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Environmental, Social and Governance (ESG) Criteria – An Investor’s Explainer

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Socially responsible investing has been progressively gaining momentum for more than a decade. Increasingly, investors want to understand a more comprehensive profile of the stocks in which they invest. In light of fiascos like the BP Oil spill and Volkswagen’s false fuel efficiency claims, these issues have gained attention. But it’s more than whether or not a company exhibits environmentally friendly policies and donates to the community. Today’s investors want a more comprehensive perspective that examines environmental, social and governance (ESG) criteria. As a result, ESG investing has attracted not only the attention of investment firms but regulators as well.

In recent weeks, the U.S. Securities and Exchange Commission (SEC) proposed new rules pertaining to ESG criteria. Though these have yet to be finalized, this suggests that investment firms will need to provide greater disclosures. And as a trickle-down effect, this will also push corporations to get more serious about their efforts in these areas. While much progress still needs to be made in these areas, ESG investing is clearly a hot topic. So, what better time than now to offer an overview of ESG criteria as they currently stand.

“Investors are really looking for the ESG funds, and they’re not naive on these matters. They truly want to see how a company addresses all three of the pillars of ESG before they’re willing to put their money into a business.” – Katelyn Adams, Corporate Advisory Partner with HLB Mann Judd

An Overview of ESG Criteria

As noted, ESG stands for environmental, social and governance aspects of a corporation. To some extent, these may seem self-explanatory. But in practice, they can be quite varied and, at times, confusing. In terms of environmental ESG criteria, this examines various policies and practices of firms as it affects the climate and the Earth. Criteria may thus include energy use, waste management, pollution, natural resource conservation, and EPA regulatory compliance. Notably, firms with more favorable environmental profiles will attract more ESG investing dollars. But as is true for all ESG criteria, few profiles use the same metrics when reporting corporate behaviors.

The ”S” and “G” components of ESG criteria are even more varied and sometime vague when compared to the “E” component. Social criteria tend to refer to how firms manage various relationships. This not only pertains to their customers and employees. But it also considers supplier requirements and relations and how corporations interact with their communities. In terms of governance, several other factors may be considered in ESG investing profiles. Leadership diversity, conflicts of interest, legal issues, and political ethics might be included in addition to accounting transparencies. Some or all of these contribute to the resultant ESG score that an investing firm awards companies.

(Read more about the importance of diversity for business success in this Bold story!)

“These [SEC] requirements are a welcome first step in policing exaggerated marketing claims about ESG and in providing consistent, comparable disclosures that diligent investors can actually rely on.” – Shivaram Rajgopal, Professor at Columbia Business School

Recent Developments in ESG Investing

Given the lack of consistency among investment firms regarding specific ESG criteria, the SEC recently proposed major changes. Proposed amendments to rules and reporting would require investment companies to provide more complete disclosure regarding their specific ESG metrics. This level of transparency is needed to help with ESG investing. At the same time, these same firms must reveal the level of engagement they have with firms in examining ESG issues. While these proposals have yet to be finalized, most analysts anticipate they will soon be requirements. Likewise, most support this as a step in the right direction.

A hand holding some digital projections
ESG criteria make investing considerations more complex, but many feel it’s all worth it.

Some of the issues currently with ESG criteria relate to not only variations among firms but among industries. For example, the S&P 500’s ESG ratings recently dropped Tesla’s ESG score but maintained ExxonMobil’s at a higher level. Considering the environmental impacts of fossil fuels compared to electricity, this seems inaccurate. But Tesla operates in a different sector than ExxonMobil, and therefore, is subject to different ESG investing metrics. Likewise, environmental criteria in ESG scores do not consider specific impacts of products but only those of operations. This also favors ExxonMobil in what seems to be an unjust manner. These are some of the issues the SEC hopes to improve upon with their proposed changes.

“Investors concerned about ESG often value different objectives – one investor may really care about human rights in South America while another is focused on climate change. When ESG ratings try to force all of those objectives into a single number, they obscure the fact that there are trade-offs.” – Tom Lyon, Business Economics Professor, University of Michigan

Examining the Pros and Cons

For investors, there are both pros and cons with it comes to ESG investing. Naturally, the benefits involves being socially responsible with the stocks one chooses. This is why ESG investing has also been called responsible investing and impact investing. At the same time, ESG criteria help investors avoid companies that might be engaged on risky activities. Those with policies and operations that harm the environment, result in discriminations, or create social inequities can be ignored. This is why the use of ESG criteria for investing will reach $50 trillion in assets by the year 2025. By comparison, this figure was only about $20 trillion in 2016.

Regarding disadvantages of ESG investing, some suggest that this approach may cause investors to miss out on good opportunities. Specifically, some energy stocks and those related to military defense may have lower ESG criteria. But they tend to have high-performing stocks despite these features. While this may be true, increasing popularity of ESG criteria use will likely drive all companies to pay greater attention. This is particularly true in social and governance aspects if the SEC proposals move forward. For now, however, it pays to perform some due diligence when examining ESG ratings. The wise investor will define exactly which ESG criteria are important and invest accordingly. And in all likelihood, the ability to perform this due diligence is likely to be much easier in the near future.


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