What was once dismissed as “optional” or a “fringe” has now become the core of decision-making by not just investors, stakeholders, and employees, but the customers of companies as well.
Where financial statements were limited to the profitability and growth prospects, ESG ushers in an entirely new set of questions: how do companies manage their environmental impact? How are their employees treated? What is the relationship with their communities? How is the company governed and managed? Today’s investors aren’t just asking questions related to revenue and accounts receivable, but also carbon footprints and the diversity of their board of directors, in pursuit of uncovering value and derisking their investment portfolios.
What an ESG Score Really Measures
An ESG score is a numerical “rating” that assesses a company’s performance across three areas: environmental footprint, social value creation, and governance systems. This score is typically compiled using company disclosures and is combined with other data to compile an overall ESG score. Each rating agency has its own methodology, but the common objective is to generate a numerical output that allows investors to gauge how well a company is managing its risks as a corporate citizen.
A high ESG score signals that a company has actively incorporated sustainability into its risk-management processes. As a result, the company is likely to have better regulatory compliance, stronger operational efficiencies, and a healthier brand reputation — all of which are optimally related to sustained corporate profits.
Why Investors Are Prioritizing ESG Factors
Investing with ESG principles is about more than ticking the sustainability box. Investors are flooding towards ESG investing in a bid to protect their portfolios for the future. Climate change has become a real risk, rather than a distant threat. With floods, wildfires, and droughts becoming more frequent, supply chains and corporate activity are being disrupted around the world. Investors want to know how businesses are going to cope with such upheaval, and ESG reveals the answers.
The Global Sustainable Investment Alliance reported that, by 2020, global ESG assets under management had breached 35 trillion dollars. The figure continues to rise, and many investors can no longer allocate funds without addressing ESG concerns. Mandatory ESG risk disclosures are already hitting some parts of the investment markets, but will soon become more commonplace as regulators step up oversight.
The Broader Impact of ESG on Business Strategy
Outside of investing, ESG has implications that stretch as far as talent acquisition and brand loyalty. Members of the workforce today — particularly younger generations — value sustainability, diversity, and ethical leadership. Companies with solid ESG programs are better able to attract top talent, decrease turnover, and develop strong workplaces with staying power.
Consumer needs and values are also evolving. Shoppers “vote with their dollars,” preferring to patronize businesses that share their ethos. Companies that refuse to take ESG priorities into account will see their reputations tarnished and will begin to lose market share, regardless of how healthy their finances may seem at first glance.
Challenges and Controversies in ESG Ratings
Despite the increasing importance of ESG ratings, they do face criticism on a few fronts. One of them is the lack of standardization in ESG rating methodologies. Since each of the ESG rating agencies uses its own approach to rating companies and weights on various risk factors, it is very common for the same company to have widely different ESG ratings depending on which rating agency you ask. This has caused some doubt in the minds of investors with respect to the usefulness of ESG ratings.
Another issue is the rise of “greenwashing” employed by companies to over-exaggerate and oversell their ESG reporting, making it seem like they are taking a lot more responsibility than they actually are. Since it is extremely difficult to ascertain what companies are enforcing or implementing with respect to ESG reporting, given the current lack of clarity on ESG reporting standards, there is always a fear that these ratings can be easily manipulated.
In response to these criticisms, there have been emerging frameworks globally to address these ESG ratings standardization issues. The International Sustainability Standards Board (ISSB) is a good example that has been trying to push for a framework that can set down ground rules for how companies should report their ESGs in the future. As such standardization framework becomes more widely accepted and adopted by companies, ESG metrics may play an even larger role in future financial reporting in times to come.
Looking Ahead: ESG as a Long-Term Value Driver
ESG’s rise to prominence is not simply a flash in the pan. It represents a larger, more profound global shift in the underlying drivers that signal corporate and investment performance. Traditionally, the true north of wild success was simply profits. Now, however, those profits must be balanced against the scales of accountability, transparency, and sustainability. ESG scores are not yet perfect stand-ins for the more three-dimensional view of corporate power and investor might they are meant to represent, but they are an important indicator that the marketplace is already moving us toward a whole health approach to company performance.
For companies that place technology, growth, and human experience at the center of their business model, ESG is a conversation that is entirely about creating wealth for tomorrow. With increased governance mandates and shifting stakeholder demands, companies that appreciate ESG for the power principles that they are — de-risking well into the future and encouraging meaningful, design-oriented innovation — are creating sustainable strategies right now.
