What is ESG (Environmental, Social and Governance)?

ESG is an acronym that refers to the three fundamental pillars of corporate conduct assessment: environmental social and governance. It is a non-financial framework that measures companies’ responsibility and sustainability in these three areas.

Understanding what is ESG means recognizing the importance of these parameters in guiding decisions, assessing long-term risks, and establishing a trust relationship with stakeholders.

Globally, ESG has taken center stage in shaping corporate reputation and compliance with emerging regulations, directly influencing access to capital and the ability to operate on international markets. 

The following article will explore the principles underlying ESG and the increasingly significant impact of this approach on global business strategy.

Understanding ESG: Definition and Components

To fully understand the ESG approach, it is necessary to analyze its three elements separately.

• The environmental pillar relates to greenhouse gas emissions management, energy, and responsible use of natural resources, climate change adaptation, and generally how the company is addressing their effect on the environment.
• The social pillar is based on how the company interacts with society collectively. Social aspects include human rights generally, but also working conditions, diversity and inclusion, health and safety in the workplace, as well as the social effects of their actions in general.
• The governance pillar concentrates on the composition of the board of directors, whether decision-making processes and management are transparent, how conflicts of interest are determined, and if there are limitations on expected ethical standards.

Together, these three pillars form a helpful assessment framework for analyzing corporate conduct in terms of resilience to non-financial risks and responsibility towards all stakeholders (learn more what is corporate governance), providing insights into long-term sustainability.

What is ESG in Business?

When we discuss what is ESG in business, we refer to how a company takes environmental, social, and governance criteria into account in its business strategy and operations. Companies following ESG principles seek to find risks and opportunities that a company wouldn’t typically notice on its financial statements.

The company could have sustainability goals and targets, such as achieving carbon neutrality, for example. It could also consider ethical sourcing and may even look at making the board of directors more independent and professional so they can set a tone for the organization and enhance overall sustainability practices. 

The Evolution of Environmental, Social and Corporate Governance

ESG dates back to the 1960s when ethical investment movements became more prevalent. During this time, the conversation was about socially responsible investors choosing to exclude certain sectors of the economy (like tobacco or arms) from their investments.

Quick forward to today, the focus has become a framework for a more structured and measurable approach to responsible investing. The introduction of the UN’s Principles of Responsible Investment (PRI) in 2006 provided a framework, enabling institutions and institutional investors to adopt accountable practices and engage with ESG as a structure for investment management decision-makers.

Over the last couple of years, this concept has converged further with the emergence of standards, like GRI and TCFD for reporting, and increased scrutiny by regulators.

ESG vs. Corporate Social Responsibility (CSR)

ESG and Corporate Social Responsibility (CSR) are similar concepts with very different meanings and approaches. In general, CSR is a voluntary process where companies endeavor to contribute to society positively—whether through financial donations, a community project or ethical practices—to gain a better reputation.

ESG is a structured framework for companies to formalize corporate responsibility into decision-making utilizing evidence-based data. ESG does not only represent reputation, but it informs risk assessment, regulatory compliance, and investor interest.

In summary, CSR represents what a company chooses to do out of moral responsibility, while ESG represents what it must do to demonstrate long-term strength and reliability.

How ESG is Measured and Reported

ESG measurement and reporting are based on internationally recognized standards created to provide consistency, transparency, and comparability between companies. The main references include:

• Global Reporting Initiative (GRI), which provides guidelines for communicating environmental, social, and economic impacts;
• SASB Standards focused on sector materiality;
• Task Force on Climate-related Financial Disclosures (TCFD) focused on climate risk.

In addition to reports produced internally by companies, numerous ESG rating agencies—such as MSCI and Sustainalytics—analyze company performance using proprietary criteria, creating ESG reporting and insights consulted by investors and stakeholders. However, the absence of universal standards can lead to score inconsistencies and leave room for phenomena such as greenwashing.

ESG and Corporate Governance

Incorporating ESG criteria into corporate governance demonstrates a progression in the meaning of corporate leadership. Governance stewardship is no longer based solely on financial metrics but also includes measures of environmental, social, and governance responsibility.

Boards of directors must supervise many ESG policies by relying on dedicated committees (what is an audit committee?) or executives with defined duties. A methodology like this will allow ESG priorities to be integrated into internal controls, risk management, and decision-making.

