A Crash Course in ESG

1 minutes reading time
Published 18 Sep 2023
Author: Emil Persson
Reviewed by: Peter Westberg
Updated 4 Jun 2024

Environmental, Social, and Governance (ESG) and what it entails is something that wasn't quantifiable, and much less discussed at the turn of the millennium. Now, more than 15 years since the term was first mentioned, it is something that all those who invest need to be familiar with. Regardless of whether you have a basic understanding of what ESG is and what it entails in the world of investing, or if this is the first time you've heard of it, this article is the perfect place to start.

Key Insights

  • Recognizing ESG risks: Being aware and pro-active about ESG risks is.

  • Funds and ESG: Large investment funds all have to take ESG into account - some more than others.

  • Investing with the criteria in mind: While all investors have their own view of ESG, completely disregarding it can open investors to a host of various risks.

The Definition of ESG

ESG (Environmental, Social, and Governance) criteria are a set of standards for a company's operations that investors can use to screen potential investments. These criteria help to evaluate how a company performs in relation to the climate, how it manages relationships with employees, suppliers, customers, and the communities where it operates, and how it governs itself. Companies can, and do, also use this framework in their day-to-day operations.

Environmental Considerations

Environmental in the context of ESG refers to the criteria companies use to measure their impact on the planet and the environment, with the most critical areas being climate change and carbon emissions. This involves assessing a company's contribution to climate change through its greenhouse gas emissions, including measuring its carbon footprint, setting targets to reduce emissions, and implementing strategies to achieve these targets.

It also includes evaluating how companies are preparing for the effects of climate change and whether they have strategies to mitigate potential associated risks. This also covers measures taken to prevent pollution and the technologies employed to reduce harmful discharges. Sustainable practices like water conservation, responsible sourcing of raw materials, efforts to preserve biodiversity and pollution control are also taken into account.

Energy usage is another component, focusing on the sources of energy a company uses, such as renewable versus non-renewable energy, and whether or not actions are being taken to lessen energy consumption. Tying into this is the impact of a company's products through its entire lifecycle, from production to disposal. This includes considerations such as product design, packaging, and end-of-life handling.

Evaluating environmental criteria helps companies identify and mitigate environmental risks that could potentially lead to financial losses or reputational damage. Adhering to strict environmental regulations not only avoids legal penalties but can also enhance a company's reputation, and many use this in advertising or other promotional material.

Being seen as environmentally friendly is generally a net positive for a public company, as it paints them in a favorable light to both investors and consumers.

Social Responsibility

Social criteria encompass various aspects related to how a company interacts with its employees, customers, suppliers, and the communities in which it operates. One significant area is labor practices, which include fair wages, good working conditions, employee safety, and adherence to labor rights.

Companies are evaluated on their commitment to providing a safe and equitable workplace, supporting worker rights, and ensuring non-discriminatory practices. Human rights are, naturally, of extra importance, especially for companies operating in regions with weak labor laws or human rights protections.

This includes ensuring that their operations and supply chains do not contribute to human rights abuses, such as forced or child labor. Companies are expected to conduct due diligence and take corrective actions to uphold human rights standards, which includes making sure that products they themselves use are ethically sourced. Social criteria also encompass supply chain management, focusing on ethical sourcing and the treatment of suppliers.

Customer relations and product responsibility are also significant. Companies must ensure that their products and services are safe, of high quality, and ethically produced. This includes responsible marketing practices, data protection, and customer privacy. Evaluating social criteria helps companies identify and address social risks that could lead to operational disruptions, legal issues, or reputational damage.

Companies that excel in social criteria are often seen as more sustainable and resilient, attracting investors and customers alike.

Governance Criteria

Governance criteria encompass various aspects related to how a company is managed and controlled. This includes the structure and composition of the board of directors, which should reflect a balance of skills, diversity, independence, and expertise in order to generate a high ESG score. Executive compensation is a factor that is analyzed, focusing on how executive pay aligns with company performance and long-term shareholder value.

Companies are evaluated on their practices related to shareholder voting, communication, and participation in decision-making processes, as effective governance requires mechanisms that allow shareholders to influence important decisions and ensure their voices are heard. Ethical business practices and corporate transparency are fundamental to good governance.

Transparency in financial reporting, operations, risk management, and business practices helps build trust with investors, employees, customers, and other stakeholders. Strong governance practices enhance a company’s credibility, reduce the risk of scandals, and improve long-term performance, making the company more attractive to investors who value ethical and transparent business practices.

Large Funds and ESG

In recent years, there has been a marked increase in the number of investment funds incorporating ESG principles into their strategies. This shift is driven by a growing recognition of the risks, but also the opportunities associated with ESG factors. Funds adhering to these principles range from those adopting broad, flexible guidelines to those enforcing stringent criteria.

