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.
Key Points:
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 and brokerage firms, 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.
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.
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.
Types of Environmental, Social, and Governance (ESG) Criteria
There are three key parts to ESG investing—the environmental, social, and governance aspects.
Environmental
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
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?
Governance
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.
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. The value of an investment is no longer just about returns. An increasing number of investors are also calling for their money to make a positive impact on society and the world at large.
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