ESG

ESG is the acronym for Environmental, Social, and (Corporate) Governance, which are the three broad categories that define socially responsible investing. These investors consider it essential to incorporate their values and concerns (such as environmental impact) into their investment selection, rather than focusing solely on potential profitability or risk.

Within each ESG category are specific concerns. For example, the Environmental category includes factors like pollution, waste production, and issues related to climate change.

ESG investing is also referred to as sustainable, impact, or mission-related investing. These investors tend to be more activist investors, participating in shareholder meetings and actively working to influence company policies and practices toward responsible goals.

ESG Investing is Growing

ESG investing is rapidly gaining popularity and influence, driven primarily by younger demographics. The trend reflects a fundamental shift in how investors view financial markets, moving beyond simple profitability to incorporate personal values.

Values-Driven Investing: The trend is fueled by Millennial investors who are highly motivated to align their investments with their values. Surveys, like those conducted by Morgan Stanley, found that nearly 90% of Millennial investors are interested in pursuing investments that reflect their values.
Asset Growth: By 2018, socially responsible investing strategies had already been applied to approximately $12 trillion worth of investment assets. As Millennials continue to grow and comprise a larger segment of the total investor pool, ESG investing is expected to expand right along with their increasing financial influence.
New Products: Firms have introduced various ESG-focused products, such as Exchange-Traded Funds (ETFs). Both BlackRock and Vanguard, the two largest ETF providers, offer extensive choices of ESG-focused funds (e.g., BlackRock added six new ESG funds in 2020).
Organizational Focus: Asset managers are embedding sustainability into their core teams (e.g., BlackRock now includes a Head of Sustainable Investing).
Custom Services: Brokerage firms routinely offer stock analysis employing ESG investment strategies, and automated platforms like robo-advisors (such as Wealthfront) can be configured to seek out socially responsible investments.

Although formal ESG metrics are not currently a required part of financial reports for publicly traded companies, many companies proactively include them in their statements or separate documents. Regulators globally are increasingly agreeing that some form of standardized ESG disclosures will soon be mandatory for publicly-traded companies on most major stock exchanges.

Is Socially Responsible Investing a Responsible Investment Strategy to Follow?

The trend toward socially responsible (ESG) investing faces significant criticism, primarily centered on the belief that it compromises profitability and efficiency, contrasting sharply with arguments that highlight its long-term financial and ethical benefits.

Critics, notably the late Milton Friedman (a key figure in neoclassical economic theory), argue that ESG investing detracts from profitable investments and makes both businesses and financial markets operate less efficiently.

Friedman asserted that evaluating a stock should focus solely on the company’s financial value and bottom-line profits.
He viewed socially responsible corporate expenditures as “non-essential expenses” that ultimately erode corporate and shareholder profits.

This critical stance was reinforced in 2020 when the U.S. Department of Labor issued a ruling requiring fiduciaries of retirement plans to implement strategies based solely on bottom-line investment performance effectively discouraging the consideration of ESG factors in these funds. This ruling made managers of retirement plans reluctant to consider ESG-focused investments.

Supporters of socially conscious investing, however, mount vigorous arguments for ESG investing as both “the right thing to do” and an approach most likely to provide investors with the best possible risk-adjusted return on investment (ROI) over the long term.

John Elkington, a co-founder of SustainAbility (which offers ESG consulting), is a strong proponent of including non-financial considerations, such as environmental and social factors, in assessing stock value.
The argument suggests that companies with strong ESG practices are more resilient and better prepared for future regulatory and social challenges, ultimately leading to sustained financial performance.

ESG Criteria

Each of the three elements of ESG investing – Environmental, Social, and (Corporate) Governance comprises various criteria used by socially responsible investors and companies aiming for an ESG-friendly operational stance.

Many ESG criteria are somewhat subjective, focusing on qualitative factors such as a company’s success with “diversity” or “inclusion”. Historically, a company’s standing often depended less on substantive, measurable practices and more on the effectiveness of its public relations.

However, significant moves are underway across several fronts to provide more objective and credible ratings of a company’s performance regarding its ESG policies and actions. This standardization is critical for ensuring that ESG claims are backed by verifiable data. Businesses such as Accountability offer consulting services to help companies implement comprehensive, measurable ESG-friendly policies and practices.

ESG – Environmental

Environmental criteria focus on a company’s impact on and stewardship of the natural world. Investors look at several factors to assess this:

Land Management: Whether the company follows biodiversity practices on land it owns or controls.

Resource Use and Waste: This includes a company’s use of renewable energy sources and the effectiveness of its waste management program.

Pollution Control: How the company handles potential air or water pollution problems arising from its operations, as well as deforestation issues (if applicable).

Climate Change: The company’s attitude and actions around climate change issues (e.g., carbon emissions and climate risk mitigation).

Supply Chain: Consideration of raw material sourcing (e.g., using fair trade suppliers and organic ingredients).

The Social (S) criteria cover a wide range of issues focusing on a company’s relationships with its people (employees) and the communities it affects.

1. Employee Relationships and Welfare

This is a key area for socially responsible investors, covering:

Compensation and Benefits: Assessing if employee pay is fair or generous compared to industry standards. This also includes the types of retirement plans offered, whether the company contributes to them, and any unique benefits or perks provided (e.g., free meals, on-site fitness centers).
Workplace Environment: Examining policies on diversity, inclusion, and the prevention of sexual harassment.
Development and Opportunity: Evaluating employee training and education programs (e.g., financial support for higher education or flexible working hours). This also includes opportunities for employees to be trained in new job skills that lead to higher-paying positions.
Engagement and Input: Measuring the level of employee engagement with management and how much input employees have in determining operational procedures within their departments.

2. External Social Impact

These criteria assess the company’s broader role in society and its interactions with customers:

Mission and Impact: Evaluating the company’s mission statement to see if it is socially relevant and beneficial to society as a whole.
Customer Management: Assessing how well customer relationships are managed, including responsiveness and efficiency of the customer service department. It also looks at customer engagement on social media and whether the company has an adverse history of consumer protection issues (e.g., product recalls).
Public and Political Stance: Considering the company’s public or political stance on human rights issues and whether it donates money to charitable causes.

ESG – Governance

Governance (G) criteria assess how a company is managed by its top executive management and board of directors. It is fundamentally about how well these leaders attend to the interests of the company’s various stakeholders (employees, suppliers, shareholders, and customers) and whether the company is a responsible member of its community.

Key Areas of Focus

Transparency and Fiduciary Duty: Financial and accounting transparency, along with complete and honest financial reporting, are vital elements. Board members must act in a genuine fiduciary relationship with stockholders, carefully avoiding conflicts of interest with that duty.
Board Structure and Diversity: Investors examine the composition of the leadership, looking for a diverse and inclusive group among board members and company executives.
Executive Compensation: This is a primary focus for many ESG investors. They scrutinize whether extra compensation is appropriately tied to increasing the business’s long-term value, viability, and profitability, and generally do not favor multi-million-dollar bonuses when a salary freeze is imposed on other employees.

Example: Responsible Compensation at Intuit

An example of responsible corporate governance can be seen in the policies of Intuit (NASDAQ: INTU):

Required Stock Ownership: The top-level CEO is required to maintain stock ownership equivalent in value to ten times their annual salary. This ensures the executive has a strong vested interest in the company’s ongoing, long-term success, not just short-term gains.
Balanced Bonuses: Executive bonuses depend on more than just revenue or income; factors such as employee, shareholder, and customer satisfaction are also included in the calculation.

Evita Veigas

5 min read