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

ESG investing is kind of like picking a sports team to root for…

You might have many reasons to support a team. Maybe you like the coaching style, the attitude or abilities of the players, or maybe you grew up in the city that the team represents. Investors have reasons for picking companies to back in the same way. They may choose which companies to back based on whether the companies hold similar environmental, social, and governance values, a practice known as ESG investing.

ESG criteria are a set of standards that investors use to evaluate the sustainability and ethics of a company while also evaluating the company’s finances. The ESG criteria framework consists of three parts: Environmental, Social, and Governance.

• Environmental criteria generally focus on how the company addresses its effects on the environment and may include sustainability initiatives, climate change mitigation steps, or recycling policies.
• Social criteria are all about how the company interacts with and treats people, and in some cases, animals. What are its hiring practices? How well does it train employees? Are the pay scales balanced and fair? Other social criteria for ESG investing might include how well the company gives back to the community it’s based in, whether it works with ethical suppliers (i.e., the suppliers do not employ child laborers), and what its track record is with animal rights.
• Governance criteria are often about the leadership and management of the company. Do they have fair pay structures? Do they have unreasonably large bonus packages or exit packages for the executives? Is there strong oversight by the board or owners? Do they engage in risky practices that will cause the company shares to lose value?

Investors use ESG criteria to pick companies or funds to invest in that align with their values. Many investors also feel that ESG criteria work to help reduce risk while focusing on the future, long-term growth of a company. This combination can allow investors to support companies whose values align with their own while also receiving a return on their investment.

An ESG investor may object to fossil fuels, for instance, yet still hold a stake in a profitable fossil fuel company if they feel the company is doing the most good relative to its peers.

A similar type of investment strategy, Socially Responsible Investing (SRI), differs in that investors may be willing to accept less financial gain when a company’s actions align with the investors’ personal values and ethics. An SRI investor may avoid fossil fuel investments entirely, for instance, and instead choose a renewable energy company to make a responsible investment and limit environmental risks.

A company with strong ESG principles can reduce risks in multiple ways.

• By focusing on its environmental impact, for instance, it can reduce or prevent expensive accidents such as oil spills or wildfires.
• Having strong social and governance policies may help it avoid future lawsuits about hiring and promotion practices or sexual harassment. Strong social principles can even have the simple effect of preventing employee turnover or unionization because employees are happy.
• Committing to fair and ethical governance practices often translates into stronger financing opportunities, or simply helps increase customer satisfaction and loyalty.

While ESG principles may vary slightly from one industry to another, there are many examples of ways companies are incorporating them.

• They are reducing their carbon footprint.
• They are reducing waste.
• They are using renewable energy.
• They are hiring a diverse workforce.
• They are implementing equal pay and equal advancement opportunity.
• They are offering livable wages.
• They are eliminating animal testing.
• They are eliminating excessively large executive exit packages.

Sometimes the multitude of acronyms can be confusing, so here’s a brief summary:

ESG: Environmental, Social, and Governance investing. ESG investors want to invest in financially stable and successful companies that proactively address each of these criteria in their management and growth.

SRI: Socially Responsible Investing. Also known as Sustainable, Responsible, and Impact Investing, SRI is a type of investing that enables people to invest in companies that hold values and ethics in line with their own. SRI doesn’t have the same emphasis on corporate governance or economic value as ESG investing does.

CSR: Corporate Social Responsibility is essentially a code of ethics for a company. This generally tends to be an internal guideline companies use when addressing social, ethical, and charitable policies.

Because of the growing interest in ESG and SRI, values-oriented mutual funds and Exchange Traded Funds (ETFs) are becoming more common. But since investors do not have control over the exact stocks that are invested in through these funds, they may want to look deeper when ESG or SRI is important to them.

Most ESG funds should avoid including companies that use animal testing, for instance, or engage in environmentally risky business operations, but investors should confirm this for themselves.

Many investors want to support companies that have values and ethics similar to their own, while also getting a good return on their investment. Someone who is concerned about climate change, for instance, may not want to support companies who may be contributing to the problem.

Instead, an environmentally conscious investor wants to support companies that are working toward mitigating climate change. Not only is this approach good for the environment, but it also reduces the potential risk of loss in the future due to lawsuits or expensive environmental cleanup initiatives.

Other investors are more concerned about how a company treats its human assets in their decision-making process: Employees, customers, and even the communities they have facilities in. Treating employees well generally keeps them happy and reduces turnover, which is more cost-effective than continuously hiring and training new people.

Treating customers well can generate loyalty that translates into additional future spending, and being good neighbors in their community may generate goodwill and word-of-mouth advertising.

Some investors feel that the way a corporation governs itself is critical to its future success, so they may select investments based on wage equity, hiring diversity, how they treat their shareholders, or whether the company takes steps to reduce potential future harm.

Generally these criteria help reduce costs, increase profits, and solidify a company’s position for the future, thus earning a return for the investor while also being good to the world it operates in.

While there are many examples of ESG investing, a few key trends have stood out recently, particularly regarding diversity and the environment.

In January 2020, Goldman Sachs announced that it would no longer underwrite IPOs for companies that do not have one or more diverse directors on their board. Goldman Sachs’s primary goal for 2020 is to get more women on corporate boards, but race is also a focus for the following years.

Along the same lines, the state of California has a law that will fine public companies $100,000 if they have an all-male board.

Other trends include climate change mitigation and initiatives, stakeholder capitalism (where employees and customers are just as important as shareholders), and ESG-friendly lending policies.

Watch for these trends to make an impact on the way companies provide transparency in all three areas. Many corporations have begun to supply more specific information about the steps they’re taking to reduce their carbon footprint, for instance, increase diversity, and give more voice to all stakeholders.

This increase in transparency will provide the desired framework and data that ESG investors want to make informed and responsible decisions.