Understanding ESG: Definition and Significance

Understanding ESG: Definition and Significance


Environmental Social and Governance (ESG) is a vital framework used to assess the sustainability and ethical impact of investments in businesses or companies. When evaluating potential investments, socially responsible investors rely on ESG criteria to screen companies.

ESG is a widely recognized term in capital markets, employed by investors to evaluate a company’s behavior and predict its future financial performance.

These factors, namely Environmental, Social, and Governance, fall under the umbrella of non-financial performance indicators. They encompass ethical, sustainable, and corporate governance issues, such as establishing systems for accountability and managing a corporation’s carbon footprint.

The incorporation of ESG factors into investment funds has seen significant growth since the beginning of this decade, and this trend is projected to continue over the next decade.

Environmental Criteria: Protecting Our Natural Environment

The environmental criteria under ESG scrutinize a business’s role as a steward of the natural environment. Key areas of focus include:

  • Waste and pollution
  • Resource depletion
  • Greenhouse gas emissions
  • Deforestation
  • Climate change

Social Criteria: Empowering People and Communities

The social criteria evaluate how a company treats individuals and emphasizes the following aspects:

  • Employee relations and diversity
  • Working conditions, including the elimination of child labor and slavery
  • Support for local communities, funding projects or institutions that uplift impoverished and underserved communities globally
  • Health and safety measures
  • Conflict management

Governance Criteria: Ensuring Corporate Responsibility

The governance criteria analyze how a corporation governs itself and prioritize the following:

  • Tax strategy
  • Executive remuneration
  • Donations and political lobbying
  • Prevention of corruption and bribery
  • Board diversity and structure

Investors interested in purchasing ESG-screened securities should consider socially responsible mutual funds and exchange-traded funds.

It’s important to note that defining an appropriate set of ESG criteria is subjective and depends on individual priorities. Therefore, conducting thorough research is crucial for identifying investments that align precisely with one’s values.

ESG’s Influence on Alternative Investments

ESG standards are progressively becoming a significant aspect of the alternative investment landscape. ESG issues not only evaluate the sustainability of non-financial impacts but also have a tangible effect on the long-term risk and return profile of investment portfolios.

A recent study discovered that investors who opt for ESG-screened investments gain a ‘double dividend’ in the form of reduced risk and improved rate of return.

Businesses that adopt ESG standards tend to be more conscientious, less risky, and therefore more likely to achieve long-term success in their commercial endeavors.

Traditional investors are increasingly drawn to the ESG framework, using its criteria to assess risk in their investment decision-making process.

According to TriLinc Global LLC, a private investment management company committed to launching and managing innovative products:

“ESG standards provide an additional level of due diligence that serves shareholders’ best interests. The introduction of UNPRI by the UN in 2006 and the involvement of watchdogs like Bloomberg and MSCI have made it abundantly clear that ESG is not a short-lived fad.”

“ESG eliminates unsustainable companies with outdated practices and harmful side effects while minimizing risk for investors. It enables them to invest in more responsible companies that are more likely to achieve long-term success.”

ESG-Screened Investments: A Sound Choice

The practice of considering environmental, social, and governance issues when seeking investment opportunities has evolved significantly over time.

Various methods are currently employed by both value-motivated and values-motivated investors to assess ESG issues across different asset classes.

Contrary to popular belief, socially responsible investing does not come at a cost; it often leads to financial gains. In an article published by the CFA Institute last year, titled “Environmental, Social, and Governance Issues in Investing: A Guide for Investment Professionals,” Usman Hayat, CFA, and Matt Orsagh, CFA, CIPM stated:

“For investment professionals, systematically considering ESG issues enhances investment analyses and improves investment decision-making.”

In another paper from the CFA Institute, “Integrating ESG into the Fixed-Income Portfolio,” Christoph Klein, CFA, claimed that incorporating ESG criteria into fixed-income analysis can reduce idiosyncratic and portfolio risk while enhancing performance by helping investors anticipate and avoid investments susceptible to credit rating downgrades, widening credit spreads, and price volatility.

The Financial Times Lexicon defines Environmental, Social, and Governance (ESG) as a generic term used in capital markets to evaluate corporate behavior and predict companies’ future financial performance. ESG factors encompass sustainable, ethical, and corporate governance issues, including managing a company’s carbon footprint and ensuring the presence of systems for accountability.

Shifting Attitudes of Individuals

A survey conducted by Google and Impax, involving over 300 investors with long-term savings and investments of £500,000 ($700,000) or more, aimed to assess their attitudes toward climate change following the COP21 Conference in Paris.

Key findings from the survey include:

  • 70% of respondents expressed concern about climate change.
  • Among the respondents, 15.3% indicated that they had proactively invested in sustainable and clean energy stocks while refraining from investing in fossil fuels.
  • 33.5% reported having investments focused on clean energy, energy efficiency, or sustainability.

In her Financial Times article, Nyree Stewart quoted Hamish Chamberlayne, an SRI manager at Henderson Global Investors, who stated:

“In the next few decades, the global economy will transition to a low-carbon economy, which will be one of the most significant investment events of our lifetime.”

“Our current global economy, valued at roughly $80 trillion (£56.3 trillion), heavily relies on carbon. Transitioning to an economy with reduced carbon dependency will cause substantial disruptions to established industries, geopolitical relationships, and the functioning of the global economy. In the next 10-20 years, there will be immense risks and opportunities.”

As ESG considerations gain prominence, investors are recognizing the importance of aligning their investments with sustainable and ethical practices. By integrating ESG criteria into their decision-making processes, investors can contribute to positive change while potentially achieving favorable financial outcomes.

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