What does ESG mean and what are its different components? Why do we need ESG and how has it evolved into the common practice it is today?
The ESG acronym stands for environmental, social, and governance factors. In this changing world, environmental responsibility, social awareness, and corporate transparency are increasingly important to all stakeholders. The new generation of consumers prefer environmentally responsible products, the evolving culture of employees led to the adoption of socially responsible actions by employers and as a result, investors now emphasize ESG investing in their asset allocations.
In Europe companies with more than 500 employees are mandated to report their ESG practices, therefore many global and US-based companies now voluntarily disclose them in a separate sustainability report or include them in their annual financial report.
The first step to meaningfully using ESG data is knowing what ESG is. Due to the complex nature of environmental, social, and governance issues, each component is further divided into several sub-topics to ensure maximum accountability.
To answer the question what does ESG mean, one has to take into account that ESG considerations encompass a wide range of subtopics, all of which help companies fine-tune their levels of responsibility.
The sub-topics under ‘E’ in the ESG definition include different topics such as carbon emissions, energy efficiency, biodiversity, air and water pollution, and water/carbon/waste management.
The ‘S’ in ESG branches out into human rights, labor standards, gender and diversity, customer satisfaction, and supply chain risks, among others.
Governance, or the ‘G’ in ESG, considers topics such as board composition, executive compensation, audit committee structure, policy creation, and whistleblower schemes.
The ESG investing definition is about backing companies that demonstrate a commitment to environmental, social, and governance issues, thereby promoting environmental and socially responsible investing.
You can view ESG performance with two lenses: the risk lens and the impact lens.
The ESG risk lens considers what risks the environment and society pose to companies and their businesses.
Prospective stakeholders can be wary of how ESG practices affect companies before making investment decisions. To protect shareholders and create transparency, Europe and the U.S. have created and are in the process of creating, binding regulations requiring companies to disclose ESG metrics.
In Europe, there are two standards for ESG reporting — the Corporate Sustainability Reporting Directive (CSRD) and the Sustainable Finance Disclosure Regulation (SFDR). These apply to companies that employ more than 500 people and specify the disclosure of statistics relating to environmental impacts, human rights, and diversity on corporate boards.
In the U.S. the Securities and Exchange Commission (SEC) voted 3:1 to issue a proposal for public companies to have climate related disclosure rules and the EEOC obliges companies to report their employee diversity.
These initiatives demonstrate the increasing significance of ESG reporting globally.
The impact lens of ESG focuses on how the company impacts society and the environment. Consumers, employees and Gen Z continue to shape the marketplace and work environment with values centered around social responsibility, environmental sustainability, and transparency.
Studies by McKinsey and PwC show willingness by Gen Z consumers to make a switch to brands that demonstrate excellent corporate social responsibility.
Considering all the risk and impact factors, and the changing culture of stakeholders, it’s easy to see why ESG data is essential for sustainable investing and why asset managers are now considering ESG factors when they are choosing what companies to buy in their portfolios.
While the core values of ESG criteria aren’t new, they’ve seen an increase in popularity since taking root in the 1950s and 1960s.
Especially in the last few years, with the world experiencing significant natural disasters and growing disparities in healthcare and income, companies have increasingly looked for ways to improve their stewardship in ESG matters.
The modern understanding of ESG factors results from the many milestones we’ve crossed over the years.
First, in the 1950s and 1960s, electrical and mine workers’ unions began investing their pension capital in healthcare facilities and affordable housing.
Then, in 1968, the financial brokerage house Paine, Webber, Jackson & Curtis displayed the increasing relevance of corporate social responsibility with an ad declaring that peace in Vietnam “would be the most bullish thing to happen to the stock market.”
The 1960s also served as the beginning of mainstream consideration toward various ESG-related issues like racial equality, gender equality, and environmental causes.
In recent years, there has been a heightened interest in corporations reducing greenhouse gas emissions, being attentive to various social factors, and demonstrating transparency through corporate disclosures.
The chart below documents this timeline.
As boardrooms recognize the long-term value created by ESG, it has increasingly become an area of focus. As a result, a growing number of companies now disclose their ESG-related efforts.
When a company highlights its steps to implement positive ESG practices, it shows genuine transparency to consumers and investors alike.
With ESG’s heightened importance, it continues to quickly evolve, causing the formation of new methodologies, regulations, and ESG-focused positions for executives and teams that help with internal assessment, execution, and reporting.
Especially for large public companies, ESG reporting is now more of a standard practice rather than a possibility.
One area of concentration driven by ESG goals is corporate governance. Companies have developed methods for demonstrating honesty and accountability to the public and specify policies, practices, and a governance structure that outlines their efforts on ESG accountability.
Year-by-year data shows a notable increase in the rate of S&P 500 companies publishing in their proxies the panel managing ESG. While in 2020, 72% of S&P 500 companies made this disclosure, in 2021, that figure rose to 86%. These figures indicate how more and more corporations see ESG as a fundamental part of their business.
With the heightened focus on corporate responsibility, there’s been a push for ESG-related regulations that specify reporting standards.
In the U.S., the SEC recently indicated four topics pertaining to ESG that fall under its domain: human capital management, board diversity, climate change, and cyber-risk governance. The SEC also provided a “Dear-CFO” letter illustrating different commentaries relating to sustainability and climate disclosures. That letter mainly focused on disclosures concerning climate risks and how they affect financial reporting.
Since ESG issues affect people and countries worldwide, there’s also a move toward creating a global standard. At a recent U.N. Climate Change conference, the International Financial Reporting Standards (IFRS) Foundation established the International Sustainability Standards Board (ISSB).
The ISSB criteria aim to raise the standards for sustainability to be on a par with those for financial and accounting reports. The goal is to elevate transparency and dependability in sustainability reports to better guide those who use general-purpose financial reporting in decision-making.
Additional standardization organizations delving into ESG include the Financial Accounting Standards Board (FASB) — which published a staff educational paper on the convergence of ESG topics and financial accounting standards — and the Commodity Futures Trading Commission (CFTC), which created a climate risk unit.
As more and more companies gravitate toward emphasizing ESG data to consumers and investors, accurate ESG reporting is more critical than ever. ESGgo is a one-stop-shop technology tool that helps you collect, monitor, analyze, and optimize your company’s ESG posture.