingly, investors want to know how a given company or organization is materially addressing these factors in order to better assess its long-term prospects.
As recent events have shown, environmental, social, and governance issues present different risk factors to different organizations and can impact performance in the short and long term. While an agricultural business may have issues with chemical groundwater pollution, a financial firm may need to address transparency and ethics, and another may contend with plastic waste.
Despite the inconsistencies in how ESG criteria are applied, industry research suggests that funds that use ESG strategies are competitive with funds that adhere to more conventional strategies.
Recommended: Beginner’s Guide to Sustainable Investing
How Does ESG Work?
There are a few ways investors can use ESG criteria to evaluate potential investments via an online investing platform or other means. As noted, there isn’t a unified ESG playbook with a set of rules that apply across the board, yet many companies strive to incorporate certain standards into their processes and products.
Using ESG Criteria
In the last 25 years or so, many organizations have developed voluntary ESG frameworks that some companies embrace, while others may adhere to their own proprietary standards and metrics. Thus, it remains difficult to measure accurately whether an organization has met specific ESG targets owing to a lack of consistency in standards.
Nonetheless, there are numerous nonbinding (i.e., voluntary) frameworks available that can provide investors with a basic grounding in ESG standards. A few are more prominent than others, owing to their wide adoption.
Global Reporting Initiative (GRI)
Established in 1997, the GRI is an independent organization that helps companies and governments evaluate and disclose their efforts in light of climate change, human rights, and corruption, using its voluntary methodology. The GRI standards are the world’s most widely used sustainability reporting framework. Companies representing about 62% of global market capitalization and 40% of large publicly traded companies use them.
International Financial Reporting Standards (IFRS) Sustainability Disclosure Standards
In response to the number of companies seeking ways to incorporate sustainability into their accounting and reporting practices, the IFRS Foundation set up the International Sustainability Standards Board (ISSB) in 2021. The ISSB subsequently developed its Disclosure Standards, which build on a number of preexisting frameworks.
Sustainability Accounting Standards Board (SASB) Standards
In 2018, SASB Standards were established to support accurate disclosure of sustainability-related information across 77 different industries. These standards were folded into the IFRS Foundation in 2022 and are now maintained by the ISSB for companies that use this method.
CDP
The CDP (formerly the Carbon Disclosure Project) is an international nonprofit that helps not only companies but also state and local governments to evaluate and voluntarily disclose key environmental impacts such as carbon and greenhouse gas emissions, water quality protection, and deforestation. According to the CDP, over 22,100 companies around the world rely on the CDP disclosure framework.
United Nations Global Compact
Though nonbinding, the U.N. Global Compact is one of the world’s most prominent corporate sustainability initiatives. It offers 10 voluntary principles to help organizations adhere to policies that support human rights, fair labor practices, the environment, and anti-corruption measures. In general, the 10 principles align with the 17 U.N. Sustainable Development Goals.
In addition, investors can do their own research by looking at data on a company’s website, shareholder reports, and other industry studies.
Large financial institutions, such as public pension funds, have started incorporating ESG criteria into their investment selections. In addition, there are now ESG-focused ETFs and mutual funds being offered by mutual fund companies, online investing platforms, and brokerage firms.
Recommended: The Growth of Socially Responsible Investing
The Three Pillars of ESG
Each of the three pillars of ESG includes a range of areas that investors can evaluate in two ways: in terms of whether a company is making positive changes in a given area material to its performance and whether it is addressing potential ESG risks.
| Environmental | Social | Governance |
|---|---|---|
|
• Climate change mitigation • Waste and resource management • Pollution prevention • Biodiversity conservation |
• Human rights protections • Fair labor practices and workplace safety • Diversity and inclusion • Data privacy and cybersecurity |
• Anti-corruption and fraud prevention • Transparent executive compensation • Balanced board oversight and decision-making • Ethical business practices and accountability |
Environmental
Environmental criteria for green investments typically set standards for energy use, pollution and waste management, greenhouse gas emissions, water use, chemical use, and other factors that can negatively impact the planet and consume nonrenewable resources.
Companies may set policies and goals, such as reducing or eliminating carbon emissions by a certain date, shifting to renewable energy, and limiting pollutants in the air and water.
Risks a company should disclose include reliance on certain types of energy that could compromise production, oil spills or pollution that may occur, or other potential health and environmental hazards.
