What Are Environmental, Social, and Governance (ESG) Criteria?
Environmental, social, and governance (ESG) criteria are a set of standards for a company’s operations that socially conscious investors use to screen potential investments. Environmental criteria consider how a company performs as a steward of nature. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights.
- Environmental, social, and governance (ESG) criteria are an increasingly popular way for investors to evaluate companies in which they might want to invest.
- Many mutual funds, brokerage firms, and robo-advisors now offer products that employ ESG criteria.
- ESG criteria can also help investors avoid companies that might pose a greater financial risk due to their environmental or other practices.
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How Environmental, Social, and Governance (ESG) Criteria Work
Investors (notably younger generations) have, in recent years, shown interest in putting their money where their values are. As a result, brokerage firms and mutual fund companies have started offering exchange traded funds (ETFs) and other financial products that follow ESG criteria.
Robo-advisors, such as Betterment and Wealthfront, have used them to appeal to these investors. According to the most recent report from US SIF Foundation, investors held $17.1 trillion in assets chosen according to ESG criteria at the beginning of 2020, up from $12 trillion just two years earlier.
Human influence is unequivocally to blame for the warming of the planet and some forms of climate disruption are now locked in for centuries, according to a report from the U.N. Intergovernmental Panel on Climate Change. "This report must sound a death knell for coal and fossil fuels, before they destroy our planet," said United Nations Secretary General Antonio Guterres.
ESG investing is sometimes referred to as sustainable investing, responsible investing, impact investing, or socially responsible investing (SRI). To assess a company based on environmental, social, and governance (ESG) criteria, investors look at a broad range of behaviors.
Demand for ESG investments soared in 2020. Nearly 60% of respondents to an Investopedia and Treehugger survey indicated an increase in interest in ESG investments and 19% reported incorporating ESG standards into their portfolios.
Types of Environmental, Social, and Governance (ESG) Criteria
There are three key parts to ESG investing—the environmental, social, and governance aspects.
Environmental criteria may include a company’s energy use, waste, pollution, natural resource conservation, and treatment of animals. The criteria can also be used in evaluating any environmental risks a company might face and how the company is managing those risks.
For example, there might be issues related to its ownership of contaminated land, its disposal of hazardous waste, its management of toxic emissions, or its compliance with government environmental regulations.
Social criteria look at the company’s business relationships. Does it work with suppliers that hold the same values as it claims to hold? Does the company donate a percentage of its profits to the local community or encourage employees to perform volunteer work there? Do the company’s working conditions show high regard for its employees’ health and safety? Are other stakeholders’ interests taken into account?
About governance, investors may want to know that a company uses accurate and transparent accounting methods and that stockholders are allowed to vote on important issues.
They may also want assurances that companies avoid conflicts of interest in their choice of board members, don't use political contributions to obtain unduly favorable treatment and, of course, don't engage in illegal practices.
No single company may pass every test in every category, of course, so investors need to decide what's most important to them and do the research.
On a practical level, investment firms that follow ESG criteria must also set priorities. For example, Boston-based Trillium Asset Management, with $4.8 billion under management as of Sept. 2021, uses a selection of ESG factors to help identify companies positioned for strong long-term performance.
Determined in part by analysts who identify issues facing different sectors and industries, Trillium's ESG criteria include avoiding:
- Companies that operate in higher-risk areas or have exposure to coal or hard rock mining, nuclear or coal power, private prisons, agricultural biotechnology, tobacco, tar sands, or weapons and firearms.
- Or companies that have major or recent controversies with human rights, animal welfare, environmental concerns, governance issues, or product safety.
Things that Trillium seeks out, or considers positive ESG criteria, include:
- Companies that put out carbon or sustainability reports
- Limits harmful pollutants and chemicals
- Seeks to lower greenhouse gas emissions
- Uses renewable energy sources
- Companies that operate an ethical supply chain
- Supports LGBTQ rights and encourages diversity
- Has policies to protect against sexual misconduct
- Pays fair wages
- Companies that embrace diversity on their board
- Embraces corporate transparency
- Employs a CEO independent of the board chair
Pros and Cons of Environmental, Social, and Governance (ESG) Criteria
In years past, socially responsible investments had a reputation for requiring a tradeoff on the investor's part. Because they limited the universe of companies that were eligible for investment, they also limited the investor's potential profit. "Bad" companies sometimes performed very well, at least in terms of their stock price.
More recently, however, some investors have come to believe that environmental, social, and governance criteria have a practical purpose beyond any ethical concerns. By following ESG criteria they may be able to avoid companies whose practices could signal a risk factor—as evidenced by BP's (BP) 2010 oil spill and Volkswagen's emissions scandal, both of which rocked the companies' stock prices and resulted in billions of dollars in associated losses.
As ESG-minded business practices gain more traction, investment firms are increasingly tracking their performance. Financial services companies such as JPMorgan Chase (JPM), Wells Fargo (WFC), and Goldman Sachs (GS) have published annual reports that extensively review their ESG approaches and the bottom-line results.