The business environment is evolving and becoming more open and inclusive of exploring impact and contribution that goes beyond profits and financial numbers. And investors are warming up to the idea of also looking at the environmental, social and governance impacts a firm makes along with the traditional financial metrics to make their investment decision.
The three aspects of ESG address issues from sustainability, carbon emissions, climate change, diversity and inclusion, human rights, supply chain, and an organization’s internal governance and operations.
ESG investors are concerned about making a positive impact with their investment and therefore are interested in aligning with organizations that understand their objectives. They do so by evaluating organizations on various ESG metrics through company reports and even third-party evaluations.
But altruism is not the only reason why green, sustainable, and ESG-oriented investment as a concept is finding favor. The soaring growth of the ESG-oriented global asset under management is set to grow $53 trillion by FY2025 while the global sustainable finance market size is to reach $22485.6 billion by 2031, the opportunity for growth is endless, not to mention the prospects of robust ROI.
Reasons For the Growth of ESG Investment
Investment for Impact – The rising ESG investment opportunities have a lot to do with the fact, that the public and the global regulatory authorities are pushing for businesses to be more transparent, ethical, and responsible for the planet, communities, and people. The younger generation of institutional investors concern themselves closely with the impact and objective of their investment and want to use their money for a larger good.
Enhanced Return on Investment – Many institutional investors perceive that sustainable investments have better returns and if not better, they certainly provide market-rate returns comparable to any other investment approach therefore, the investor question has evolved from “why” to “why not”?
Risk Management – Investors have observed that ESG-related issues can impact profits and ROIs and damage the reputation of the firms while posing risks to business continuity. ESG aspects cannot be overlooked while assessing investment-related risks.
With this understanding of the status of ESG investment in the capital market, in the next section, we take a closer look at the ESG factors and how they get defined.
ESG: Key Concepts
ESG stands for Environmental, Social, and Governance. It refers to the three key factors to evaluate the sustainability and ethical impact of an investment in a company or organization.
Environmental criteria refer to a company’s impact on the natural world, such as its carbon footprint, climate impact, water usage, and waste management practices.
Social criteria refer to a company’s impact on people and society, including its labor practices, community engagement, and relationships with suppliers and customers.
Governance criteria refer to a company’s internal management and oversight, including its leadership structure, executive compensation, and shareholder rights.
Examples of ESG Issues and their Impact on Companies and Society
ESG issues have gained a lot of prominence in recent years because of the increased focus of governments on climate change and the impact businesses have on it. The Glasgow Climate Pact, COP26, and the recently held COP27 conferences have raised awareness regarding the dire climatic situation, and the need to limit global warming to 1.5 degrees and reduce GHG emissions.
These measures cannot wait any longer to be implemented, and several governments around the world were galvanized into action toward bringing in new regulations. The regulatory and standard-setting bodies actively started working toward creating baseline standards for these critical climate issues, which led to work toward mandatory ESG reporting and climate disclosures.
Several businesses are taking concrete steps to display their commitment toward climate goals in alignment with the objectives of their stakeholders and to preserve business interests. In an announcement made by TotalEnergies at their Board Meeting on 21.03.2023, they announced profit with a ROACE of more than 28% while undertaking efforts to diversify into a multi-energy company with a firm focus on building low-cost and low-emissions assets. The company attributes its success to this resilient and profitable portfolio. Some performance indicators shared by the company included a reduction in methane emissions, a reduced life cycle of carbon-intensity energy products, and reduced emissions from petroleum products compared to their baseline year 2020 and 2021.
The above example shows how working toward the E in the ESG is profitable for businesses and investors.
A rather impressive example of the ‘S’ of ESG is Mastercard’s dedicated efforts towards equal pay at work and dedicated support and mentorship and scholarship for young girls in the age group of 8-14 to pursue STEM (Science, Technology, Engineering, and Mathematics) to bridge the wide gender gap in these fields.
To illustrate an example of G of ESG, we may consider Hewlett Packard Enterprise, the winner of the 2019 Corporate Governance Award has a code of business conduct and ethics for directors, officers, senior executives, principal financial officers, and employees known as the Standards of Business Conduct which they align with their commitment toward serving stockholders and maintaining integrity in the marketplace.
Those were the three aspects of ESG but, how do investors measure the ESG initiatives of a firm to make investment decisions?
ESG Ratings and Metrics
Every business has an impact, intended or not intended; positive or negative and investors need to evaluate those impacts to determine risks and ROIs. Ratings and metrics allow investors to evaluate the impact a business creates using defined standards and measurements.
There are two lenses to look at the ESG impacts of a business, while one lens focuses on the impact a business has on the environment, social and governance factors, the other lens is directed inward and looks at the environment, social and governance factors have on business.
Which of these approaches should be adopted is determined by what component is material information from the investment perspective.
ESG rating agencies have developed standards and metrics to help companies understand their ESG impacts and allow investors to assess and evaluate those impacts in a standardized manner.
ESG Rating Agencies
GRI – GRI is an independent, international, and non-governmental organization responsible for developing the world’s most widely used sustainability reporting standards and best practices. GRI standards address three different goals, universal standards, applicable to all businesses, sector-specific standards, and topic-specific standards that are applied based on their materiality impact.
SASB – Sustainability Accounting Standards Board is an independent not-for-profit body that provides industry-specific performance measures or metrics for 77 industries to disclose ESG and sustainability-related information.
