ESG: Environmental, Social, and Governance Criteria

The idea behind ESG:

ESG – Environmental, social, and governance criteria are considered standards for a company’s operations. Socially aware investors use those operations to analyze potential investments. The criteria consider how a company performs as a host of nature. Social standards always measure how it manages relationships with suppliers, employees, clients, and the communities where it operates. Governance operates with executive pay, a company’s leadership, audits, shareholder rights, and internal controls.

In recent years, particularly younger investors showed an interest in putting their finance where their values are. Mutual fund companies and Brokerages started to offer ETFs and different financial products according to ESG criteria. Robo-advisors such as Wealthfront and Betterment also used those techniques to appeal to these investors. According to the recent report from SIF Foundation, investors decided to keep around $11.8 trillion in assets based on ESG criteria, which seems to increase from $8.3 trillion two years ago.

How does ESG Work?

Investors look at a wide range of behaviors to assess a firm based on environmental, social, and governance (ESG) criteria.

Environmental criteria might also include a company’s waste, energy use, pollution, treatment of animals, and natural resource conservation. These criteria might also evaluate any environmental risks any company might face.

For example, there are some questions whether these issues are related to its ownership of polluted land, its control of hazardous waste and toxic emissions, or its agreement with government environmental regulations?

Social criteria view the company’s business relationships.

Does it work with suppliers that operate the same values as it claims?

Does the firm donate some percentage of its earnings to the local community or support employees volunteering there?

Do the working conditions show high regard for the company’s employees’ safety and health?

Does the company take other stakeholders’ interests into account?

Concerning governance, investors might want to know that a company uses transparent and accurate accounting systems and allow stockholders to vote on important issues.

They might also want to ensure that companies avoid conflicts of interest among their board members, don’t use political contributions to get highly favorable treatment, and don’t engage in illegal practices.

It seems impossible for any company to pass every test in each category, so investors have to decide what seems more meaningful and do the research.

On a rational level, investment companies following ESG criteria also have to set priorities. For instance, with $2.9 billion under management, Boston-based Trillium Asset Management uses ESG factors to help distinguish companies positioned for long-term performance. Analysts determine and identify issues facing different industries. Trillium’s ESG criteria involve avoiding associations with known appearance to coal mining and a specific percentage of nuclear power or weapons revenues.

Pros and Cons of Environmental, Social, and Governance Criteria

Recently, responsible investments started to demand a tradeoff on the investor’s part because they limited the eligibility of companies for investment. They also determined the investor’s potential profit.

More recently, some investors genuinely believe that ESG criteria hold a practical purpose in any ethical concerns. By obeying ESG criteria, they might avoid companies whose practices indicate a risk factor evidenced by BP’s oil spill and Volkswagen’s emissions scandal, which affected their stock prices and resulted in losses of billions of dollars. After business practices based on ESG get more traction, investment companies are frequently tracking their performance. Financial service companies published annual reports extensively reviewing their ESG approaches and results.

Is Socially Responsible Investing a Responsible Strategy to Follow?

Critics of the trend in socially responsible investing say that it decreases profitable investments. Besides, it makes the financial markets and businesses operate less efficiently. One of ESG investing’s sharpest critics was Milton Friedman, following the neoclassical economic theory. Friedman debated that stock evaluation should focus on the company’s financial value and profits.

However, several supporters involved in more socially conscious investing are raising strong arguments promoting ESG investing. They consider it the right thing to do and an approach to investing that could provide investors with the best possible ROI over the long term: risk-adjusted return on investment. A co-founder of the company, SustainAbility, John Elkington, provides ESG consulting services to firms. He is considered a strong defender of non-financial considerations, such as social and environmental factors, in assessing stock value.

The advocates of ESG investing undergone a setback a year ago when the U.S. Department of Labor published a new ruling of retirement plans for only implement investment strategies based only on investment performance. Because of the new ruling, retirement plans managers might seem reluctant to consider ESG-focused firms or investment funds.

ESG Criteria

Each element of ESG investing: social, environmental, and corporate governance comprises several criteria that socially responsible investors or companies might consider.

While many ESG criteria are somewhat subjective, like evaluations of inclusion or diversity, moves occur on several fronts created to provide more reliable ratings of a company’s performance according to ESG policies and actions. In the previous years, a company’s standing in ESG often depended more on the quality of the firm’s public relations department instead of substantive practices. Companies like AccountAbility mainly choose to offer companies ESG consulting services to implement broad ESG-friendly policies and procedures.

ESG – Environmental

Environmental criteria cover a firm’s waste management program, its use of renewable energy sources, handling potential problems or water pollution from its operations. Also, there are other issues such as deforestation and its actions throughout climate change issues.

Other possible environmental issues include whether a company follows biodiversity practices on its land.

 

ESG – Social

Social criteria include a wide range of potential issues. There are many different social aspects of ESG, but essentially about social relationships. According to many socially responsible investors, one of the main relationships for a company is its relationship with its employees.

ESG – Governance

In ESG, Governance is basically about how top floor executive offices manage a company. How well they perform in executive management.

Accounting and Financial transparency with complete and honest financial reports are considered critical elements of standard corporate governance.