What is the ESG meaning?
nvironmental, social, and governance known as ESG represent a framework used to evaluate some organization’s business practices and performance from the
perspective of sustainability and ethical issues. It can also provide a method to measure business risks and opportunities in these areas.
The goal of the EGS program is to catch all of the non-financial threats and opportunities essential for a company’s day-to-day business operations.
Many companies are choosing to publish their ESG reports to align with the ESG reporting frameworks, standards, and regulations and also to prove a level of transparency and reveal the environmental, social, and governance elements that are contributing to all of the risks and opportunities involved in the company’s business operations.
Usually, the data that are included in the report can be from greenhouse gas emissions, labor practices, diversity of the workforce to the executive compensation, and even more.
The ESG meaning has spread in the 21st century and it’s used mostly in the conversations where sustainability and corporate social responsibility ( CSR) are present. While these two function more as end goals or philosophies, the ESG program is more a real and tangible idea, because it contains data and metrics that guide the companies and investors in the decision-making process.
The beginning of the ESG concept
The first time when the term was used dates back to 2004, when the then General Kofi Annan, the United Nations Secretary, invited 55 chief executive officers from important financial institutions to an international conference about integrating ESG metrics in capital markets.
Back then, that group managed to produce a study in 2005 named “Who Cares Wins”. The study was planned to set out the business case for including some factors in the ESG investment decision, and also to improve the sustainability of markets and lead some better outcomes for society.
The report included some concerns that were potentially impacting the ESG investment values over a longer-term time view and some intangible aspects that are impacting the company’s value.
In the report, there were four general goals:
- To create a stronger and more resilient financial market
- To contribute to sustainable development
- To boost the awareness and mutual understanding among the involved parties
- To build trust in financial institutions
So, we can say that the ESG program has its roots in the financial world, and it’s based on the belief that companies are performing much better on issues that can increase shareholder value.
Since the beginning of ESG, investing has shown significant growth and one indicator of that is the increase in the number of signatories and resources from the Principles for Responsible Investment Initiative (PRI)
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The Three Dimensions Of ESG
While the number of ESG funds for managing investments is increasing, business and IT leaders from companies are more and more interested in ESG as a functional approach to doing business. Every aspect of the ESG criteria plays an essential role in the efforts that are put in to increase the company’s focal point to sustainable and ethical practices
Here are some details on the ESG criteria that are used by investors and companies:
Environmental
It refers to the environmental responsibility that companies and organizations have, including their energy use and how they can manage the environmental impact as a caretaker of our planet.
Global production and consumption are having a significant impact on the environment. The fact that we can produce and consume everything from food to cars, we also participate and contribute to climate change, waste, pollution, and even deforestation and these things can damage the planet without realizing it.
Some examples of environmental issues are:
- The carbon footprint, with the greenhouse emissions
- Deforestation
- Air and Water pollution
- Waste disposal
- Climate change effects
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Social
The Social factors are focused on how a company treats different groups of people from employees, suppliers, and customers to community members. Every company has a responsibility for their employees and also for their impact on the society in which they function.
So for this criteria, the companies will report data that covers a wide range of topics such as:
- Support the Human rights
- Diversity, equity, and inclusion programs
- A Workplace that ensures a healthy and safe environment
- Data protection and privacy policies
- Customer satisfaction levels
- Employee experience and involvement
Governance
This criteria from ESG represents how companies are guided and the way the leaders are responsible for the company’s actions. Increased transparency for governance has become a standard for all companies.
This can play the role of a controlling mechanism for corruption, tax, internal control, or executive remuneration. Active corporate governance represents an essential element of the development process of the companies and can offer some long-term benefits for shareholders, employees, or even society.
Some issues that are related to the governance include:
- Shareholder rights
- Independent directors
- Board elections
- Open configuration options
- Ethical business practices
How does ESG work?
Today, the customer's behavior has slightly changed and they are now focusing on more sustainable habits. People are now interested in recycling, minimizing waste, and in making greener choices on products and services from companies that act responsibly. These goals can also influence ESG investment choices.
Usually, individual and institutional investors that are taking into account the ESG issues, are also looking to use their money to support the organizations and companies that are in line with their values about sustainability and social responsibility.
In addition to that, these companies might have some better long-term financial results and performances and also new marketing opportunities that can potentially lead to surpass the stock market.
The ESG process involves multiple measures to offer ESG data relevant to investors. The organizations are tracking the internal ESG metrics and they can vary from one organization to another. After that, every company can use some ESG reporting frameworks to document and publish the results of the report. Next, many ESG rating agencies examine their reports and give ESG scores.
