What are Environmental, Social and Governance (ESG) criteria?

ESG criteria explained in less than 2 minutes

Environmental, social and governance (ESG) criteria create a framework to help investors who want to incorporate personal values into their investment approach. The ESG screening process identifies companies that have built sound environmental practices, strong social responsibility principles and ethical governance initiatives into their corporate policies and day-to-day operations.

If you are interested in aligning your investments with your values, take a closer look at ESG criteria: how to find them, how ESG compares to other types of socially conscious investments, and whether ESG investments have an impact on performance.

What are environmental, social and governance criteria?

ESG criteria allow investors to know a company’s adherence (or lack of adherence) to ethical practices. The three components are defined in the following ways:

Environmental:

A company’s impact on the environment and its ability to mitigate various risks that could harm the environment. This can include a company’s carbon footprint as well as its record on energy efficiency, waste management, conservation of water and other natural resources, and treatment of animals.

Social factors:

Assesses a company’s relationships with other businesses, its standing in the local community, its commitment to diversity and inclusion among its workforce and board, its charitable contributions, and whether it is known for employee policies that promote health and safety.

Corporate governance:

Assesses a company’s internal processes, such as transparent accounting methods, executive compensation and board composition, as well as its relationships with employees and stakeholders. It may also include internal regulations designed to prevent conflicts of interest and unethical behaviour.

How ESG metrics work

Many companies measure their performance on ESG metrics and publicise them in annual reports and other documents. ESG performance for individual companies is also measured and reported by third-party providers such as Morningstar, Bloomberg and MSCI, as well as by the media.

Investors can research companies to find out their ESG criteria score using websites such as Sustainalytics, a division of Morningstar, which reports companies’ ESG rankings and compares them to other companies in that sector.

You can also search online by company name and ‘ESG report’. Keep in mind, however, that companies often report on themselves, so third-party validation is recommended.

The emergence of the ESG factor

According to the Commonfund Institute, an asset management company that serves non-profit organisations and public pensions, responsible investing dates back to colonial times, when some religious groups refused to invest their endowment funds in the slave trade.

However, socially responsible investing (SRI) did not emerge until the mid-20th century. It was driven in the 1960s by opposition to the Vietnam War and the civil rights movement, and in the 1970s by increased environmental awareness and broad opposition to apartheid in South Africa.

As interest in value-based investments grew, the models for evaluating them transformed. The emergence of ESG criteria over the past two decades has flipped the concept of socially conscious investing from one of excluding companies to one of including companies that rank high in the ESG criteria.

According to George Padula, director and chief investment officer of Modura Wealth Management, LLC, “People have decided that they would rather include companies that have certain aspects - good governance, inclusion, diversity, and environmental qualities - than simply exclude the so-called ‘sin stocks’ (tobacco, firearms, gambling, and alcohol).”

Types of ESG criteria

ESG issues can be difficult to categorise neatly, but the CFA Institute has effectively categorised them as follows:

Other terms and alternatives to environmental, social and governance (ESG) criteria

An increasing number of people are trying to match their approach to investing with their values, and different terms are being used to do this. Common terms that intersect and overlap with ESG criteria are the following:

• Corporate Social Responsibility (CSR) investment: CSR typically refers to the exclusion of ‘sin stocks’.
• Socially responsible investment (SRI): Interchangeable with CSR.
• Sustainable investment: Interchangeable with ESG, or may be specific to environmental practices.
• Value-based investment: A broad term that could be inclusive of any of these others.
• Impact investing: Investing in companies in order to effect a specific social or environmental change related to the mission.

ESG vs. CSR

CSR and SRI are considered by many to be interchangeable terms referring to more nebulous and voluntary measurements and reports of business practices that have a positive environmental and social impact. ESG investing is more closely related to an inclusive approach that evaluates companies on their positive actions through environmental, social and governance criteria using more quantifiable metrics.

Moreover, measuring CSR is an internal function, whereas ESG is an external one. That is, CSR programmes are proposed and executed internally. It is up to those within the company to measure the success of CSR programmes, decide which ones to continue and rework those that are not achieving the desired results.

ESG, on the other hand, is a measure that external analysts can use to objectively compare ESG effectiveness between companies.

ESG investment performance

One of the most common concerns about following sustainable investment guidelines is whether it produces returns that track broader market indices or comparable investments. But according to a 2019 Morningstar study, ‘41 of Morningstar’s 56 ESG indices have outperformed their non-ESG equivalents (73%) since inception’.

Padula adds that ‘with the growth of ESG ETFs and index funds, the expense ratio has come down a lot while the number of options has gone up a lot. Returns are competitive with every asset class they follow and some have done better’.

Article source: www.thebalance.com