ESG (Environmental, Social and Governance)

The framework for assessing the impact of the sustainability and ethical practices of a company

What is ESG (Environmental, Social, and Governance)?

ESG is the acronym for Environmental, Social, and (Corporate) Governance, the three broad categories, or areas, of interest for what is termed “socially responsible investors.” They are investors who consider it important to incorporate their values and concerns (such as environmental concerns) into their selection of investments instead of simply considering the potential profitability and/or risk presented by an investment opportunity.

 

ESG (Environmental, Social and Governance)

 

Within each ESG category are various specific related concerns, discussed below, that may or may not be pertinent in a given situation, depending on the specific investment being examined. For example, under the “Environmental” category are concerns such as pollution or waste material that a company produces and factors related to climate change.

Socially responsible, or ESG, investing may also be referred to as sustainable investing, impact investing, and mission-related investing. ESG investors tend to be more activist investors, participating at shareholder meetings and actively working to influence company policies and practices.

 

Summary

  • ESG is the acronym for Environmental, Social, and (Corporate) Governance, the three broad categories or areas of interest for what is termed “socially responsible investors.”
  • ESG concerns are growing as more of the millennial generation make up the total pool of investors.
  • The issue of executive compensation is the primary focus of many ESG investors.

 

ESG Investing is Growing

ESG investing, despite the criticisms, is becoming increasingly popular and is most likely to be an investing approach used by millennials. Morgan Stanley Bank (NYSE: MS) recently conducted a survey that found that nearly 90% of millennial investors were interested in pursuing investments that more closely reflect the values they hold.

By 2018, approximately $12 trillion worth of investment assets were selected using a socially responsible investing strategy. As millennials begin to comprise a larger segment of the total pool of investors, you can expect ESG investing to expand right along with them.

The financial services industry’s responded to the growing demand for ESG investments by making moves such as offering ESG-focused exchange-traded funds (ETFs). Both of the two largest ETF providers – BlackRock and Vanguard – offer clients a choice of ESG-focused funds. BlackRock added six new ESG funds in 2020, and its equity investment team now includes a Head of Sustainable Investing. Brokerage firms now customarily offer stock analysis employing ESG investment strategies, and robo-advisors such as Wealthfront can be set to seek out socially responsible investments.

Although ESG metrics are not currently a required part of financial reports for publicly traded companies, a growing number of companies are proudly including them in their reported statements or a separately issued document.

 

To learn more about the ESG framework and its relevance to making financial decisions, check out CFI’s Introduction to ESG course!

 

Is Socially Responsible Investing a Responsible Investment Strategy to Follow?

Critics of the trend toward socially responsible investing charge that it detracts from profitable investments and makes both businesses and the financial markets operate less efficiently. One of ESG investing’s harshest critics was the late Milton Friedman, the leading light of neoclassical economic theory. Friedman argued that evaluating a stock should focus on the company’s financial value and bottom-line profits, period, and that socially responsible corporate expenditures are nearly always “non-essential expenses” that erode corporate and shareholder profits.

However, supporters of more socially conscious investing are mounting vigorous arguments supporting ESG investing as both “the right thing to do” and as an approach to investing that is most likely, over the long term, to provide investors with the best possible risk-adjusted return on investment (ROI). John Elkington is a co-founder of the firm, SustainAbility, which provides ESG consulting services to companies. He is a strong proponent of including non-financial considerations, such as environmental and social factors, in the assessment of stock value.

The advocates of ESG investing suffered a setback in 2020 when the U.S. Department of Labor issued a new ruling requiring fiduciaries of retirement plans to only implement investment strategies based solely on bottom-line investment performance (i.e., not based on ESG concerns) – in short, echoing the attitude of Friedman. Because of the new ruling, the managers of retirement plans may be reluctant to consider ESG-focused companies or investment funds.

 

ESG Criteria

Each of the three elements of ESG investing – environmental, social, and corporate governance – comprises a number of criteria that may be considered, either by socially responsible investors or by companies aiming to adopt a more ESG-friendly operational stance.