ESG funds represent a nontraditional way because they focus on:
- A performance report that is monitored to review business sustainability.
- Taking a long-term point of view to improve the financial stability of organizations.
- Investing in industries and companies that can meet certain criteria based on ESG.
Why Is ESG Important For Businesses?
It has become very clear that a company can have a major impact on the surrounding ecosystem on a global scale and even on the local community. However, people are more concerned about the ESG issues regarding climate change or human rights.
So, sustainability is an important aspect and it stays on top of mind for executives and investors in today’s business landscape.
Taking into consideration that the stock market usually mirrors the public sentiment, the investors have changed their management strategy to also focus on ESG standards and not only on financial performance.
More than ever, companies are now analyzed by institutional investors who are searching to adjust their values for ESG investment strategies.
How Can ESG Metrics Be Disclosed?
The companies are starting to include their ESG metrics in the annual reports to support stakeholders in more sustainable investment choices. With ESG reporting, businesses can show how their activities can be compared to the industry’s standards using qualitative and quantitative data to evaluate the performance of ESG initiatives.
The ESG reporting can also show stakeholders the essential insights for making an informed and safe decision according to the potential risks and opportunities that could affect the long-term value of the company.
There are multiple methods to outline an ESG report. Usually, these are created by using an ESG framework that can provide some instructions on which ESG is more important to focus on. The ESG framework can help companies understand better how to prepare and structure their information to earn a higher rating or a higher ESG score.
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ESG Investing And Other Strategies Of Investment
Many ESG investment decisions are made with the influence of the ESG criteria, and investors have started to take a new approach to managing assets. Even though they seem so similar, between ESG investing and other strategies are a few key differences such as SRI or socially responsible investigation and impact investing.
ESG investing is taking into consideration multiple ESG factors next to the traditional financial metrics. Despite that, there is an extra component that manages the opportunities and risks and analyzes the environmental external factors into a company’s valuation. And finally, the financial returns are one of the biggest priorities when speaking about ESG investing.
On the other hand, SRI, known as sustainable investing, has a reduced focus on financial returns and a bigger one on ethical considerations. For example, an investor can avoid a mutual fund or an exchange-traded fund (ETF) in a situation where one of the companies is operating in an industry that is harming the environment.
Impact investing might be considered one of the most philanthropic methods of investing because positive results are the top priority. So, it should be considered to invest in an ETF or a company that is focusing only on renewable energy or is following the way to net-zero operations.
Because of these new strategies of investment, more ESG funds have appeared and managed to indicate the importance of ESG in the stock market now. Having a complete ESG strategy is no longer a luxury for companies but a requirement, and this means that every organization should be more informed about ESG disclosure.
Advantages and disadvantages of ESG
Using ESG practices for investors and organizations can bring some advantages like:
- A mix of investment returns and sustainability. According to performance data from Morningstar, sustainability funds can achieve equal or even better returns compared with traditional funds.
- ESG has the power to attract new customers and supplementary growth. Businesses and even consumers that consider ESG factors in their buying decisions are more likely to search for products and services that are provided by ESG-focused companies.
- ESG investing is pressuring organizations to make positive decisions in investing. Companies that have ESG initiatives are usually focused on a range of environmental issues and ethical practices.
- Also, ESG can help companies to attract and keep high-quality employees. By giving them a sense of purpose, ESG can boost employee motivation and increase productivity.
- It can cut costs. When some ESG practices are included in the framework of the company, the operating expenses, energy bills, and others can be reduced in time.
Even though we exposed some pros of using ESG in companies, it also has some disadvantages that should not be overlooked.
- It doesn’t follow an approach that applies to everyone - usually, a method that works for one organization, might not work for another and this complicates the management of ESG initiatives and ESG investing. The necessity to include ESG efforts in the day-to-day business practices and also in long-term strategies to complicate even more the overall process.
- ESG strategies that are not authentic have a bigger chance of failing - it’s important to focus on ESG because if a company is doing it inconsistently the strategy is prone to fail. If a company is engaging in greenwashing, which is a term to define false and misleading claims about environmental actions, it can face some problems with the revenues and the value of its stock.
- It is not guaranteed a stock market performance - even though some successful stories exist, the focus on ESG can’t guarantee a great performance on the company’s stock. Besides internal factors, the changes that are made in market conditions, business trends, or the overall economy might negatively affect the company's performance as well as ESG funds.
