With the world increasingly focused on issues such as climate change, human rights, and gender equality, many companies are reflecting on the ways they do business. In this age of disruption, you may have frequently heard of the term ESG. What does it mean? How is it being measured by investors?
In short, ESG stands for environmental, social, and governance. It marks a shift in mindset from the view that firms should only maximise profits and shareholder value, to the view that firms should have at its heart the interests of its stakeholders. This comes as society holds firms to higher standards about their transparency as well as measures firms based on the benefits they deliver to their surrounding people and places.
Environmental refers to a business’ efforts to conserve the natural world, which may include actions to address issues such as:
- Climate change
- Deforestation
- Carbon footprint
- Water and air pollution
Social refers to a firm’s consideration of its people across the supply chain and its relationships with them. This involves addressing issues such as:
- Employee welfare
- Customer welfare
- Fostering diversity (gender, race, sexuality, religion etc)
- Community relations and philanthropy
Governance refers to a company’s set of internal regulations and standards. Factors to consider include:
- Board of directors
- Executive compensation
- Internal controls and audits
- Shareholder rights
For investors, this means that people are increasingly putting funds into stocks that perform well in terms of their ESG scores. Investors can both apply positive screens and increase their exposure to ‘clean’ stocks such as technology companies with low carbon footprints, or adopt negative screens and reduce exposure to stocks in sectors that perform poorly in terms of their ESG practices such as coal mining and tobacco. These days, investors are also assessing companies based on additional criteria such as an organisation’s integration of ESG into its core business, its moral values and beliefs, and the positive impacts it brings to the community. To make this process easier, the MSCI also releases data on company carbon metrics and ESG performances. This trend in ESG investing has been bolstered by the fact that higher ESG scores have been found to be correlated with stronger financial returns.
First making an appearance in the 1960s, the ESG investing market has grown exponentially. In 1995, the US Forum for Sustainable and Responsible Investment Foundation found that the size of the US sustainable and responsible investment universe was worth $639 billion. In 2018, sustainable investment assets were measured by the Global Sustainable Investment Alliance to stand at $30.7 trillion.
In the twenty-first century, data is becoming more publicly available, and individuals are becoming more aware of major global events. With new risks popping up everyday, it’s important that businesses rethink their operating models to become more resilient and respond to the changing face of our future. This begins by playing their part in tackling critical ESG problems of our world.
