By Kaili Emery
Business Student, Contributing Writer at Trade Impact Foundation
Historically, investment has been solely based on financial gain. Today, we are seeing a shift in investor priorities and, in turn, company priorities. Many have argued this emphasis on shareholder return has led to growing inequality, increasing environmental risks, and other social impact issues. A more holistic view of investment that seeks to provide value for all stakeholders is therefore gaining more and more popularity.
In line with this thought system, the three letters “ESG” have created significant buzz in annual reports, news headlines, and LinkedIn posts alike. ESG is a reference to Environmental, Social, and Governance. But what does the acronym really mean and how can we use its methodology in our own choices? In this blog post we will look at the origins of ESG, translate its meaning and try to understand how we can navigate an ESG rating.
ESG was first mentioned by the UN in 2004 and has become more and more mainstream over the years. By 2019, 181 of the top CEOs signed a statement redefining the purpose of business by committing to lead their companies for the benefit of all stakeholders - including customers, employees, suppliers, communities, and shareholders. Soon after, ESG metrics were widely adopted to measure progress in alignment with stakeholder capitalism.
The acronym itself can be broken down into three categories: Environmental, Social, and Governance. For each of these standards, it can be helpful to think about what questions we should be asking when investing in or supporting a company.
Environmental: Consider a company’s impact on the environment. Are they working to mitigate their negative environmental impact? Do they measure carbon emissions both directly and indirectly caused by their manufacturing or operations? Do they apply low-carbon solutions available today, and are they innovating to reduce their emissions and broader environmental impact?
Social: A company’s social impact can range from donating to the local community to supporting diversity and inclusion within the organization. Is the company continuously improving its social impact? Social responsibility carries over to all the people and communities impacted by a company’s operations and can even extend to a company’s third-party relationships throughout its supply chain.
Governance: Consider a company’s governance structure. How is leadership driving positive change? What policies are they putting in place? It is important to take into account the transparency within an organization. Does the company practice ethical business, and do they uphold these values throughout the organization?
Breaking down each of these categories and asking the important questions can help you to measure a company’s impact on the world and make more informed decisions about the organizations that you choose to support. No company is perfect, and the extent of their efforts and commitment to each of these categories will likely vary.
Much of the discussion surrounding ESG has focused on empowering the investor to choose sustainable investments as a way to have a positive impact while receiving financial returns. In fact, a study conducted by the NYU Stern Center for Sustainable Business found a positive relationship between ESG investing and financial performance. Its popularity is catching on to both investors and companies, with 88 percent of publicly traded companies having ESG initiatives in place. The idea is that ESG investing gives you the freedom to align your financial decisions with your personal values.
That said, we must also evaluate what lies beneath an ESG rating. The factors going into these ratings are in many instances very subjective and it can be very difficult to sum up the impact of a company in one number. Consider a company that is at the high end of an industry standard when it comes to environmental sustainability - huge investments in green innovation; working hard to mitigate their carbon emissions; reporting closely on the use of toxic chemicals in their factories. What if that same company buys their raw materials from third-party suppliers who employ child or forced labor? The ESG rating system often compiles large amounts of data into one simple rating that may not accurately reflect the entire story, or only represent one area of concern (such as climate change).
In addition, we have seen examples of ESG claims and ratings later subject to criticism due to lack of transparency or threats of false claims - such as greenwashing (i.e., false claims about the environmental impact of a product).
Given the above, when trying to navigate the world of ESG, three points are helpful to keep in mind:
First, remember that there are no consistent benchmarks used in this area yet, so making sure you understand the breakdown of a company’s ESG rating and what factors are being considered is key;
Second, always remember that at the end of the day, you are getting a glimpse of the real impact behind an investment - or a company. Generally, the more details you have about the investment or company you are seeking to support, the better; and
And third, keep in mind the unavoidable subjectivity in the realm of ESG, and that a healthy cynicism is likely going to help you along the way.