- It can be hard to create a diverse investment portfolio - for those investors who are mainly focused on an investment strategy based on ESG, creating a diverse portfolio that aligns with the goals can be a difficult process.
- It can be difficult to have a detailed performance report with different ESG criteria - the majority of the ESG factors are not related directly to some financial data, and that means that it is necessary an extra effort to offer real performance results.
The ESG compliance
ESG compliance represents a method that requires companies to join some special environmental, social, and governance standards that are set through rules and legislation. Simply, it also includes the adoption of some practices that are sustainable, ethical, and responsible in the ESG report of activities.
This way, it can be ensured that organizations and companies can handle the impact that they have on the environment, uphold social justice, practice good governance, and also secure a sustainable long-term path for their activities.
The internal regulators, especially those based in the EU, are now paying more attention to ESG issues. The laws in other countries like the U.S.> Foreign Corrupt Practices Act, known as FCPA, and the UK Bribery Act are already covering some ESG topics and governments are now passing laws that directly address ESG.
These new rules require companies to report on ESG and make sure that they are contributing a key part in their decision-making process.
What are the alternatives to ESG investing?
ESG investing indeed seems to be now the most visible and accessible form of sustainable investing, but it’s not the only option. For those who are interested in similar approaches, here are some of them. Even though the following approaches and alternatives are usually used interchangeably, at their core they have some differences:
SRI or socially responsible investing
SRI focuses exclusively on investing in companies that match the environmental, ethical, and social values that an investor has. Socially responsible investing excludes the companies that for example manufacture some products that harm the environment or profit from it.
It concentrates more on the values that an investor has besides the organization's financial reports and performances. In comparison, ESG investing strategies are more focused on a high standard of corporate behavior but sometimes consider the business performance together with the ESG criteria.
Also, ESG investing is usually based on quantitative data because it is using ESG scores and metrics.
The impact investing
The impact investing strategy is mostly focused on helping a company accomplish definite goals about social or environmental benefits. Impact investing can, for example, support a company that aims to develop renewable energy technology or is promising to donate some of the profits to charitable groups.
It can also help to encourage corporate social responsibility initiatives in organizations. Known as CSR, corporate social responsibility represents self-regulation which emphasizes the ideas of doing good and also taking positive actions.
Conscious capitalism
It’s not the same as the other strategies, and conscious capitalism refers more to a socially responsible economic and political philosophy. Conscious capitalism focuses on the idea that companies should be operating ethically while they are pursuing profits.
This strategy accentuates the concept that an organization should assist its entire ecosystem, not just shareholders. Other beliefs and ideas of conscious capitalism include:
- The companies need to have a bigger purpose besides pure profits to be able to inspire and engage their important stakeholders.
- To create and optimize value for all the stakeholders, the focus must be firstly on the entire business ecosystem.
- Good leadership must follow the collective “we vs. me” mindset to push the business to great performance.
What regulations does ESG have?
Several regulations have been introduced to help organizations and companies make ESG a standard component in reports. For example, the Corporate Sustainability Reporting Directive (CSRD) represents an EU rule in which companies must report the environmental and sustainable impact that results from their business activities, as well as ESG initiatives.
The Sustainable Finance Disclosure Regulation, also known as SFDR, is planning to include the same thing by standardizing the reporting of the ESG metrics.
Also, multiple frameworks have been developed to help organizations with their ESG disclosure process. For example, in Europe, CDP or Carbon Disclosure Project allows companies to give environmental information to stakeholders. It also consists of risks and opportunity management, environmental targets, and scenario analysis.
In the same manner, the Global Reporting Initiative (GRI) can offer a global framework that standardizes the approaches regarding materiality, management reporting, and disclosure for all ESG issues.
Indeed, these rules and regulations are specially designed to guide companies and also investors to more sustainable business practices, but they are not a method to discourage greenwashing and green fraud.
Also, the pandemic of COVID-19 has created issues and exposed problems in the company’s supply chains, health, and also in financial services, and more importantly the environment itself. Facing a level of uncertainty, the experts began to worry about the company's initiatives to further prioritize the ESG in their reports.
Some organizations have followed the same path, but some of them discovered something interesting, that they had a greater ESG performance because they were more equipped to face the pandemic and the possible issues that may appear.
It’s important to remember that an ESG program is more than just metrics, regulations, and framework on a report. In essence, ESG is more of a method to measure progress and support companies towards a more sustainable future.
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