WEF – World Economic Forum came up with its set of ESG performance metrics, called the Stakeholder Capitalism Metrics which is a set of universal performance measures.
MSCI ESG Ratings – MSCI Inc.’s MSCI ESG Ratings division provides support tools and services for investment decisions and has delivered ESG ratings and research for 14000 firms across the world on their ESG performance.
Sustainalytics – Serving investors in 40 countries, Sustainalytics provides ESG ratings and research reports and has covered 40,000 companies to date.
Institutional Shareholder Services (ISS) ESG – A major provider of corporate governance and responsible investment solutions, ISS is the parent company of ISS ESG. To assist investors in incorporating ESG considerations into their investment decision-making processes, ISS ESG offers ESG research, data, analytics, and ratings.
RobecoSAM – RobecoSAM is a sustainable investing specialist that provides sustainability data, research, and ratings which are used to construct the Dow Jones Sustainability Indices.
Vigeo Eiris – Vigeo Eiri provides ESG research and ratings for emerging and developing markets covering 4,000 companies globally with ESG ratings, research reports, and custom ESG solutions.
There are several topics under each ESG category and definitions and metrics vary across organizations the effort is toward convergence and having a standardized approach to ESG performance metrics.
Types of ESG Metrics
Based on the standards and research reports, certain metrics are common across organizations while some are specific to an industry or sector.
- GHG Emissions- Scope 1,2 and 3
- Energy Management of a business includes information like total energy consumed, percentage of renewable energy used, and other relevant information.
- Waste management and information like the amount of waste generated, how it was disposed of, how much of it was recyclable, etc.
- Water management concerning consumption and wastage and replenishing efforts.
- Diversity and inclusion with efforts taken to expand representation and reduce discrimination.
- Labor practices and their fairness with the percentage of the workforce covered under the scope of collective bargaining.
- Efforts for employee health and safety measures at the workplace.
- Equal pay for equal work.
- Cybersecurity and efforts are taken to reduce data breaches.
- Business ethics for increased transparency and mitigating corruption risks.
- Business model resilience with a focus on recycling, composting, and processing waste.
- Executive compensation ratio of CEO to the median for all employees.
- These ratings and metrics are helpful for investors in creating an efficient strategy for investment.
Strategies for ESG Investing
Investors who want to consider ESG-focused investment can consider several approaches.
ESG-Focused Funds – Investing in ESG-focused funds is a good beginner strategy as these funds already have a ready pool of companies that meet certain ESG criteria and can involve factors like carbon emissions, labor practices, and board diversity. Investors can select ESG funds based on their strategic objectives and preferred ESG impacts.
Integration of ESG Factors into Investment Analysis – Another approach to ESG-focused investment could be considering ESG factors within the ambit of traditional investment, for example, along with traditional financial metrics, investors can also investigate ESG risks and opportunities that a business presents before deciding.
Engagement and advocacy as a form of ESG Investing – Investors can leverage their power to influence corporate behavior on ESG issues and can persuade businesses to provide more information on their ongoing ESG initiatives or adopt them in case they are absent. Investors can drive change by engaging with the businesses like engaging with company management, filing shareholder proposals, or voting on ESG-related issues at shareholder meetings.
Impact investing and its Role in ESG Investing – Impact investing involves taking investment decisions based on impact themes like renewable energy, affordable housing, or sustainable agriculture. impact investing could be to avoid or reduce the negative impacts of a business or to increase the positive impact.
Benefits of ESG Investing
Potential for Higher Returns and Reduced Risk – ESG investing helps investors manage risk by locating and reducing potential risks connected to a company’s governance structure, and environmental and social policies. A business with poor environmental policies, for instance, may be more susceptible to regulatory penalties or reputational harm, which could have a detrimental effect on its financial performance.
Alignment With Personal Values and Societal Goals – Investors are increasingly opting to create a more positive impact with their investment choices and most of them have values or goals they feel strongly about and want to be reflected in their investment decisions. Businesses with strong ESG policies offer that chance to investors.
Reputation Management – Investment choices reflect the personal brand of the investors, if the businesses they invest in falls short on ESG-related compliance or encounter backlash for their business practices, processes, or policies, it also reflects on the investors
Challenges and Criticisms
One of the biggest challenges in making ESG-based investments is the lack of standardization in ESG reporting which means with no agreed-upon universal standards or regulations means data is not comparable. However, that is soon going to change with new ESG standards being developed by ISSB and the soon-to-be-adopted ESRS in the EU.
Difficulty in measuring and quantifying ESG factors- Lack of standards also mean investors find it difficult to quantify and measure ESG factors, while GHG can be easily quantified but diversity and inclusion are difficult to measure.
Criticisms of ESG investing as a form of “greenwashing”
An often-discussed aspect of ESG and ESG-focused investing is the fear that businesses use voluntary ESG-related disclosures as a cover to appear socially responsible while taking very little or no concrete efforts to bring substantial positive impact. It makes it difficult for investors to differentiate between businesses that are committed and authentic and the ones that are greenwashing.
ESG-based investing is a great way of ensuring that the capital invested by the stakeholders is being used to create a meaningful impact, using ESG metrics and rating agencies provides investors with a more granular and objective understanding of a business’s ESG efforts and aids decision-making. With tremendous growth forecasted for the sustainable finance sector, ESG investment also promises great ROIs while being useful to the people and planet. A win-win for all.