Investors, customers and other stakeholders are beginning to contend with new risk factors when it comes to their data, including climate change, demographic shifts, cybersecurity issues and regulatory pressures. These complex changes have resulted in a new approach to evaluating enterprise data and business strategies: Environmental, social and corporate governance.
What is ESG?
ESG is a framework for how an organization can integrate environmental, social and corporate governance factors into business objectives. It is a type of non-financial performance indicator used to determine how advanced an organization is in terms of its sustainability goals and ethical impact. ESG is becoming increasingly important for businesses as more investors, customers and regulators are looking at environmental sustainability as a major value indicator of an organization.
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A similar concept to ESG is corporate social responsibility, but the major difference between ESG and CSR is that ESG is measurable. ESG’s clear metrics make it far more popular with investors; CSR is more of a general sustainability framework used by the organization to report its efforts to relevant stakeholders.
Now, let’s break down each component of ESG:
The environmental aspect of ESG primarily refers to how an organization protects natural resources by reducing its carbon footprint. Companies are expected to minimize their environmental impact on things such as air quality, water quality, biodiversity and waste management.
The social aspect of ESG is the relationship a company has with its employees and stakeholders. This includes diversity, inclusion and equity. Some of the factors used to determine the social performance of an organization include human capital management metrics like employee engagement and fair wages.
Corporate governance policy
Corporate governance refers to how an organization is managed by its leaders. This includes how leadership promotes accountability and transparency in their organization, executive compensation, prevention of corruption, cybersecurity policies and practices, data quality and privacy, and organizational structure.
Who uses ESG?
ESG is used by asset managers, investors, financial institutions, customers and other stakeholders to measure and compare ESG performance. It is also used in pension funds and endowments. The increasing popularity of ESG means it has become the focus of business leaders as an investment community. Some financial service and product companies are now offering exchange-traded funds, green bonds, index funds and other financial products that align with ESG criteria.
There are also several ESG rating agencies that use environmental, social and corporate governance data to measure the level of ESG performance and compliance for an organization. There are no common standards for determining an ESG rating; each agency has its own criteria and metrics. Some rating agencies such as ESG Analytics use artificial intelligence and big data to assign ESG scores to organizations.
ESG growth acceleration predictions
There has been a significant increase in ESG growth as the business community focuses on more sustainable investing. The economic uncertainty caused by the pandemic has resulted in businesses realigning their focus toward environmental, social and corporate governance factors. Although ESG has grown its presence steadily over the past 15 years, the pandemic has acted as a catalyst to transform ESG from a niche market to one of the major points of focus for businesses.
2021 was a record year for ESG investing with the popularity of green bonds, but the market continues to outpace its previous growth trends. The ESG assets under management worldwide are expected to increase from $41 trillion in 2022 to $50 trillion or more in 2025, according to Bloomberg Intelligence.
Climatologists have predicted that the weather will continue to get worse, which can result in more natural disasters and unpredictable climates. This global crisis means that ESG and how businesses approach their environmental responsibilities will gain more prominence in the coming years.
There is also an expectation amongst experts that ESG standards will converge to form some common standards and ESG practices for organizations in the future. According to Prosper Insights & Analytics, there has been an increase in demand for environmentally responsible brands, and this trend is expected to continue.
Pros and cons of ESG
Pro: ESG minimizes business risks
Stakeholders can benefit from ESG by minimizing their risk. Using ESG, stakeholders can identify companies with practices that make them vulnerable to environmental, social and corporate governance factors. As we learned from the BP oil spill and Volkswagen emissions scandal, neglecting the importance of environmental factors can result in huge losses for a business.
Con: No standardized approach to ESG practices is in place
A disadvantage of ESG is that its ratings are not accepted by everyone, as current ESG ratings are not federally regulated. This has raised some questions about the reliability of ESG ratings and whether organizations are being honest in their ESG disclosures.
Most ESG ratings rely on corporate disclosures to assign ESG scores. A recent study has highlighted that the more information an organization discloses about its EGS incentives, practices and goals, the more rating agencies are likely to disagree with how well that organization is performing in terms of ESG criteria.
There is more disagreement on ESG outcomes compared to input metrics such as ESG policies. As ESG practices become more prevalent and ratings become more standardized, this disadvantage is expected to diminish.
Pro: ESG increases competitive edge
From the organization’s perspective, prioritizing ESG makes them more attractive to investors, employees and customers. The organization gains an edge over other competitors that are not performing as well in ESG metrics.