- Environmental, Social, and Governance (ESG) is a score for companies based on various parameters.
- Investors look to these to engage in what is called ESG investing.
Investors generally diversify their portfolios to minimize and distribute their risk. Often, when choosing companies, investors look at several factors, such as plans, product performance, price history, and legal pursuits. Recently, ESG, which stands for Environmental, Social, and Governance has also become a parameter to consider.
This parameter throws light on the duties, responsibilities, and responses of these companies towards the environment, society, and their governance board. These factors help them screen companies that, along with performing well, are aligned with their vision and moral values.
The ESG Parameter
The environmental factor mainly concerns the responsibility of a company regarding its surroundings. It is mainly judged by company policies regarding waste management, pollution, climate change, global warming, deforestation, and carbon footprint. They need to prevent the use of toxic chemicals, adopt sustainable practices and engage in resource conservation.
The social factor mainly accounts for the practices undertaken by companies to foster a strong relationship with their employees, customers and the local community around them. Companies that donate a part of their profits, organize volunteer programs for employees, follow corporate ethics, and focus on social justice and community growth tend to have a higher ranking. In addition to these, they need to ensure that no racial, sexual, or gender-based discrimination is observed.
The governance factor is to ensure that the company is transparent about its audits and executives’ pay. While selecting leaders and members of the board, it does not engage in political influence or special treatment for some and follows ethics and diversity in its process. The company is accountable to its shareholders and is not trapped in any legal mishap.
Research firms such as Bloomberg, JUST Capital, Refinitiv, S&P Dow Jones Indices, and MSCI issue ESG scores to various companies after considering several factors. Although they may differ individually, some common elements include annual reports, sustainability measures, management of resources and employees, and existing board structure. The scale generally ranges from 0 to 100, with a higher score indicating better performance.
Pros and Cons of ESG
Despite the moral values investors look for in companies, investing based on ESG can also help them avoid companies that are following unethical and hidden practices that can cause future risks. Examples include the oil spill in the Gulf of Mexico by BP and the scandal of Volkswagen going public, which caused their shares to fall sharply.
Companies are becoming aware of the choices of investors and they try to include the ESG approach in their practices to attract their attention. Several firms, like Wells Fargo, Goldman Sachs, and JPMorgan Chase, are known to produce annual reports that highlight their objectives.
By screening companies early, investors can lose grip on some major players. The best examples are the tobacco and defense (weapons and ammunition) industries, which are avoided by ESG investors. Although they have a history of performing well and producing good returns, investors may lose their chance of diversifying their portfolios by investing in them.
Conclusion
From the point of view of companies, adopting ESG practices right from the start may sound challenging and expensive. It demands better working conditions for employees, an inclusive atmosphere from the bottom of the ladder to the board, a contribution to the social good, and lastly, a positive impact on the environment.
However, in the long run, it is bound to benefit as governments tighten the regulations around labor laws, and the social and environmental duties of businesses and as more investors look for your ESG score.
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