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What is ESG? Explaining the Basics of Environmental, Social, and Governance

By Green Investing, Purpose of Finance, Stewardship No Comments

What is ESG? Explaining the Basics of Environmental, Social, and Governance

ESG, an acronym for Environmental, Social, and Governance, is a framework for a holistic measurement of the impact a corporation generates beyond its materialistic goals to maximize profits. Each of the three categories covers various issues related to impact.

Environmental

A company’s interaction with the natural world through resource and energy consumption and waste discharge.
Examples: climate change, greenhouse gas emission, deforestation

Social

A company’s relationships with people and institutions, particularly with employees.
Examples: DEI, labor standards, health & safety

Governance

A company’s internal system of practices, policies, leadership, and other governing systems.
Examples: bribery, corruption, board practices, accounting practices

History of ESG

Where did ESG come from? In 1992, the UN Framework Convention on Climate Change convened in Rio De Janeiro, where 154 countries signed an international environmental treaty, which was operationalized as the Kyoto Protocol. 

Then in 1997, the Global Reporting Initiative (GRI) was founded in response to the protocol to provide organizations with a common language to understand their impact. 

And in 2000, the UN Global Compact was launched to call companies to align to principles of Universal human rights, labor and environmental conservation. These international milestones helped to lay the groundwork for ESG. 

ESG issues were first mentioned in the 2006 United Nations Principles for Responsible Investment (PRI) report, with a focus on developing sustainable investments. Since then, ESG has been used with the intention to understand the external, non-business risks of a company that can affect future profitability. 

ESG Performance Measurement

At a first glance, the measurement of ESG may be difficult to conceptualize. It involves the conversion of subjective ESG concepts into objective metrics. Many standards and frameworks are available, with each providing distinct guidelines for companies.

Companies choose standards based on their industry, company strategy and requirements, and intended audience. Many companies use multiple standards and frameworks to portray their ESG statements in suitable ways. A few of popular standards include:

United Nations Global Compact
A framework consisting of 10 principles for companies to uphold sustainability and social responsibility

Global Reporting Initiative (GRI) Standards
An independent, international organization that aims to help companies understand and report their impacts on the economy, environment, and people. GRI Standard is a
modular system comprising universal, sector, and topic-specific standards that allows companies to report relevant and most significant information. It is the world’s most used standard, especially among large corporations including over 70% of G250 companies.

Sustainability Accounting Standards Board (SASB) Standards 
Managed under the global non-profit organization, Value Reporting Foundation (VRF), SASB focuses on industry-specific and financially-material sustainability information that is cost-effective for companies and decisions useful for investors. It is widely used with over half of S&P Global 1200 companies using SASB standards.

OECD Guidelines for Multinational Enterprises
Recommendations for multinational enterprises of OECD member countries on their business conducts to ensure they act in accordance with the policies and expectations of these countries.

Task Force on Climate-Related Financial Disclosures (TCFD) 
Framework aimed to provide efficient climate-related financial disclosures. TCFD recommendations, themed around governance, strategy, risk management, and metrics, guide companies to provide decision-useful, forward-looking information.

Climate Disclosure Standards Board (CDSB) framework
Aimed to help companies report environmental and social information in mainstream reports. With an effort to standardize different standards and frameworks, CDSB framework aligns with TCFD and builds on popular standards, such as GRI.

 

Because many organizations have developed standards and frameworks to disclose financially material information on relevant ESG topics, ESG reporting is not standardized.

Despite the CDSB framework coalescing many standards and frameworks, many companies still mix and match different ESG frameworks. This tends to reflect their individual industry needs. Inconsistencies could hinder long-term progress and confuse or alienate investors. The lack of standardization in ESG reporting continues to be a major criticism of the movement. 

ESG Ratings

Unlike ESG frameworks that offer guidance on what and how financial information should be disclosed, ESG Rating is a metric given to companies based on the evaluation of their performance by independent third-parties.

These rating platforms include the Institutional Shareholder Service (ISS), Carbon Disclosure Project (CDP) and Morgan Stanley Capital International (MSCI). Similar to a credit rating, it is a measure of a company’s exposure to long-term environmental, social, and governance risks. Higher ratings indicate efficiency in managing these risks. 

