Dec 8, 2022
ESG 101 - What is it? What is its origin? Pros and cons. How is it being used?
ESG 101- What is ESG?
ESG, short for environmental, social and governance, is a structured approach to understanding the sustainability of a company. Using ESG as a framework, companies measure and report on a set of sustainability metrics across these three dimensions and stakeholders and investors can use this information to better understand a company’s management of sustainability risks and opportunities.
ESG has grown exponentially in significance when it comes to investing over the last several years. Asset owners, e.g retail investors or institutional investors such as pension or investment funds, are increasingly channelling their money towards sustainable and ESG-rated assets, growing at 28% year over year for the past 4 years, reaching a third of total global assets under management. Investors are actively integrating ESG into their investment processes and screening companies based on the latter when making their investment decisions. Investors are now thinking beyond just financial metrics due to the increasing importance and financially material impact of ESG, driven by regulators, society, asset owners and consumer preferences.
ESG is not only used by investors but also by companies themselves. ESG helps make companies more resilient and sustainable by providing focus and direction to their sustainability efforts and if applied right, creates strong, adaptable companies that are environmentally conscious and forward thinking. Strong ESG efforts can lead to positive value through revenue growth, cost reduction, increased employee motivation, productivity and investment optimisation.
Besides increasing regulation within the field, one of the main drivers of ESG adoption has been the ‘E’, the environmental factor as a response to fighting climate change with a particular focus on greenhouse gas emissions. The other areas are gaining attention, especially the social. According to an analysis social-related shareholder proposals increased by 37 percent in 2021 compared to the previous year.
To Summarise, ESG:
What Does ESG Really Mean?
To truly understand ESG, we need to really understand its meaning. ESG refers to Environmental, Social and Governance. Let’s take a closer look at each of these terms and the questions they ask.
Environmental refers to the effect that a company has on the environment. This includes quantitative measures and policies erected by the company relating to issues such as, greenhouse gases, renewable energies, waste creation, natural resource conservation and the treatment of animals. Through this lens, organisations can evaluate environmental risks and their management.
Social has to do with a company’s impact on society. Social looks at the relationship the company has with its stakeholders, such as employees and suppliers. Are the company’s suppliers operating ethically with an environmental focus? Are local communities supported and are volunteer opportunities present? Is the company providing a diverse, inclusive and safe working environment with fair wages? How is the company dealing with data security and handling personal data?
Governance refers to the ways in which a company governs, in terms of accounting methods, leadership and policy transparency. Are the company’s board of directors diverse? What are the codes of conduct at the company? How does a company manage climate risk? Does the company offer equity ownership to its employees?
These are questions that ESG asks of companies in order to gain a more in-depth understanding of how they are operated from those three perspectives. Thanks to ESG, the internal life of a company is better understood, but should not be mixed up with “impact”, a more external method of examining a company.
Pros and Cons of ESG:
Is ESG as accurate at tracking social responsibility as it seems? With all of the different criteria and standards available when it comes to assessing a company’s behaviour, is ESG really the most reliable approach?
With the growing commitment to transition to net-zero becoming more widespread, analysing a company’s behaviour and strategy when it comes to sustainability is crucial. It’s just not possible to plan for business success without considering the longevity of capital, both natural and social in a world of finite resources.
ESG provides a comprehensive scope for determining whether a company is growing and evolving sustainably and ethically. If ESG is applied correctly, ESG can help ensure sustainable growth and lasting positive environmental impact. Not only this, but ESG helps create business value, with ESG investments on track to reach $53 trillion by 2025.
ESG investing reaps profitable results, not unlike passive investing, according to a 2019 report by Morgan Stanley Institute for Sustainable Investing. Their paper argues that there is no financial trade-off in the returns of sustainable funds compared to traditional funds. A total of 11,000 funds was analysed and results showed that sustainable funds proved more stable.
While ESG reporting has become fairly widespread and accepted, a lack of clear ESG standards remains an issue. Although there are internationally used ESG frameworks such as GRI and SASB, there’s no standardisation around reporting formats, guidelines or data, making it challenging to complete truly accurate ESG reports. Standardisation needs to be introduced to limit confusion and help ensure total transparency and visibility on behalf of companies.
Another con is simply the fact that no company can succeed in every facet of ESG. Companies have strong points and weaker points. And how do you even compare companies across industries? One company may have highly diverse leadership while another may have excellent strategies to lower carbon emissions. So how do you accurately quantify ESG success in this case, and how do you even make something as complex as sustainability quantifiable in the first place?
Our view of ESG can be clouded, fragmented and sometimes manipulated. This is where ‘greenwashing’ can have a real effect on a company’s outward ESG performance. For this reason, regulators are playing a vital role in creating standards, such as the European Commission via its sustainable action plan with evolving regulations such as the EU Taxonomy, Sustainable Finance Disclosure Regulation (SFDR) and the Corporate Sustainability Reporting Directive (CSRD).
Where has ESG come from? And how long has ESG been an important part of the journey towards sustainability?
ESG practice traces to the 1960s, as investors began taking ethical considerations. Investors started assessing the social responsibility of companies, especially those involved with tobacco production or the South African apartheid.
Next came the ‘The Triple Bottom Line’ in the 1990s, when People, Planet and Profit garnered attention. This set the foundation for ESG as investors began looking for more than just financial success.
ESG was first formally introduced in the 2006 United Nation’s Principles for Responsible Investment report. ESG was brought into the limelight, requiring companies to incorporate ESG criteria into their evaluations and reports.
Since 2006, ESG standards and reporting have become more of a mainstream company imperative. In 2015, The United Nations introduced The Sustainable Development Goals. These further emphasised the global move towards developing strategies around sustainability and now act as guidelines and inspiration when it comes to improving company ESG ratings.
Where is ESG now?
Since being formally introduced in 2006, ESG factors are playing an increasingly important role in investment decisions. ESG adoption is rapidly accelerating, largely fuelled by regulation. ESG rated assets under management (AuM) have grown 28% YOY for the past 4 years, reaching 33% of all AuM. Today, ethical and sustainable efforts are unlikely to go unnoticed by investors and ESG factors are being taken into consideration alongside traditional financial factors. While ESG should not be confused for a tool that automatically perfects an organisation’s sustainability reputation, it is an excellent foundation from which to start, providing transparency and valuable guidance.
Financial accounting has been shaped over centuries leading to international standards such as the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). Non-financial accounting, such as sustainability data reporting, is fairly new in comparison. Challenges such as creating standards, improving and automating data collection and assuring data still need to be overcome.
Important drivers are asset owners, who want to invest their money towards sustainable and resilient companies, and regulators, such as the European Commission and US SEC which are shaping the boundaries for reporting sustainability data. Society and consumers are also becoming more aware of company’s sustainability ethos and employees are increasingly favouring working for sustainable and impactful organisations.
How is ESG used today?
It’s hard to argue against the fact that ESG is becoming a real asset to organisations. Especially since the COVID pandemic, ESG has increasingly proven to be a sign of resilience for organisations and key stakeholders are taking notice. With the sudden rise of unforeseen risk, in terms of the pandemic and the recent energy crisis, investors and stakeholders have started to prioritise well-functioning businesses with a sound sense of social responsibility.
Following the criticism of tech companies such as Tesla, ESG helps shed light on issues such as unsafe working environments. For the reason of risk mitigation as well as regulatory pressure, investors are increasingly relying on ESG data to guide their investment decisions.