Insights | Article | ESG 101

ESG 101

11 August 2022

ESG stands for environmental, social and (corporate) governance, which spans a diverse range of issues from climate change, biodiversity and pollution (E) to human rights, diversity and employee engagement (S) to remuneration, board composition, and risk management (G).

What is ESG?

How can companies manage all these issues that are assessed in so many ways?

Box ticking can land a company a good ‘ESG score’, but this does little to mitigate controversy. Company objectives are unique, as are their impacts on stakeholders and the environment. Consequently, the relevance (materiality in financial jargon) of certain ESG issues are also unique — it is these issues that should be the focus. Good management of material ESG issues requires a deep understanding and consideration of its stakeholders, like employees, customers, communities and shareholders, along with the environmental impacts it has across the life-cycle of its products or services.

Employees and stakeholders recognise when a company’s efforts are disingenuous; the protection of cultural heritage sites or preventing incidents of sexual harassment is not only determined by having policies in place. Good practice in these areas is as much a function of corporate culture, and although difficult to capture in an ESG rating, these qualitative aspects are critical consideration for long term investors.

How did ESG become such a huge phenomenon?

In some sense, this shift was inevitable; responding to issues like climate change, the collapse of biodiversity or the gender pay gap impacts investors too. Looking back, however, an ‘ethical’ investing approach can be traced to Quackers banning investment in slaves as early as 1758. Events like the anti-apartheid divestment movement signalled an awakening of the broader industry, but it was not until 2006 and the establishment of the UN backed Principles for Responsible Investment (PRI) that ESG started going ‘mainstream’.

Is ESG the same as Sustainability?

The short answer is no. As the industry evolved there was an important difference between ESG and sustainability, which today is often conflated and is the source of ‘greenwash’. ESG are a set of criteria, mostly focused on company practices, whilst true sustainability relates to outcomes. While logically adhering to the criterion should result in sustainable outcomes, this is not the case. For example; highly polluting companies can receive strong ESG scores because they have strong policies, systems and reporting in place despite their products causing harm.

In this sense assessing ESG is often seen as a risk management consideration for the company, as highly polluting companies should have excellent practices for managing pollution and avoiding accidents to avoid costly regulation and litigation, whereas more sustainably minded investors will be as concerned with the impact the company has on people and the environment, including the sustainability of the products and services themselves. While these two dimensions create a feedback loop, the risk to the company vs the risk to people and planet are often treated differently depending on the investor’s focus.

What impact did COVID have?

Where to now?

The regulatory focus on ESG and sustainability will increase. This will partly be to combat greenwash and false claims but also as policy makers recognise that the risks to companies and investors from these issues continues to grow. It is also a recognition that the transition to a zero carbon economy or the eradication of modern slavery cannot happen without the investment and influence of private markets.

In Australia, those on the wrong side of the transition to a more a sustainable economy will find the forces of shareholder, consumer, regulator and NGO focus will put increasing pressure on their business models and operations. Meanwhile, for high-quality companies that are contributing to more a sustainable future, the opportunities have never been greater.


Related research

ESG 2.0: Measuring and managing investor risks beyond the enterprise-level

This paper discusses how current institutional investing practices and asset allocation strategies conflict with ESG objectives. It encourages institutional investors to review their systematic risk-management practices and recommends the diversification of asset allocation to more regenerative investment structures and asset classes.

ESG and corporate financial performance: Mapping the global landscape

This white paper highlights whether integrating environmental, social and governance (ESG) criteria into the investment process has had a positive effect on corporate financial performance (CFP), whether the effect was stable over time, how a link between ESG and CFP differs across regions and asset classes and whether any specific subcategory of E, S or G had a dominant influence on CFP.

ESG considerations in fixed income: Observation of 10 ESG integration trends

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This paper shares key ESG integration trends that Russell Investments has found in the fixed income market. It is based off observations derived from their 2019 Annual ESG Manager Survey and discussions with fixed income market practitioners looking at ESG considerations and implementations in their investment process.

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This article originally appeared in the Australian Shareholders’ Association magazine.