ESG: environmental, social and governance investing explained
ESG investing has gained popularity in recent years as institutional investors and individuals realize the significance of considering more than just financial returns.
According to a 2022 PwC report, ESG-focused institutional investment is expected to increase 84% to $33.9 trillion by 2026.
So, what is ESG? ESG stands for “environmental, social, and governance,” and is a framework that considers non-financial factors impacting a company’s long-term success. ESG criteria include environmental sustainability, social impact, and the quality of a company’s governance practices.
In this article, we’ll explore each component of ESG and discuss why they matter in the world of sustainable investing. Throughout our discussion, we’ll highlight how ESG factors can impact a company’s financial performance and society’s overall well-being.
What is ESG investing?
ESG investing refers to the practice of incorporating Environmental, Social, and Governance factors into the investment decision-making process. This approach goes beyond traditional financial analysis by evaluating how a company’s operations impact the environment, how it manages relationships with employees, suppliers, customers, and communities, and the quality of its leadership, audits, internal controls, and shareholder rights.
Environmental criteria consider how a company performs as a steward of the natural environment, focusing on its energy use, waste, pollution, natural resource conservation, and treatment of animals. The criteria can also help investors evaluate any company’s environmental risks and how those risks are managed. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. This includes labor practices, product safety, data protection, and privacy. Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights.
Investors who apply ESG criteria believe that these factors can provide critical insights into a company’s long-term prospects, making companies with strong ESG practices more resilient and potentially more profitable investments. ESG investing has gained momentum as more investors seek not only financial returns but also to contribute to positive societal outcomes. This trend reflects a growing belief that sustainable, responsible business practices are linked to a company’s overall performance and risk profile.
Why is ESG investing important?
ESG investing is important because it aligns investment strategies with broader social, environmental, and ethical considerations, addressing the growing recognition that these factors can significantly impact a company’s risk and return profiles.
By incorporating ESG criteria, investors can identify companies that are better positioned to navigate the challenges of climate change, social unrest, and governance scandals, which can adversely affect profitability and sustainability. This approach promotes corporate practices that are environmentally sustainable, socially responsible, and well-governed, contributing to the long-term health of financial markets and leading to more stable and inclusive economic growth.
ESG investing also empowers investors to contribute to positive social and environmental outcomes, supporting the transition to a more sustainable and equitable global economy. As public awareness and regulatory scrutiny around these issues increase, ESG investing becomes crucial for identifying future-proof investments and driving meaningful change through the capital markets.
What are some ESG considerations in investing?
Investors and asset managers use ESG considerations to determine whether companies are making an effort when it comes to sustainability and environmental responsibility. It helps them make smarter choices that match their own values and support companies that care about the environment and social and ethical responsibility.
When it comes to the environment, ESG investors look at how a company’s actions impact our planet. They pay attention to how much carbon dioxide a company releases into the atmosphere, how efficiently it manages waste, and how it uses energy and water.
Investors who care about the environment want to support companies committed to reducing their impact on the planet and promoting sustainability.
Some key areas within environmental considerations include:
- Climate change and carbon emissions. ESG investors are interested in companies that are actively working toward combating climate change and embracing a more environmentally friendly way of doing business. They pay close attention to how a company is dealing with climate change and reducing its carbon footprint. They also look at whether the company is using renewable energy sources, implementing energy-saving measures, setting targets to reach net-zero emissions, and participating in programs that offset carbon emissions.
- Resource depletion and pollution. ESG investors want to find companies that are smart about managing resources, follow circular economy principles, and make an effort to minimize their footprint on the environment. They look at how well companies care for natural resources and prevent pollution. They also check out how the company uses resources, manages waste, and controls pollution.
- Biodiversity and conservation. ESG investors like companies that take their role as environmental stewards seriously, get involved in conservation projects, and do their best to minimize harm to delicate ecosystems. They pay attention to how companies take care of wildlife and protect nature. They also look at whether a company is preserving habitats, conserving biodiversity, and responsibly managing land and water.
Now, let’s talk about the social side of ESG investing. Investors consider how the company respects human rights, treats workers, promotes diversity and inclusion in the workplace, ensures product safety, keeps customers happy, and gets involved in the community.
Investors who care about the social aspect want to support companies that do the right thing, value their employees, and positively impact society as a whole.
