ESG - What is Environmental, Social and Governance

November 29, 2022
Glossary
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What is the definition of ESG?

ESG is an acronym for Environmental, Social and (Corporate) Governance. It refers to the non-financial factors of a corporation’s impact.

ESG can be considered a sub-topic of sustainability, whose definition by the UN World Commission on Environment and Development can be paraphrased as ‘meeting the needs of the present without compromising the ability to meet needs of future generations’.

Sustainable practices support ecological, human, and economic health, and operate under long-term priorities with an assumption that resources are limited.

ESG encompasses three pillars of responsibility :

  • Environmental: refers to a firm’s impact on the environment, such as the company’s energy usage, pollution/waste, use of natural resources, and/or positive improvements like switching to renewable energy.
  • Social: correlates to a firm’s impact on society and company stakeholders—this can include factors such as product safety, employee treatment and diversity, charitable initiatives, supply chain relationships, impact on local communities, etc.
  • Governance: refers to the company’s internal governance structure. Metrics for governance might include board diversity, accounting policies, executive pay and compensation, ownership structure, and ethical behavior within the higher management chain.

ESG Key Concepts and Terms

Where does the ESG concept come from?

The specific term ‘ESG’ was coined in a 2004 report by the Global Compact, entitled “Who Cares Wins,” in a recommendation urging analysts to “better incorporate environmental, social and governance (ESG) factors in their research”.

However, the practice of considering non-financial factors in company evaluations has been in use since even earlier; some might point to the 2001 launch of the FTSE4Good Index Series, a series of ethical investment stock market indices, as the beginning of mainstream ESG.

Despite the rapid growth of ESG influence in recent years, the idea of sustainable investing, or investing with specific values, is far from new.

‘Impact investing’—investments aimed at generating not only financial return, but positive social and environmental impact as well—has its origins in religious groups, who placed ethical parameters on their portfolios (refusing, for example, tobacco, alcohol, and gambling businesses).

The concept of ESG itself is fairly broad. It includes three separate topics within its scope and can also be expanded depending on the inclination of the company or investor in question.

It is important to note that investors and companies interact with ESG criteria somewhat differently; investors usually seek to integrate ESG criteria into their investment decisions, and companies have an added responsibility of not only integrating ESG criteria, but also of disclosing ESG data to stakeholders (notably investors).

Listed below are some of the most relevant ESG (and ESG-adjacent) terms.

Many of these terms have similar meanings and are sometimes used interchangeably—however, understanding the differences in connotation will help place ESG within the spectrum of corporate sustainability.

ESG vocabulary

  • ESG integration: the practice of incorporating ESG information into investment decisions to help enhance risk-adjusted returns.
  • ESG disclosure: the disclosure of data relating to an organization's environmental, social and governance performance.

Investor vocabulary

  • Impact investing: investing in businesses/organizations that have a positive and/or less negative impact on social and environmental criteria.
  • Socially Responsible Investing (SRI): Investing in companies that have positive social impact. In other words, actively removing or choosing investments based on specific ethical guidelines.

Vocabulary for companies

  • Corporate Social Responsibility (CSR): The European Commission has defined Corporate Social Responsibility (CSR) as “a concept whereby companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a voluntary basis” In short, CSR refers to companies’ practical implementation of sustainability.
  • Materiality (in the context of sustainability information): The effectiveness and financial significance of a specific measure as part of a company's overall ESG analysis. The Global Reporting Initiative’s (GRI) Materiality Principle states that a sustainability report should include information that “reflect[s] the organization’s significant economic, environmental, and social impacts” or “substantively influence[s] the assessments and decisions of stakeholders.”

Additional Key Institutions and Decisions

  • 1984 - US Sustainable Investing Forum founded
  • 2000 - Global Compact Initiative founded, Global Reporting Initiative (GRI) launched
  • 2004 - Global Compact produces “Who Cares Wins”
  • 2006 - United Nations Principles for Responsible Investment (PRI) launched
  • 2007 - Climate Disclosure Standards Board (CDSB) was born at the WEF meeting in Davos to create a generally accepted framework for climate risk reporting by corporations
  • 2009 - Global Impact Investing Network launched
  • 2010 - International Integrated Reporting Council (IIRC) formed to develop an overarching integrated reporting framework for both material financial and non-financial information
  • 2011 - Sustainability Accounting Standards (SASB) formed to set standards for corporate reporting on ESG metrics
  • 2015 - Task Force on Climate-Related Financial Disclosures (TCFD) which aims at developing a set of voluntary climate-related financial risk disclosures
  • June 2021 - SASB and IIRC officially merged into the Value Reporting Foundation (VRF)
  • Nov 2021 - IFRS Foundation announces the creation of International Sustainability Standards Board (ISSB), which is a consolidation with CDSB and VRF

Recent ESG developments

As of 2021, ESG is set to grow rapidly and shape the corporate sustainability agenda. Here are some of the most crucial developments.

