With climate and social change concerns heating up, stakeholders expect more accountability from corporations and institutions. So you hear this acronym more often. ESG stands for Environmental, Social, and Governance.
You can view each element as a pillar containing five relevant issues.
The Environmental pillar contains these issues:
- Climate Change
- Resource Depletion
The Social pillar addresses:
- Human Rights
- Modern Slavery
- Child Labor
- Working Conditions
- Employee Relations
The Governance pillar focuses on these issues:
- Bribery and Corruption
- Executive Pay
- Board Diversity and Structure
- Political Lobbying and Donations
- Tax Strategy
The term originated in 2005, with the UN’s Who Cares Who Wins conference. Decades earlier, social and environmental issues like apartheid and the massive 1989 Exxon Valdez oil spill created waves of activism and policy changes.
As ad-hoc responses grew, people looked for more comprehensive policies for positive environmental and social outcomes. As a result, movements around Responsible Investing and Corporate Social Responsibility took shape. In 2006, The UN Principles of Responsible Investing emphasized the use of the ESG model.
An Emerging Standard
Ultimately, ESG became the standard framework for organizations and individuals interested in sustainability.
ESG-related assets under management increased from $22.8 trillion in 2016 to $30.6 trillion in 2018. Bloomberg forecasts these investments to reach $53 trillion in 2025, representing one out of every three of all investments.
Yeah, But Does It Work?
McKinsey lists five links between an organization’s ESG strategy and value creation:
- Top-line growth
- Cost reductions
- Regulatory and legal interventions
- Productivity uplift
- Investment and asset optimization
So, for example, a B2C company with a sound environmental strategy could:
- Attract new customers who share environmental concerns
- Reduce energy costs
- Have fewer regulatory or legal actions over issues like pollution
- Increase productivity as employees feel more engaged
- Improve ROI through energy efficiency and environmental stewardship
McKinsey found that companies that take serious sustainability actions outperform those that don’t. They created a metric of energy, water, and waste use compared to revenue. The top sustainability performers across several industries had the best financial results.
Dick’s Sportings Goods’ decision to stop selling guns may be an example of a successful sustainability policy. While the move cost millions in sales, the company’s stock price has improved.
Looking forward, IKEA’s shift from recyclable to modular products may create a strategic advantage.
Many firms rank companies and funds in terms of ESG. But ratings aren’t just about policies and practices. They are also driven by whether concerns are financially material within industries and by levels of risk exposure.
Want to check up on a particular company? You can look up ESG Ratings from investment research firm MCSI here:
Where ESG Ratings Fall Short
While the focus on sustainable policies is welcome, there are a few problems with reporting and ratings.
There is no standard ESG reporting system. Instead, GRI (Global Reporting Initiative) and SASB (Sustainability Accounting Standards Board) have produced their own sustainability standards used by many companies.
Of course, companies self-report, which goes into the ESG ratings created by financial companies and analysts.
- Companies provide ESG data to multiple rating organizations
- The companies use different reporting systems
- The ratings people ask for ESG information in different ways
- Then each ratings group creates its ESG scores for companies and industries
Does all this activity produce an accurate picture? Then SEC Chairman Jay Clayton complained in 2020 that combining E, S, and G data into a single score may create “over-inclusive and imprecise” analysis.
Another reason for imprecision is that some sustainability concepts are hard to quantify. For instance, how can you score ethical behavior?
Perhaps more unified standards will emerge. For example, GRI and SASB have recently collaborated, showing how companies can use hybrid approaches. They are also working together with the EU on a potentially unifying system for European Union members.
The Longer View
Financial analysts have been keenly aware of the growing importance of ESG policy.
But the election of two environmental advocates to the Exxon board in 2021 is a breakthrough moment, with extensive media coverage building ESG awareness.
Large and influential public employee retirement systems support the move to ESG. For example, CalPERS (California Public Employees’ Retirement System) backed the Exxon changes. In 2022, 6.3 million federal workers will be able to choose an ESG investment option in their Thrift Savings Plan retirement accounts.
Next Time: Making a Better Target
While the ESG framework has become a standard, it lacks specificity. As a result, some companies are turning to a related set of goals to show how their policies create impact. Next time: What is SDG?
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