ESG factors explained:
Environmental | Social | Governance
Environmental, social, and governance (ESG) factors can have a profound impact on corporate performance and investment returns. Understanding these factors and how they may influence companies and markets can help investors enhance their returns and reduce their risk.
As more investors demanded ethical alternatives, however, a growing body of research began to undermine the idea that a focus on the bottom line was the best strategy for generating returns. Researchers increasingly found that ethical companies pursuing sustainable growth strategies often outperformed those focused exclusively on profit.
To address the debate, the United Nations (UN) commissioned a study and, in 2005, the UN Financial Sector Initiative published a report entitled Who Cares Wins. The report found that considering nonfinancial ESG factors was not inconsistent with investment managers’ fiduciary responsibilities. In fact, it found that failing to do so was.
It recommended the active integration of environmental, social, and governance concerns into corporate management and capital allocation and encouraged investment managers to consider ESG factors, investors to seek out and invest in top-performing ESG assets, and organizations to make ESG considerations central to their operational and management approaches.
What are environmental factors?
Environmental factors are considerations related to a company’s impact on the natural environment.
Key issues range from carbon emissions and climate change to biodiversity, resource depletion, and even noise pollution.
At their core, environmental factors focus on the sustainable use of natural resources.
Air, water, wildlife, and plant life are shared global resources.
Historically, businesses did not generally consider their impact on these resources.
Factories emitted waste without worrying about air and water pollution, and companies cut down rainforests without considering their impact on animals or the climate.
This imposed costs on third parties, such as the communities forced to breathe dangerous, dirty air or drink polluted water.
Such impacts – known as negative externalities – are a cost of doing business that companies did not have to pay because the price was paid by third parties.
Over time, however, these costs began to add up and third parties began to protest.
Today, the high cost of environmental neglect is becoming increasingly clear and investors, governments, and companies are under growing pressure to manage and mitigate environmental risks.
What are social factors?
Social factors are related to a company’s impact on people, including employees, suppliers, customers, shareholders, communities, and society at large.
All businesses rely on these human beings. Yet many companies treat them poorly.
For example, many companies employ workers in emerging markets at very low wages and in difficult or unsafe conditions.
In the last decade, fires and unsafe buildings killed thousands of workers who produce clothing for the fast fashion industry at garment factories in emerging markets.
Similarly, consumers around the world have been harmed by companies that produce and market unsafe or exploitative products.
Some argue, for example, that predatory financial companies have harmed communities and individuals by selling inappropriate and costly financial products.
Over time, pressure from consumers and voters has led to regulations that govern how companies treat people.
These include workplace health and safety rules, consumer product standards, human rights laws, and anti-discrimination statutes.
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What are governance factors?
Governance factors relate to how a company is managed and run.
Corporate governance is the collection of rules, relationships, systems, and processes by which companies are managed, including the mechanisms used to hold companies and their management to account.
The goal of good corporate governance is to have companies operate in ways that benefit all key stakeholders.
Governance concerns are driven by the fact that managers are not always incentivized to act in ways that benefit other stakeholders.
Managers may be focused on short-term growth to earn bonuses, for example, rather than focusing on long-term growth that would benefit shareholders.
Managers may also ignore potential issues such as negative social or environmental practices when internal structures do not hold them accountable for corporate actions.
Governance and oversight failures can have catastrophic consequences for companies.
Financial mismanagement and fraud, for example, can lead to total corporate failure, causing job losses, debt defaults, and the destruction of shareholder value.
Identifying and avoiding companies with weak corporate governance practices can thus help insulate investors from a key source of downside risk.
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This content is taken from Intuition Know-How, the world’s leading digital learning solution for finance professionals.