An analysis of the ESG industry

New types of rating agencies that focused on non-financial criteria began to develop in the early 2000s.

Rating processes were developed to help investors conduct in-depth analyses of the companies within their portfolios and how well those companies adhered to ESG criteria, and such agencies incorporated a review of a company’s environmental, social and governance (ESG) performance in addition to their economic performance.

These agencies are commonly called social and environmental rating agencies, or, extra-financial rating agencies.

Each extra-financial rating agency has its own evaluation grids and criteria, its own methodology.

Just as there is a multiplicity of ESG standards and frameworks (GRI, IIRC, SASB, etc.), there are a number of different extra-financial rating agencies, each with their own process and ESG questionnaires.

Nevertheless, ESG rating processes are trending towards homogenization.

An initial consolidation movement (mergers, acquisitions or alliances) in the 1990s led to the appearance of the currently well-known extra-financial rating agencies operating on an international scope – Vigeo (France), MSCI ESG Research (United States), EIRIS (United Kingdom), oekom research (Germany), Inrate (Switzerland), Solaron (India) and Sustainalytics (Netherlands) – and the 2010s have seen continued consolidation, in a market increasingly dominated by American corporations.

Some of the most significant recent developments in the extra-financial rating ecosystem include:

  • 2015 - Vigeo merges with Eiris
  • 2018 - Oekom Research is acquired by ISS
  • 2019 - Vigeo-Eiris is acquired by Moody’s Corporation and becomes V.E.
  • 2020 - Sustainalytics is acquired by Morningstar

ESG funds

ESG funds are growing rapidly, indicating huge market demand for application of ESG strategy.

CNBC puts ESG fund inflow at over $21 billion during the first quarter of 2021, an increase from the $51 billion for the entire year of 2020 and $21.4 billion in 2019.

A BlackRock representative attributes this increase in interest for ESG to more visibly impactful methods of incorporating sustainable investments. Financial experts now view ESG as a “core-type strategy”- and this trend looks like it will only continue in the coming decades.

Data and Tech in ESG evaluations

ESG leaders are still struggling to get a hold on the unwieldy world of ESG data, but the standardization of ESG reporting and disclosure is of high priority.

ESG analysts from Forrester suggest that industry regulations will become increasingly specific, detailed, and relevant in coming years.

Companies are also reacting to dynamic materiality and the unpredictability of factors like new knowledge, regulations, and global events by adopting and developing new procedures to measure risk.

Shareholder Activism and ESG Proxy Voting Policies

Shareholder activists are people who use their influence, through ownership of company shares, to enact change within a company and/or in that company’s external impact.

As partial owners of the company whose shares they own, shareholder activists can initiate important conversations with the board of directors and enact change.

Tactics for enacting change vary, especially because there are different classes of shares that allow for a range of voting privileges. Examples of tactics include: a dialogue with managers, formal proposals, social pressure through social media, and lawsuits.

Market reactions to the climate crisis

According to the most recent IPCC climate report, the world has reached an increase of 1.1°C compared with the average in 1850–1900, resulting in extreme weather such as the 2020 Australia wildfires.

In order to achieve the Paris Agreement limit of a 2°C increase by the end of the 21st century, MSCI’s Warming Potential estimates that every company in the MSCI ACWI IMI would have to reduce total carbon intensity (Scopes 1, 2 and 3) by an average of 8%-10% per year from 2021 until 2050.

The need for steep reductions in emissions in portfolios means that companies would have to find means of decarbonizing rapidly, and investors/investment firms are faced with the choices of convincing companies to undergo massive overhaul of procedure, change their portfolio concentration, and/or shift assets.

The urgency of the climate crisis indicates a dire need for a change of status quo in corporate environmental impact.

As society faces unprecedented challenges—climate change, protests and social upheaval, increasing technological capabilities, and the ongoing COVID-19 pandemic—the need for frameworks that quantify and mitigate unpredictable risks becomes clear.

Environmental, social, and governance (ESG) strategies can help meet those needs: they are here to stay.

To learn more about ESG...

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