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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.
Business
2023-08-03T00:00:00.000Z
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Businesses exert influence over a spectrum of environmental, social, and governance (ESG) factors, which can have positive or negative effects on others. That's why a robust ESG performance can add significant value throughout a company's operations.

Unlike straightforward transactions like making a sale, ESG value creation is a nuanced process. However, it yields lasting and even quantifiable benefits for businesses. Recognizing this, an increasing number of companies are actively measuring, reporting, and enhancing their actions related to ESG criteria.

As an indicator of a company's potential for long-term success, ESG criteria have emerged as the key ingredient that investors rely on to build a sustainable investment portfolio. Improved governance within an organization, legal compliance, and transparency when it comes to company emissions, can lead to both social and environmental gains. These interconnected factors make ESG not just a checkbox exercise but an integral part of modern business strategy.

👉 In this article we’ll explore the different ESG criteria and the various benefits that they bring to businesses that adopt them.

First up, what is ESG?

ESG definition

The acronym ESG stands for Environmental, Social, and Governance, and encompasses the criteria used to evaluate an organization's impact in these areas. Beyond financial measures, ESG represents a comprehensive approach that companies adopt to foster sustainable business practices and create enduring value.

ESG criteria are designed to provide benefits that extend beyond mere economic gains, enriching society and various stakeholders including investors, customers, employees, and community members in more holistic and meaningful ways.

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 will normally follow 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 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.

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What is the difference between ESG and CSR?

Environmental, Social, and Governance (ESG) and Corporate Social Responsibility (CSR) are interconnected concepts, both involving corporate reporting on environmental and social effects. Yet, despite their similarities, there are some nuanced differences between the two that merit attention. 

ESG investing has catalyzed a growing demand for standardized, comparable criteria and metrics that investors can apply to gauge a company's ESG performance. This interest has fostered an increase in third-party ESG data compilers, enhancing consistency in reporting across various organizations.

In contrast, CSR actions are more challenging to distill into specific, comparable metrics or data points across a diverse array of companies. This complexity stems from CSR's intimate alignment with an organization's unique mission, culture, and objectives, rendering it a more internally focused endeavor.

Companies typically undertake self-monitoring and reporting of their CSR initiatives and programs, often employing internal teams to design and oversee their CSR activities. ESG, on the other hand, calls for tangible data points and metrics that analysts can utilize to evaluate ESG performance, a process that frequently includes external validation.

👉 To learn more about ESG investing, why not read our article on the trend. You can also check out our article detailing the top 5 ESG investment funds in 2023.

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What are the different ESG criteria?

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

Environmental

ESG criteria related to the environment serve as tools to assess a company's environmental risks and potential damage to the ecosystem. They encompass critical environmental challenges that society faces, including climate change, water security, environmental health hazards, the burden of waste, and the loss of biodiversity and potential extinctions.

These challenges often present as interconnected risks that can be mitigated through a proactive approach to management. Companies should do more than merely meet the bare minimum standard. Instead, they can earn higher ESG ratings by actively taking measures to enhance the environment. 

Some examples of environmental criteria include:

  • Climate change and efforts to reduce carbon emissions
  • Energy efficiency practices
  • Addressing water scarcity
  • Combating air and water pollution
  • Implementing waste management strategies
  • Preventing deforestation
  • Protecting biodiversity and averting loss of species
mining in the middle of the forest

Social 

Social ESG criteria encompass a company's engagement and interaction with the various groups it engages with, aiming to enhance social well being in a number of ways. These criteria may encompass efforts to reduce inequalities, uphold human rights, and safeguard the health and safety of both workers and the surrounding communities.

These considerations enable businesses to cultivate operations that are inclusive, fair, and positively impactful, fostering vibrant communities on both a local and global scale. Social criteria permeate all levels of the company, from the executive offices to the factory floors within the supply chain.

Social aspects of ESG criteria resonate with a broad spectrum of social groups: including customers, employees, suppliers, and local communities. Through deliberate policies regarding employees, vigilant due diligence, and thoughtful supplier contracts, businesses can amplify the social values ingrained in their corporate structures.

The pursuit of social ESG goals goes beyond mere compliance with basic rights and standards. Companies can take extra strides in cultivating a nurturing work environment by offering flexible working conditions, dedicating time to professional growth, and providing opportunities for internal promotions.

Examples of social criteria include:

  • Human Rights Observance
  • Compliance with Labor Standards
  • Customer Satisfaction Measures
  • Data Protection and Privacy Safeguards
  • Promotion of Gender Equality and Diversity
  • Employee Engagement Strategies
  • Community Relations Initiatives
open spaced modern office

Governance

Governance is a fundamental component of ESG criteria, focusing on the business leadership and transparency mechanisms that define a corporation's ethical backbone. This encompasses the policies that help install a diverse board of directors, uphold stringent corporate accounting standards, govern executive compensation, ensure public disclosure, manage conflicts of interest, and address other legal and ethical considerations.