While many ESG criteria are rather subjective (such as evaluations of “diversity” or “inclusion”), moves are occurring on several fronts that are designed to provide more objective, credible ratings of a company’s performance in terms of ESG policies and actions.

In the past, a company’s standing in terms of ESG has often depended less on substantive practices and more on how good the company’s public relations department is. Businesses such as AccountAbility offer ESG consulting services for companies that want to implement broad ESG-friendly policies and practices.

 

ESG – Environmental

Environmental criteria include a company’s use of renewable energy sources, its waste management program, how it handles potential problems of air or water pollution arising from its operations, deforestation issues (if applicable), and its attitude and actions climate change issues.

Other possible environmental issues include raw material sourcing (e.g., does the company use fair trade suppliers and organic ingredients?) and whether a company follows biodiversity practices on land it owns or controls.

 

ESG – Social

Social criteria cover a vast range of potential issues. There are many separate social aspects of ESG, but all of them are essentially about social relationships. One of the key relationships for a company, from the point of view of many socially responsible investors, is its relationship with its employees. Following is a brief rundown of just some of the issues that may be considered when examining how a company handles its social relationships:

  • Is employee pay fair, or perhaps even generous, compared to comparable jobs or similar positions throughout the industry? What type of retirement plans are employees offered? Does the company contribute to the employee retirement plans?
  • In addition to basic wages or salary, what benefits or perks are employees provided with? With ESG-concerned investors, it can make a big difference in the evaluation of your company if, for example, you do things such as providing a free, very lavish buffet lunch for all employees every Friday – or provide other types of benefits that aren’t exactly commonly found at all workplaces, such as an on-site fitness center.
  • Workplace policies regarding diversity, inclusion, and prevention of sexual harassment are also frequently considered.
  • Employee training and education programs; for example, does your company provide financial support for continuing or higher education and/or flexible working hours for employees pursuing further education; what opportunities exist for employees to be trained in new job skills at the company that will qualify them for higher-paying positions?
  • What level of employee engagement with management is there? How much input do employees have in determining operational procedures within their respective departments?
  • The level of employee turnover
  • What’s the company’s mission statement? Is it socially relevant and beneficial to society?
  • How well are customer relationships managed? Does the company engage with customers on social media? How responsive and efficient is the customer service department? Does the company have a negative history of consumer protection issues, such as product recalls?
  • Does the company take a public or political stance on human rights issues? Does it donate money to charitable causes?

 

ESG – Governance

Governance, in the context of ESG, is essentially about how a company is managed by those in the top floor executive offices. How well do executive management and the board of directors attend to the interests of the company’s various stakeholders – employees, shareholders, and customers? Does the company give back to the community where it is located?

Financial and accounting transparency and full and honest financial reporting are often considered key elements of good corporate governance. Also important are board members acting in a genuine fiduciary relationship with stockholders and being careful to avoid conflicts of interest with that duty. Are the board members and company executives a diverse and inclusive group?

The issue of executive compensation is a primary focus of many ESG investors, who, for example, don’t tend to favor multi-million-dollar bonuses for executives while the company imposes a salary freeze in effect for all other employees. Is extra compensation for executives appropriately tied to increasing the long-term value, viability, and profitability of the business?

An example of how responsible corporate governance is put into practice can be seen in the policies of the company, Intuit (NASDAQ: INTU). One of the company’s corporate policies that is aimed at helping to ensure that company executives take on a strong vested interest in the company’s ongoing success, rather than just in earning some quarterly bonus, is a rule that requires the top-level chief executive officer to maintain stock ownership equivalent in value to ten times their annual salary.

In addition, executive bonuses depend on more than just revenue or income – factors such as employee, shareholder, and customer satisfaction are also part of the calculation.

 

For more information about the ESG framework, check out CFI’s Introduction to ESG course!

 

More Resources

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