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ESG

ESG (Environmental, Social, Governance) refers to the criteria that investors use to assess risks and opportunities relating to a company’s environmental impact, social responsibility, and corporate governance.

ESG refers to criteria that investors are increasingly using to assess the performance, risks, and opportunities for a company or potential investment. ESG is inherently subjective, as the issue areas that fall under the environmental, social, and governance categories often vary based on the strategy of the investor and the company’s industry.

WHY ESG?

Some investors are simply looking to align investments with values.

 

Most investors believe environmental, social, and governance practices impact financial performance. Investors are seeking data that illustrates a complete picture of an asset's risks and opportunities. 

 

Other investors believe that companies that are leaders on issues such as clean energy or workforce diversity, for example, will deliver superior financial returns.

Todd Cort

Lecturer at the Yale School of Management

Faculty Director at the Yale Center for Business and Environment

Faculty Director at the Yale Initiative on Sustainable Finance

Faculty Director, Yale SOM Executive MBA Sustainability Track

ENVIRONMENTAL

 

What impact does a company have on the planet and what risks does the business pose with regards to climate change or depletion of ecosystems?

 

The investor may use environmental criteria to divest from entire industries – such as fossil fuel industries – or to avoid companies with negative environmental impacts, such as high greenhouse gas emissions, toxic pollution, or destruction of biodiversity.

SOCIAL

How does a company manage relationships with its employees, suppliers, customers, and the communities in which it operates?

Investment strategies may seek greater racial and gender diversity within a company and its leadership, safe and healthy working conditions for employees, relationships with suppliers that share its values, and charitable giving programs.

GOVERNANCE

Does a company’s leadership ethically manage the business in a way that promotes accountability, legality, and transparency?

Investors who are concerned with governance may evaluate companies based on qualifications of executives and managers, corporate policies, employee compensation structures, transparent accounting methods, auditing processes, and ethics and fraud protections.

Interest in ESG is growing and evolving

 

No longer confined to a small niche of socially responsible investors that arose in the 1960s, the desire for metrics that gauge ESG performance has expanded into the mainstream. Socially-responsible investors of the past focused primarily on negative screening, or excluding unfavorable industries from their investments – such as alcohol, tobacco, or gun manufacturing – or companies with bad track records on issues such as pollution control or respect for labor rights. Today’s sustainability-minded investors are more diverse in their interests and areas of focus.

The move of ESG investors into the mainstream is evident in a series of recent events:

2014

The Global Sustainable Investment Alliance (GSIA) reported that $6.57 trillion of U.S. assets under management are invested in sustainable, responsible, or impact investment strategies.  This represented a 76% increase since 2012.

2016

The United National Principles for Responsible Investment (UNPRI) reported over 1700 signatories, including almost 1200 investment managers and asset owners representing over $59 trillion in assets under management. This number was $4 trillion in 2006. 

2020

The number of UNPRI signatories increased by 78% from 2016, representing $103.4 trillion assets under management. 

2021

The Securities and Exchange Commission announced the creation of a Climate and ESG Task Force, directing more of the federal government's attention to ESG-related issues

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Source: unpri.org

This is an encouraging trend, but a lot of challenges still exist that make ESG data difficult to use effectively. For example:

1. Much of the existing data focuses on risks rather than the promise of sustainability-enabled growth or productivity. This provides little foundation for identifying the companies whose sustainability strategies offer the promise of delivering marketplace upside.

2. Timeliness remains a fundamental challenge. Some of the published metrics reflect information from many years earlier.  Infrequent reporting can make ESG scores useless or even misleading.

3. Studies have indicated that ESG data suffers from inconsistencies, lack of standardization, and mixed levels of transparency.  A 2012 Rate the Raters survey found only 40% of investors are “very” or “extremely” satisfied with ESG ratings. Investors’ dissatisfaction stems in large part from poor data quality and opaque methodologies that are a major impediment to ESG confidence.

Professor Todd Cort discusses current challenges with ESG reporting 

Towards better data

The most likely path towards better ESG data is through standardization.  However, it may be impossible, and even counter-productive, to force homogeneity across investors.

 

Instead, one strategy would be to implement standard processes for determining, collecting, and validating data, as opposed to standards that dictate which data to collect.  Trust in ESG data would be most easily established if ESG metrics and methodologies were determined by a governmental body and incorporated into formal reporting structures, such as the SEC's 10-K requirements. 

An ESG data standard might be structured into 3 “tiers”:

 

1. A core set of ESG metrics and reporting methodologies for all companies

2. Additional standards for industry-specific disclosure obligations 

3. A platform for company-determined additional information

Data could verified through:

 

1. Government standards and review

 

2. 3rd party auditing by the established reporting platforms such as GRI (Global Reporting Initiative) or CDP

 

3. Data vendors such as MSCI, Sustainalytics, Thomson Reuters, IHS Markit, ISS-Oekom, or Bloomberg

Here are some examples of ESG in action today:

Barclays's 2020 ESG Report 

 BNP Paribas integrates ESG into its sustainability strategy

JP Morgan's approach to ESG investment options

Additional Resources

A Way Forward 

World Economic Forum "Measuring Stakeholder Capitalism" Report

World Business Council for Sustainable Development ESG Disclosure Handbook

The Reporting Exchange, a platform collating  information on ESG reporting requirements and resources

Footnotes

1. Amel-Zadeh, A. & G. Serafeim. 2017. Why and How Investors Use ESG Information: Evidence from a Global Survey.