What is ESG and why is it important?

If you sit on the management team or board of a company you will probably have heard of the term, so what is ESG and why does it matter?

Environmental, social and governance (ESG) is a set of standards for how a company operates in regard to the planet and its people.

ESG is important because socially conscious investors now use ESG criteria to screen potential investments.

Environmental criteria examine how a company performs as a steward of the planet. Social criteria examine how a company manages relationships with employees, suppliers, customers, and the communities where it operates. Governance defines a set of rules and best practices, along with a series of processes that determine how an organisation is managed and controlled.

Environmental criteria may include a company’s energy use, the waste and pollution it creates, how it conserves natural resources, and the way it treats animals.

The criteria are often used in evaluating any environmental risks a company may face and how the company is managing those risks. For example, does it own contaminated land? How does it dispose of hazardous waste? How does it manage toxic emissions, and how does it comply with environmental regulations?

Social criteria examine the company’s business relationships. Does the company have a high regard for employee health and safety? Does the company allocate a percentage of its profits to its local community? Do company employees engage in volunteer work? Are other stakeholders’ interests taken into account?

Investors looking at a company’s ESG will want to see that it is accurate and transparent in its accounting and reporting methods. Investors will also look at how a company treats its shareholders and their right to vote on important issues. Investors will seek assurances that the company doesn’t engage in illegal practices and avoids conflicts of interest when it chooses its board members.

Investors now understand that environmental, social, and governance criteria go beyond ethical concerns. With robust ESG criteria, companies can avoid practices that involve risk. For example, Volkswagen’s emissions scandal rocked the company’s share price, and investors lost billions.

Investors and investment firms look for ESG-minded companies and financial services companies like Goldman Sachs and JPMorgan Chase now publish annual reports that review the ESG approaches of various companies.

There are approximately 30 notable ESG rating agencies and data providers around the world.

The following ESG rating agencies cover global large-cap firms and are the most used by asset managers and investors.

• RobecoSAM Total Sustainability Rank – ranks companies against industry peers across E, S and G metrics.

• ISS Governance Quality Score – Identifies corporate governance risks based on board structure, shareholder rights, remuneration and audit.

• CPD – measures the level of commitment to climate change mitigation, adaptation and transparency.

Although ESG ratings are not perfect, they serve a vital role in providing a snapshot of a company’s performance to support more sustainable investment decisions.