No matter where you sit in a business, you’ll likely have heard of environmental, social, and governance (ESG). Your peers in finance, legal/compliance, and risk will have heard of it a lot. And we’ll all be hearing a lot more about it in the coming years. But ESG can mean a lot of different things, depending on who is saying it and the context in which they’re saying it, which leads to confusion.
What Is ESG?
Essentially, ESG denotes the qualitative and quantitative data that either:
- describes a business’s environmental status, societal characteristics, and corporate governance (thus ‘E’ for environment, ‘S’ for social and ‘G’ for governance) or …
- … reflects a business’s or sector’s or investment’s exposure to, and management of, environmental-, social-, or governance-related risks.
The Significance For Businesses
Interest in ESG started with arguments such as those of Harvard economist Michael Porter that businesses (and capitalism as a whole) benefit from thinking about value generation beyond the purely economic — that is, businesses should focus their value generation on all of their stakeholders (including communities, employees, and customers), not just shareholders or owners.
This broader interpretation of value would provide for longer-term competitiveness, profit, and business health, because it both drives down risk and makes the most of scarce resources. In fact, it was the investment community that coined the term, as they sought to widen their analysis to nonfinancial factors
This broader understanding of value generation has worked its way into the echelons of corporate management; even the cradle of Milton “profit is everything” Friedman, the University of Chicago Booth School of Business, teaches ESG.
ESG performance, the managerial decisions that drive it, and the data points that reflect it have become a form of proxy measurement on the quality of a business’s management, right alongside its financial data. Naturally, they have then become a matter of board attention, leaders’ attention, and operational discussions, with supporting functions, processes, and technologies across a company.
ESG now features much more prominently in just about every company’s key strategic discussions, especially at its highest levels. As the battle over Exxon last year and McDonald’s right now show, these decisions determine the futures of companies. And Elon Musk’s recent ESG post on Twitter, meant to disparage the term, reveals its importance even in companies that resist its influence.
Expect ESG to become more important, driven especially by climate change and scrutiny of capitalism’s social impact but also by companies’ efforts to seek competitive advantage and differentiation and investors’ desire to incorporate nonfinancial analysis for better returns.
ESG investing, despite the criticisms, is becoming increasingly popular and is most likely to be an investing approach used by millennials. Morgan Stanley Bank (NYSE: MS) recently conducted a survey that found that nearly 90% of millennial investors were interested in pursuing investments that more closely reflect the values they hold.
By 2018, approximately $12 trillion worth of investment assets were selected using a socially responsible investing strategy. As millennials begin to comprise a larger segment of the total pool of investors, you can expect ESG investing to expand right along with them.
The financial services industry’s responded to the growing demand for ESG investments by making moves such as offering ESG-focused exchange-traded funds (ETFs). Both of the two largest ETF providers – BlackRock and Vanguard – offer clients a choice of ESG-focused funds. BlackRock added six new ESG funds in 2020, and its equity investment team now includes a Head of Sustainable Investing. Brokerage firms now customarily offer stock analysis employing ESG investment strategies, and robo-advisors such as Wealthfront can be set to seek out socially responsible investments.
Although ESG metrics are not currently a required part of financial reports for publicly traded companies, a growing number of companies are proudly including them in their reported statements or a separately issued document. Increasingly there is consensus among many regulators that some form of standardized ESG disclosures will be required of publicly-traded companies on most major global stock exchanges.
Each of the three elements of ESG investing – environmental, social, and corporate governance – comprises a number of criteria that may be considered, either by socially responsible investors or by companies aiming to adopt a more ESG-friendly operational stance.
While many ESG criteria are rather subjective (such as evaluations of “diversity” or “inclusion”), moves are occurring on several fronts that are designed to provide more objective, credible ratings of a company’s performance in terms of ESG policies and actions.
In the past, a company’s standing in terms of ESG has often depended less on substantive practices and more on how good the company’s public relations department is. Businesses such as AccountAbility offer ESG consulting services for companies that want to implement broad ESG-friendly policies and practices.
Environmental criteria include a company’s use of renewable energy sources, its waste management program, how it handles potential problems of air or water pollution arising from its operations, deforestation issues (if applicable), and its attitude and actions around climate change issues.
Other possible environmental issues include raw material sourcing (e.g., does the company use fair trade suppliers and organic ingredients?) and whether a company follows biodiversity practices on land it owns or controls.
Social criteria cover a vast range of potential issues. There are many separate social aspects of ESG, but all of them are essentially about social relationships. One of the key relationships for a company, from the point of view of many socially responsible investors, is its relationship with its employees. Following is a brief rundown of just some of the issues that may be considered when examining how a company handles its social relationships:
- Is employee pay fair, or perhaps even generous, compared to comparable jobs or similar positions throughout the industry? What type of retirement plans are employees offered? Does the company contribute to the employee retirement plans?
- In addition to basic wages or salary, what benefits or perks are employees provided with? With ESG-concerned investors, it can make a big difference in the evaluation of your company if, for example, you do things such as providing a free, very lavish buffet lunch for all employees every Friday – or provide other types of benefits that aren’t common at all workplaces, such as an on-site fitness center.
- Workplace policies regarding diversity, inclusion, and prevention of sexual harassment are also frequently considered.
- Employee training and education programs; for example, does your company provide financial support for continuing or higher education and/or flexible working hours for employees pursuing further education; what opportunities exist for employees to be trained in new job skills at the company that will qualify them for higher-paying positions?
- What level of employee engagement with management is there? How much input do employees have in determining operational procedures within their respective departments?
- The level of employee turnover
- What’s the company’s mission statement? Is it socially relevant and beneficial to society?
- How well are customer relationships managed? Does the company engage with customers on social media? How responsive and efficient is the customer service department? Does the company have a negative history of consumer protection issues, such as product recalls?
- Does the company take a public or political stance on human rights issues? Does it donate money to charitable causes?
Governance, in the context of ESG, is essentially about how a company is managed by those in the top floor executive offices. How well do executive management and the board of directors attend to the interests of the company’s various stakeholders – employees, suppliers, shareholders, and customers? Does the company give back to the community where it is located?
Financial and accounting transparency and full and honest financial reporting are often considered key elements of good corporate governance. Also important are board members acting in a genuine fiduciary relationship with stockholders and being careful to avoid conflicts of interest with that duty. Are the board members and company executives a diverse and inclusive group?
The issue of executive compensation is a primary focus of many ESG investors, who, for example, don’t tend to favor multi-million-dollar bonuses for executives while the company imposes a salary freeze in effect for all other employees. Is extra compensation for executives appropriately tied to increasing the long-term value, viability, and profitability of the business?
An example of how responsible corporate governance is put into practice can be seen in the policies of the company, Intuit (NASDAQ: INTU). One of the company’s corporate policies that is aimed at helping to ensure that company executives take on a strong vested interest in the company’s ongoing success, rather than just in earning some quarterly bonus, is a rule that requires the top-level chief executive officer to maintain stock ownership equivalent in value to ten times their annual salary.
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