However, ESG ratings may not always be reliable and consistent. Scores differ based on the third-party provider. Due to different methodologies, metrics, and weightings, the comparison of ratings might not tell the full story about the real performance of the company.

 

5 Perspectives on ESG from Leaders in Finance, Business, and Government


1.    Allison Herron Lee, SEC Commissioner

“Increasingly, boards of directors are called upon to navigate the challenges presented by climate change, racial injustice, economic inequality, and numerous other issues that are fundamental to the success and sustainability of companies, financial markets, and our economy. This call, welcomed by some and eschewed by others, is attributable in part to the large and growing influence that corporations hold over the social and economic well-being of people and communities everywhere. A study from 2018, for example, showed that 71 of the top 100 revenue generators globally were corporations while only 29 were countries. In other words, corporations – in many cases U.S. corporations – often operate on a level or higher economic footing than some of the largest governments in the world. That is a dynamic worthy of reflection – and one that drives home the weighty consequences and obligations associated with some corporate decisions.”

– Allison Herron Lee, SEC Commissioner, in her 2021 Keynote Address to the Society for Corporate Governance 


2.   Sandra Horbach, Managing Director at The Carlyle Group

“ESG [environmental, social, and governance] is climate change, worker conditions, diversity; it’s everything. There’s so much that sponsors can do to help these companies do better. We don’t have a dedicated impact or ESG platform; we’re bringing ESG in and trying to embed it across all our portfolio companies.”

– Sandra Horbach, Managing Director at The Carlyle Group, on how ESG is transforming the investment industry in a new interview, as quoted by McKinsey


3.    Martin Whittaker, CEO of JUST Capital

“The ultimate goal is to build a more just marketplace that works for all Americans, one that deals with people’s economic insecurities and heals fear and division. The fault lines of capitalism cause widening inequality and social conflict, and undermine our ability to mount sustained, collective efforts to tackle our most pressing challenges: education, health, local and global environmental well-being, community vitality, upward mobility, and more.”

– Martin Whittaker, CEO of JUST Capital, on his organization’s approach to ESG investing and advocacy, as quoted by Motley Fool


4.    Kenneth P. Pucker and Andrew King, Harvard Business Review

“Despite a historic surge in popularity, ESG (environmental, social, and governance) investing will not tackle our generation’s urgent environmental and social challenges. Consider the battle against climate change: Estimates are that humanity will need to invest an average of $3.5 trillion annually over the next 30 years. Unfortunately, these trillions are not the same trillions that are presently invested in assets managed according to many forms of ESG investing — those are dedicated to assuring returns for shareholders, not delivering positive planetary impact. The separation of profit and planet is by design. ESG ratings which underlie ESG fund selection are based on “single materiality” — the impact of the changing world on a company’s profits and losses, not the reverse.”

– Kenneth P. Pucker and Andrew King, ESG Investing Isn’t Designed to Save the Planet in Harvard Business Review on the difference between ESG and Impact Investing.


5.   Larry Fink, CEO of BlackRock

“Stakeholder capitalism is all about delivering long-term, durable returns for shareholders. And transparency around your company’s planning for a net zero world is an important element of that. But it’s just one of many disclosures we and other investors ask companies to make. As stewards of our clients’ capital, we ask businesses to demonstrate how they’re going to deliver on their responsibility to shareholders, including through sound environmental, social, and governance practices and policies…our conviction at BlackRock is that companies perform better when they are deliberate about their role in society and act in the interests of their employees, customers, communities, and their shareholders.”

– Larry Fink, CEO of BlackRock, in his Annual 2022 Letter to CEOs entitled The Power of Capitalism

Summary

ESG has been around for more than two decades. It has entered the mainstream of finance, thanks to support from retail investors and attention from luminaries like Larry Fink.

Looking forward, ESG investing is a fast growing sector of finance. According to Bloomberg Intelligence, global ESG assets are likely to surpass $41 trillion in 2022 and $50 trillion by 2025.

Still, there are many challenges ahead for ESG. Controversies around greenwashing, the lack of data, and the lack of comprehensive standards across industries pose barriers. The SEC is now proposing two rules to combat greenwashing, offering signs that challenges may be closer to resolution.

RELATED: Read Sophia Radionova’s (SOF NYU) commentary on the intersection of Ethics & ESG in her career exploration.

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