What is Environmental, Social, and Governance (ESG)

By Jessica Dosseh

Environmental, Social, and Governance—(ESG) refers to the three key factors that are used to measure the sustainability and ethical impacts of an organization or company.

Some investors use ESG criteria to screen companies before investing to better understand non-financial performance indicators.

Key Takeaways

• Environmental, Social, and Governance are the three main factors that socially responsible investors measure when deciding whether or not to invest in a company.

• If you are an investor and would like to buy ESG securities, you should consider socially responsible mutual funds, exchange-traded funds, or cherry-picking.

The Overview

"The practice of ESG investing began in the 1960s as socially responsible investing, with investors excluding stocks or entire industries from their portfolios based on business activities such as tobacco production or involvement in the South African apartheid regime." ~ MSCI

Today, investors deeply integrate ESG factors into their investment process along with traditional financial analysis. This ultimately means that moving forward, directors and CEOs must consider ESG as part of the company's overall development strategy.

ESG investing is growing exponentially as more investors utilize ESG with an array of data and tools to support their investment decision-making. This framework is used to evaluate metrics that measure and estimate a company's risk by considering three factors.

Types of Environmental, Social, and Governance (ESG) Criteria.

ESG issues can be difficult to classify neatly; nevertheless, they can be broken down as follows:

For a more in-depth review, read the CFA Institute’s guide on "ESG issues in investing – Guide for Investment Professionals."

Environmental Factors

These factors focus on a company's positive environmental impact and ability to reduce various risks that could harm the environment:

• Climate change.

• Waste management.

• Carbon emissions or sustainability report.

• Reducing the use of harmful pollutants and chemicals.

• Lowering greenhouse gas emissions.

• Increasing the use of renewable energy sources.

• Preventing deforestation.

Social Factors

These factors focus on assessing a company's efforts in supporting people's rights, health, and safety:

• Human rights.

• Labor standards and working conditions.

• Diversity and intersectionality.

• Customer satisfaction.

• Data protection and privacy.

• Employee relations.

• Product liability.

• Operating an ethical supply chain.

• Community's health and safety.

Governance Factors

These factors focus on assessing a company's internal structure and processes.

• Diversified board composition.

• Audit committee structure.

• Corporate transparency.

• Corporate behavior.

• Corporate rules and regulations.

• Eliminating bribery and corruption.

• Political contributions.

Pros and Cons of Environmental, Social, and Governance (ESG) Criteria

One of the most common concerns about following sustainable investing guidelines is the return performance compared to the performance of traditional investing. In the past, some investors assumed that ESG criteria would lead to investors sacrificing self-interest to some degree by avoiding investments based on non-financial factors. It's understandable why investors may feel this way; the production of tobacco, firearms, and alcohol are lucrative industries but are often rejected by ESG investors.

This issue of performance continues to be debated; however, through the use of ESG, many investors can avoid the backlash and inevitable consequences that occur when companies operate in a risky or unethical manner. Avoiding this type of backlash allows investors to choose companies with healthier balance sheets, stronger competitive advantages, and lower volatility than their mainstream counterparts.

*Some recent ESG results

ESG can be quite beneficial for most long-term investors.

So how does ESG work?

ESG performance is usually measured by individual companies and by third-party providers. The performance analysis is then documented in an annual report.

How to find a company's ESG report:

• You can search online by company name and "ESG report" (third-party validation is often recommended to avoid misleading information).

• You can also use websites such as Sustainalytics.

Now that you have the ESG report, it's time to set your objectives.

What are the common investor objectives?

In most cases, ESG investors seek to ensure the companies they fund are socially responsible, promote good practices, and are led by accountable managers. To make sure they choose the right companies, each investor needs to determine their overall objectives and set up an analysis strategy.

Here is a general overview of objectives:

• Investment approach

  • Create a system that evaluates ESG risks and opportunities with the intention of enhancing long-term risk-adjusted returns.

• Investment values

  • Make sure your investment strategy aligns with your values and beliefs and that of the organizations you choose to support.

• Investment impact

  • Determine the type of positive impact you want to support. Clearly define your intentions and financial return goals.

How to take action

Once you have done your research and know the impact you want to support, you can either pick individual stocks to invest in or choose a mutual fund or ETF with ESG stocks as part of the investment portfolio. If you need more help, consider hiring a professional to help you decide the right portfolio strategy.