Common sense dictates that ROI (return on investment) is the most important acronym in a portfolio, but another three-letter term has been catching up: ESG. Standing for Environment, Social, and (Corporate) Governance, ESG is an emerging metric that measures a company’s overall approach to ethical corporate citizenship as viewed through the lenses of environmental responsibility, treatment of the individuals and groups, and leadership.
Where previously such factors were seen as nice-to-have in the business world, growing concern over both the public-relations and ethical ramifications of company behavior has turned proper ESG planning into a must-have for any leading business. What should investors know about ESG, and does this metric measure any tangible value, or is it an intrusion of non-business concerns into the market?
History and Important Factors
The codification of ESG first began around the turn of the millennium, though movements toward corporate accountability have been a trend since at least the 1950s. ESG has been a response to growing internal and external pressure to judge companies on more than their bottom line. ESG refers both to the three factors it considers, and to each individual company’s strategy regarding those factors.
All three of the major areas of concern covered by ESG are extremely broad, but some of the most common concerns in each category are self-evident. When discussing ESG, it is important to remember that no company’s ESG plan can possibly account for all contingencies, and attitude and track record are at least as important as comprehensive preparedness, as a company that has shown it is serious about ESG concerns is likely to adapt well to emerging issues.
Environment, Social, Governance
Environmental considerations are those that deal with a company’s impact on the ecosystem both at large and in direct relation to its operations. As more and more executives and investors acknowledge the inescapable truth of the climate crisis, the market is adjusting to prefer behaviors that will slow or avert major climate catastrophe. Likewise, sustainability is a major area of interest as firms seek to do business without exhausting their resources or creating an untenable world for future generations.
Social concerns involve the ways in which companies interact with individuals and groups. This refers both to hiring and human resources practices such as diversity, closing the gender wage gap, and providing adequate time off and cutting-edge benefits. Companies should also avoid human rights violations in their operations and take the health and welfare of communities into account. Consumer protection has also grown in importance recently, with companies now under scrutiny for selling faulty or dangerous goods and for practices like predatory lending. Even animal welfare is included under the social part of ESG, to prevent needless cruelty in the treatment of livestock.
Finally, governance refers to the behavior of company leadership, less in regards to profitability and more with an eye toward ethics, corruption, transparency, and tax responsibility. This category covers the behavior not just of CEOs, but of C-suite executives, shareholders, and even employees, and focuses on management structure, workforce relations, and compensation for both executives and workers. Governance can also include the company’s own history for ethical investment, making sure businesses are judged not only on their own behavior but on those of the companies they support.
Why ESG Matters
Today, ESG is effectively a social credit score for companies, giving potential partners, customers, and investors a view into a firm’s attitude toward ethical concerns. These metrics are important regardless of how individuals feel about the need for moral action among businesses.
From an idealistic standpoint, ESG matters because it differentiates ethical from unethical companies and tangibly rewards decency and selflessness while exposing bad actors. Many individuals and groups feel laissez faire capitalism is unacceptable in an enlightened society, and that traits such as fair treatment of workers and customers, honest leadership, and good environmental stewardship provide inestimable value regardless of fiscal yield.
A more pragmatic approach can still value ESG as the traits it measures often indicate foresight and lateral thinking. Leaders with a good ESG strategy understand the ROI in things like positive public relations, a motivated workforce, and a stable ecosystem. Even for people with a hardline, profit-driven view of our free-market economy, understanding that many others, including the press, the employee pool, activist groups, and consumers, take ESG seriously is a good reason to do so as well.
ESG and Your Portfolio
Thus far, we have explained what exactly ESG is and why it is considered so important in today’s business world. But what should investors take away from all this information, and should ESG come into consideration when building a portfolio?
Part 2 of this series will discuss the facts and market research around ESG, and determine what role this metric should play, if any, in how investors allocate their funds.
