Why do ESG factors matter to investors?
Traditionally, investment decisions were made solely on the financial results of a company. Today, however, environmental, social, and governance (ESG) factors have gained a foothold in those decisions. More companies are accepting this rising business practice and recognize that business decisions have a huge impact on a range of environmental and social issues. As ESG investing continues to gain popularity, companies are pressed to understand its principles.
ESG factors impact investing
ESG measures certain impacts of a company:
- Environmental criteria consider factors such as a company’s emissions, energy use, waste minimization methods, and conservation efforts.
- Social criteria focus on the company’s relationships — how they relate to their employees, customers, supply chains, and community.
- Governance criteria examine the company’s leadership, focusing on aspects related to policies and audits, internal controls, inclusion, and its readiness to share information in the reporting process.
ESG investing assesses these non-financial factors in the analysis of material risks and growth opportunities. ESG investors then use this measure of sustainable finance to determine a company’s future financial performance and overall impact.
ESG scores matter
Third-party companies that specialize in the rating process calculate ESG scores. There is no universal way to calculate ESG scores. However, scoring may examine a company’s internal audits and reports, news stories and social media presence, securities filings, and information from government databases. Typically, experts use propriety processes, so no two rating companies will produce the same results.
Regardless of vendor used for assessment, ESG scores are provided on a scale of 0-100 and described as either poor, average, good, or excellent. A “poor” score would be less than 50 and signifies that no best practices are used. That poor-scoring company has a negative impact on all three factors. A score of over 70 represents an excellent rating and suggests that the company is performing well in all three areas with little to no problems.
ESG scores are becoming increasingly more important to today’s investors, and here’s why:
- A higher ESG score presents a company with fewer internal and external liabilities. These are prime candidates for investors. For example, a high score indicates that stakeholders are happy, and the company has positive community relations and practices in place for environmental protection and conservation. Investors may also choose companies with similar values based on ESG scores.
- Companies with low ESG scores represent future risks associated with poor governance and stakeholder relations, environmental pollution, and a negative community and media presence. These companies are undesirable to investors because of the risk to the company’s bottom line.
ESG concerns
Despite the wide acceptance of ESG scoring, the lack of rules and clarity for calculating ESG scores is a global concern. Varied approaches by third parties often make it difficult for investors to compare companies. For these reasons, an investor should not base his or her decision solely on the ESG score. Rather, the score should be used along with other metrics to paint a complete picture of the company’s impact.
The good news is that the Securities and Exchange Commission (SEC) is working to address the lack of standards for climate-related disclosures.
Current and upcoming ESG activity
Many different regulatory bodies reference ESG or a component of the factors in some way. Major ESG activities include the following:
- The Department of Labor’s final rule under the Employee Retirement Income Security Act (ERISA) (November 2022) recognizes that ESG factors are relevant to the risk-return assessment of potential investments. Under this rule ESG factors will complement other disclosures. At the federal level this is one of the few ESG measures.
- The Sustainability Accounting Standards Board (SASB) includes ESG disclosures that pertain to financial performance in different industries. This approach enables companies to communicate with stakeholders and investors on both financial and ESG factors.
- The SEC proposed regulatory amendments in March 2022. If finalized, this rule would require registrants to include certain climate-related information in their registration statements and reports. The proposed rule aims to offer investors a consistent and comparable framework for climate-related disclosures.
Key to remember: ESG disclosures and scores allow investors to assess company liabilities not accounted for on a finances-only balance sheet. As ESG investing continues to gain popularity and more regulations are issued, companies are pressed to understand its principles.