What is ESG (Environmental, Social and Governance)?

Key highlights:

• ESG refers to the three central factors that investors consider when assessing the sustainability and ethical impact of an investment in a company or business. These factors include the company's environmental performance, its impact on society, and the way it is managed.
• ESG investing involves considering ESG criteria when making investment decisions and can be motivated by a desire to align financial and social or environmental goals. This approach can involve a variety of strategies, such as exclusionary screening, best-in-class selection, and impact investing.
• The importance of ESG has gained significant attention in recent years, with many investors and companies recognising the potential benefits of strong ESG practices, including improved financial performance, risk management, enhanced reputation, and greater alignment with personal values.

Environmental, social and governance factors are becoming increasingly relevant for modern investors. Not only because of social consciousness but also because it might harm the returns of their portfolios. ESG investing started in the 1960s but has grown immensely as investors focus on ESG standards and climate data to analyse shares. Let’s take a closer look at what ESG is and how to follow the framework during the investment process.

What is ESG (Environmental, Social and Governance)? 

ESG stands for Environmental, Social, and Governance. It is a term used to describe the three key areas that are considered when evaluating the sustainability and ethical impact of an investment in a company or business.

Environmental factors refer to the impact that a company has on the environment, including its greenhouse gas emissions, energy efficiency, use of natural resources, and waste management practices.

Social factors refer to the way that a company treats its employees, customers, and other stakeholders, including its policies on diversity, inclusion, and human rights.

Governance factors refer to the way that a company is managed and governed, including its senior executives and board members, transparency, and ethical practices.

ESG has become increasingly important in recent years, as investors and consumers increasingly consider the social and environmental impact of their investments and purchases. Many companies now publish information about their ESG framework and performance in order to attract investment and demonstrate their commitment to sustainability.

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How does the Environmental, Social and Governance criteria work?

The Environmental, Social, and Governance (ESG) criteria are used to evaluate the sustainability and ethical impact of an investment in a company or business. The criteria are often used by investors and financial analysts to assess a company's performance and determine its potential risks and opportunities.

Companies may be evaluated using a variety of methods, including self-reported data, third-party audits, and industry benchmarks. This information is then used to assess the company's overall ESG performance and identify any areas for improvement. Many investors and financial analysts consider ESG data when making investment decisions, as it can provide insight into a company's long-term financial performance and risk profile.

How is ESG calculated for companies?

There is no one standardised method for calculating a company's Environmental, Social, and Governance strategy. Different organisations and analysts may use different methods and criteria to evaluate a company's ESG performance.

One common method is to use publicly available information, such as a company's annual report or sustainability report, to assess its performance in each of the three ESG areas. This may include information on a company's greenhouse gas emissions, water usage, waste management practices, policies on diversity and inclusion, ethical governance practices, and other factors.

Another approach is to use third-party data sources, such as specialised research firms or industry benchmarks, to assess a company's ESG performance, like MSCI ESG Ratings. These sources may use their own proprietary methods and criteria to evaluate a company's ESG scores, and may also take into account additional factors such as stakeholder engagement and community involvement.

It is important to note that there is no single "right" way to calculate a company's ESG performance, and different methods and criteria may produce different results. As a result, it is important to consider multiple sources and perspectives when evaluating ESG scores.

MSCI ESG Ratings Model Source: MSCI

Environmental, Social, and Governance considerations

Environmental factors

Environmental factors refer to the impact that a company has on the environment.

There are many different ways to measure and assess a company's environmental criteria, and different organisations and analysts may use different methods. Some common ways to evaluate a company's environmental performance include:

• Greenhouse gas emissions: Companies may be evaluated based on their greenhouse gas emissions, including carbon dioxide (CO2) and other gases that contribute to climate change. This information may be reported by the company itself or may be calculated using industry benchmarks or third-party data sources.

• Energy use: A company's energy use can impact the environment through the use of fossil fuels and other non-renewable energy sources. Companies may be evaluated based on their total energy use, as well as their use of renewable energy sources.

• Water usage: A company's water usage can impact local water resources, particularly in areas where water is scarce. Companies may be evaluated based on their total water usage, as well as their efforts to conserve water and protect water quality.

• Waste management practices: A company's waste management practices can impact the environment through the release of pollutants and the use of non-renewable resources. Companies may be evaluated based on their efforts to minimise waste, recycle materials, and safely dispose of hazardous materials.

• Product and service impact: The environmental impact of a company's products and services is also an important factor to consider. This may include the resources used to produce the products, the energy and water used in the production process, and the impact of the products on the environment during use and disposal.

Social factors

The social factor of ESG is concerned with how a company's operations and policies impact the well-being of people and society, and whether the company is taking steps to be a responsible and ethical member of the community.

Here are some examples of social issues that may be included in the ESG analysis of a company:

• Labour practices: This includes issues related to fair wages, working hours, safety conditions, and non-discrimination in the workplace.

• Human rights: This includes a company's policies and practices related to protecting the human rights of employees, communities, and other stakeholders.

• Diversity and inclusion: This includes a company's policies and practices related to promoting diversity and inclusion in the workplace and throughout the supply chain.

• Community relations: Community relations looks at the impact on the local communities in which it operates, including issues related to environmental impact, economic development, and social responsibility.

• Product safety: This includes a company's policies and practices related to ensuring that its products are safe for consumers.

Governance factors

The governance factor refers to how a company is managed and the systems in place to ensure that it is operating in a transparent, responsible, and ethical manner. Good governance is essential for the long-term success of a company and can help to build trust with stakeholders, including investors, employees, customers, and the wider community.