Governance also actively works to instill a sense of organizational fairness through a robust system of internal checks and balances. This safeguards against illicit activities, ranging from bribery and corruption to tax evasion.

Furthermore, ESG governance criteria extend to the broader architecture of the organization. This includes policies that govern organizational composition and structure, rules for maintaining solvency, and best practices in management.

By embracing these various aspects, governance serves as a tool for responsible and ethical business conduct.

Examples of governance criteria include:

  • Executive Compensation Policies
  • Board Composition and Diversity
  • Anti-Bribery and Corruption Measures
  • Lobbying Regulations
  • Oversight of Political Contributions
  • Implementation of Whistleblower Schemes
  • Audit Committee Structure and Functioning
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What about ESG investing?

The rise of ESG investing

As a vital component of the broader sustainable finance movement, ESG (Environmental, Social, and Governance) investing has seen a meteoric rise in popularity. Global sustainable investment now stands at a staggering $37.8 trillion in assets under management, a tenfold increase since 2004.

This remarkable growth isn't merely a trend but is substantiated by research indicating that businesses with superior ESG ratings benefit from reduced business risk, robust return on investment (ROI), and enduring business sustainability. These tangible metrics elevate ESG from a pleasant addition to an essential cornerstone of sound business practice.

Numerous studies have highlighted the positive correlation between ESG investments and ROI. For instance, Morningstar's 2019 study demonstrated that 73% of its 56 ESG indexes - 41 in total - outperformed their non-ESG counterparts.

Consequently, ESG-themed ETFs (Exchange-Traded Funds) have become an attractive avenue for retail investors looking to support companies with strong ESG performance.

The emphasis on ESG investing also reflects a broader transformation from passive to active investment styles, with various approaches available. Some ESG investors might opt for negative screening based on value-driven rules (for example by avoiding investing in funds that support oil and gas companies), while others might actively engage in promoting robust ESG practices through their shareholder voting strategies.

One example of ESG's broader impact is Nasdaq's (an online global marketplace for buying and trading securities) proposal to the SEC (the United States Securities and Exchange Commission) for a board diversity requirement. Prompted by the strong correlation between organizational diversity and financial performance, this proposal mandates companies in its index to include at least two diverse members, such as one female and one person from an underrepresented minority or identifying as LGBTQ+.

In 2022 the SEC approved the proposed rule change and by December 2023, companies listed on the Nasdaq Global Select Market or Global Market must have - or explain why they don’t have - at least one diverse director. This requirement will extend to two diverse directors by 2025.

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ESG investing challenges

While ESG investing continues to thrive, it is not without challenges. Investors are increasingly demanding high-quality ESG data in comparable, standardized formats to refine their assessments. Significant data gaps also persist, particularly when companies fail to report essential information like carbon emissions.

However, these challenges do not detract from the fact that ESG investing has moved from a niche interest to a mainstream financial strategy. It embodies a growing recognition that responsible investment is not only ethical but also makes sound financial sense. As such, ESG investing will likely continue to shape the investment landscape, reflecting a more conscientious and holistic approach to finance.

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How can ESG create value for companies?

As ESG (Environmental, Social, and Governance) investing and reporting continue to grow, the intricate link between ESG impact and financial value creation has come to the forefront of discussions. In fact, ESG initiatives can serve as a multifaceted value-creation strategy, influencing various aspects of business practices.

Namely, ESG initiatives often spur the following:

  • Core Business Growth: Aligning with societal values to open new market opportunities.
  • Cost Savings: Implementing sustainable practices for efficiency improvements.
  • Good Relations with Regulators and Legal Compliance: Building trust and surpassing legal standards.
  • Employee Productivity and Talent Acquisition: Attracting top talent through social and environmental commitments.

While ESG may seem a less direct approach than mainstream managerial strategies, it can smooth operations through improved alignment with values and societal demands. These strategic opportunities provide a sensible business lens through which managers can navigate an ESG strategy, creating not only a socially responsible organization but one that is financially robust and resilient. It's a testament to the fact that ESG isn't merely nice to have; it's a fundamental part of good business.

Let’s take a closer look at the benefits of ESG strategy:

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Core business growth

Incorporating an ESG strategy into the core offerings of a business can enable companies to tap into sustainable marketing opportunities. This strategic move enhances their competitive edge in traditional markets while providing a platform for expansion into new markets through the introduction of innovative, sustainability-centered practices.

Competitive Edge

By aligning their core offerings with sustainability metrics, business managers can employ analytical strategies such as life cycle analysis to identify and reduce underlying design inefficiencies and flaws. This approach helps in crafting products and services that resonate with contemporary values and consumer expectations, offering a competitive edge.

Benefits to both traditional and innovative businesses

Both traditional and innovative business models can reap significant benefits from an ESG-aligned strategy. Even industries typically associated with high environmental impacts, such as steel and mining, have successfully implemented sustainability strategies. Through ESG integration, these sectors manage to build public trust. This trust facilitates swifter navigation through periods of public scrutiny or regulatory review.