At the more lenient end of the spectrum, some funds use ESG criteria as one of many considerations in their investment processes. These funds may integrate ESG factors into their risk assessment and decision-making frameworks but do not exclude companies solely based on these criteria.

Conversely, there are funds with strict ESG mandates that only invest in companies meeting high standards of environmental sustainability, social responsibility, and robust governance. These funds often exclude entire sectors such as fossil fuels, weapons, tobacco, and similar things. A clear example of this is Norway's Sovereign Wealth Fund, which adheres to very strict ESG policies. Some privately run funds also invest after very strict ESG criteria, using this to attract investors who are keen to invest in line with their personal beliefs.

The rigor of ESG adherence varies significantly among funds, influenced by factors such as investor demand, regulatory requirements, and the fund's own mission and values. European funds, for instance, tend to exhibit higher ESG integration levels, partly due to stringent regulations like the EU’s Sustainable Finance Disclosure Regulation (SFDR), which mandates transparency in sustainability-related disclosures.

In the United States, while regulatory frameworks are less prescriptive, investor pressure and market trends have prompted many funds to improve their ESG commitments. Large investment funds adhering to these principles often rely on third-party ratings and data providers to assess companies' ESG performance. For example, MSCI provides ESG ratings and analysis for a wide range of public companies.

The growing importance of ESG reflects a broader shift in the investment community toward recognizing the importance of sustainability and ethical governance. While the degree of strictness in ESG adherence varies, the trend is clear: integrating ESG criteria is becoming a standard practice among large investment funds, driven by both market forces and the evolving expectations of investors and regulators.

Why ESG Matters

Ignoring ESG considerations can lead to a wide host of problems for a company, which in turn can spill over to the shareholders. From a regulatory perspective, companies failing to comply with evolving environmental and social standards may face fines, legal penalties, or restrictions. Governments worldwide are increasingly implementing stringent regulations on carbon emissions, waste management, and labor practices. Investors increasingly demand transparency and accountability regarding ESG issues, and those companies lagging in these areas may find it challenging to operate at maximum efficiency or to attract investment. For a modern company being aware and working with ESG in mind has become an expectation from everything from employees to investors. Even large tech companies such as Microsoft and Apple, are in today's day and age expected to keep ESG criteria in mind during their day-to-day operations.

The Rise of “Ethical Investing”

Ethical investing is a term and concept that has that, just as ESG, has risen to prominence in recent years. Ethical investing is an approach where an individual investor (or fund) strictly adheres to ESG principles in order to be a force for positive change in the world. However, some investors also use this framework as guidance in order to invest in causes and companies they believe are doing good for society and the world as a whole. It can be things such as investing in green energy, a clothing company that uses ethical sourcing, food producers that focus on the ethical treatment of animals, and similar things.

Counterarguments Against ESG

However, ESG and all that it entails is not completely free of controversies. One major critique is the lack of standardization in ESG reporting. Unlike financial reporting, which follows established accounting principles, ESG metrics can vary widely between companies.

This inconsistency makes it difficult for investors to compare companies on a like-for-like basis. Different rating agencies often use their own methodologies, leading to discrepancies in ESG scores for the same company. This lack of uniform standards can undermine the reliability and credibility of ESG ratings.

Another point of criticism is the potential for "greenwashing." Some companies might engage in superficial or misleading practices to appear more environmentally friendly or socially responsible than they actually are. This can deceive investors who are looking to support genuinely sustainable practices. The emphasis on positive ESG ratings can incentivize companies to focus on improving their scores through marketing rather than making substantive changes to their operations.

Moreover, the economic implications of ESG investing are debated. Critics argue that prioritizing ESG factors may compromise financial returns. While some studies suggest that ESG-focused investments can perform well, others indicate that the emphasis on non-financial criteria might lead to suboptimal financial outcomes. This trade-off raises questions about the primary purpose of investing and whether it should be driven by ethical considerations or financial returns.

Additionally, there is concern about the subjectivity inherent in ESG criteria. Determining what qualifies as socially responsible or environmentally beneficial can be subjective and culturally dependent. This subjectivity can lead to biases in how ESG factors are assessed and valued.

Closing Words

While companies are being pushed towards being more and more aware and proactive in regard to ESG criteria, individual investors all have different approaches and mindsets. For some investors, investing in companies that align with their personal beliefs and values is very important. Other investors are strictly focused on placing capital in companies with the best opportunities for growth. There is no right or wrong way to go about ESG, and it is a decision that all investors must make for themselves.

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