An office building is implementing a custom, clean-stream recycling program. Your company may place a high priority on diversity, equity, and inclusion when it comes to promoting employees within the company. Another enterprise may consistently donate to a particular political party and have its own lobbyists at all levels of government to secure its own interests. All of these things and more factor into what is known as an ESG rating.
ESG stands for Environmental, Social, and Governance rating and it is a series of factors showing “socially responsible investors” in nearly all aspects of a company. With a major push now to fight climate change and implement socially responsible behaviors, it is becoming an increasingly popular way to invest.
We’re diving into what it is, how it’s calculated, and why it’s becoming such a major player in the financial world.
What is ESG?
Boiled down, it is a series of factors outside of the financial realm that measure the “ethical impact and sustainability of investment in a company” and how that company is managing risks specific to that industry. For example, if you’re looking to invest in a company that aligns with your own values in terms of sustainability, diversity, and/or ethics, you can evaluate those and other criteria before deciding where to place your money. Traditionally, things such as a company’s climate impact, inclusionary hiring guidelines, and the diversity of board members are not included in a financial analysis. It’s believed the impacts of the COVID-19 pandemic accelerated the interest in ESG as many industries were pressured from all different directions.
It is important to note, however, that just because a company has a high ESG rating does not necessarily mean that it is in fact working toward building a more sustainable world or fighting for social justice. For some rating agencies, it simply means the opposite: that the impacts of climate change or social unrest on a company won’t mess with its bottom line.
Let’s break down each of the three main categories that make up ESG, highlighting a few of the aspects that make up each one.
This category is fairly straightforward. It involves how a business impacts the environment.
• What is its carbon footprint?
• Does it use toxic chemicals in manufacturing?
• Is it working to reduce greenhouse gas emissions?
• Where does it source its energy from, fossil fuels or green energy?
• How does it deal with waste management?
Other aspects include whether or not a company uses fair trade practices in sourcing materials or employs energy-efficient equipment.
The social category involves considering how a business values its people and relationships.
• Does the company use child labor overseas to source or manufacture products?
• Are employees paid a fair wage?
• Is there a high turnover rate?
• Does it offer a retirement plan and does the company contribute to it?
• Are there other perks employees are offered, such as gym memberships or on-site child care?
• Is there a strong policy regarding diversity, equity, and inclusionary hiring practices?
• Does the company support LGBTQ+ equality?
• Does the company get involved in social issues beyond its own interests that a majority of people feel contribute to the greater good?
This category takes a hard look at the leadership of a company. It delves into executive pay, political donations, and the diversity of board members.
• How is the company managed and do leaders pay attention to the wants and needs of employees, customers, and shareholders?
• Are audits and financial transparency a part of the company?
• Have there been any bribery or corruption accusations or investigations?
• Does the company give back to the communities where it has an office or a presence?
How a score is calculated
Despite not having a clear, widely agreed-upon rating system, major ESG research companies include Bloomberg, S&P Dow Jones Indices, JUST Capital, and MSCI. Scores generally follow a 100-point scale and the higher the score, the better a company is performing. Ratings vary among firms as they use different metrics and calculations. Things taken into consideration are annual reports, media coverage, and exposure to a wide variety of risks.
There are some hefty criticisms when it comes to ESG. Some rating agencies will boost a company for implementing an employee survey despite it making no effort to limit greenhouse gas emissions, for example. The data behind the ratings can easily be confusing. Some agencies evaluate a business from a list of 700 different aspects and the calculations are complex. There is no uniform standard across the financial world. There is little consistency between firms and industries. As a result, companies may face unintended consequences for not considering any and all ESG elements.
Several groups are now working to create a more unified system that can be adopted across the board. The Securities and Exchange Commission (SEC) and the European Commission are expected to start offering guidance on which activities corporations can undertake to affect their scores.
ESG is becoming a big deal when it comes to investing
If ESG ratings can be so inconsistent, why is it becoming so widely used? According to CGLytics, about a quarter of all professionally managed funds across the globe involve ESG investing. At the beginning of 2020, one report found that $17.1 trillion of U.S. assets were managed under ESG strategies, a 42% increase from 2018.
A major part of this is Millenials are becoming increasingly involved in the financial industry. As a generation, they’re more interested in supporting companies that align with at least some aspect of their own value system. Many investors feel a high ESG rating can predict a healthy long-term performance for a company. It’s believed that adhering to the criteria results in a well-run business which in turn performs well on the stock market.
Studies have shown that ESG funds performed at least the same or better than traditional funds. A 2019 analysis from Morgan Stanely found ESG funds showed a lower risk when compared to traditional ones, meaning there’s less of a potential to lose value. Morningstar looked at 26 index funds that adhered to ESG criteria and found that 24 of them outperformed traditional ones in the first quarter of 2020. JUST Capital’s U.S. Large Cap Diversified Index, which tracks large public companies with high ESG scores, outperformed similar funds for three years in a row. According to Reuters, $649 billion was invested in ESG funds across the globe through the end of Nov. 2021, a new record.
Furthermore, there is a growing understanding that what is good for the planet is good for business. Companies are taking notice of their future, from shoring up supply chains that can fall prey to the effects of climate change to installing energy-efficient office lighting. Business and financial service company Moody’s found more than 5,000 publicly-traded companies and approximately 2 million underlying support facilities face “substantial exposure to physical climate risks.” With the potential for catastrophic impacts on their interests, it makes sense that a corporation would want to protect its profitability.
The impact of ESG on the global economy is exploding, and it’s only expected to continue rising. With countries adopting stricter standards to mitigate climate change and social justice issues continuing to emerge, ESG has gone from a marginal way to look at a company to nearly mainstream. It’s not out of the realm of possibility that a company’s ESG report is analyzed right alongside its traditional financial audits in the not-too-distant future. A willingness to pursue sustainability goals can end up creating jobs and boosting business for companies that get serious.