What is ESG? Definition and meaning

ESG stands for Environmental Social and Governance and refers to the three key factors when measuring the sustainability and ethical impact of an investment in a business or company. Most socially responsible investors check companies out using ESG criteria to screen investments.

It is a generic term used in capital markets and commonly used by investors to evaluate the behavior of companies, as well as determine their future financial performance.

ESG metrics serve as a benchmark for companies aspiring to align with global sustainability standards.

The Environmental Social and Governance factors are a subset of non-financial performance indicators which include ethical, sustainable, and corporate governance issues such as making sure there are systems in place to ensure accountability and manage the corporation’s carbon footprint.

The number of investment funds that incorporate ESG factors has been growing rapidly since the beginning of this decade and is expected to continue rising significantly over the decade to come.

ESG’s three central factors are:

Environmental

Environmental criteria, which examines how a business performs as a steward of our natural environment, focusing on:

  • waste and pollution
  • resource depletion
  • greenhouse gas emission
  • deforestation
  • climate change
Social

Social criteria, which looks at how the company treats people and concentrates on:

  • employee relations & Diversity
  • working conditions, including child labor and slavery
  • local communities; seeks explicitly to fund projects or institutions that will serve poor and underserved communities globally
  • health and safety
  • conflict
Governance

Governance criteria, which examines how a corporation polices itself – how the company is governed and focuses on:

  • tax strategy
  • Executive remuneration
  • donations and political lobbying
  • corruption and bribery
  • board diversity and structure
ESG
Environmental Social and Governance are the three main factors that socially responsible investors measure when deciding whether to invest in a company. It is a generic term used in capital markets.

If you are an investor and would like to buy ESG-screened securities you should consider socially responsible mutual funds and exchange-traded funds.

Experts say that what constitutes an appropriate set of ESG criteria is subjective – it depends on what your priorities are – so you will need to do the research yourself if you really want to seek out investments that precisely match your own values.

ESG and the alternative investment world

ESG standards are gradually becoming a significant part of the alternative investment world. ESG issues are not only important when measuring the sustainability of the non-financial impacts of investments – but they may also have a material impact on the return profile and long-term risk of investment portfolios.

A recent study found that investors who choose ESG-screened investments receive a ‘double dividend’ in the form of lower risk plus a better **rate of return.

** Rate of return is the ratio of the income from an investment over its starting cost.

It has been found that businesses that adopt ESG standards tend to be more conscientious, less risky, and consequently more likely to be successful in their long-term commercial aims. 

Traditional investors are becoming increasingly interested in the ESG framework, and many have begun using its criteria for assessing risk in the investment decision-making process.

ESG-screened investments are good investments

The practice of considering environmental, social, and governance issues when seeking out investment opportunities has evolved considerably from its origins.

Several different methods are currently being used by both value-motivated and values-motivated investors in considering ESG issues across all classes of assets.

Socially Responsible Investing
SRI (Socially Responsible Investing) is an umbrella term for investing strategies that account for the social implications of their capital allocation. There are several SRI approaches, the main ones being Impact Investing, ESG Investing, and Ethical Investing.

It is a myth to think that socially responsible investing comes at a cost – that you will make less money – in fact, the opposite is often the case.

In an article published by the *CFA Institute last year – Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals – Usman Hayat, CFA, and Matt Orsagh, CFA, CIPM wrote:

“There is, however, a lingering misperception that the body of empirical evidence shows that ESG considerations adversely affect financial performance.”

“For investment professionals, a key idea in the discussion of ESG issues is that systematically considering ESG issues will likely lead to more complete investment analyses and better-informed investment decisions.”

* The CFA Institute, based in Charlottesville, Virginia, offers the Chartered Financial Analyst (CFA) designation.

In another paper published by the CFA Institute –Integrating ESG into the Fixed-Income Portfolio – Christoph Klein CFA claims that integrating ESG criteria into the fixed-income analysis can reduce idiosyncratic and portfolio risk, while at the same time improving performance by “helping investors anticipate and avoid investments that may be prone to credit rating downgrades, widening credit spreads, and price volatility.”

The Financial Times Lexicon says the following regarding Environmental, Social and Governance:

“ESG (environmental, social and governance) is a generic term used in capital markets and used by investors to evaluate corporate behaviour and to determine the future financial performance of companies.”

“ESG factors are a subset of non-financial performance indicators which include sustainable, ethical and corporate governance issues such as managing the company’s carbon footprint and ensuring there are systems in place to ensure accountability.”

People’s attitudes are changing

Google and Impax carried out a survey of over 300 investors with £500,000 ($700,000) or more of long-term savings and investments. The aim was to determine what their attitudes to climate change were following the COP21 Conference in Paris.

Below are some of the survey’s findings:

  • 70% of respondents said they were concerned about climate change.
  • 15.3% said they had taken steps of both investing in sustainable/clean energy stocks plus not investing in fossil fuels.
  • 33.5% claimed to currently have investments that are focused on clean energy, energy efficiency, or sustainability.

Writing in the Financial Times, Nyree Stewart quotes Hamish Chamberlayne, an SRI manager at Henderson Global Investors, who said:

“The big picture is that in the next few decades, the global economy is going to transform to a low-carbon economy and it will be one of the biggest investment events of our lifetime.”

“We have a global economy that is roughly $80trn [£56.3trn] and extremely dependent on carbon, so transitioning to an economy where we are much less dependent on carbon will result in enormous disruption to established industries and geopolitical relationships and how the global economy works. In the next 10-20 years there will be huge risks and opportunities.”

This shift is prompting innovative financing models focused on sustainability and long-term ecological balance.

ESG vocabulary and concepts

There are many compound nouns in English containing the letters “ESG.” Let’s take a look at a few of them, their meanings, and how we can use them in a sentence:

  • ESG Criteria

The standards a company is judged by regarding its environmental, social, and governance practices.
Example: “The investment fund uses strict ESG criteria to screen potential assets for its green portfolio.”

  • ESG Compliance

The state of following established ESG standards and regulations.
Example: “Our company’s annual report demonstrates our commitment to ESG compliance.”

  • ESG Performance

How well a company does in managing and reporting on environmental, social, and governance issues.
Example: “The firm’s ESG performance has improved significantly since the adoption of new sustainability protocols.”

  • ESG Reporting

The process of disclosing data on a company’s ESG practices and outcomes.
Example: “Investors are increasingly demanding more transparent ESG reporting from corporations.”

  • ESG Integration

The inclusion of ESG factors into traditional financial analysis.
Example: “ESG integration has become a standard approach for our investment decision-making process.”

  • ESG Score

A rating given to companies based on their adherence to ESG principles.
Example: “Companies with a high ESG score often attract more conscientious investors.”

  • ESG Strategy

A company’s plan and actions to incorporate ESG considerations into its business model.
Example: “The board has approved a new ESG strategy to guide our operations over the next decade.”