What is ESG (Environmental, Social, and Governance)?
ESG is the acronym for Environmental, Social, and (Corporate) Governance, the three broad categories or areas of interest for “socially responsible investors.” They are investors who consider it essential to incorporate their values and concerns (such as environmental concerns) into their selection of investments instead of simply considering the potential profitability and/or risk presented by an investment opportunity.
Within each ESG category are various specific related concerns discussed below that may or may not be pertinent in a given situation, depending on the particular investment being examined. For example, under the “Environmental” category are concerns such as pollution or waste material that a company produces and factors related to climate change.
Socially responsible, or ESG, investing may also be referred to as sustainable, impact, and mission-related. ESG investors tend to be more activist investors, participating in shareholder meetings and actively working to influence company policies and practices.
ESG Investing is Growing
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 their values.
By 2018, a socially responsible investing strategy selected approximately $12 trillion worth of investment assets. As millennials begin to comprise a larger segment of the total pool of investors, you can expect ESG investing in expanding right along with them.
The financial services industries 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, many companies proudly include them in their reported statements or a separately issued document. Increasingly, many regulators agree that some form of standardised ESG disclosures will be required of publicly-traded companies on most major global stock exchanges.
Is Socially Responsible Investing a Responsible Investment Strategy to Follow?
Critics of the trend toward socially responsible investing charge that it detracts from profitable investments and makes both businesses and the financial markets operate less efficiently. One of ESG investing’s harshest critics was the late Milton Friedman, the leading light of neoclassical economic theory. Friedman argued that evaluating a stock should focus on the company’s financial value and bottom-line profits, period and that socially responsible corporate expenditures are nearly always “non-essential expenses” that erode corporate and shareholder profits.
However, supporters of more socially conscious investing are mounting vigorous arguments supporting ESG investing as both “the right thing to do” and as an approach to investing that is most likely, over the long term, to provide investors with the best possible risk-adjusted return on investment (ROI). John Elkington is a co-founder of SustainAbility, which includes ESG consulting services to companies. He is a strong proponent of including non-financial considerations, such as environmental and social factors, in assessing stock value.
The advocates of ESG investing suffered a setback in 2020 when the U.S. Department of Labor issued a new ruling requiring fiduciaries of retirement plans to only implement investment strategies based solely on bottom-line investment performance (i.e., not based on ESG concerns) – in short, echoing the attitude of Friedman. Because of the new ruling, the managers of retirement plans may be reluctant to consider ESG-focused companies or investment funds.
Each of the three elements of ESG investing – environmental, social, and corporate governance – comprises several 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 somewhat 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 comprehensive ESG-friendly policies and practices.
ESG – Environmental
Environmental criteria include a company’s use of renewable energy sources, its waste management program, how it handles potential air or water pollution problems 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 it follows biodiversity practices on land it owns or controls.
ESG – Social
Social criteria cover a vast range of potential issues. There are many different social aspects of ESG, but they are essentially about social relationships. From the point of view of many socially responsible investors, one of the key relationships for a company 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 centre.
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 an adverse 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?
ESG – Governance
In the context of ESG, governance 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 complete and honest financial reporting are vital 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 favour multi-million-dollar bonuses for executives. At the same time, the company imposes a salary freeze effective for all other employees. Is extra compensation for executives appropriately tied to increasing the business’s long-term value, viability, and profitability?
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 are 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.
In addition, executive bonuses depend on more than just revenue or income – factors such as employee, shareholder, and customer satisfaction are also part of the calculation.