Environmental, Social, and Governance (ESG), Explained

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.

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; compliance with regulations.

•   Social factors may include: Fair labor policies; support for worker safety and diversity; community relationships; customer satisfaction.

•   Governance factors may include: Composition of executive and board leadership; ethics and transparency in management and accounting; fraud prevention, and more.

Lack of ESG Standards

While there is 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 insure 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.

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, however, 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 non-binding (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, including:

Global Reporting Initiative (GRI)

Established in 1999, 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 their voluntary methodology. Some 78% of the world’s biggest companies have adopted the GRI reporting standards, making it the most widely adopted framework.

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 pre-existing 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 non-profit that helps not only companies, but state and local governments to evaluate and disclose key environmental impacts such as carbon and greenhouse gas emissions, water quality protection, and deforestation on a voluntary basis. According to CDP, over 23,000 companies around the world rely on the CDP disclosure framework.

United Nations Global Compact

Though non-binding, 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 more; 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 include 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 they are addressing potential ESG risks.

Environmental	Social	Governance
•   Environmental impacts such as pollution, waste, greenhouse gas emissions, and water use •   Internal environmental policies and goals •   Adherence to regulations and certifications •   Potential exposure to risks and measures taken for risk prevention and management	•   Treatment of workers and employees •   Factory conditions •   Labor standards •   Diversity •   Community engagement •   Customer satisfaction •   Volunteer initiatives	•   Internal auditing and reporting •   Decision-making structures •   Shareholder rights •   Makeup of board •   Leadership performance •   Ethics and transparency •   Bribery and corruption •   Lobbying •   Executive compensation

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 non-renewable 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.

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, support for the community and other stakeholders.

Investors can look at the types of factories and suppliers a company works with, labor standard 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 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 includes 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 lack of consumer data protection, poor capital allocation, 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 is 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 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.

•   Also, if a company takes action to better manage its waste, energy, or water use, these efforts 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. With this increased awareness, there is a commensurate interest in the value of investing in more responsible companies and sustainable business practices.

Investors have learned that using ESG criteria to evaluate companies can help with identifying potential risks and opportunities as well. Financial criteria are not the only thing one should take into consideration when selecting companies to invest in.

These days, a company’s long-term performance also depends on the organization’s ability to address environmental, social, and governance risk factors proactively.

What Investors Should Know About ESG

If an investor is looking into ESG-related funds or ETFs, they should investigate the specific criteria that particular asset takes into account to see if it fits with their own personal impact goals.

When doing their own research, investors should 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, some are concerned about environmental, social, and governance risk factors that can impact performance.

Although there is a push to create clearcut 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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