ESG Investing and Stakeholder Expectations

ESG investing has experienced an accelerated growth rate in recent years. Investors, consumers, and regulators are changing the conversation.

Investors have moved beyond simply pursuing financial returns; they expect transparency and accountability on environmental social and corporate governance issues. The statistics suggest a rising trend in capital allocated to ESG, as well as a growing focus on firms that have initiated credible sustainability updates.

This external pressure is certainly affecting operational practices within firms, as many ESG reporting companies are trying to become more ‘ESG-oriented’ in order to help maintain their overall market confidence and generate meaningful insights for investors.

Benefits of ESG Integration

Integrating ESG into business strategies can provide real and sustainable benefits.

• Strengthened brand reputation and customer loyalty: ESG-oriented companies enjoy a stronger reputation, resulting in greater customer loyalty and more stable relationships with investors.
• Minimizing regulatory and operational risk: Companies that behave more responsibly and consistent with stakeholder expectations will reduce risk.
• Access to ESG financing and reduced cost of capital: From a finance perspective, aligning to ESG objectives allows for better access to capital tied to sustainability objectives and, in some cases, may include more favorable terms.
• Long-term value creation: Implementing a credible governance model with accelerated environmental and social issues can increase business resilience and strengthen a company’s capability to address long-term management challenges.

The adoption of ESG practices is thus not only reacting to external pressure but taking a chance to optimize shared value.

Risks and Criticisms of ESG

While the ESG model continues to grow and thrive, challenges and hurdles still exist.

• Inconsistent standards: ESG scores and assessments fluctuate widely depending on the agency and create complexities in evaluating and measuring performance.
• Greenwashing: Companies may simply be interested in creating ESG policies as a public relations strategy rather than a genuine commitment to ESG.
• Internal contradictions: The purpose of ESG may conflict with the maximum immediate profit.

Challenges are evident, however, many companies prove that it is possible to pursue societal good and competitiveness given they align and are disclosed.

ESG Regulations and Global Developments

Regulatory progress and ongoing developments in reporting globally are shifting ESG from a voluntary to a mandatory commitment. For example, companies in Europe are now required to report on multiple facets of their environmental as well as their social performance by reporting on the Corporate Sustainability Reporting Directive (CSRD).

In the U.S., the Securities and Exchange Commission (SEC) proposed rules that require listed companies to disclose climate risk and greenhouse gas emissions.

Finally, there is a growing appetite in the Asia-Pacific region as well, as regulations evolve in Japan, Singapore, and South Korea.

Implementing an ESG Strategy

To successfully implement ESG, businesses need to complete a materiality analysis to understand the relevant environmental, social, and governance issues for stakeholders and industries. So, engagement with stakeholders is a necessary first step to understand priority levels.

At the appropriate time, sound internal policies are created and aligned within a governance structure. The information is organized to track progress, and management is responsible for taking action where necessary.

FAQs

What is ESG and why does it matter?

ESG are the environmental, social, and governance factors that guide a company’s management operations.

What is ESG in business used for?

ESG serves to align business practices with stakeholder values by identifying any sustainability risks that affect financial performance and reputation.

How does ESG relate to corporate governance?

Management is one of the three pillars of ESG. It ensures accountability, ethical decision-making, and oversight of sustainability goals.

Who sets ESG standards?

ESG standards are developed by global frameworks, such as GRI, SASB, and TCFD, and are influenced by regional regulators.

Are ESG practices legally required?

In many countries, yes. ESG is becoming increasingly mandatory, particularly for listed companies and those operating in regulated sectors.

References

Deloitte. (2018). Audit Committee Resource Guide. Deloitte Development LLC https://www2.deloitte.com/content/dam/Deloitte/us/Documents/center-for-corporate-governance/us-aers-audit-committee-resource-guide-2018-041818.pdf

KPMG. (2021). Audit Committee Guide. KPMG International. https://assets.kpmg.com/content/dam/kpmg/id/pdf/2021/11/kpmg-audit-committee-guide.pdf

PwC. (s.d.). Audit committee responsibilities. PwC Governance Insights Center. https://www.pwc.com/us/en/services/governance-insights-center/library/audit-committee-responsibilities.html