Some key aspects of social considerations are:
- Human rights and labor practices. ESG investors want to know how companies handle social issues within their operations and throughout their supply chains. They look at how a company treats its employees and respects their rights. This means checking whether they pay fair wages, provide safe working conditions, have policies against discrimination, and take steps to prevent forced or child labor.
- Employee welfare and diversity. ESG investors want to see whether companies create a supportive and inclusive workplace, provide good benefits and opportunities for growth, and help employees maintain a healthy work-life balance. They also pay attention to a company’s commitment to diversity, equity, and inclusion (DEI) within its workforce, including having a good mix of genders and races represented at all levels of the organization.
- Community relations and stakeholder engagement. ESG investors appreciate companies that actively engage with stakeholders, respond to community needs, and aim to create value that goes beyond just making money. They closely examine how a company interacts with the people and communities it impacts. They also want to know whether the company listens to their concerns, gets involved in the community, and does things that benefit society.
Corporate governance is all about how a company is managed and controlled. ESG investors want to support companies that value accountability, transparency, and making decisions that create long-term shareholder value.
They look at the company’s governance practices and leadership structure, whether the board of directors is independent, how transparent they are with financial reporting, how they compensate their executives, and whether they follow ethical standards.
Some key aspects of governance considerations include:
- Board structure and independence. ESG investors value companies with a well-structured, diverse, and independent board because they can better represent the interests of shareholders and provide good strategic guidance. They also look for companies with strong leadership at the top and the right structures and processes to guide the company and ensure everything runs smoothly.
- Executive compensation and accountability. ESG investors want to know whether executive pay is fair, transparent, and tied to the company’s long-term success. They look at whether executive incentives encourage sustainable performance and responsible behavior. They also check to see whether executives are accountable for their actions and ensure proper checks and balances in the company’s governance structure.
- Shareholder rights and transparency. ESG investors appreciate companies that prioritize open communication, provide clear and timely information, and create an environment that encourages shareholders to participate and voice their opinions. They believe companies with strong shareholder rights and transparent practices foster trust and accountability, leading to better long-term performance and alignment with investor interests.
How do investors assess ESG impact?
When it comes to assessing a company’s ESG impact, there isn’t a universal approach that fits all investors. Instead, investors have the flexibility to use a combination of different methods and tools to evaluate ESG factors.
They may rely on existing frameworks and industry standards as a starting point but often customize their criteria based on their specific investment goals and values.
ESG investors use several approaches to assess a company’s environmental practices and identify investments that align with their environmental goals.
- Screening and exclusion criteria. ESG investors may set specific criteria to exclude companies engaged in environmentally harmful activities like deforestation or fossil fuel extraction. This helps investors align their portfolios with their environmental values.
- Emissions and carbon footprint analysis. ESG investors may assess a company’s greenhouse gas emissions and its efforts to measure, report, and manage them. They consider data on emissions, reduction targets, and initiatives aimed at transitioning to low-carbon operations.
- Renewable energy and clean technology investments. ESG investors may seek companies involved in renewable energy generation, energy storage, energy efficiency technologies, and other clean technologies. By supporting these companies, investors contribute to the development of sustainable energy solutions and the reduction of reliance on fossil fuels.
ESG investors may consider additional environmental factors like waste management, water usage, and biodiversity conservation in their valuation.
ESG investors use various approaches to assess a company’s social impact, gain insights into its corporate social responsibility practices, and make investment decisions that align with societal goals and values.
- Supply chain analysis. ESG investors examine the labor practices, human rights records, and ethical standards within a company’s supply chain. This helps ensure the company maintains fair labor practices, safe working conditions, and human rights throughout its operations.
- Employee satisfaction and diversity metrics. ESG investors consider factors like employee turnover rates, employee satisfaction surveys, and diversity statistics to gauge how well a company supports its workforce. Companies that prioritize employee well-being, promote diversity, and provide equal opportunities are seen as having a positive societal impact.
- Philanthropic initiatives and community investments. ESG investors also assess a company’s charitable giving, community development projects, and social impact programs to understand its efforts to contribute positively to society. They value companies that actively engage in philanthropy and make meaningful contributions to address social issues and improve local communities.
ESG investors may also consider product safety, customer privacy, and responsible marketing practices when assessing a company’s societal impact.
ESG investors use various approaches to gain insights into company management, operations transparency, and shareholder rights protection.
