ESG Investing: What it Means, How it Works, and Developing Trends
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Investing in companies based on the environmental and social sustainability of their business practices has gained traction in recent years. ESG, or environmental, social, and governance standards investment objectives, appeal to socially conscious investors. For example, the asset management giant BlackRock has been a major proponent of ESG investing.
The analysis of investment opportunities based on non-financial factors, rather than solely on a company’s financial performance, is based on ESG reporting frameworks created by several organizations. Standard setters and reporting frameworks include the Recommendations of the Task Force on Climate-related Financial Disclosures, the Value Reporting Foundation, and the Global Reporting Initiative (GRI) Standards.
Many companies voluntarily highlight their ESG practices in annual sustainability reports. However, pressure is increasing from investors and regulators, particularly in the United States and Europe, to implement mandatory ESG disclosure requirements for public companies.
The determination of which ESG issues are material to a specific company depends on the company’s size, industry, and geographic presence. ESG issues fall into three broad categories. Standard setting organizations help investors measure a company’s performance in each of these areas.
Environmental: Some common sustainability indicators under the environmental category include:
- Water Usage
- Climate Risk Mitigation
- Energy Usage
- Energy Mix
- GhG Emissions
- Environmental Oversight
Social: Social factors cover topics like diversity and inclusion, community involvement, and human rights. Some common sustainability indicators include:
- CEO Pay Ratio
- Gender Diversity
- Child & Forced Labor
- Injury Rate
- Employee Turnover
- Global Health & Safety
Governance: Governance factors refer to the corporate governance practices of a company. Corporate governance encompasses the system of rules and policies companies use to promote accountability, transparency, and compliance with laws and ethical standards. Some common sustainability indicators include:
- Board Diversity
- Ethics & Anti-Corruption
- Collective Bargaining
- Data Privacy
- Sustainability Reporting
- Board Independence
- Supplier Code of Conduct
ESG Sustainability Organizations and Frameworks
Global sustainability organizations are attempting to create standardized ESG reporting criteria for companies to follow.
UN Global Compact
The United Nations Global Compact is one of the largest efforts to create a ESG framework for companies. The UN Global Compact provides recommendations for companies to follow on topics including environmental sustainability, human rights, anti-corruption, labor relations, and other issues.
UN Sustainable Development Goals (SDGs)
All member states of the UN adopted its Sustainable Development Goals (SDGs) in 2015 as part of a broader effort to address global social and economic issues. There are a total of 17 Sustainable Development Goals. Different benchmarks have been created to measure progress.
Many asset management firms, institutional investors, and companies align their ESG strategy with the framework set forth by the UN SDGs.
UN Principles for Responsible Investment (PRI)
The United Nations Principles for Responsible Investment (PRI) were developed in collaboration with the UN Global Compact and the UNEP Finance Initiative. The UN PRI lays out six investment principles that emphasize the integration of ESG standards with other metrics of investment performance.
Sustainable Stock Exchanges (SSE) Initiative
The Sustainable Stock Exchanges (SSE) Initiative has created a model framework that provides guidance to member stock exchanges. It identifies 30 key performance indicators (KPIs) related to ESG issues that it recommends companies disclose to investors.
ESG Reporting Standards
Task Force on Climate-related Financial Disclosures (TCFD)
The Task Force on Climate-related Financial Disclosures (TCFD) is an organization chaired by Michael Bloomberg that consists of 32 members globally. It has created a voluntary company disclosure framework. The TCFD’s recommendations are intended to help companies determine how to disclose their sustainability risks and practices to the public.
Carbon Disclosure Project (CDP)
The Carbon Disclosure Project (CDP) is a non-profit charity organization that provides a scoring methodology for companies. The CDP publishes a questionnaire companies can complete to measure their ESG performance. It is focused on three areas: climate change, deforestation, and water security.
World Economic Forum (WEF)
The World Economic Forum (WEF) has set forth ESG metrics it developed in partnership with the big four accounting firms: Deloitte, Ernst & Young, KPMG, and PricewaterhouseCoopers (PwC). It has organized its guidance around principles of governance, plant, people, and prosperity. The WEF published its recommendations in a white paper called “Measuring Stakeholder Capitalism: Towards Common Metrics and Consistent Reporting of Sustainable Value Creation.”
Climate Disclosure Standards Board (CDSB)
The Climate Disclosure Standards Board (CDSB) is composed of an international group of business and environmental NGOs. It offers technical content for companies to guide their environmental disclosures in public filings or company publications.
Moving Toward a Single Global Framework for ESG Reporting
Several organizations have published guidance on ESG reporting. The growth of ESG initiatives has accelerated in recent years, driven by a push from investors and regulators on socially conscious investing. However, the number of different reporting frameworks has made it difficult to make proper comparisons of ESG performance between different companies.
There have been efforts to harmonize and consolidate different ESG reporting frameworks. These efforts could be accelerated by regulatory actions to mandate certain climate and ESG disclosures. For example, in March 2022, the U.S. Securities and Exchange Commission (SEC) announced a proposed rule to require disclosure of certain climate-related risks by U.S. public companies.