ESG criteria: what you need to know

Environmental, Social, and Governance (ESG) criteria correlate to strong business value creation. Learn how your business can access ESG benefits.

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May 13, 2022

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Businesses have impacts across a range of environmental, social, and governance (ESG) criteria which can either positively or negatively affect other people. This is why having strong ESG performance can create value across a company’s operations. 

ESG value creation is not a direct transactional process like making a sale, but it does bring lasting and even measurable benefits to businesses. This is why more and more companies are measuring, reporting, and improving their ESG criteria actions.  

As a predictor of business longevity, ESG criteria have become the secret sauce investors turn to for creating a sustainable investment portfolio. 

Another thing to keep in mind about ESG criteria is their interconnected relationships. Both social and environmental benefits can arise when the governance within an organization ensures legal compliance or transparency for company-wide emissions. 

🤔 What is ESG ?

ESG, definition 📖

The acronym ESG refers to Environment, Social, and Governance criteria assessed within organizations. The acronym is used to describe the different non-financial criteria companies use to support sustainable business practices and value creation. 

ESG criteria are intended to benefit society and diverse stakeholders such as investors, customers, employees, and community members in ways other than economic gains. 

How does it work? ⚙️

ESG is a voluntary business activity that companies can choose to pursue or not. However, many are given explicit requests from their investors or shareholders to disclose company-wide ESG information. 

Companies communicate ESG issues to their stakeholders in annual reports which they usually publish publicly. The ESG data included in these reports usually follows a set of criteria established by the specific ESG standards and frameworks the company adheres to. 

ESG investors can then use the data from the ESG reports to give the reporting company an ESG rating. These ratings are used to compare the relative ESG performance of different companies. 

Third-party providers like Morningstar, Bloomberg, and MSCI may also independently measure ESG performance for different companies to share with investors. 

Data providers such as Sustainalytics, owned by Morningstar, compile data on company scores across different ESG criteria. This enables investors to research a company’s performance in relation to its competitors. 

What is the difference between ESG and CSR? 👀

Environmental, Social, and Governance (ESG) and corporate social responsibility (CSR) are closely related concepts. They both include corporate reporting on environmental and social impacts. However, there are a few key differences worth noting.  

ESG investing has spurred an interest in comparable, standardized criteria and metrics that investors can use to assess a company’s ESG performance. This has led to a greater number of third-party compilers of ESG data, which has led to greater consistency in reporting across organizations. 

CSR actions are not always easily quantified into specific metrics or data points that are comparable across a range of companies. This is because CSR is heavily involved in the unique mission, culture, and goals an organization has, giving it more of an internally significant role. 

Companies self-monitor and report on their CSR initiatives and programs and usually hire their own internal teams to develop and manage their CSR activities. ESG requires concrete data points and metrics that analysts can use to assess ESG performance, so it often includes external validation. 

Here the main differences between CSR and ESG: 


 

👋 What are the ESG criteria?

Below you’ll find common examples of the main ESG criteria used to assess ESG performance by investors. Investors use these criteria along with weighted scoring systems to evaluate a company’s relative ESG success. 

Environmental 🌱

ESG criteria for the environment are used to measure a company’s environmental risks and harm to the environment. Environmental criteria cover the main environmental risks facing society: climate change, water security, environmental health risks, the waste burden, and biodiversity loss and extinction. 

These issues are often interconnected risks which improve with a proactive approach to managing them. Companies should do more than merely meet the bare minimum standard. Instead, they can earn higher ESG ratings by taking actions that improve the environment. 

Business leaders who understand the benefits brought by natural resources will strategically pursue business in a way that preserves these valuable assets for generations to come. 

Example environmental criteria:

  • Climate change and carbon emissions reduction
  • Energy efficiency
  • Water scarcity
  • Air and water pollution
  • Waste management
  • Deforestation
  • Biodiversity protection and loss

Social 👥

Social ESG criteria highlight a company’s relationships with the many groups of people it engages with. The aim is to improve overall social wellbeing in a number of ways. For instance, a company may seek to lessen inequalities, ensure human rights, and protect worker and community health and safety. 

This helps businesses to build inclusive, fair, and positive operations, which foster thriving communities–both globally and locally. Social criteria span the company from the executive offices to the supply chain factories. 

Social issues touch on the points of connection with a wide range of social groups: customers, employees, suppliers, and local communities are all considered in the social ESG criteria. 

Employee policies and benefits, due diligence, and supplier contracts are all used to leverage the social values embedded in corporations. 

Beyond ensuring the bare minimum of rights are maintained, companies can go further to build a supportive work culture with their flexible work conditions, time devoted to professional development, and internal promotion opportunities. 

Example social criteria:

  • Human Rights
  • Labor Standards
  • Customer satisfaction
  • Data protection and privacy
  • Gender and diversity
  • Employee engagement
  • Community relations

Governance 💪

Business leadership and transparency structures are at the core of the Governance ESG criteria. These include its policies for inviting diverse board of directors, upholding corporate accounting standards, executive compensation, public disclosure, conflicts of interest, and other legal and ethical concerns. 

 

Governance also covers the policies used to promote organizational fairness through its system of internal checks and balances. This prevents illegal activities from bribery and corruption to tax evasion. 

Finally, ESG governance criteria also encompass policies surrounding the organizational composition and structure, rules for solvency, and management practices. 

Example governance criteria:

  • Executive compensation
  • Board composition
  • Bribery and corruption
  • Lobbying
  • Political contributions
  • Whistleblower schemes
  • Audit committee structure

💰 What about ESG investing?

