Environmentalism, social responsibility, and corporate governance are in the spotlight. ESG is a framework for evaluating a firm’s performance in the areas of environmental, social, and governance. It allows firms to evaluate their priorities in these three areas relative to their industry, investor priorities, peer comparisons, and the cultural and leadership priorities of the organization. Many companies now publicly report these ESG data points. This has given rise to ESG investing as more investors look for like-minded firms to support.
What does ESG stand for?
Environmental refers to a company’s impact on the environment, including greenhouse gas emissions, use of natural resources, and waste. Social factors include issues such as diversity, equity, and inclusion. Governance refers to corporate governance issues such as fiduciary oversight by the board of directors and their accountability.
Inside ESG scoring
ESG has become very popular in recent years. Financial services companies have developed ESG scoring tools to help guide investors and have created ESG funds, such as mutual funds, index funds, and exchange-traded funds (ETFs), that allow investors to invest in a collection of socially responsible companies.
A white paper published by the Morgan Stanley Institute for Sustainable Investing found that total returns of sustainable mutual funds and ETFs often outperform traditional funds. It also found that sustainable funds are less risky than other funds, even when the market is experiencing turbulence. During the COVID-19 pandemic and recession, ESG funds have posted strong performance.
ESG has many supporters
For decades, companies have focused on corporate social responsibility (CSR)—practices and policies for fulfilling economic, legal, ethical, and philanthropic responsibilities. Buzz grew as did accountability. Now, investors rely on measurable ESG criteria to assess a firm’s impact. CSR can be viewed as a strategic approach or ideal while ESG can be viewed as a measurable outcome.
Many investors and activists support ESG reporting because it improves transparency, and it stands to standardize CSR reporting. Not everyone, however, is sold.
What critics have to say
First, ESG reporting is, in fact, not standardized at present. Firms can report a variety of numbers, but without a way to accurately compare the numbers, the metrics are often not meaningful. Many voluntary reporting frameworks exist to create unison, but some firms, have rejected ESG reporting altogether. Even BlackRock, a multinational investment management company with a long history of supporting sustainable investing, has said many proposals on climate disclosures are too constraining.
Second, many business leaders disagree on how to measure ESG. After Tesla, arguably one of the most environmentally friendly car companies in the world was dropped from Standard & Poor’s (S&P’s) ESG index, Tesla criticized ESG in its annual impact report, writing that today ESG measures investment risk instead of positive impact on the world. From this perspective, if the wrong measurements are used, this could lead to greenwashing or deceptively creating a positive association with environmental issues for an unsuitable product, service, or practice.
Third, some people believe companies should focus on one thing and one thing only: profits. Some lawmakers and business leaders have discouraged companies from getting involved in social, political, and environmental issues. Some critics view ESG as a politicization of investing.
The future for ESG
Many believe ESG is not going away. While ESG metrics and be inconsistent and difficult to measure, they are becoming more standardized as regulators establish reporting requirements. The Securities and Exchange Commission (SEC) is under pressure to propose new climate disclosure rules, but critics say the SEC is overreaching.
In the Classroom
This article can be used to discuss social responsibility and sustainability (Chapter 2: Business Ethics and Social Responsibility) and investing (Chapter 16: Financial Management and Securities Markets).
What is ESG and how does it relate to investing?
Why do you think ESG has become popular in recent years?
Briefly describe the arguments for and against ESG.
This article was developed with the support of Kelsey Reddick for and under the direction of Geoffrey Hirt, O.C. Ferrell, and Linda Ferrell.
Alana Benson, "ESG Investing: A Beginner's Guide," Nerd Wallet, June 18, 2021, https://www.nerdwallet.com/article/investing/esg-investing
Andrew Ross Sorkin, Vivian Giang, Stephen Gandel, Lauren Hirsch, Ephrat Livni, Jenny Gross, David F. Gallagher, and Anna Schaverien, "The Pushback on E.S.G. Investing," The New York Times, May 11, 2022, https://www.nytimes.com/2022/05/11/business/dealbook/esg-investing-pushback.html
Sam Metz, "EXPLAINER: ESG Investing and the Debate Surrounding It," U.S. News, May 19, 2022, https://www.usnews.com/news/business/articles/2022-05-19/explainer-esg-investing-and-the-debate-surrounding-it
Tesla, "Impact Report," 2021, https://www.tesla.com/ns_videos/2021-tesla-impact-report.pdf