What is environmental, social and governance (ESG)?

The term “ESG” was popularized in the 21st century and often comes up in the same conversation as sustainability and corporate social responsibility (CSR). However, while sustainability and CSR function more as philosophies or end-goals, ESG is more tangible; it encompasses the data and metrics needed to inform decision-making for companies and investors alike.

The impact a company can have on its surrounding ecosystem has become vividly clear, whether it’s on a global scale or within its local community. At the same time, people have become increasingly concerned about ESG issues such as climate change, human rights and executive compensation. And so, embedding sustainability in business is top-of-mind for executives and investors alike in today’s eco-conscious business landscape.

Given that stock markets traditionally mirror public sentiment, investors have recalibrated their asset management strategy to focus not only on financial performance but also various ESG factors. Now more than ever, businesses are being scrutinized by institutional investors looking to align their investment strategies with their values—namely their ESG considerations.

Since many investment decisions are influenced by ESG criteria, investors have taken a new approach to asset management. And while they may seem similar, there are a few key distinctions between ESG investing and other strategies such as socially responsible investing (SRI) and impact investing.

ESG investing looks at various ESG factors alongside traditional financial metrics. However, there is an added opportunity and risk management component that factors environmental externalities into a company’s valuation. Ultimately, financial returns remain the biggest priority when it comes to ESG investing.

SRI, or sustainable investing, focuses less on financial returns and more on ethical considerations. For instance, an investor may avoid mutual funds or an exchange traded fund (ETF) if one of the companies operates in an industry that’s been detrimental to the environment.

Impact investing could be considered the most philanthropic form of investing in which positive results are the highest priority. That means the investment needs to lead to a tangible social good. That could mean investing in an ETF or company that focuses exclusively on renewable energy or is on the path to net-zero operations.

In light of these new investment strategies, multiple ESG funds have sprouted up signaling the growing importance of ESG in today’s stock market. For companies, having a comprehensive ESG strategy is no longer a luxury but a requirement, which means organizations must become well-versed in ESG disclosure.

Organizations are increasingly including ESG metrics in their annual reports to help stakeholders make more sustainable investment choices. Through ESG reporting, companies can show how they compare to industry benchmarks and targets using qualitative and quantitative data to measure their progress across ESG initiatives. ESG reporting also provides stakeholders with the necessary insights to make informed decisions by highlighting potential ESG risks and opportunities that might affect the company's long-term value.

There are numerous ways to draft an ESG report. Typically, they’re created using an established ESG framework that can offer instruction on which ESG topics to focus on. ESG frameworks also help organizations understand how to best structure and prepare information for disclosure so that they can earn a higher rating or ESG score.

An ESG score is used to track a company’s ESG performance, providing greater visibility into its operations for investors, stakeholders and regulatory bodies. Organizations that provide more robust ESG reports typically score higher, whereas those that don’t track or showcase their ESG performance will often have a lower ESG rating.

The Task Force on Climate-related Financial Disclosure (TCFD) is an organization that provides a set of recommended climate-related disclosures that companies and financial institutions can use to inform shareholders. Similarly, the Sustainability Accounting Standards Board (SASB) has helped establish and maintain industry-specific standards to guide the disclosure of organizations’ sustainability information.

Institutional investors can also look towards organizations like Morningstar, Morgan Stanley Capital International (MSCI) and others to offer up ESG data on certain companies. All these providers play a crucial role in delivering key ESG metrics that can help determine how investible an organization is.

There are several regulations that have been put forth to help companies take ESG factors into account. For instance, the Corporate Sustainability Reporting Directive (CSRD) is a European Union legislation that requires companies to report on the environmental and sustainable impact of their business activities, as well as their ESG initiatives. The Sustainable Finance Disclosure Regulation (SFDR) aims to do the same by standardizing the reporting of ESG metrics.

Various frameworks have also been created to aid companies in their ESG disclosure. In Europe, the Carbon Disclosure Project (CDP) enables companies to provide environmental information to their stakeholders and consists of risks and opportunity management, environmental targets, as well as strategy and scenario analysis. In that same vein, the Global Reporting Initiative (GRI) provides a global framework that standardizes approaches to materiality, management reporting and disclosure for a full range of ESG issues.

While these regulations and frameworks are designed to steer organizations and investors toward more sustainable business practices, they’re not a fool-proof deterrent against greenwashing or green fraud. Nor are they a buffer to a global disruption.

The COVID-19 pandemic quickly exposed the fragility of companies’ supply chains, health and financial services, as well as the climate itself. In the face of uncertainty, scholars grew concerned that companies would deprioritize their ESG initiatives to stay afloat. And while this was the case in some instances, an interesting discovery was made: companies that had strong ESG performance were better equipped to weather the pandemic as they had already accounted for the possibility of disruption.¹

It’s a powerful reminder that ESG is more than just metrics, regulations and frameworks. At its core, ESG is an actionable way to measure progress and take steps towards a more sustainable future.