ESG (Environmental, Social and Governance)
A framework for understanding and measuring how sustainably an organization is operating
ESG is an acronym for Environmental, Social, and Governance. ESG takes the holistic view that sustainability extends beyond just environmental issues.
ESG is best characterized as a framework that helps stakeholders understand how an organization is managing risks and opportunities related to environmental, social, and governance criteria.
While the term ESG is often used in the context of investing, stakeholders include not just the investment community but also customers, suppliers, and employees. All of them are increasingly interested in how sustainable an organization’s operations are.
- ESG is a framework that helps stakeholders understand how an organization manages risks and opportunities around sustainability issues.
- ESG has evolved from other historical movements that focused on health and safety issues, pollution reduction, and corporate philanthropy.
- ESG has changed how many investment and capital allocation decisions are made.
Overview of E, S, & G
Environmental criteria refer to an organization’s environmental impact(s) and risk management practices. These include direct and indirect greenhouse gas emissions, stewardship over natural resources, and the firm’s overall resiliency against physical climate risks (like climate change, flooding, and fires).
The social pillar refers to an organization’s relationships with its stakeholders. Examples of factors that a firm may be measured against include Human Capital Management metrics (like fair wages and employee engagement metrics) but also an organization’s impact on the communities in which it operates and on supply chain partners, particularly those in developing economies where environmental and labor standards may be less robust.
Governance refers to how a company is led and managed. ESG analysts will seek to better understand how leadership’s incentives are aligned to stakeholder expectations, how shareholder rights are viewed, and what types of internal controls exist to promote transparency and accountability by leadership.
The Evolution of ESG
The ESG lens helps assess how an organization manages the risks and opportunities created by changing conditions, such as shifts in environmental, economic, and social systems.
Some of these conditions have been identified in earlier versions of sustainability-focused strategy and regulatory frameworks, including:
1. EHS (Environmental, Health, and Safety)
As far back as the 1980s, organizations in the United States were considering how to use regulation to manage or reduce pollution (and other negative externalities) produced in the pursuit of economic growth. They sought to also improve employee labor and safety standards, although much progress remains to be made even today.
2. Corporate Sustainability
EHS evolved in the 1990s into what was then known as the Corporate Sustainability movement. This emerged as some management teams wanted to focus on reducing their firm’s environmental impacts beyond the reductions that were legally required of them.
It’s widely agreed that Corporate Sustainability was often employed by management teams as a marketing tool to overstate or otherwise misrepresent efforts and environmental impacts – a practice that would later become known as greenwashing.
3. CSR (Corporate Social Responsibility)
By the early 2000s, the Corporate Sustainability movement began to integrate ideas around how companies should respond to social issues – this would become known as Corporate Social Responsibility.
Corporate philanthropy was a key component of CSR, although some critics argue that tax incentives made cash donations as attractive as their ultimate economic impact on recipients. Employee volunteerism was another hallmark of CSR.
Finally, by the late 2010s and into the 2020s, ESG started to emerge as a much more proactive (instead of reactive) movement.
ESG has now evolved into a comprehensive framework that includes key elements around environmental and social impact, as well as how governance structures can be amended to maximize stakeholder well-being.
ESG & Investing
ESG has really gone mainstream because of how important the framework has become in the investment community. There are a growing number of ESG rating agencies and reporting frameworks, all of which have evolved to improve the transparency and the consistency of the ESG information that firms are reporting publicly.
The Capital Markets can be a powerful tool to create change. By restricting access to capital (or making the terms under which it’s available less favorable), bad actors may be incentivized to improve performance across E, S, or G measures. Conversely, rewarding companies and their management teams that are performing well against ESG factors has an equally positive impact on encouraging continuous improvement.
Many ESG investment vehicles have emerged, including green bonds, mutual funds, ETFs, and index funds (among others). These publicly traded instruments make it easier for investors to align their investment decisions more closely with their own beliefs and values around E, S, or G criteria.
Thank you for reading CFI’S guide to ESG ( Environmental, Social, and Governance). To keep advancing your career, the additional CFI resources below will be useful:
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