Guide to ESG: Environmental, Social and Corporate Governance

Guide to ESG: Environmental, Social and Corporate Governance

What is ESG?

The practice of ESG has been around since the 1960s and was back then known as socially responsible investing. The concept of ESG can be seen to have started in 2004 when former UN Secretary-General Kofi Annan wrote to over 50 CEOs of major financial institutions, inviting them to participate in a joint initiative under the UN Global Compact with support from the International Finance Corporation and Swiss Government. The goal of the initiative was to find ways to integrate ESG into capital markets. However, the term ESG was only officially first coined in 2005, in the study “Who cares wins”. 

The crux of ESG is that it provides a set of standards so that investors can make their decisions in a sustainable and compliant manner. To understand what ESG is, let us look deeper into its three pillars. There are three aspects to the abbreviation: the environmental sector, the social side, and the governance aspect.  

Environmental 

This aspect of ESG looks predominantly at the energy created, and discharge wasted. It investigates the resources that are needed for creating a product or service and for the general business operations. This area is particularly focused on carbon emissions and climate change:

• Carbon emissions  
• Waste management (especially in supply chains)  
• Air and water pollution  
• Energy efficiency  

Social 

The social aspect focuses on how a business treats its employees, stakeholders, and the wider community. This is often just as key an area for firms as the environment. It is imperative for companies to maintain a good reputation with their potential customers, as well as score well on measures that can guide potential investors regarding the work culture:

• Inclusion, Diversity & Equity (IDE)  
• Employment equality  
• Gender diversity  
• Employee health and safety  
• Community relations  

Governance 

Governance is the internal system of practices, control and procedures set up to assist with decision making and law compliance:

• Diversity within the board  
• Business ethics 
• Director’s remuneration  
• Bribery and corruption  
• Political lobbying  

Why is ESG so popular? 

ESG in recent years has become a hot topic, and with a worsening climate, it is a trend that is going to continue to remain relevant for a long time. However, helping the environment is not the only reason that ESG is so popular with companies, as other factors have also contributed to ESG’s popularity. 

External Pressure 

There is increasing pressure from legislators, investors, media, and consumers to implement ESG factors. Without doing so, firms would lose a large base of their customers. The emphasis on this pressure is presented by the fact that 49% of millennial millionaires make their investments based on social factors. Societe Generale has shown through looking at the impact of “high ESG controversy” events on stock performance, two-thirds of the time, shares underperformed in the general market by an average of 12% in the following 2 years. This highlights the potential losses for firms, especially those that are listed, and are not investing in initiatives promoting ESG.   

Regulation 

From the 6th of April 2022, the UK Government has announced that more than 1,300 of the largest UK-registered companies and financial institutions will have to disclose climate-related financial information in line with the TCFD. The TCFD stands for the Task Force on Climate-Related Financial Disclosures, and it was created in 2015 to force institutions to start providing consistent climate-related financial risk disclosures. In the future, based on current trends, these regulations will likely expand and become tighter on firms. At the same time, by being proactive and effectively complying with compulsory reporting, firms can get ESG reporting to work in their favour to uplift their public image.  

Competition  

The advantages of a robust ESG program not only helps short term growth and a firm’s reputation, but it can also provide a new path for firms to compete and build a stronger brand, benefiting both the companies and their investors. This competition also helps the wider community and environment, as companies push to be increasingly sustainable, fairer, and compliant with regulations.  

Employee attraction and retention  

A study by business service provider DWF showed that two in five businesses are failing to find staff due to their ESG policies being recognised as “weak”. Companies that have a strong ESG and labour proposition, as well as labour relations, have been shown to have better productivity. It has been found that addressing the gap between executive and workforce pay, as well as a fairer incentive structure helps create an inclusive culture, encourages people to work harder.  

A study by Mercer, looking at “ESG as a Workforce Strategy” shows that top employers grouped by employee satisfaction and attractiveness to talent have significantly higher ESG scores than their peers. This further suggests that ESG helps better employee satisfaction and attracts prospective employees. With happier employees, it can be expected that they will be more likely to work harder, longer and be more enthusiastic about their job.  

Potential downfalls of ESG:  

Greenwashing  

Greenwashing may or may not be a term that you have come across before, but it is very much prevalent within the field of ESG. It is where a company or brand attempts to make itself look more sustainable than it really is, through PR stunts, packaging changes, rebranding or making claims that cannot be proven with substantial evidence. An example of this happened in 2019 when McDonald’s introduced paper straws, which to the public seemed like a step in the right direction. However, instead of working towards decreasing the use of plastic in the supply chain, the straws that the company chose turned out to be non-recyclable.  

Who is doing well?  

Not all the ESG factors are easily quantifiable, which can be a significant challenge when trying to assess companies. The changes may not always transfer to profit, so it can also be hard to see how much change happens. There is a risk that firms may overestimate the resulting benefits of any initiatives put in place, and it would (currently) be difficult to measure how accurate what they report is. Additionally, vital areas where firms could help may be overlooked as it would not create a profit or as they would not be able to quantify progress/ benefits to show their stakeholders.  

Is ESG attainable for every firm?  

Through a few internet searches, it is easy to notice that there is often a disagreement about what ESG exactly constitutes. Though all the various measures mentioned before, it can be seen that there is no clear-cut definition of the term. Although a firm may have a diverse board, treat its staff well and try to cut supply-chain waste, would it mean that every firm is “good”? If a tobacco or liquor firm has met all the goals mentioned, could they still be considered responsible if they are knowingly selling goods that cause detriment to its user’s health as well as creating large negative externalities?  

Conclusion  

The three pillars constituting the foundations of ESG are no longer an afterthought, as it used to be. They are pivotal to attracting investors, creating a positive reputation for a firm, and adding value to a company. I believe that as we go forward, with clearer definitions and regulations, companies’ innovation will progress tremendously to be able to operate in a sustainable manner. I have no doubt that this space of work will excel in the years to come, and that with temperatures increasing, climates worsening and countries committing to sustainability, ESG will become imperative to firms across various industries.