Last Updated on December 2, 2024
Overview – The Rising Prominence of ESG
Up until now, the focus of investment analysis has been on traditional quantitative and qualitative variables – earnings, debt levels, free cash flow, business prospects, management competency, etc.
For decades, these traditional variables have helped guide the decisions of countless investors, and no doubt will continue to guide the decisions of many more investors for years to come.
While a company’s earnings strength and management competency are of great importance, traditional variables fall short when it comes to assessing a company’s impact on the environment, how well the company interacts with other businesses and communities, and the efficacy of corporate governance when it comes to managing internal affairs.
A new metric is needed to measure these important variables that do not appear on financial statements: Environmental, Social, and Governance (ESG) is the name of the metric that does just that.
ESG and ESG-focused investing have gained popularity in recent years, with more investors making ESG a central measure of investment merit. So what exactly is ESG?
Understanding its Components
As the name of the metric suggests, ESG is comprised of three components: environment, social, and governance. ESG isn’t a single metric per se, but rather a general term that covers three major, non-financial elements. Let’s go over each one1:
Environment – this component looks at a company’s impact on the environment through its operations, and how well the company reduces or minimizes that impact.
A company’s environmental performance may be measured by how much energy they consume, how much waste they produce, or how much pollution they release.
Social – this relates to a company’s relationships with other businesses and the communities they operate in.
Social performance is usually based on attitudes towards diversity and human rights, to name a few considerations. Community volunteering initiatives are an example of a company’s social impact.
Governance – the final component of ESG is concerned with how effective corporate governance is with respect to handling company affairs, transparency, and the company’s relationship with stakeholders such as employees and shareholders.
Measuring and Considering ESG
While ESG addresses the weaknesses of traditional variables when evaluating investment merit, the major problem it faces is that there is no universally accepted method to calculate it2.
Unlike commonly used ratios and metrics such as the price-to-earnings ratio and free cash flow, there is no formula (or set of formulas) investors can apply to calculate ESG.
ESG is not some number an investor can simply calculate for each company, compare it to competitor or industry averages, then reach an investment decision based on this numerical value.
For example, let’s consider a company’s greenhouse gas (GHG) emissions. The consensus is that the less GHGs emitted from a company’s operations, the better a company’s environmental score. But the problem then shifts to defining what “less” GHGs mean – less with respect to some absolute level, with respect to a company’s peers, or some combination of both?
What about the Social and Governance components? Surely an enterprise’s social impact or managerial transparency can’t simply be distilled to a single number.
Is a company with 500 volunteer hours immediately superior to a company with only 450? How would a company with “excellent governance” be quantitatively assessed?
In April 2020, financial data company Refinitiv put together a framework to assign ESG scores, but it is by no means as straightforward as something like P/E.
To address this problem of trying to quantify individual components, a commonly used approach to implement ESG without attempting to calculate anything is to impose certain qualitative criteria investments must satisfy.
For example, in 2019 Norway’s Government Pension Fund dumped the shares of 134 oil and gas companies, citing their desire to rely less on oil and gas companies in their portfolio.
Instead of trying to arrive at some arbitrary ESG value, the Fund simply imposed a specific environmental criterion (greatly reduce exposure to oil and gas activities) and applied it to their investment decision-making.
Retail investors can impose their own ESG-centered requirements on investments as well. Perhaps an investor is interested in companies who perform environmental remediation after projects, donate lots of money to public schools, or have a reputation of having a very forthcoming management team.
ESG and Socially Responsible Investing
The three elements of environmental, social, and governance are linked very closely with the concept of responsible investing, or socially responsible investing (SRI).
SRI is an investment paradigm where investors choose to invest in companies not necessarily for their financial strength, but rather on the positive social impact of a company’s products or services.
For example, an investor who adheres to SRI may refrain from investing in companies that offer addiction-based services or products such as casinos, tobacco, and alcohol. They may instead choose to focus on endeavours that help address poverty, hunger, or the production of clean energy.
More and more investors, both retail and institutional, are putting a greater emphasis on ESG-driven investing. Recent data suggests that the wave of SRI in recent years may not be a fad, but rather a fundamental shift in how people choose to invest.
Wrapping Up
Traditional ratios and metrics have been indispensable to investors for decades, but many of them are too narrow in their scope when it comes to evaluating non-financial measures.
To address the shortcomings of traditional financial variables, Environmental, Social, and Governance (ESG) was presented as the solution.
While ESG is a very holistic metric, the components it measures are very subjective, and therefore there is no universally accepted methodology to calculate it. ESG is not some number investors can simply compare to certain averages or benchmarks.
The tenets of ESG make it closely related to the Socially Responsible Investing (SRI) paradigm, a framework where investors focus heavily on the impact a product or service has on society and people.
Although the rise of SRI and ESG-centered investing may be a recent phenomenon, findings suggest that this may be a major shift in investment behaviours and not just another passing fad.
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