As one part of a broader sustainable finance movement, ESG investing has grown significantly in popularity. Global sustainable investment has reached $30 trillion, ten times its level in 2004. 

This impressive rise is supported by research suggesting businesses with higher ESG ratings have lower business risk, a strong return on investment, and long-term business sustainability. These concrete metrics show that ESG is something that isn’t just nice to have: it’s fundamental to good business. 

A growing body of research suggests a positive correlation between ESG investments and ROI. Morningstar published a study in 2019 showing that 41 of its 56 ESG indexes–73%--have performed better than comparable non-ESG indexes. 

As a result, ESG-themed ETFs have become a popular way for retail investors to support companies with better ESG performance.

A strong correlation between organizational diversity and financial performance prompted Nasdaq to propose a board diversity requirement to the SEC. This calls on companies in its index to include at least two diverse members (one female and one underrepresented minority or LGBTQ+ identifying person).  

ESG investing marks a broader shift from passive to active investment styles, which come in different varieties. ESG investors may simply choose to negatively screen according to values-based rules, or they may go further by actively pursuing stronger ESG actions within their shareholder voting strategies. 

Along with ESG growth comes various challenges among investors. Many investors seek higher quality ESG data in comparable, standardized formats to improve their assessments. Investors also show significant data gaps from companies that fail to report on key areas such as carbon emissions.

👩‍💻 How can ESG create value for companies?

As ESG investing and reporting has grown, more people have started to ponder the underlying link between ESG impact and financial value creation. In fact, there are a wide range of ways ESG initiatives can serve as a sound value creation strategy. 

Namely, ESG initiatives often spur the following business practices: 

  • Core business growth. 
  • Cost savings. 
  • Good relations with regulators and legal compliance. 
  • Employee productivity and talent acquisition. 

While ESG may seem a less blunt instrument than mainstream managerial strategies, it can remove friction thanks to improved values alignment. These strategic opportunities provide a sensible business lens through which managers can navigate an ESG strategy.  

Core business growth 📈

Applying an ESG strategy to core products and services can help businesses leverage sustainable marketing opportunities. This helps them compete in conventional markets and expand to new markets through innovative business practices. 

When aligning core business offerings with sustainability metrics, business managers can apply strategies like life cycle analysis to reduce underlying design inefficiencies and flaws. 

Both conventional and innovative business models can benefit from an ESG business strategy, as the success of implementing sustainability strategies in heavy industries like steel and mining. ESG helps them gain the trust needed to pass through periods of public comment more quickly. 

Beneath a strong ESG proposition lies a stronger social contract which leads to less friction for gaining regulatory approvals and customer satisfaction. 

One McKinsey consumer survey showed that 70 percent of consumers would pay 5 percent more for products from greener businesses across industries. 

Customer demand for sustainable products and services has grown so much that many businesses (44%) are pursuing sustainability for its growth opportunities, according to McKinsey. 

Cost savings 💸

Inefficiencies within business operations come with significant costs. When considering the waste stream, whether it’s wastewater, solid waste, or unsold product, waste represents a value vacuum. 

The sustainability mantra “reuse, reduce, and recycle” brings financial benefits to businesses through cost savings. Reducing energy and material costs, reusing scarce natural resources such as water, and designing with recycled materials prevents unnecessary value losses across operations. 

These cost savings can multiply as companies push their ESG strategies to the max. 3M is the perfect example of this. Since 1975, when it adopt its “3P” policy, “pollution prevention pays,” it has saved $2.2 billion. 

Some of the strategies it applied included changing product formulations, manufacturing updates, equipment redesigns, and mining its own waste stream for reusable materials. 

By swapping 20% of its conventional vehicle fleet with electric and hybrid vehicles, FedEx has cut down on 50 million gallons of fuel. Its long-term goal is to transition its entire fleet of 35,000 vehicles. 

Regulation and compliance ⚖️

While legal compliance and regulation may seem like the bare minimum to achieve for a sustainable business model, ESG-related regulations are diversifying across different regions. McKinsey estimates that a third of profits gained by corporations is at risk from regulatory pressures.  

Early adoption of ESG activities help reduce the administrative burden caused by emerging regulations that advance ESG aims. The underlying benefits to business are reduced litigation risk, lower regulatory fees, and stronger relationships with regulatory bodies and organizations. 

Consumer protection laws and governmental interventions vary industry to industry. They range from around 25-30% for pharmaceuticals and healthcare, to 50-60% for banking, automotive, defense, and tech, all of which depend heavily on government subsidies. 

Motivating and attracting employees 👋

ESG matters a lot in terms of employee attraction, retention, and satisfaction. To access the best talent pool, it’s important to provide employees with a sense of underlying purpose. 

Businesses cannot overlook the importance of a high-quality, motivated talent pool, as it correlates with higher shareholder returns. The companies featured on Fortune’s “100 Best Companies to Work For” list had 2.5-3.8% higher stock returns each year over a 25-year time period. 

A strong or weak ESG proposition can either boost or slacken employee motivation as well as reduce supply chain risks. White collar and blue collar working conditions alike reduce the risks of fast turnover or internal organizational conflicts. 

🌳 What about Greenly?

One of the most critical data points ESG investors look for is the carbon emissions of a company. Greenly helps companies improve their environmental impact with a streamlined process for carbon emissions data collection, measurement, and strategy. Learn more.

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