Strengthened relationships

Underpinning a robust ESG proposition is an even stronger social contract with stakeholders, including customers, regulators, employees, and communities. This alignment can lead to smoother interactions and faster approvals, reflecting a company's commitment to broader societal goals and building goodwill.

Responding to Consumer Demand

A growing appetite for responsible consumption is driving change. In fact, a McKinsey consumer survey revealed that 70 percent of consumers would pay 5 percent more for products from businesses demonstrating green practices. This willingness to invest in sustainability stretches across various industries.

Growth Opportunities

Customer demand for sustainable products and services has developed to the point that many businesses are now actively pursuing sustainability not just as a moral imperative but as a growth strategy. According to McKinsey, 44% of companies are embracing sustainability for their tangible growth opportunities.

An ESG strategy is far from a mere compliance mechanism; it is an engine for innovation, market differentiation, and long-term growth. As consumer consciousness and regulatory scrutiny continue to grow, those businesses that embed ESG considerations into their strategic planning will likely find themselves ahead of the curve.
London city skyscrapers

Cost savings

Inefficiencies within business operations come with significant costs. When we analyse waste streams, encompassing elements like wastewater, solid waste, or unsold products, waste isn't merely discarded material—it represents a value vacuum where financial resources are lost.

Sustainable Practices: A Blueprint for Savings

The sustainability principle of "reuse, reduce, and recycle" is more than just an ecological guideline. It serves as a blueprint for financial efficiency. By curtailing energy and material costs, conserving valuable natural resources like water, and integrating designs that employ recycled materials, businesses can prevent the unnecessary loss of value throughout their operations.

Significant savings - case studies

The cost savings stemming from sustainability practices can be significant when companies actively integrate ESG strategies. One such example of this is manufacturing company 3M's pioneering "3P" policy - ie. its pollution prevention pays policy. Since its inception in 1975, this approach has yielded phenomenal savings of $2.37 billion for the company.

3M's multifaceted method included innovative steps such as modifying product formulations, updating manufacturing processes, reengineering equipment, and exploiting its waste stream for reusable resources. Such ingenious practices transformed potential waste into opportunities for value creation.

This example shows that sustainability is not just a moralistic concept - it's a practical strategy that creates real-life financial advantages. It fits perfectly with smart business practices and companies that understand this, and make sustainability a part of their day-to-day operations, will not only benefit the environment but also create measurable value for their stakeholders. 

woman placing coins into a piggy bank

Regulation and compliance

Complying with laws and regulations may seem like the bare minimum for maintaining a sustainable business model. However, the landscape of ESG-related regulations is becoming more diverse across different regions, which can pose a significant challenge. The global consulting firm, McKinsey, estimates that up to a third of corporate profits could be at risk due to state regulatory pressures.

Engaging in ESG activities early on can help alleviate the administrative burden resulting from these emerging regulations aimed at promoting ESG objectives. The various benefits to businesses include a decreased risk of litigation, lower regulatory fees, and stronger relationships with regulatory bodies and organizations.

👉 The influence of consumer protection laws and government interventions can vary widely from industry to industry. They can impact around 25-30% of sectors such as pharmaceuticals and healthcare. In contrast, industries like banking, automotive, defense, and tech, which rely heavily on government subsidies, can see impacts ranging from 50-60%. Therefore, it is vital for businesses to be proactive in understanding and adhering to ESG criteria in their respective industries.

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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. Studies have shown that publicly traded companies featured on Fortune’s “100 Best Companies to Work For” list consistently beat the market average when it comes to returns. 

A robust ESG proposition can significantly influence employee motivation and reduce supply chain risks, while a weak one may have the opposite effect. By focusing on both white-collar and blue-collar working conditions, companies can mitigate the risks of high employee turnover and internal organizational conflicts. Ensuring fair treatment, providing proper working environments, and aligning organizational goals with sustainable practices not only fosters a positive workplace culture but also contributes to operational stability and efficiency.

employees working at an office desk

ESG is the future

Environmental, Social, and Governance (ESG) criteria have evolved from being buzzwords to fundamental aspects of modern business strategy. Emphasizing sustainability, ethical conduct, and responsible governance, these principles are reshaping industries by reducing costs, boosting employee motivation, enhancing brand image, and opening new market opportunities. 

As global awareness of environmental and social issues continues to grow, ESG criteria are poised to become even more integral to business operations. With increasing regulatory pressures and shifting consumer preferences, companies that align themselves with ESG standards stand to gain a competitive edge, not only surviving but thriving in a future where responsible business is synonymous with success.

👉 To find out more about ESG reporting and why your company should be doing it, head over to our article on the topic.

What about Greenly?

At Greenly we can help you to assess your company’s carbon footprint, and then give you the tools you need to cut down on emissions. Why not request a free demo with one of our experts - no obligation or commitment required. 

If reading this article has inspired you to consider your company’s own carbon footprint, Greenly can help. Learn more about Greenly’s carbon management platform here.

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