ESG – What does it mean?

No longer a buzzword on the fringes, “ESG” is on track to become mainstream. But what does it actually mean, and why does ESG matter? Dr Kaushik Sridhar explains.

What does it mean? 

ESG refers to the environmental, social, and governance practices of an investment that may have a material impact on the performance of that investment. 

The integration of ESG factors is used to enhance traditional financial analysis by identifying potential risks and opportunities beyond technical valuations. While there is an overlay of social consciousness, the main objective of ESG valuation remains financial performance. 

Companies operating in almost every sector are now coming under pressure to report on their ESG credentials and policies. ESG is sometimes used synonymously with such terms as corporate social responsibility, responsible investing, and sustainable investing.

It was derived from the “triple bottom line”, also known as “people, planet and profits”, a concept introduced in the 1990s. It argued that businesses should focus on each of the three P’s and not just on profits, since they were equally important for any commercial enterprise to be sustainable. This concept evolved into the focus of ESG, which today is the bedrock of sustainable and responsible investing (SRI).

Buzzword to mainstream

ESG was seen as a buzzword in 2019; the term is on track to become mainstream in 2021. 

Whether it’s the devastating effect of the global COVID-19 pandemic, Greta Thunberg’s crusade for climate change action, or the new wave of green energy initiatives, environmental, social and governance (ESG) issues are hot topics.

The term ESG has been brewing for a while, and is hitting the mainstream now, driven by united demand from employees, investors and customers. All three groups seem to have shifted from a passive to an active stance and are forcing companies to step up against climate change and social injustice. 

As the pressure becomes explicit, companies are responding with a shift in operating principles, proving again the power of the conscious consumer in today’s market.

The “E”

The impact of business practices on the environment has been in the headlines for years, particularly in relation to climate change and pollution. There appears to be more focus on the environment within ESG because it is a generally larger area than social themes such as education and housing. When you think of the environment, it covers utilities, energy and industrials. It’s a bigger universe from which to come up with a viable investment strategy and also reflects the fact there’s been a lot of focus on environmental issues.

The “S”

This category covers community and employee relations, including human rights abuses and discrimination, community impact and involvement, employee treatment, and occupational health and safety.  

Another metric to determine if a company is a good steward of the “S” is to look for an engaged and happy workplace. Is the company a sought-after employer? What kinds of policies and programs are in place to attract and retain workers? Companies that score well on these questions have a competitive advantage over others. Studies show that contented workers tend to be more productive and efficient, which helps a company’s bottom line.

The “G”

When analysing environmental, social, and governance factors, the “G” element is often forgotten amid considerations over climate risk, societal implications and other “E” and “S” risks and opportunities. However, understanding governance risks and opportunities in decision-making is critical, as poor corporate governance practices have stood at the core of some of the biggest corporate scandals. 

Volkswagen’s emissions tests scandal, Facebook’s misuse of data and other recent incidents have caused significant financial damage to these companies. In the face of companies’ missteps and expanding awareness of global diversity and income inequality, corporate governance is a core component of ESG.

Why does ESG matter?

Across the investment space from major quoted companies to private equity and other forms of private capital, investors are demanding that the companies they invest in have regard to ESG and report on how they do so.

Proxy voting services are now recommending votes against approval of the accounts of listed companies that do not include a sustainability or similar report in their annual report and accounts. And in his CEO letter of January 2020, Larry Fink of BlackRock stated that they will not be investing in companies that do not show progress in meeting climate-related risks.

Currently it is the “E” in climate change that seems to have the most focus. The UK government is hosting the COP26 UN Climate Change Summit in Glasgow this November and its Green Finance Strategy includes a requirement for all listed companies to disclose in line with the recommendations of the Task Force for Climate Related Financial Disclosures (TCFD) by 2022.

Conclusion

ESG, and in particular ESG investing, can no longer be categorised as the future of investing. It is a reality today, just as issues such as climate change, cybersecurity, data protection, workplace diversity and inclusion, and better stakeholder alignment are now widely accepted as vital for better corporate citizenship and social outcomes. 

While we agree that practices such as greenwashing are deplorable, the fact is that committed ESG asset managers – acting for investors who entrust us to manage their capital – will play an essential role in tackling the key environmental, social and governance challenges we face today.

ESG should matter to you as it is something that investors now, and in the future, will demand. They will also expect that you “walk the walk” as well as “talk the talk”.