There are also existing environmental regulations that companies must adhere to and optional steps they can take, such as product and supply chain certifications. As large public companies work to meet mandatory disclosure requirements, they are pushing ESG data requests down their supply lines.
Social
Social criteria involve the ways a company relates to both internal and external individuals and groups. This includes fair labor practices, safe work environments, diversity and inclusion initiatives, and support for the community and other stakeholders.
Investors can look at the types of factories and suppliers a company works with, labor standards, and the workplace conditions of factory workers and employees. Companies may also have programs in place to give back to local communities or for employees to volunteer in those communities.
Risks include a lack of worker safety, flouting local laws and regulations, and actions that could result in reputational harm.
Governance
The third pillar of ESG is governance. Governance criteria include internal accounting and auditing standards, leadership performance, shareholder rights, fraud prevention, and general issues relating to transparent and ethical decision-making in the organization.
Risks may include a lack of consumer data protection, poor capital allocation, and inefficient management strategies.
Benefits of ESG
ESG strategies may offer investors a few advantages:
• The most obvious benefit of ESG is that investors can put their money toward goals that they value. The more transparent companies are about their actual progress in specific areas and how they measure those outcomes, the more this can be tracked and improved upon.
• While it has been a common assumption that ESG strategies don’t provide competitive returns, there’s a body of research that suggests ESG strategies can be competitive with conventional ones in some cases.
• Although industries such as oil and gas have historically had periods of high returns, they also come with risks such as negative publicity, lawsuits, and environmental hazards. When these types of events occur, stocks can go down. Companies with an ESG focus may face fewer risks that can impact performance.
• If a company takes action to better manage its waste, energy, or water use, these efforts will potentially help save money and thereby increase profits.
Drawbacks of ESG
There are a few downsides to ESG investing.
One is that some companies engage in greenwashing, the act of making themselves and their products appear to have a more positive environmental impact than they really do. Investors can watch out for this by making sure the companies they invest in publish actual data and reports, rather than just putting out vague marketing materials.
The lack of consistent ESG standards unfortunately can contribute to greenwashing, especially because companies are not required to disclose data about their ESG policies, although many disclose some data voluntarily.
Also, certain activities may appear positive but can have negative side effects. For instance, there have been cases of renewable energy installations displacing communities or creating pollution, as well as irresponsible reforestation practices.
Why ESG May Be Growing in Popularity
Investors today are more aware of where products come from, who makes them, and the impact they have on the world. As awareness has grown, so has interest in companies that prioritize responsible and sustainable business practices.
Investors have also learned that using ESG criteria to evaluate companies can help identify potential risks and opportunities. According to recent research from PwC, 75% of investors say that measuring a company’s social and environmental impact helps them better understand its material risks and opportunities. Financial information remains important, but it’s only one part of the investment decision.
A company’s long-term performance may also depend on how effectively it addresses environmental, social, and governance risks and opportunities.
What Investors Should Know About ESG
If an investor is looking into ESG-related funds or ETFs, it’s important to investigate the specific criteria that a particular asset takes into account to see if it fits with their own personal impact goals.
When doing their own research, investors may also want to make sure that company claims are backed up by facts and transparency, wherever possible.
The Takeaway
ESG criteria are becoming a popular way to evaluate companies in addition to traditional financial metrics. Some investors seek to put their money into sustainable businesses, while others are concerned about environmental, social, and governance risk factors that can impact performance.
Although there’s a push to create clear-cut standards for measuring a company’s progress on specific ESG targets, these have yet to be established. Nonetheless, investors continue to find ESG funds of interest.
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FAQ
What does ESG stand for?
ESG stands for environmental, social, and governance. These three areas help investors evaluate how a company manages issues such as its environmental impact, relationships with employees and customers, and corporate leadership.
Why do investors pay attention to ESG?
Some investors use environmental, social, and governance (ESG) information to better understand the risks and opportunities a company may face over the long term. While ESG factors are only one part of the decision-making process, they can provide additional insight beyond traditional financial data.
Does a strong ESG rating guarantee a good investment?
A strong environmental, social, and governance (ESG) rating does not guarantee that a company’s stock will perform well or that it’s the right investment for everyone. It’s important to consider ESG information alongside factors such as financial performance, valuation, and your own investment goals.
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