Here are some examples of governance issues that may be included in the ESG analysis of a company:

• Board composition: Board composition looks at the diversity and independence of the company's board of directors, as well as their experience and expertise.

• Executive pay: This includes the transparency and fairness of executive pay and compensation, as well as the alignment of executive incentives with the long-term interests of the company.

• Transparency and disclosure: Transparency and disclosure focus on the company's policies and practices related to the disclosure of information, such as financial statements and sustainability reports.

• Risk management: Risk management includes the company's policies and practices related to identifying and managing risks, such as financial, operational, and compliance risks.

• Corporate culture: This includes the company's values, mission, and leadership style, and whether they promote ethical and responsible behaviour.

What are the advantages of ESG criteria?

Using ESG criteria can help investors make informed decisions about their investments, while also contributing to a more sustainable and ethical business environment. There are several advantages to using environmental, social, and governance criteria when evaluating investments:

• Improved financial performance: Companies with strong ESG practices may be better positioned to manage risks and capitalise on opportunities, leading to improved financial performance over the long term.
• Risk management: By considering ESG factors, investors can identify and mitigate risks that may not be apparent from traditional financial analysis alone.
• Enhanced reputation: Companies with strong ESG practices may be perceived as more reputable and attractive to ESG investors, customers, and employees.
• Greater alignment with personal values: Using ESG criteria allows investors to align their investments with their personal values and social and environmental goals.
• Increased transparency: Companies that are proactive in disclosing their ESG practices may be more transparent and accountable to stakeholders, including investors.

What are the disadvantages of ESG criteria?

While ESG criteria can be a valuable tool for investors, it is important to carefully consider the potential limitations of this approach. This means there can be some disadvantages to using the ESG criteria when evaluating investments:

• Limited data: There is often a lack of standardised and comparable data on ESG issues, which can make it difficult to accurately assess a company's performance on these metrics.
• Subjectivity: ESG criteria can be somewhat subjective, as different investors may place different values on different issues. This can make it difficult to create a consensus on the importance of different ESG factors.
• Short-term focus: Some critics argue that focusing on ESG criteria can lead to a short-term focus on meeting certain targets rather than long-term value creation.
• Costs: Implementing ESG practices can involve additional costs for companies, which may impact their financial performance in the short term.

What is ESG investing?

ESG investing, also known as sustainable, ethical, or impact investing, refers to the practice of considering environmental, social, and governance (ESG) criteria when making investment decisions. This means that in addition to traditional financial factors, investors consider how a company's operations and policies impact the environment, society, and the way it is managed.

What is the difference between ESG vs SRI?

ESG (environmental, social, and governance) and SRI (socially responsible investing) are both investment approaches that consider the social and environmental impact of an investment in addition to traditional financial factors. However, they differ in their specific focus and methodology, here are some key differences between the two:

• Focus: ESG investing focuses on three specific areas: the environment, society, and governance. SRI, on the other hand, is a broader term that can encompass a variety of socially and environmentally responsible investment strategies, including those that focus on specific issues such as human rights or climate change.

• Methodology: ESG investing typically involves evaluating a company's performance on specific ESG metrics and using this information to inform investment decisions. SRI can include a wider range of approaches, such as exclusionary screening, best-in-class selection, and impact investing.

• Motivation: ESG investing is often motivated by a desire to align financial and social or environmental goals, and may be driven by the belief that companies with strong ESG practices are better positioned for long-term success. SRI can be motivated by a variety of factors, including ethical, moral, or religious values, as well as a desire to create positive social or environmental change.

Environmental, Social and Governance FAQs

What are the top 5 ESG companies based on their ESG score?

Some of the top ESG companies based on the MSCI ESG rating are NVIDIA (NVDA), Microsoft (MSFT), Xylem (XYL), Texas Instruments (TXN) and Accenture (ACN). Check out more of the top ESG stocks available to trade on Stake.

What is the difference between ESG vs CSR?

ESG and CSR (corporate social responsibility) are related concepts that both involve considering the impact of a company's operations on society and the environment. However, there are some differences between the two:

• Focus: ESG is primarily concerned with how a company's operations and policies impact the environment, society, and the way it is managed. CSR, on the other hand, refers to the voluntary actions that a company takes to address the social and environmental impacts of its operations.

• Audience: ESG is primarily focused on the perspective of investors, while CSR is focused on the perspective of the company and its stakeholders, including employees, customers, and the wider community.

• Motivation: ESG is motivated by a desire to align financial and social or environmental goals, and may be driven by the belief that companies with strong ESG practices are better positioned for long-term success. CSR is motivated by a desire to be a responsible and ethical member of the community, and may be driven by a variety of factors, including ethical, moral, or reputational considerations.

Are ESG companies a good investment?

It is generally believed that companies with strong environmental, social, and governance practices may be better positioned for long-term success and may be more attractive to investors. This is because ESG factors can affect a company's financial performance, risk profile, and reputation.

For example, a company with strong ESG practices may be better able to manage risks related to environmental regulations, labour practices, and supply chain management, and may be perceived as more reputable and attractive to customers, employees, and other stakeholders.

However, it is important to note that the relationship between ESG and financial performance is complex and not all ESG companies are necessarily good investments. As with any investment, it is important to thoroughly evaluate the financial and non-financial factors that may impact a company's performance. When researching stocks it's important to analyse financial statements, management and governance practices, and industry trends, as well as considering the company's ESG performance.