- Board composition analysis. ESG investors consider factors like the presence of independent board directors who are not affiliated with the company, their expertise and qualifications, and the existence of relevant board committees. A diverse and independent board can provide effective oversight and ensure decisions are made in shareholders’ best interests.
- Executive pay ratio and alignment. ESG investors analyze the ratio between executive pay and the average employee pay to gauge fairness. They also assess the transparency and accountability of executive compensation structures, ensuring they incentivize long-term value creation and responsible behavior.
- Proxy voting and engagement with management. ESG investors use proxy voting to vote on important matters, such as director elections, executive compensation plans, and shareholder resolutions. Engaging in direct dialogue with company management allows investors to express their concerns, advocate for improved governance practices, and promote shareholder rights.
ESG investors may also consider risk management, audit practices, political contributions, and disclosure transparency, as well as governance frameworks, codes, and regulatory factors specific to the region or industry where a company operates.
What is the role of ESG ratings in investment decisions?
ESG ratings serve as a benchmark for investors in the decision-making process. Rating agencies like MSCI ESG Research and Morningstar evaluate companies based on their ESG reporting. The agencies then assign ESG scores that indicate a company’s relative performance within its industry.
Investors use these ratings to compare companies and identify those with strong ESG practices that align with their sustainability objectives. ESG ratings inform investment decisions, portfolio construction, and company engagement.
However, it’s important to recognize that ESG ratings have limitations, relying on sustainability reporting that may vary in quality and consistency. So, investors should consider ESG ratings as one tool among many and conduct additional due diligence to better understand a company’s ESG practices.
ESG investing Frequently Asked Questions
Here are some additional frequently asked questions related to ESG investing.
1 . How is ESG investing different from socially responsible investing?
ESG investing looks at how well a company performs in areas like the environment, social issues, and governance issues. This helps investors identify opportunities and risks.
On the other hand, socially responsible investing (SRI) focuses on investing in companies that match specific social or ethical values. For example, SRI investors might avoid companies involved in things like tobacco, weapons, or fossil fuels.
Both approaches aim to support companies with a positive impact on society.
2. How is ESG investing different from impact investing?
ESG investing focuses on improving financial performance and promoting sustainable practices. It considers environmental, social, and governance factors when making investment decisions. The goal is to integrate these considerations into the investment process.
Impact investing goes beyond financial returns. It aims to make a measurable social and environmental impact while generating financial profits. Impact investors intentionally invest in projects, sectors, or organizations that directly address social and environmental issues.
While both approaches incorporate nonfinancial factors, impact investing places a stronger emphasis on creating positive and measurable outcomes for society and the environment.
3. Is ESG investing profitable?
ESG investing is all about creating long-term value and promoting corporate sustainability. It goes beyond just financial returns and considers factors that contribute to society’s well-being.
The profitability of ESG investing depends on various factors, such as how well ESG analysis is conducted, the specific strategies used, the goals of the investor, and short- and long-term market conditions. Considering ESG issues can contribute to financial success by managing risks and creating long-term value.
Investors should do their homework and gather reliable ESG data from providers when incorporating ESG factors into their investment decisions.
How can you embrace ESG investing?
As an organization or business professional, embracing the potential of ESG investing is a step towards not just a future-proof strategy, but also towards creating meaningful impact.
When properly integrated, ESG investing spurs organizations to proactively address environmental, social, and governance issues, fostering a robust sustainability narrative. Moreover, it opens doors to the detection of new business opportunities, risk mitigation, and an enhanced operational efficiency.
The commitment to ESG performance also brings the distinct advantage of attracting capital from investors with a sustainability focus, thereby bolstering access to funding pools, including ESG-specific ones. This commitment simultaneously enhances a company’s reputation, building trust, drawing in new customers, and setting your organization apart in an increasingly competitive landscape.
In essence, ESG investing is more than a buzzword; it’s a roadmap to aligning businesses with societal expectations, ensuring enduring success in a progressively sustainable global business arena.
Embarking on an ESG journey can be complex. It requires a thorough understanding, strategic integration, and skillful execution.
At IMD, we offer a wide range of programs designed to equip professionals with the knowledge, skills, and tools to embrace ESG and leverage it for both business and societal advantage. Our offerings help business leaders decipher ESG complexities, guiding them to construct and implement an effective ESG strategy, navigate related challenges, and create long-term sustainable value for all stakeholders.