Environmentalism, social responsibility, and corporate governance are hot topics in business. Many companies have turned to ESG, a framework for evaluating a firm’s performance in the areas of environmental, social, and governance, 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.
This has given rise to ESG investing, a type of sustainable investing that considers a firm’s ESG performance. Likewise, ESG bonds have become popular debt instruments in corporate financing as companies improve their reputation for sustainability, social responsibility, and corporate governance.
What Does ESG Mean?
- Environmental refers to a company’s impact on the environment, including climate change, use of natural resources, waste, and pollution.
- Social considerations include issues such as treatment of stakeholders and product liability.
- Governance refers to corporate governance issues such as leadership, executive compensation, oversight, and accountability.
How ESG Is Used by Investors
The ESG investing trend is rapidly growing. Many companies publish annual sustainability and social responsibility reports that can be helpful for investors researching individual companies. Additionally, investors can turn to mutual funds and exchange-traded funds (ETFs) rather than individual stocks. Financial services companies such as Morningstar have developed ESG scoring tools to help guide investors.
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 Bonds in Corporate Financing
Many finance experts believe ESG-linked bonds will have a positive impact on the world. Bonds, discussed in Chapter 16: Financial Management and Securities Markets, are debt instruments that larger companies sell to raise long-term funds. In the context of ESG, the bondholder loans the issuer of the bonds cash in exchange for regular interest payments until the loan is repaid.
Many investors are familiar with green bonds, which have been available for more than a decade. ESG bonds (green bonds, social bonds, and sustainability bonds) are popular capital-raising tools for reaching ESG targets. These bonds use a structure that finances specific projects.
A more recent innovation, the key performance indicator (KPI)-linked bond (also known as a sustainability-linked bond), incentivizes the issuing company to achieve higher ESG ratings across the entire business rather than financing a specific project. If the issuer of the bond does not achieve its KPIs within a specified timeframe, the company is penalized with a coupon step-up on the bond, creating a direct, enforceable monetary incentive for performance.
The Future of ESG Investing
As investors become more interested in ESG, concerns about greenwashing have grown. Greenwashing, discussed in Chapter 2: Business Ethics and Social Responsibility, refers to deceptively creating a positive association with environmental issues for an unsuitable product, service, or practice.
Fears related to greenwashing have resulted in calls for more transparency and regulation around ESG standards. Case in point, the U.S. House of Representatives passed legislation that would require public companies to report ESG metrics to the U.S. Securities and Exchange Commission (SEC). Next, the bill faces the Senate.
In the Classroom
This article can be used to highlight social responsibility, sustainability, and greenwashing which are discussed in Chapter 2: Business Ethics and Social Responsibility. This article could also be used to support Chapter 15: Money and the Financial System in conversations about mutual funds, exchange-traded funds, and investing trends or Chapter 16: Financial Management and Securities Markets in a discussion about bonds.
- Explain the ESG framework and why it has become a popular tool for investing.
- Do you think regulation of ESG standards will be effective at reducing or eliminating greenwashing?
- What companies come to mind when you think of ESG and social responsibility?
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
CNBC, "The Rise of ESG Investing," YouTube, June 25, 2020, www.youtube.com/watch?v=OQ1cliM0b0Q
O.C. Ferrell, John Fraedrich, and Linda Ferrell, Business Ethics: Ethical Decision Making and Cases, 13th edition, Cengage Learning, 2021, p. 228.
Shawn Keegan and Salima Lamdouar, "Making Sense of ESG Bond Structure," Bernstein, May 27, 2021, https://www.bernstein.com/our-insights/insights/2021/articles/making-sense-of-esg-bond-structures.html?mid=eml